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How has the global financial crisis effected latin America

Introduction

The world was hit by the worst financial crisis in 60 years in the summer of 2007. The International Monetary Fund has estimated that the total loss to both American Markets will be close to 8 trillion dollars by 2010 (Krugman, 2009). The effects of this crisis are at play even today and the economic regions are only now showing growth patterns. Each region has been hit in a different way. Some have undergone major turmoil in their financial system while in others the effects have been much less (Foxley, 2010). In this essay I exhibit the situation and policies in the Latin American economy that has enabled it to hold back the major repercussions of the crisis. To achieve the situation in Latin America will be compare to the one in Europe.

Global Economic Recession

The current financial crisis has become of the most devastating events of the 21st century. Though the degree and area affected by this crisis is relatively extensive it has features that are reminiscent of the past economic depressions. This crisis like all others was preceded by a period of growth and low risk premiums. In addition to this there was also an abundant availability of liquidity coupled with soaring asset prices. Last but not the least there was the development of bubbles in the real estate sector (Sapir, 2008).

In the early stages of the crisis financial institutions were the only ones affected as they found it increasing difficult to obtain liquid assets. The main cause of this was that they kept reinvesting their debt which led to rigid conditions in the market. During this period the creditworthiness of financial institutions was decreasing but there was not concern of a full universal collapse. In this phase, concerns over the solvency of financial institutions were increasing, but a systemic collapse was believed to be unlikely. This view however changed when the US investment bank Lehman Brothers went bankrupt (Directorate-General for Economic and Financial Affairs of the European Commission, 2009).

Crisis in the United States of America

The current crisis began in the United States of America when the real estate coupled with the mortgage market collapsed. What is central to this is the housing bubble that expanded with the stock bubble in the mid-90s. People who had invested in stock were getting huge returns and the most common effect of this is a consumption boom where saving began to drop as people started spending. This spending free caused people to invest their money in real estate which in turn brought about a housing bubble. As demand for houses increased and the stock was limited the prices of houses began to rise. But this rise led buyers to believe that their houses were worth far more than their real prices. This expectation led the home buyers into purchasing houses at a very high rate. Another effect of this was the rise in rents.

As house rents and house prices increase it cause a boom in the development sector. This was fuelled more so by the loss of confidence in the stock market after the crash of the stock bubble. Investors believed that the real estate market was a much safer area to invest their money. Abnormally low interests rates made housing prices continue to rise. In addition to this there was also relaxation of lending standards. This again led to more consumption as people began to invest less. The building boom that this accompanied this cause a massive oversupply of houses. Eventually prices could not be support by the supply in the market. Prices had peaked in the end of 2006 and then onwards it had been a continuous slope downwards (Baker, 2008).

As prices fell the number of home owners facing foreclosure began to rise. Most of the time this was voluntary the ones who wanted to keep their homes were also affected equally. These home owners who would normally have borrowed against the houses equity to pay off the mortgage were unable to do so because of the low value of equity. Voluntary foreclosures occurred when people got the impression that they owe more than what the house is worth. Both these sources of foreclosures flooded the market with excess homes. In many areas the number of foreclosures exceeded the number of sales. And this sudden boom in defaults made banks increase the strictness of their lending procedures with larger down payments. The total loss in the housing bubble was around 7 trillion dollars i.e. 100 thousand dollars per investor and such a huge collapse had serious financial implications (Baker, 2008).

Lack of Regulation

The biggest culprit behind the crash was the large number of abuse cases in issuing, securing and repackaging of mortgage loans. The market didn’t have any regulations and whatever it possessed was also not followed. The number of subprime loans increased by around 11 percent before the crash and if this was regulated then it would have become apparent that something was wrong in the financial markets (Baker, 2008).

A lot of the regulatory bodies from both state and government could have intervened but out of these it’s the Federal Reserve is to be blamed for missing the clues. The Fed thought that financial bubbles are natural events and to prevent them would be impossible. In truth financial bubbles can be contained but it needs the focus of a central bank (Baker, 2008).

