Disclaimer: The views expressed by the author are his own and are not associated with the institution in which he is enrolled into.
After my recent blogs titled "Is Srilankan Economy Really Under Pitfall?" and "Where is The Economy of Developing Countries Heading Into?", I started receiving appreciation from many of my friends, to how much of these was predicted by me during economic shutdown enforced by countries around the world. Anyone who was found commenting against shutdowns and the increased lending provided by domestic banks was either asked to move to Pakistan or to accept that he/she was not a patriot.
Prof. Jayati Ghosh in one of her interviews with Karan Thapar during the economic shutdown had predicted that the economy of small and developing economies will fall off the cliff, if such restrictions were not taken down by governments around the world. Though she was positive about her remarks on Thapar's repetitive confirmation of whether she would stand by her remarks, we did not see a short-term negative effect on the economy due to COVID-19 just after economic shutdowns were lifted. All of this happened, as most of the small-scale businesses were operating behind the curtain and did not affect much of the domestic chain. Though this turned on the pause button to extend the negative impacts of the shutdown, it was not sufficient to eliminate the long-term negative impacts.
Though small-scale businesses were running behind the curtain, the global supply chain was considerably affected. The direct effect due to most of this was not instantly observed, but we had started observing inflation behind the curtain. Most of it was agitated once the war between Russia and Ukraine began. We have now started experiencing record inflation and shortages of essential commodities. This has happened at a rapid pace in small and developing countries while the same trend is slowly making its grip in developed and large economies. The world has started observing problems in the economy instantly due to the war which would have otherwise taken more than a fiscal year to show the real picture.
Before we discuss the financial problems various countries have been facing, understanding why financial problems arise and how such things in the past were sorted would be good. For millennials, the 2008 US financial crisis and the eurozone crisis which occurred in the aftermath of the 2008 crisis might be a good case study, to begin with, as all of these are well documented for millennials to access.
The US 2008 crisis began with the failure of Lehman Brothers. After the year 2000, extensive investment in the real estate sector started. This trend was not only limited to the US but was observed everywhere in the world. The investments in the real estate sector made the fortune of many while costing a fortune to others. Banks at that period were issuing loans for real estate investment without checking the credit profile of the client. As everyone started accumulating property just for sake of trading, a moment came when the market got saturated and heavy sales started. This resulted in a fall in the property prices followed by banks' agitation to auction collateral. As Lehman's exposure to such NPAs was high, and the US government had no intention to save it, Lehman finally failed. This resulted in extreme panic resulting in sell-offs in the stock market worldwide and the accumulation of Gold and Crude Oil in the commodity market.
Whenever an economic uncertainty surrounds, the price of commodities that are limited in nature rises. Something which can be observed from the chart below:
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| Click on the image for a clearer view |
The rise in the oil prices after 2008 due to the crisis is eminent from the chart. Two instances of rising crude prices can be attributed to uncertainty caused either by the 2008 crisis or due to the Russia-Ukraine war at the present date. The only landmark which resulted in a fall in prices of crude oil was during COVID-19 restrictions, though many thought of inflation in crude oil. The only reason behind this was; the fall in demand for crude, as a pause button was initiated for economic activities by governments. Though production was continuous, there was no storage for such production. In addition, many future contracts in the commodity market were expiring at the same time with no one to accumulate due to financial tensions. In short, investments move to safe havens which include commodity markets in periods of economic tensions. The same happened during the 2008 crisis, which resulted in huge sell-offs of bonds and company shares in the stock markets around the world. The problem from this sell-off was the wipe-off of investments that come through FDIs or reduced credit rating of bonds issued by the US.
This, uncertainty pulled off huge investments from Euro Zone too. The countries which were most affected were small economies such as Greece and Portugal, though Greece was hard hit. The crisis in the US created a domino effect. US was stressed by the fact that China and Japan which hold most of the bonds issued by the Fed may start flooding the market with bonds resulting in reduced credit rating and a huge devaluation of the USD. Fed which controls the US economy had to have an economic stimulus in plan to reduce any possible negative impact on the US economy. It started buying back bonds, increased yields on bonds, and the rise in crude oil prices due to economic uncertainty created additional demand for USD which tried balancing the ill effect created by the crisis. If only the stimulus was not in line, the implications would have been very serious. Though the crisis was pushed at that time, the US still owes billions to different countries, most of which are linked to China and Japan. The US has enjoyed much of its development through cash inflows from national and international bonds.
The work of the Fed during the crisis has continuously been appreciated everywhere. Fed's approach of convincing the US government for a bailout bill, quantitative easing, and currency swap agreements with European counterparts helped in stabilizing the panic. The 700 billion dollar bank bailout, though was criticized to help the rich become richer somehow helped the economy supported by a buy-back scheme of bonds creating liquidity in the financial system. US could not buy all the bonds back, while its European counterparts could not wait long to dilute their investments in the US. To, maintain its credibility, the US had to have a currency swap agreement with its European counterparts which is known as quantitative easing. Srilanka too is looking for quantitative easing these days, as much of its foreign reserves have depleted.
The present economic crisis faced by small economies is totally different than what the US observed long back. As much of the international trade was pegged with USD, it was easier for the US to have its bailout plan welcomed by the world. However, small economies, most of which owe a considerable amount towards their infrastructure scheme cannot bargain for either quantitative easing or fiscal stimulus within the domestic economy. Srilanka's foreign reserves have been highly depleted followed by Pakistan which resulted in political instability in these countries. The countries following these trends in South Asia are Bangladesh and Nepal. Both Bangladesh and Nepal might not get trapped as Srilanka or Pakistan, as these countries sensed their financial standing before it was too late. However, this might not be true, if the tension between Ukraine and Russia does not end soon.
