The worsening global economic crisis

Dr. Satish Chand
What started as a global credit crunch has now spawned into a full blown economic crisis. The crisis originated within the financial sector in America last year but now has spread throughout the globe and to all sectors of the economy. You will feel the heat—how much depends on your particular circumstance, however. My advice to family and friends this time is to ‘plant some tavioka/manioc and bele/ibika’!
Coastal communities must conserve their marine resources as a source of protein. Those on atolls better look after their breadfruit trees and coconut palms as a source of food. Just don’t sleep in their shade!
The current crisis will end but when exactly is anybody’s guess. The problem is that crises of this nature can become self-fulfilling. That is, an expectation of worsening economic conditions can create this very outcome. Consumers and investors, following a loss in confidence in the prospects for the immediate future, defer expenditure. This induces a contraction in demand that leads to job losses. Job losses in turn dampens confidence further, feeding more contraction in demand and thus to a downward spiral in economic activity. And once triggered, such a spiral is hard to reverse—that is, until the bottom is struck. Policymakers in such a situation use expansionary fiscal and monetary policies to try and cushion the fall in aggregate demand.
ISLANDS BUSINESS has been vigilant on the effects of the global crisis on the islands.
Deepening crisis: Our cover story last October was on the ‘Global Credit Crunch and how it will affect us’.
The crisis has deepened and has spread to the rest of the economy since.
Six months is a long time in finance—currencies and stock markets can swing in seconds.
Were our warnings on target? What more can be said about the prospects for 2009?
Our advice six months ago was to ‘Prepare for a rough ride ahead and hold tight in the meantime’. This is as pertinent now as it was six months ago. Let us update you on the possible ramifications of the deepening economic crisis on the islands.

Bad banks, dead banks and an ugly mess
A simple way of thinking about what has gone sour over the past year globally is that many of our financial institutions (banks, etc) have gone bad, some have turned up dead, leaving an ugly mess to be cleaned up by taxpayers. Post-mortems of the latter will continue in the indefinite future.
For those dead, their now defunct CEOs and the regulators, under whose watch this mess was created, will share the blame for the fatalities. Shareholders and taxpayers have lost hard cash and are likely to shoulder the bulk of the massive costs of the cleanup.
The immediate policy challenge is one of saving the sick (bad) ones. The risk is that some of those already on life support from treasuries will die.
Bailouts are never pretty. Cleaning up the mess created by the crumbling global financial institutions remains a medium-term challenge. Identifying and then fixing the causes of the current problems is a long-term challenge. The last will occupy the minds of many for decades.
Why should we worry about the banks going bust? Why not let them die? Many businesses do so regularly.
Catastrophic: A few banks turning ‘belly-up’ could be a good-thing. It could cleanse the industry of the laggards, for example. Many doing so simultaneously is a disaster, however. They run the risk of sucking in even the good ones with them. That is, the domino effect of even a large financial institution collapsing can be catastrophic on any market economy.
Credit dries up when the financial sector fails in health. The consequent jump in interest rates, this being the price of credit, has knock-on effects on the rest of the economy. Firms, investors and households reliant on a well-oiled financial sector now face higher costs of borrowing.
Loss of trust in the safety of deposits in the banks scares away savers. Sick banks in large numbers risk ceasing up the entire financial system.
The lone silver lining in the current global credit crisis for the islands is that our banks are relatively healthy.
The ‘Big Four’ Australian banks have been left largely unscathed by the shockwaves emanating from New York and London. And it is them who have the majority market share in the islands.
Other smaller banks serving the region look healthy as well. Thus, the financial sector in the islands has largely been spared the pains being experienced by their counterparts in America and Europe.
Not time to celebrate yet! They will feel the effects of the global economic slowdown. This will be via: (i) a drop in remittances as employment conditions in the rich world deteriorate; (ii) a fall in demand for island exports, tourism and natural resource exports particularly; and, (iii) a fall in donor support. (See our cover story in the October 2008 issue on each of the above enumerated.)