Latin American Economy

Latin American countries have a long and distressing history when it comes to their economy. They have been in and out of recession many times for various reasons. Individual countries have undergone many forms of financial crisis such as debt and currency crisis. Unlike the rest of the world though Latin American countries have always bounced back quickly. This is mainly attributed to the reforms that have been put in place after the many financial downfalls. Due to this Latin America has been able to survive the 2007 Global Recession without much damage. In addition to this the countries in this region have also received a large amount of international aid. The region has low fiscal and account deficits while it boasts a higher level of international reserves. Apart from this it has very low levels of short term debts. Another reason for this is its strong economic link with China, which has experienced unparalleled growth even during a crisis. Latin America has therefore benefited from all the trade with China (Cardenas & Henao, 2009).It will of course be hasty to think that the country has not been affected at all. Compared to its own past and other regions the effects are a lot less though.

After 6 years of growth the Latin American economy as measured by the GDP has fallen by 2.8 percent. The impact of the crisis was felt during the latter part of 2008 and the beginning of 2009. However recovery plans had ensured that a positive growth was projected during the second and third quarter of 2009. On the other hand the expected results were not met and there were shortcomings in all markets. These shortcomings then moved into the labor market and people started losing jobs. The unemployment rate rose to 8 percent throughout the whole region and new jobs that were created are of poorer quality and standards (United Nations ECLAC, 2009).

Latin American Economy: Recent Trends

In order to fully understand why the Latin American economy was not hit as badly as the other regions it is necessary to see what the conditions in Latin America. Between 2004 and 2008 Latin America found itself in a situation where there was steady growth the like of which had not been seen since 1960s. The region experienced a current account surplus because of the improvement in trade and the increasing amounts of remittance money flowing in from its immigrant workers. Because of this excessive surplus and abundant liquidity in international markets the countries were able to reduce their deficits considerably by paying off debts. Even though the crisis put the region back into deficit the local financial sectors were not exceedingly affected. There were no problems in the domestic systems of finance or currency. In fact this even helped them meet their international obligations the combination of good external financial conditions and sensible management of the countries’ macroeconomic and fiscal policies had enabled Latin America to withstand much of the effects. The region had reduced its outstanding debt while using its surplus to increase international reserves. Latin America therefore went into the crisis with an exceptional advantage as it had vast amounts of liquidity in reserve to help it. In addition to this the macroeconomic policies that were setup during the previous crisis allowed access to international markets and boosted capacity for new public policies (United Nations ECLAC, 2009).

Transmission

The economic crisis of 2007 hit the Latin American region through four different sectors. They are external financing, demand for exports, prices of commodities and remittances. Unlike previous times there has been no currency depreciation, bank failures, debt evasion or inflation. Most of the countries in the region have continued to possess banking systems with liquid assets. This is not the case in the other regions as the banking sector was the first to be hit.

The crisis entry into Latin America had mainly to do with exports. During the second period of 2008 the value of export fell by 23.4 percent while volume fell by 9.6 percent (United Nations ECLAC, 2009). As the crisis hit the global economy and exports began to fall the commodity prices began to fall as well. Commodity prices were on the rise in the beginning of 2008 but were hit hard by the collapse of the Lehman Brothers bank. The terms of trade deteriorated by 6 percent for the whole region as average prices fell. The consequences of this mainly affected the oil producing countries while the food production countries were affected only to a slight degree (United Nations ECLAC, 2009).

Tourism is another sector that has declined globally and Latin American countries which depending on it have not escaped the outcomes. In addition to this the largest numbers of emigrants from Latin America move to the United States or the Spain both of which have been heavily hit by the global recession. Remittances have fallen by around 10 percent because of this. Although the major effects of the recession hit the trade sector some of the countries had exceptional losses to their financial segment as well (United Nations ECLAC, 2009).

Impact on Latin America

There have been three main consequences of the economic crisis in the countries of the Latin American Region. The first of these is recession, as is the case with most of the countries in the world. Latin American economic growth has fallen from 4 percent to around 2 percent. A direct implication of this is the increase in poverty. The crisis has been estimated to make around 8 million Latin Americans go into poverty. If we look at the period before the crash we notice that around 60 million people had left poverty between 2002 and 2008 (Marcelo M. Giugale, 2009). In comparison the 8 million going back to poverty is a huge setback to the region’s economy. Middle class families are most affected by this because falling trade and consumption has led to an overall decline in demand for urban technologically advance workers. The third effect will be a general decline in foreign financing within the region. Although Latin American sovereign buyers had secured foreign financing, corporation had a much tougher time with their financial situation. The net capital flow into the region has in fact fallen to less than 200 billion dollars (Marcelo M. Giugale, 2009). During the peak in 2007 the amount of capital flow equaled 1 trillion dollars and this 800 billion dollar fall and the other impact on the region’s economy has had huge repercussions (Marcelo M. Giugale, 2009).

