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Volume 3 Issue 11 | November 2008



Original Forum Editorial

Month in Review: Bangladesh
Month in Review: International
Bangladesh's Revolution Addiction--Afsan Chowdhury
Fallout-Forrest Cookson
Atlas Shrugged-- Hasan Imam
Money on the Table--Mamun Rashid
Amrao Manush - The Pavement Dwellers --Shehab Uddin/Drik/Concern
Which Way is the Shore? -- Rubayat Khan
Time to Get Streetwise-- Anita Aparna Muyeed
Paradise Lost -- Madan Shahu
Battle for the Soul of Bangladesh-- Amirul Rajiv


Forum Home


Atlas Shrugged

Hasan Imam examines the global financial crisis and its consequences for Bangladesh

"Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned."
- W.B. Yeats, The Second Coming.

When the Irish poet W.B. Yeats composed his masterpiece, I cannot imagine he was thinking of Wall Street, much less sub-prime. Rather, he was describing a Biblical event possessing immense destructive power -- one originating from a localised centre and quickly spiraling out of control to engulf the world -- raining misery upon millions of innocents.

Fifty years later, however, it is hard to find words more appropriate than these of Yeats' to characterise the financial crisis the world is in the midst of today. While the US is at the focal point of this magnitude 9.0 financial earthquake, after-shocks are quickly engulfing capital markets and economies across the globe. And even Bangladesh, thousands of miles away and innocent of any responsibility for the original events, is nevertheless threatened with its consequences.

To Panic or Not to Panic
In this age of 24 hours media exposure, CNN, BBC and Google broadcast the news and pictures from across the globe into our homes and offices. Though far removed from the epi-centre of this financial tsunami, Bangladeshis cannot escape the visuals of the unfolding disaster. Panicked Londoners lining up at the doorsteps of failed banks, New York stock traders staring helplessly at their computer screens as trillions of dollars of wealth is wiped out, tearful workers from Iceland to China walking out of factories closed forever -- these are the pictures streaming across our TV screens every night.

When you combine such emotion-filled information with the human instinct for self-preservation, and add to it an element of uncertainty, there is one natural outcome: panic. Panic is sometimes an appropriate reaction to danger, but it can also trigger irrational behaviour that is ultimately self-destructive.

On a mass scale, panic can lead to bank runs, stock market collapses and social unrest. And if you think this is far-fetched, consider the following: in our neighbouring India, a large and well-capitalised commercial bank was recently the target of rumours that it would collapse from the effect of the global financial crisis. While the rumours ultimately turned out to be false, it took extraordinary intervention from the central bank and political leaders to calm panicked depositors. From Bangladesh, I have already received phone calls from friends and relatives asking which Bangladeshi banks are safe and which are at risk of a failure "like the banks on TV."

Arm yourself with information. The only real weapon against panic attacks, besides taking sedatives, is to educate oneself of the issues. Once you understand what is going on, and how it impacts you, it is easier to make rational decisions to protect yourself from financial harm. And toward this end, I hope this article will help, by enhancing your understanding of the root causes of the current financial crisis, mapping out how the events are unfolding, predicting what can happen next, and analysing the consequences for Bangladesh.

Root Causes of the Financial Tsunami
Something as big as the current financial crisis does not happen in a day. Rather, immense stresses had been building up in the global financial system for over a decade, till eventually the tipping point was reached, when a relatively small catalyst pushed the world economy over the edge. While many events, some local some global, have contributed to the crisis, I think they can be synthesised down to three root causes, which I discuss next.

Cheap money: In Bangladesh, burdened with loan interest charges greater than 15% per year, we may not be aware of something remarkable that has been happening in the outside world: during the last decade, it has been incredibly cheap to borrow money in the world's developed financial markets.

Led by Japan and the US, the world's largest economies have been pushing interest costs lower and lower. In Japan, the central bank cut interest rates close to zero in the 1990s in order to steer the economy out of a decade of economic stagnation. In the US, after a major stock market crash in the year 2000, the central bank cut interest rates to historic lows in order to stimulate the economy.

Following this lead, developed countries across the world adopted "easy" monetary policy. The availability of this cheap money had a number of unintended consequences that ultimately led to the recent crisis.

