Global financial crisis:

Impact on international trade

Trevine FERNANDOPULLE

Very rightly, these are being called the toughest times the world economy has seen in recent years and the worst is not over yet.

This crisis has intensified in magnitude and reach and we are now in a global recession. Growth targets have been slashed in almost all parts of the world. There has been much said about the underlying causes of the current crisis. However, the analysis of these causes and their effect is quite complex. Let us try to understand some of these causes and effects.

The factors surrounding the crisis, particularly the scarcity of liquidity is one of the contributory factors that leads to payments and settlement risks. In the past, letters of credit have been the crucial lubricant without which the wheels of international trade cannot turn.

The sub prime mortgage crisis was the starting point of the slide of our economies. With the US housing boom fizzling out, default rates rose on “sub prime” mortgages completing the vicious cycle of sub prime lending.

Sub prime lending, also known as ‘Trailer Park Lending’ was allowed to grow uncontrolled especially in the 1990s, ignoring risk factors of borrowers who were looking for easy credit but at crunch time could not withstand the pressures of an economic downturn.

Sub prime mortgages are reckless and irresponsible. The concept was then thought to be quite innovative but of course, the “innovative bankers” who devised sub prime products did not retain the high credit risk of sub prime mortgages for themselves. Thanks to further financial innovations, they sold rights to the mortgage payments (and related credit risk) to investors, through securitization.

Financial markets

The mortgage backed securities purchased by the investors enabled the high risk of default of sub prime loans to be transferred from these innovative bankers to investors in the USA and worldwide. That is how interdependence was created between the US housing market and the global financial markets.

The majority of blame for the global credit crisis should probably be apportioned to how these sub prime loans were securitized, more than the loans themselves. While the sub prime crisis was blamed for majority of the current problems, it was not the only reason. We must recognise that overall, assets were being bought and sold with very little understanding and analysis of the risks involved.

The reason for this is that the profusion of financial instruments that were made available in the recent past was so complex and hazy that even finance professionals could not comprehend them, let alone a layman buyer.

While the assets were complex in design, they were created on very high direct and indirect leverage - which meant that with the collapse of the securitization market, banks could no longer sell nor fund these products.

That’s how banks found themselves completely unprepared to face the large losses on the assets side with a funding stretch on the liability side. It seems as if a lot of banks had assumed that wholesale funding was limitless - in retrospect it is an assumption that marked the end for some of the biggest names in the industry.

Whilst each of these were contributing factors, there is one key global trend that has to be considered when analysing the magnitude of this crisis. It is that we now have worldwide interdependence among countries and their economies.

Years of efforts to remove barriers to trade, liberalise investment and make capital flows between economies smoother, has resulted in a never before seen level of interconnection among economies across the world. The landscape of global trade has changed. Our region has come to play its part. India and China are resurgent economies and Asia is leading the pack of newly industrialised countries.

Affected segments

The Middle East with its rich resources is a force to be reckoned with. In parallel, consumption has driven the western economies in recent years, funded by cheap borrowing.

The economy as we know it today can be summed up as a tripartite that has on one side, resource suppliers; on the second, countries that operate as workshops and on the third, the consuming nations who are big on spending but low on savings. While this model drove economic growth, it also created financial imbalances.

While the developed countries and their consumers borrowed more and more at growing costs of funds, the resource rich nations and the workshop nations - particularly those in Asia - built up their reserves with their culture of high savings and low exchange rates.

As the credit risk premiums for funding moves upwards - both buyers and sellers are at risk amid the ensuing financial instability. Sri Lanka too has been exposed to international trade risk, particularly in its Tea and Apparel industries. At present these are the two segments most affected. But others also are feeling the brunt.

While the Sri Lankan Government has stepped in to control a liquidity crisis and taken measures to support the said industries and also to protect the currency via the recently enacted regulations, Governments the world over have been forced to guarantee lending and recapitalise failing financial institutions.

The factors surrounding the crisis, particularly the scarcity of liquidity is one of the contributory factors that leads to payments and settlement risks. In the past, letters of credit have been the crucial lubricant without which the wheels of international trade cannot turn.

But it now looks as if LCs may be nor more immune from the credit crunch than any other form of credit. LCs are at risk due to the weaknesses that may arise in the payment system and also due to inherent risks on banks increasing.

Although it is traditionally regarded as one of the safest forms of trade settlement, rates for trade credit have risen sharply in recent months as banks have tightened facilities to bolster Banks slow growth in lending due to the lack of confidence in the credit quality of the counterparties.

With financial institutions hoarding cash, credit for trading is scarce. This exacerbates funding pressures for banks with settlement obligations. The risk premiums for funding have been driven to all time highs due to the scarcity of liquidity. Meanwhile, counter party risks are becoming more prevalent which has a knock on effect on the level of settlement risks.

Thus the bank tier ratings have become less relevant to the dynamic landscape prevalent in our markets.

As bankers, how do we fit into all of this? If you think about it, every single non-cash commercial transaction requires the intermediation of banks on behalf of the buyer and the seller, and in most instances also produces and exporters and importers and agents. Each transaction potentially becomes a long and complex chain of banks which stand exposed to risks at all these levels.

That is why in the good old days, economies demanded that banks need to have higher capital, strict limits on leverage, tight constraints on business activity, and superior integrity of management so that they can be protected from failure. It was because central banks recognised that the failure of a single bank could have wide repercussions that undermine the entire supply chain, better known as systemic risks.

As such, the global turmoil in the market will see us re-learning the lessons of the past so that we will emerge stronger from this crisis as better economies and institutions. The importance of financial strength cannot be emphasized. The world over, we are seeing the benchmarks of acceptable leverage and capital ratios being revised and there is renewed focus on liquidity.

Market incentives

Regulators and banks themselves need to understand their liquidity vulnerabilities more clearly. Regulators will also need to address the procyclicality of capital requirements caused by the interaction of fair value accounting and Basel 2 capital adequacy rules.

Fundamentally we must also question how market and performance incentives have contributed to the crisis - those market incentives that encouraged banks to grow by taking on higher risk than was sustainable; and industry compensation structures which encourage excessive risk taking.

In the new world order, Asia will be the trendsetter - the global economy will be skewed in Asia’s favour and together, Asia and the Middle East will continue to outgrow mature markets. We expect this growth to drive the development of regional and domestic capital markets.