Foreign currency reserves of these SAARC members have depleted due to rising crude prices, calling for a rise in prices of other commodities as most of them are linked to crude. The uncertainty in the tourism sector and remittance from its nationals who work in the west or the middle east have been rising. In addition, the hundi has flourished, trapping most of the possible reserves away from the documented reserves of these countries. Countries like Bangladesh and Srilanka have already brought plans to attract remittance through banking channels by announcing schemes. Nepal too is in talk to have a discrete plan to abolish Hundi. Nepal has got enough foreign currency reserve to meet its import for the next 6 months, which is assumed to increase as most of its remittance income might again start in a few months, owing to the resume of foreign employment. In addition, tourism is believed to return back to normalcy.
A temporary solution to depleting foreign currency reserves by these countries has been to restrict the import of non-essential commodities. As right-wing politics has started making its grip around the world and people have started liking the stance of an open economy, the move to import bans is certainly not going to help, as an import ban is a temporary solution to the problem. The import ban is assumed to create a recession in the coming days as the overall economic chain will be disturbed. Countries like Nepal experienced huge foreign currency inflow during the economic shutdown, attributed to round-tripping and the return of its nationals from countries where they had gone to work. This resulted in an increase in liquidity in the banking channel. Generally, this liquidity increase is a sign of the country's growth potential to excel in financial terms. The increase in liquidity, if used for increasing domestic production is always a better sign. However, the liquidity was not involved to increase domestic production, and the banks were furious to increase their income from interest as the income from other sections have been slowly tightened by the central banks in these small economies. This resulted in the investment of liquidity in exporting non-essential items. This move further depleted foreign currency reserves followed by the current situation, where countries are forced to pay more for the same commodities due to uncertainty caused by the war.
The rapid depletion of foreign currency reserves has not only affected small economies but has also affected large economies like India. Due to inflation, economies like India, too have to spend more for the same quantity of commodities resulting in depleting foreign currency reserves. This can be confirmed by the weekly foreign currency reserves reported by the country. The country has started experiencing wide differences in reserves every week in comparison to what used to be experienced earlier. Though everyone is attributing war as the major cause of the current recession in small and developing countries, war played a role in just agitating the recession. This situation would have been observed even if war was not there. Due to the pandemic, the supply chain was hardly affected followed by the cancellation of orders which were ready to be delivered. Most of the products which had a low shelf life and were ready to be sent to market had to be disposed of as the restrictions were in place for a long time. In addition to this, businesses which had to collect their arrears from the market were not able to collect them. This happened due to two major reasons:
1) As, the payment had to be collected in a hierarchy, due from one party affected the other's party stance on payment.
2) Though businesses were in a position to settle their payment, they didn't do that in a hope of investing that same amount in the short term in the stock market, crypto, and real estate. Those who entered in initial phase made a profit while others got trapped resulting in a problem in the payment cycle.
This trend has resulted in the default of loans by many businesses and the accumulation of interest on such loans. Though most of this does not come to media, banks have started observing stress in their assets. Due to fiscal stimulus in place by many governments, businesses have got extra time for settling their obligation. However, the businesses are still not in a position to do that which has become even worse after the war, as the demand for many of the non-essential items has gone down. Additionally, many governments have started restricting non-essential imports. The economy currently works in a cycle, and whenever a single element of this cycle gets disturbed, the entire cycle gets disturbed. This has been happening currently after the restrictions agitated by the war.
Though there are solutions to the problem, much of it cannot be in place until events such as war which create a domino effect do not end. The initiative of improving the world economy should start from the improvement of the economy which has been worst hit. Letting a small economy collapse does not mean that its ill effect will not be observed anywhere else. My personal belief is to shore the economy of Srilanka first. This is required as the obligation of Srilanka to major economies is high. If it defaults, those big economies too will be hit. Currently facilitating Srilanka with quantitative easing or lengthening its payment period will certainly not help, though Srilanka wants it. As it will take time for Srilanka to generate its cash flow. It would be wiser in the present context for Srilanka to hand over its infrastructure project in lease to those who issued loans on the project. Though it might seem to go against the national interest, this seems to be only a move to ease obligations of the government and use the current foreign reserves for other important items than for payment.
The lease has not to be for a long time. It can be bifurcated for such a period until Srilanka works hard to bring the economy back in motion and then take back its infrastructure project. This will help both parties. In addition, countries that are experiencing depletion in foreign currency reserves will have to bring an action plan to increase their reserve, instead of restricting imports. As this restriction is a temporary solution and cannot be extended for a long time and is also against the open economy principles. For these countries, the first move should be to control hundi and open government contact offices in major countries from where remittance is received which will help in reducing transaction charges on money transfers which currently go up to 10%. Hundi is flourished just because the transaction charges are high. This will then help the governments to understand their real financial stand. Once this is done the next move will be to see if foreign currency reserves can be increased without exploiting their natural resources and growing reserves through tourism. This can be accomplished if an adequate budget is allocated for creating tourist spots. The next stage will be to increase agricultural production followed by the exploitation of natural resources.
If the governments, do not look for a solution at this stage, the future could go even dark. It would also be beneficial to create talks between the countries involved in the war. Any of the initiatives may fail if uncertainty due to war remains for a long time.
Feel free to leave your comments on how the economic situation will be in the future. Let us have a healthy discussion.
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