Higher risk appetite: "Grow your wealth" has been the mantra of modern capitalism; simply having a ton of cash is not enough, it must be invested to generate returns. With returns from traditional investments in their domestic markets low, investors began to fan out across the globe in search for higher returns. But higher returns usually come at a price: higher risk.

Inevitably, over the last decade, global investments have been characterised by the gradual lowering of risk standards; investments that would have been considered too risky before, began to receive funding. One such high-risk instrument, the sub-prime mortgage, lies at the heart of the current financial crisis.

Sub-prime loans, high risk for high returns: In the US, loans to customers with a highly risky credit profile are rated "sub-prime." These customers typically have lower than average income levels, are prone to spending more than they earn, and already have a high level of debt. Historically, banks have been reluctant to lend to such customers; in the rare case that these loans were granted, banks charged a high interest rate to compensate for the high risk that the customer will ultimately default on the loan.

However, in an era of cheap capital and low returns, the high interest rates paid by sub-prime borrowers became too tempting. Banks in the US began lowering their credit standards and offering home loans to customers with sub-prime credit ratings. Thus, the era of sub-prime mortgages was born. By 2007, the amount of such loans stood at a staggering $1.2 trillion. a

Teasing with ARMs: And if that were not enough, banks came up with a novel scheme for attracting the riskiest of the risky sub-prime borrowers: individuals who could not, from the beginning, afford the monthly interest payments for the loans they would be offered. Banks devised special mortgages called ARMs (adjustable rate mortgages) that offer an initial low interest rate, called a "teaser rate," for the first two to three years, and then adjust the rates higher.

This resulted in low-income customers, who could not afford the monthly cost of a standard mortgage, to take out ARMs. Needless to say, these customers did not always think through how they would make the payments once the teaser rates were adjusted upwards.

Wall Street, with its lure of million dollar bonuses, attracts some of the smartest financial talent on earth. These financiers saw an opportunity to make money out of the banks' sub-prime mortgage portfolios, one that would reduce the risk on the balance sheet of banks and at the same time allow them to earn even higher returns. How? Through the creation of a complex financial instrument called MBS (mortgage backed security).

The concept behind MBS is this: take some low-quality loans, mix it with some high-quality loans, and create a pool with an "average" to "good" risk rating. What is the benefit? Simple: you can sell this instrument to thousands of institutions globally, like other banks, insurance companies, and governments, who cannot own high-risk, sub-prime mortgages but have no constraint against owning structured assets with a better risk rating. The MBS played a pivotal role in the current crisis in three important ways.

Globalisation of US sub-prime debt: Consider a bank in Japan. Due to regulations, it can only invest in foreign assets with ratings better than average. Normally, such a bank would not be able to own the high-risk rated US sub-prime debt; however, the bank can own a MBS with average-to-good risk rating. In this way, through these complex instruments, US sub-prime exposure spread into the portfolio of institutions across the globe, from banks in Kazakhstan and China to insurance companies in Brazil and Europe to governments in Japan and the Middle East.

Mixing it up: By mixing together high-quality loans with low quality sub-prime loans, MBS created a different type of risk. Usually the portion of the sub-prime in a MBS is small, 10% or less. In theory, even if the low quality portion defaults, meaning the underlying sub-prime mortgage owner can no longer make payments to service his loan, the other 90% will remain intact. However, one of the risks that was ignored, or not properly understood, is what would happen if an investor is forced to sell a MBS after the sub-prime portion defaults. Given the complex structure of the MBS, the investor cannot just strip out the high-quality portion of the MBS and sell it; rather, the investor needs to find a buyer for the entire MBS, including the "toxic" portion. But at what price? Created by financiers on Wall Street, a banker in Kazakhstan is unlikely to have the experience to value these complex instruments. Looking back, it is clear that many institutions across the world bought these sophisticated instruments without really understanding this risk.

Multiplying the exposure: Another characteristic of the MBS market, one with devastating consequences, was the multiplier effect. While stand-alone sub-prime mortgages amounted to about $1.2-$1.5 trillion, the MBS market with sub-prime exposure was over $10 trillion! How is this possible? Well, simplifying the math slightly, if you take 10% sub-prime and 90% good debt and mix it up, the total value of the sub-prime backed instruments mushrooms to $10 trillion.