Making a bad situation worse
What must be avoided is making an already bad and deteriorating situation worse. Many policymakers and their leaders are doing exactly that.
Let me take up the case of exchange rate policy in some detail.Other than Papua New Guinea, which has a floating Kina, the rest of the islands either use a foreign currency or have their local currency pegged to a basket of foreign currencies.
Nauru and Kiribati, for example, use the Australian dollar; Cook Islands and Niue use the New Zealand dollar as their currency; and, Marshall Islands, Federated States of Micronesia and Palau make use of the US dollar.
Fiji, Samoa, Tonga and Vanuatu, on the other hand, have their currencies pegged to a basket comprising currencies of their major trading partners.
A floating exchange rate provides a means for economic adjustment. Thus, when demand for exports contract, the currency depreciates—that is, its value falls vis-à-vis the foreign currency.
The Australian dollar, as an example, has depreciated by some 35 percent from its peak around a year ago.
Such a fall, in the face of stable domestic (A$) prices, cushions the impact of a fall in global demand for Australian exports.
Tourists from Japan, United States, the United Kingdom, Europe, etc, find Australian prices in their currencies to have fallen by anything up to 35 percent since last July. This helps keep demand for Australian tourism afloat.
As shown in Figure 1, the Australian dollar was worth US$0.98 on July 15, last year. By March 3, this year, it had fallen to US$0.64. The PNG kina, in contrast, has remained below US$0.40 while the Fiji dollar fell from US$0.67 to US$0.53 in the corresponding period.
Ignoring inflation for now, the exporter from Fiji for the United States market has lost some 17 percent margin when compared to his/her Australian counterpart. The higher inflation in Fiji compared to that in Australia exacerbates this penalty.
In so far as the value of their currencies, economies with fixed exchange rate regimes have little room to manoeuvre.
Devaluation is a discrete move and one undertaken sparingly. High domestic inflation can be avoided with appropriate policies, however.
A struggle: Failure to contain domestic inflation weighs down on exports heavily when exchange rates are fixed.
Ideally, one would want domestic prices—wages in particular—to fall when demand contracts.
The worst possible combination is one where wage increases are enforced via legislation under a fixed exchange rate regime.
With domestic inflation racing ahead of those of the trading partners, keeping exports alive becomes a struggle.
But this is exactly the situation in Fiji. And at least part of the problem in reviving exports emanates from the above.
Papua New Guinea, by far the largest economy in the region, is struggling with a somewhat different problem.
The value of the Kina is being pushed up by the discovery of large deposits of natural gas.
Export revenues are expected to rise in the near future.
For those engaged in the Liquefied Natural Gas (LNG) project, this is all great news.
But for the 85 percent of the population who live in the bush and depend on exports of agricultural products such as coffee, cocoa, copra, and oil palm—nothing could be worse.
They are now feeling the double whammy of falling global prices for their exports and an appreciating kina.

Government and taxpayers to the rescue
The mantra now is to spend, and spend big to setter out of this recession! Australia poured in some A$10 billion into the pockets of consumers last Christmas. And more is on the way! The Reserve Bank of Australia slashed interest rates by four percentage (that is 400 basis) points over the past six months.
Despite the aggressive uses of fiscal and monetary levers, Gross Domestic Product (GDP) in Australia contracted by half a percentage points in the last quarter of 2008.
Australia, all but for some technical niceties and lags in reporting, is already in a recession. This is the first contraction in GDP since the introduction of Value Added Tax (VAT) in 2000.
And Australia’s position is amongst the best within the club of rich nations. United States’ GDP fell by 1.6 percent while Japan experienced a whopping fall of 3.3 percent in the last quarter of 2008. Australia still has leftover capacity to go on a spending splurge to cushion the effects of the rapidly cooling global economy. Many of our   islands nations don’t.
Papua New Guinea, some credit to its financial managers, had tucked away funds during its export boom of the past five years.
The nation is in a position to spend big. The onus is on the leaders to do so, and wisely. High yielding infrastructure maintenance programmes were long overdue.
Public investments now could boost short-term demand whilst putting in place the infrastructure necessary for continued growth.
Educational and health services are also due for a revitalisation. Most schools and scores of aid posts (health centres in rural districts) have been in a state of despair (not just disrepair).
They could all be jolted back to life with a well-targeted stimulatory fiscal package.
Nauru, Solomon Islands, Samoa, Tonga, and Vanuatu may have to lean more heavily on their ‘good’ donors to lend a hand in funding needed public investments. Fiji, unfortunately, does not have too many donor-friends.
The Federated States of Micronesia, Republic of the Marshall Islands and Palau are possibly handicapped by the worsening economic conditions in the United States.
The planned boost to construction on Guam could provide some relief, however. Trust funds are taking a battering, leaving the Marshall Islands, Kiribati and Tuvalu in a precarious fiscal position.
Once again, international financial institutions—and the ADB in particular—may be in a position to provide ‘bridging finance’.

The tide will turn, but can you hold on?
The warning we sounded in our January cover story was for a ‘Tough 2009’ and thus this year was ‘Time to buy time’.
This is still pertinent. The one concern we have, however, is that many of the islands lack the resources (cash) to buy time. And raising this cash on the global capital markets now will be costly.
Donors may already be weighed down by the intensifying domestic concerns in light of the deepening recession. I worry for those without savings and a subsistence fall-back. The urban poor without access to land or the sea will feel the brunt of this crisis. And for them, ensuring a steady supply of food for the family may be a daily struggle. Some are already in such a predicament.
The poor and vulnerable must be helped. They deserve a helping hand in these tough times. Penny pinching by governments and society at large will be un - and vile.