Several Guyanese leaders have exalted the fact that Guyana emerged largely unscathed from the global financial crisis which broke in the summer of 2007. Of course, Guyanese investors lost money in the CLICO investment but those losses were largely restricted to that entity. The banking system continued to be liquid and well capitalized. The exchange rate remained stable and there was no rapid flight of capital from Guyana. GDP growth – although based on the global commodity boom and notwithstanding the crisis in the sugar belt – picked up some steam. As I have always said in these columns there is high- quality growth (based on structural production change) and low-quality growth (based on transient commodity price booms). High-quality growth is sustainable into the very long-term, while the low-quality form is volatile and is unlikely to be sustainable long into the future.
This column (and the next few) will explore the reasons why Guyana was able to duck the global crisis. I would examine whether it was due to wise policy decisions by our leaders or whether we were saved by the nature and structure of the Guyana economy. In addition, we would need to examine the nature of capital inflows into Guyana and the investment pattern of Guyanese financial institutions to get a feel for why we escaped.
However, before this could be done, I need to outline some of the acceptable causes of the global financial crisis that broke in the summer of 2007. For us to understand why Guyana escaped largely untouched we must first briefly examine the economic and financial structures that precipitated the crisis at the epicentre – the United States.
The US financial crisis
There is now a vast amount of literature on the causes of the crisis. However, there are some factors which stand out as crucial for fuelling the housing bubble, which eventually crashed and therefore precipitated high unemployment, financial collapse and serious social problems in the United States. The crisis was tied to the sub-prime mortgage lending. There are prime borrowers and sub-prime borrowers. The former have high credit scores and are less likely to default on their home mortgage. They always tend to pay their bills on time. The latter borrowers have low credit scores and they tend not to pay their bills on time. The sub-prime borrowers are a lot more likely to default. Starting around 2002, there was the rapid increase in sub-prime lending as prime borrowers became limited in supply. Therefore, a time bomb was planted when lending was increased to the most risky class of borrowers – those with low credit scores and bad credit history.
The Wall Street investment banks (banks that underwrite stocks and bonds and engineer more exotic financial instruments) got into the action by creating mortgage-backed securities (MBS) and other forms of asset-backed securities such as the more structured collateralized debt obligations (CDOs). These esoteric securities were created through a financial engineering process known as securitization. Essentially the investment banks bought out most of the sub-prime loans from the mortgage lenders (more or less the traditional banks) and packaged them into bonds (MBS) that were sold into the secondary markets to be traded like any bond. However, a large percentage of these securities were held in off-balance-sheet investment vehicles owned by the very investment banks – hence the emergence of the term shadow banking.
The owners of these special bonds would receive payments as homeowners repay the mortgages over time just like any mortgage. In spite of the high risk content of these securities, the rating agencies (Moody’s, Standard & Poor’s and Fitch) gave them the highest investment grades. The investment banks paid the rating agencies lucrative fees, and the investment banks themselves made hefty fees from creating the structured securities. Economists would say incentives were misplaced; however, I would say this was akin to corruption on a massive scale.
Other financial institutions like American Investment Group (AIG), an insurance company, and the investment banks themselves issued a special derivative instrument called the credit default swap (CDS), which is essentially an insurance policy on the likelihood that home owners would default and therefore providing coverage against the adverse effect this would bear on future streams of payouts on the MBS. CDS also brought in hefty fees for the sellers. Since most analysts assumed house prices would keep increasing there was no limit to the CDS sold. As at 2007 approximately US$60 trillion were (in face/notional value) were sold. Of course, the sellers made lucrative fees but increased the chance of a liquidity crisis and bankruptcy as many people make claims at the same time, as is often the case in a financial crisis.
In all of this euphoria the governance agencies responsible for regulation did not do anything. By this time the key agencies, the Federal Reserve and the Securities and Exchange Commission (SEC), were headed by individuals who believe markets are efficient and that they can self-regulate.
In other words, financial market participants can police themselves. The pervading view was that regulation can do more harm than good (see the excellent You Tube video on this issue: http://www.pbs.org/wgbh/pages/frontline/warning/view/) By this point academic departments of economics and finance mainly subscribe to the view of market efficiency and the need for limited government oversight.
Instead of regulating and monitoring the financial markets, the authorities implemented several policies that added fuel to the housing price bubble and promoted even more risk taking and private sector debt accumulation. First, the Federal Reserve kept the benchmark short-term interest rate (called the Federal funds rate) low for the pre-crash period. To maintain low interest rates the central bank had to keep feeding liquidities (easy cash) to the markets.
Otherwise, it would not be possible to target a low benchmark interest rate. These funds would then help to fuel the sub-prime loan build-up and the aggressive speculations in financial markets.
It also made it easier for investors to speculate on houses – a phenomenon known as house flipping. In addition to monetary policy, a central bank is required to maintain financial stability. Hence, it is curious that the central bank never bothered about the risky lending. I will discuss some of the other policies in the next article.
So far we have covered three primary reasons for the US financial crisis. First, the build-up of risky debt – that is lending to sub-prime borrowers. As these borrowers inevitably defaulted in large numbers the banks and investment banks were faced with a liquidity crisis and the dramatic loss of capital. Second, there was a failure by the central bank to tighten monetary policy and to properly regulate banks. Third, the rating agencies rated very risky assets as safe investments. In the next column, I will outline the notion of excessive debt leverage combined with rapid asset price collapse (while liabilities stayed the same). We will see in later columns that the lack of these two features (excessive debt leverage and rapid asset price adjustments) fortuitously steered Guyana away from a systemic crisis.
Please send comments and criticisms to: email@example.com