The stage was now set. Responding to the availability of cheap capital in search of high returns, banks lowered their credit standards and funded over a trillion dollars worth of high-risk sub-prime mortgages. Some of these sub-prime mortgages were offered at artificially low initial rates, to be adjusted upwards later, to low-income families who couldn't afford the real cost of these loans. And then, Wall Street investment bankers created complicated financial instruments, mixing up the sub-prime with higher-quality debt, and then selling over $10 trillion worth of these instruments to institutions and governments across the world. All that was needed for the whole thing to fall apart was a catalyst -- an event that would make the world of finance wake up to these risks.

The Great Unwinding
And wake up they did. True to Yeats' poem, the enormous credit bubble began to unwind from its centre, and quickly financial anarchy was unleashed upon the world. A snapshot of how it all unfolded may be illuminating:

ARMs reset: Remember those ticking bombs called ARM, the mortgages with initial teaser rates set to reset upwards later? In 2007, a trillion dollars worth of ARMs were reset higher. On average, the underlying mortgage owners suddenly had to pay 30% higher payments. For example, a family paying $300 every month in mortgage payments was suddenly asked to pay $400 a month. Low-income families, already stretched to the limit, began to default on their mortgages.

Banks tighten credit standards: With mortgage defaults accelerating, alarm bells started to go off in the risk management department of banks.

The net result was that banks suddenly started to tighten their credit requirements, and almost overnight, it became much more difficult and a lot more expensive to take out a mortgage.

So, out of every 10 applications for a mortgage, the approval rate plummeted from 90% to less than 30%.

Bursting the housing bubble: When a mortgage defaults, it triggers a foreclosure: the bank takes over the house from its original owner and tries to sell it to another buyer. But, at the same time the foreclosure numbers started shooting up, the availability of mortgages was drying up. So, there were fewer and fewer buyers at the same time more and more houses were going up for sale. The law of dwindling demand and increasing supply leads to the inevitable: price collapse in housing. With prices plummeting, even some non sub-prime house owners were faced with a difficult decision: the value of their house was now lower than the value of the mortgage they had taken out on it.

Many home-owners, even wealthy ones, began to take the voluntary foreclosure option -- stop paying the mortgage and leave the property to banks. What had begun at the sub-prime level, had now spread to the overall housing market, putting at risk $15 trillion worth of mortgages. The housing bubble had burst.

MBS market freezes: In the world of finance, the mortgage crisis hit the MBS market hard, and in an unexpected way. With the underlying 10% slice of sub-prime mortgage defaulting, in theory the MBS should have traded at 90% of its original value. But in reality, with no clear understanding of what "bad stuff" was inside these complex instruments, and how the rising defaults would impact even the better quality mortgage slices, and no way to separate the good from the bad, the entire multi-trillion dollar MBS market collapsed. Those who wanted to sell the MBS instruments simply could not find any buyers.

Mark to market rules force write-offs: Institutions, especially those that trade in the stock market, are subject to certain accounting rules. One of these rules, called "mark to market" require companies to use market prices (the latest price at which something is bought or sold in the market) to value financial assets they own. But, with no buying or selling, there was no market price for a MBS. Without a choice, the risk management divisions of banks, insurance companies, and other publicly traded companies started writing down the value of their MBS holdings. And the longer the MBS markets remained frozen, the bigger the write-downs became. By mid-2008, global institutions had written down over $400 billion worth of MBS-related assets.

With massive write-downs, investors lose confidence in financial institutions: With commercial banks, mortgage institutions, and Wall Street investment banks writing down billions of dollars every month, investors began to lose confidence in the financial sector. While some investors sold financial stocks, driving prices down, other investors took "short" positions in the same stocks to profit from the downward trend.

The net result of selling and shorting was a vicious downward spiral in financial stock prices. And the loss of confidence was not limited to the stock market; as the financial conditions of the banks weakened, their trading counterparts became concerned. And with most of their transaction done on credit, nothing is more important to the proper functioning of a bank than confidence.

