Financial crisis and its lessons for the developing world

THE 2008/09 global financial crisis has been one of the most significant happenings in this new century and it certainly caught the attention of all of us, even those far removed from the financial industry.

The average person not directly involved in the field of economics or finance, and so not that aware of economic history, would be forgiven to think that this crisis was the first and hopefully last of its kind.

The recent economic uncertainties have reminded us again of the shadow still cast by the crisis a couple of years later.

The truth though, is that such events are regular abnormalities to the world of economics and finance every few years.

The only crucial variable to consider is the degree and impact of such market movements.

Usually after times of unprecedented growth market corrections seemingly occur to remind us that the “invisible hand” is king.

Following the Leverage Buyouts (LBO) phenomenon in the mid-to-late 1980s we saw a huge fall in markets at the end of that decade.

More recently the late 1990s saw the dot-com bubble finally come to an end.

The recent financial crisis though was more gigantic in both scope and impact and hence has seeped into the consciousness of all.

For the first time we really saw the drawbacks of globalisation whereby the intimately interwoven world economy was heavily affected all at the same time by events that primarily took place in the US.

Luckily the developing world was not as terribly affected by the aftermath of the crisis as was the case in the developed world and for the most part the emerging world like Africa and Asia still experienced positive economic growth although at low rates.

It is because of this that I, like many of us, look at a financial crisis as something that can only really happen in the larger and more sophisticated economies.

This perspective could not be any further from the truth.

The truth is that financial crises have been a common occurrence in emerging market countries with devastating consequences for their economies in the past.

For example, the financial crises that struck Mexico in 1994 and the East Asian countries in 1997 led to a fall in the growth rate of GDP on the order of 10 percentage points.

The financial crises in Russia in 1998 and Ecuador in 1999 have had similar negative effects on real output. Not only did these crises lead to sharp increases in poverty, but they also led to political instability.

In seeking to prevent a financial crisis in any emerging economy it is important to understand the mechanics, context and theoretical underpinnings of the financial system.

First, a financial system performs the essential function of channelling funds to those individuals or firms that have productive investment opportunities.

To do this well, participants in financial markets must be able to make accurate judgments about which investment opportunities are more or less creditworthy.

Thus, a financial system must confront problems of asymmetric information, in which one party to a financial contract has much less accurate information than the other party.

For example, borrowers who take out loans usually have better information about the potential returns and risk associated with the investment projects they plan to undertake than lenders do.

Economists generally agree that there are four types of factors that can lead to increases in asymmetric information problems and thus to a financial crisis: 1) deterioration of financial sector balance sheets, 2) increases in interest rates, 3) increases in uncertainty, and 4) deterioration of non-financial balance sheets due to changes in asset prices.

The first stage leading up to a financial crisis in emerging market countries has typically been a financial liberalisation, which involved lifting restrictions on both interest-rate ceilings and the type of lending allowed and often privatisation of the financial system.

As a result, lending will usually increase dramatically, fed by inflows of international capital.

Now once the treasury for example has developed a framework for understanding why financial crises occur such as the one briefly described above, they can then proceed to look at what financial policies can help prevent these crises from recurring.

A study done by Frederic S Mishkin of the Graduate School of Business at Columbia University highlighted the basic areas of financial reform as the following: prudential supervision, accounting and disclosure requirements, legal and judicial systems, market-based discipline, capital controls, reduction, restrictions on foreign-denominated debt, sequencing financial liberalisation, monetary policy and price stability, and finally exchange rate regimes and foreign exchange reserves.

For the most part our financial system in Lesotho has been overshadowed by its South African counterpart.

Luckily for us the banks in South Africa were not much affected by the collapse of some of the international banks due to limited exposure, strong internal locus control as well as prudential supervision as well as stringent operating laws.

For the foreseeable future our financial system seems sound enough and a crisis is extremely unlikely but much of that depends on the trajectory of the South African economy.

The South African financial system in its current form is still very much an inheritance from the apartheid years and will inevitably be tweaked in years to come to deal with the socio-economic challenges for the country.

This in itself will provide both opportunities and challenges for Lesotho.

 Matela Lechesa is a freelance writer based in Maseru. 

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