Loss of confidence drive banks to failure: First there was a bank in Kazakhstan, then a bank in the UK, and pretty soon the biggest of the big banks were in trouble. Bear Stearns, a hundred year old major US investment bank, came to the brink of bankruptcy in March of 2008. Trying to prevent damage to the wider financial markets, the US government stepped in and engineered the takeover of Bear Stearns by another larger bank.

Next, the US government had to step in and support two of the world's largest mortgage service institutions, Fannie Mae and Freddie Mac. As the crisis of confidence snowballed, by September 2008, several of the biggest US financial institutions -- Merrill Lynch, Lehman Brothers, Washington Mutual, and AIG -- were facing bankruptcy.

Uncertain regulators save some, let others fail: Faced with the balance between preventing a massive financial meltdown and averting the rising political outcry against “saving the fat cats of Wall Street”, the regulators hesitated. Instead of taking a blanket save them all approach, the US regulators decided to help the world's largest insurance company AIG stay afloat, while allowing Lehman Brothers and Washington Mutual to go bankrupt. In retrospect, this was a bad decision, precipitating the next stage of the crisis.

Credit markets freeze up: Uncertainty is bad for confidence. The US regulators' selective actions meant the financial markets could no longer be certain that all big financial institutions would be saved. The result was panic. Institutional investors began to avoid not just the toxic MBS market, but all forms of credit, including corporate debt, inter-bank loans, and even the ultra-safe short-term money markets. Only US treasuries, fully guaranteed by the US government, were considered safe. The great credit crunch had begun.

Leading to fears of a recession: Credit is like a lubricant for the economy -- easy availability of credit typically leads to economic expansion, while lack of credit typically leads to economic contraction. In developed economies consumer spending is boosted by credit card loans, auto loans and mortgage loans, while corporations use credit not just to expand business but also to fund day-to-day operations. As the credit crunch became more severe, the probability that the US would slip into a deep recession increased. And stock markets tend to sell-off violently once the scepter of recession looms. Over the last few weeks, stock markets across the world have gyrated violently, losing a net of $7 trillion of wealth.

Forcing the US government to adopt a $700 billion bail-out strategy: Faced with a frozen credit market and a stock market crash, the US bank regulators took the extraordinary measure of asking the government policy makers to approve a $700 billion fund to fight the crisis. The massive amount would be used to restore confidence in the financial sector by supporting troubled financial sector stocks from collapsing and also buy up and remove the toxic MBS assets off the market. After much political wrangling, the US Congress approved the largest bailout fund in history.

Other developed markets join in the fight: Following the lead of the US government, a number of developed market governments in Europe and Asia have banded together, taking drastic measures to help prop up the global financial system and restore market confidence. These have included injected massive amounts of liquidity into the credit markets, guaranteeing trillions of dollars worth of deposits, and in some cases even the whole scale nationalisation of the banking sector. Will it work? The dust is still settling. But one thing is clear: a significant amount of damage is already done and it will take time to restore the normal functioning of the capital markets.

What Lies Ahead?
While economics cannot claim to be a science, and forecasting even less so, there is the equivalent of "the laws of gravity" in the world of finance, ones that postulate: "When event A happens, event B must follow." Given the events that have already taken place in the unfolding financial crisis, we make the following predictions:

More financial institution failures are inevitable, bankruptcy is not: With their balance sheets decimated and confidence in their business models all but gone, there are major financial institutions that are at the brink of failure. However, having learned a lesson from allowing Lehman Brothers and Washington Mutual to fail, and armed with a $700 billion fund, it is unlikely that the US government will allow another major financial institution to go bankrupt. Already, the US treasury has announced it will spend as much as $250 billion to buy up stocks of troubled banks, effectively nationalising the banking system.

Credit markets will eventually unfreeze, but the era of easy money is over: With confidence deeply shaken after having "stared death in the face," the credit markets are not likely to resume normal operations for some time to come. Eventually, as the massive bail-out funds go into action across the globe mopping up toxic assets and putting them in quarantine, the rate of bank failures slow, and governments step in to provide credit directly to businesses, the credit markets will gradually thaw. By year-end, a semblance of normalcy could return to credit markets. But one thing is clear; with more regulation coming, and the memory of the disaster fresh in their minds, banks are likely to keep ratcheting up credit standards, effectively ending the availability of cheap money for many years to come.

Recession is coming to the developed economies: There has never been an unwinding of a credit cycle in a large developed economy without a recession following. And this current unwinding of the credit cycle dwarfs the ones of the past, both in terms of its size and its complexity. Therefore, the US economy, followed by Europe and Japan, is likely to slip into a recession as early as the 4th quarter of 2008, and the recession is likely to be prolonged. There is already evidence of economic stress in the US; consumer spending on everything from cars to clothes to vacation is rapidly declining, while the number of business closures and unemployment figures are rising.

Emerging markets will experience growth slowdown, some more some less: A theory circulating among some economists hold that the world economy over the last decade has become a lot more diverse and therefore immune to a synchronised global slowdown. This decoupling theory predicts that when the US spends less, countries like China and India will spend more and make up for the shortfall.

However, any sensible analysis would debunk such a theory. While economies like China and the Gulf states, with strong balance sheets, may be better equipped to weather this storm, a strong dependence on declining exports to US, Europe, and Japan will inevitably curtail growth. Other emerging market like India, with weaker balance sheets and export orientation, are likely to get hit harder.

Economic recovery will take time, perhaps as long as 5 years: With central banks and governments fighting the crisis aggressively, there is hope that the global economy may avoid a deep recession and even experience a quick recovery. This may be wishful thinking. In our view, this crisis is not the contraction phase of a typical "expansion-contraction-expansion" cycle; rather, it is the third phase of an "expansion-structural meltdown-contraction-expansion" cycle.

For Japan, which experienced the latter in the 1980s, recovery has been elusive and an entire decade of economic growth lost. For the US, the last such structural meltdown happened in the 1930s, leading to the Great Depression; it took the economy a decade to recover and that too after massive fiscal stimulus. While government intervention will likely shorten the recovery period this time around, the global economy now faces at least a few years of economic contraction and stagnation.

The global stock market correction is not over yet: While we may have volatility, ups and downs in the market, the overall trajectory is likely to be down through 2008 and early 2009. Typically, when recession looms, stock markets sell-off 40-45% from the cyclical peak; in response to a severe recessionary outlook this time, the market sell-off may be even steeper. And we are not there yet in terms of the major indexes.

Over the next two months, we may see the global stock markets give up another 15-25% in value. On the positive front, just as the stock market dives in anticipation of a recession, selling off even before a recession begins, the market will also resume a positive trend ahead of a recovery. Given that the sell-off has been indiscriminate, taking many good stocks well below their true worth, the recovery provides the opportunity to make huge returns.

Amirul Rajiv

Consequences for Bangladesh
Even though Bangladesh did not contribute to the root cause of the current global crisis, it cannot escape from the aftermath. There are multiple channels through which developing nations are being impacted; Bangladesh is vulnerable to some of these but not all.

Bank failures and financial meltdown: Bangladesh remains safe. The first bank to fail during the current crisis was not in the US, rather it was in Kazakhstan! This is an example of the global dissemination of toxic US mortgage debt through financial instruments like the MBS we discussed earlier. Many financial institutions across the world still own trillions of dollars worth of such instruments and are likely to face failure in the coming months.

Is Bangladesh safe from this risk? Yes. First, Bangladeshis enjoy a high deposit rate domestically; as much as 10% from private banks and even higher from government savings instruments. Thus, there has been less of an incentive for private and corporate savings to migrate to other countries in search of higher returns. Second, because of foreign currency restrictions, private citizens and corporations cannot legally invest in foreign financial assets.

As a result, Bangladeshi institutions do not have exposure to toxic US mortgage assets and risks of failure due to write offs remain minimal. The biggest risk in this direction may be from the central bank holdings of dollar denominated assets. The good news is that historically Bangladesh Bank has been conservative in this arena, holding its dollar exposure in ultra-safe US treasuries; we have no reason to believe this exposure has changed appreciably.

Flight of liquid foreign capital: Bangladesh is relatively safe. As the risk appetite of global investors decline, liquid foreign capital is quick to flee higher risk emerging economy investments. In the positive phase of the credit cycle, foreign capital flowed into emerging markets in search of high returns, and drove up local stock indexes.

Now, in the negative phase of the cycle, these foreign investors are pulling out of these higher risk investments, thereby driving the local stock markets down. This has already happened in China (stock market down nearly 60% in 2008), India (down almost 50% in 2008) and Vietnam (down close to 60%).

Is Bangladesh safe from this effect? Yes. For the simple reason that there is not a whole lot of foreign capital in the Bangladesh stock market. While in countries like India, foreign capital inflow accounts for over 40% of trading volume, and in Vietnam more than 50%, for Bangladesh this number is closer to 5%. Even if these foreign funds were all to pull out of Bangladesh, which seems unlikely given the performance of the DSE compared to other emerging market indexes, the impact would be small. However, I would introduce a caveat here: stock market rallies and crashes are driven as much by investor sentiment as they are by fundamentals. Given the backdrop of global stock market crashes, panic among Bangladesh investors can itself lead to a sell-off. While some correction in anticipation of a long-term slowdown in the economy may be warranted, regulators, institutional investors and even individual retail investors should guard against irrational panic, so that a correction does not turn into a crash.

Global inflationary pressure, followed by deflation: Bangladesh is vulnerable. As the US government aggressively cut interest rates since 2007 in reaction to the crisis, the dollar weakened against major currencies. One of the by-products of the weakening dollar has been an upward pressure on prices of commodities such as oil, steel, and food. Because these commodities are priced in US dollars in the global markets, a weakening dollar means strengthening commodity prices, or inflation. Remember oil prices doubling in one year, from $70 a barrel to a stunning $140 a barrel? This increase cannot be explained by the less than 5% annual growth in global demand for oil; the weakening US dollar was a major contributor. The commodity price shock has hurt economic growth in every country that is a net-importer of such commodities. But now, with the world facing a recession, the direction of commodity prices is going in the opposite direction; the world is moving from an inflationary to a deflationary environment.

Will Bangladesh be impacted? Yes. Even without realising it, the "price shock" in food, oil and building materials was the first consequence of the global financial crisis Bangladeshis were impacted by. By some estimates, the commodity inflation in 2008 has already cost the country about 2% in annual GDP growth. So, should Bangladesh benefit as these prices come down? Not entirely. The global deflationary pressure is not just in commodity prices but impacts all goods and services; not only is the price of oil and steel imports declining, which is a positive for Bangladesh, but the price of exports like garments is also coming under pressure as global demand slows. However, compared to economies like China, with a much higher percentage of GDP coming from exports, the deflationary impact on Bangladesh is likely to be more benign.

Global consumption slowdown: Bangladesh is vulnerable. The financial health of the American consumer, accounting for 20-25% of global demand for goods and services, is in bad shape, and it is likely to get worse. Combine the impact of slowing US consumption with the same in other developed economies of Europe and Asia, and the impact is large on all export-oriented economies.

Is Bangladesh vulnerable? Yes. The two largest sources of foreign currency for Bangladesh are remittance and garments exports, and both are likely to be impacted negatively. (1) In the case of remittance, consider the example of the US and UK; Bangladeshis living and working in the US and UK account for approximately 30% of overall remittance inflows to the motherland. A large portion of these Bangladeshis work in the hospitality (restaurants, hotels, taxis) industry -- a sector particularly vulnerable to recession. Bangladeshis in the Middle East, who account for a majority of the remittance, are also vulnerable. The dual shocks of collapsing oil prices and the global credit crunch are threatening the pace of expansion in cities like Dubai, a major destination for Bangladeshi workers. (2) As for the garments industry, the negative impact on demand is yet to be fully appreciated. Part of the reason is because Bangladesh's garments industry has been gaining share from countries like China and has experiened strong growth in 2008 even as global demand has stagnated. However, in an extended recession, overall demand for garments from developed nations could decline by more than 30%. A decline of this magnitude would most certainly be felt in the Bangladesh garments sector.

Slowdown in foreign aid from developed countries: Bangladesh remains vulnerable. How will the current crisis impact the ability of the world's richest nations to help the poorest? This has already been a topic of conversation at a gathering of financial chiefs from the G7 nations, the world's seven largest economies. With their own populations suffering from unemployment, home losses and declining standards of living, these global leaders are facing a political backlash at home. In such a politically charged atmosphere, the topic of helping foreign nations is almost taboo. This will inevitably have a negative impact on the flow of foreign aid to developing nations, with devastating implications for some African nations surviving on foreign aid. Luckily, Bangladesh has come a long-way from our aid-dependency of the 1970s; today we have a thriving, resilient economy and we are a lot less dependent on foreign aid than in the past. This is a good thing -- since foreign aid will become harder to come by in the coming years.

Guarding Against Isolationism
While Bangladesh cannot altogether escape the impact of the global financial tsunami, it is unlikely to experience the worst of it. No doubt, the global recession ahead will negatively impact the export sectors of our economy and with it bring some hardships, but the probability of bank failures and credit market seizure remain very low, while the relative isolation of the stock market makes it less susceptible to global gyrations and more dependent on local dynamics.

It is inevitable, however, that the spectacular failure of the US financial system and the subsequent global contagion will strengthen the argument in developing nations against deregulation and globalisation of capital markets. In countries like China and India, regulators and politicians have been congratulating each other for avoiding the worst of the financial meltdown, and further opening up of capital markets seem to be taking a back seat. Bangladesh is no exception: already there have been remarks from some quarters about how the current crisis supports limiting foreign capital into our economy and delaying privatisation. This would be a mistake. Let me amplify the point with an example: There is an argument, gaining favour in Bangladesh, for restricting the free flow of foreign capital in and out of our stock markets. The proponents of this view point to the recent outperformance of the Bangladeshi stock market versus the global stock indexes as validation. However, this argument ignores three factors.

Firstly, the current sell-off in the global stock markets is not the cause of the financial crisis, rather it is an effect. A stock market is a discounting mechanism of risk adjusted earnings of the overall economy; therefore a sharp downturn simply reflects investor belief that there is significant risk of a recession.

Secondly, a stock market is a mechanism for efficiently allocating capital: direct funds to well-performing companies (positive feedback) and take funds away from companies that perform poorly (negative feedback). Few will argue against integrating our real economy into the global economy, via the export and import of goods and services; but, then we must also allow our corporations to be exposed to this global feedback mechanism through an open capital market. Let us consider an example: an export-oriented manufacturing company experiences strong demand and management decides to expand; foreign investors, attracted by the performance of the company and the prospects for growth, can provide growth capital through the stock market. This foreign fund inflow benefits the real economy through job creation. Now, suppose global demand for the company's goods decline; then capital should be taken away from this company so it does not create excess capacity that is harmful for the whole industry. For export-oriented companies, foreign capital, with its global exposure, can provide this feedback far more efficiently than domestic capital. In summary, a real economy exposed to the global demand-supply pull must also have a stock market that is open to the global feedback mechanism.

And finally, foreign capital brings with it intellectual capital that is critical for the long-term development of our stock markets. We are seeing examples of foreign funds setting up local offices, teaching our young university graduates world-class valuation, risk management and portfolio management techniques; this knowledge transfer is critical for the long-term development of our capital markets and its value should not be underestimated.

In conclusion, we are in the midst of a violent unwinding of a decade-long cheap credit cycle, and the dust has yet to settle. While Bangladesh has side-stepped the financial sector meltdown and sharp stock market corrections being experienced by other nations, we remain vulnerable to the longer-term global economic slowdown.

It is prudent, in these times, to make informed and thoughtful reforms to our economic policies and regulatory framework, but we must not give in to the impulse of isolationism. Bangladesh's stage of development can benefit enormously from the influx of foreign capital and intellectual property into both the capital markets and the real economy. Integrating into the global economic cycle, while painful sometimes, is the only way forward to sustainable prosperity.

Photos: AFP

Dr. Hasan Imam a non-resident Bangladeshi with over a decade of capital market experience at some of Wall Street's premier financial institutions. He currently holds the title of Managing Director at a global investment bank.

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