Socio-Economic Implications

The abrupt decline of the financial markets had one serious effect on the social conditions in Latin American countries. After 6 years of growth employment rate fell by around 6 percent at the peak of the crash. At the same time people were losing jobs and unemployment began to rise from 7.4 percent to 8.3 percent. In most cases it is the paid workers who lost their jobs or saw a decline in job openings but in some cases even the private business owners or self-employed also felt the impact of the recession. The most important aspect of this impact has been on the quality of jobs which had been improving in the past 6 to 8 years. The more people became unemployed the poorer the wage job quality became. Wages which had increased during the preceding year fell to a record low while the overall quality of the work force itself decreased. Due to this informality productivity has begun to fall in many sectors (United Nations ECLAC, 2009).

Social consumption and aid policies have been put in place by the various governments in Latin America to counteract the severity of these impacts. Consumption subsidies have been initiated for energy and food so that people will be able to keep buying. Support of poor people is motivated by the need to provide help in areas of housing and healthcare to the underprivileged minorities (United Nations ECLAC, 2009).

The one good part about the crisis was that it brought inflation down from 8.3 percent to 4.5 percent. Lower inflation helped keep the wages at their original worth and a result of this was poverty levels were more moderate than previously expected (United Nations ECLAC, 2009).

Policy Response

Having gone through previous tough times of recession more than once over the past 40 years the governments of Latin America were able to quickly come up with short term policies that have in the overall had a beneficial effect on the regions recovery. Unlike the other G7 countries the policies put in in place in the countries of this region are different. The priority for Latin America is to concentrate on reducing loss in its workforce. Although there is ample social assistance programs there aren’t a lot of social insurance benefits as in regions like Europe.

One of the more successful reform policies adopted by the Latin American countries is fiscal policy. Fiscal stimulus has been easy for this region because most of the countries were able to save up during years of growth. Inflation too was controlled because of this and they were able to reduce interest rates and let their currencies deflate to match external and internal conditions. The governments did not need to intervene on a micro level to promote recovery. Unlike other parts of the world private corporations and central banks did not have to be bailed out by the state. The equilibrium that had been built over the time of economic boom was preserved (Marcelo M. Giugale, 2009).

Crisis in the region is beginning though is mostly affecting the region through unemployment and debt. There is increased pressure on governments to come up with policies to counteract this. Few of the countries in the region have come up with insurance systems for unemployment coverage. Most have however decided to concentrate on intermediation services such as providing training for the work force and subsidies for youth employment. In addition to this states have also provided tax relief for small businesses and created larger budgets for cash transfer programs. As an additional program the states have also begun an aggressive public works campaign with which they aim to reduce the unemployment in the countries. By investing more than 25 billion dollars the region will be able to get at least a million of its workforce back into jobs (Marcelo M. Giugale, 2009). In fact the number of permanent jobs created because of this stimulus can reach much higher numbers than predicted.

At the onset of financial crisis the central banks in the Latin American region ordered a series of actions that aimed at ensuring the liquidity of local financial markets and subsequently their recovery. This however failed to increase credit in the private banking sector and as a reaction to this states made pay outs to compensate the outcomes (Marcelo M. Giugale, 2009). There is a new difficulty brewing underneath this and that is the amount of money that Latin America will need to borrow to maintain its economic status. By the end of the recession the country would need to borrow around 400 billion dollars and since the international financial bodies themselves are constrained it will tough to achieve this amount. Many of the previous helpers of Latin American debt are out of commission and this could bring about a new phase of domestic borrowing. The ability to roll over this debt seems to be the region’s major concern (Marcelo M. Giugale, 2009).

Latin American Economy versus European Economy

Unlike the US economy the European Economy was widely believed to be much more stable because of the growth in exports and the strong commercial position of the businesses. This view was changed when the Lehman Brothers bank defaulted. In Europe the insurance giants AIG had to be bailed out because of fear in the financial sector. Investors lost confidence in the stock market and began to move towards safer options. As the crisis picked up pace banks began to curb credit and economic activity began to plummet. As the number of sources that gave out credit became few and expensive sales dropped and industrial inventories mounded. Confidence among consumers and businessmen had grown low. Europe’s economy has been hit by a record low during this recession. (Directorate-General for Economic and Financial Affairs of the European Commission, 2009)

In comparison to the events in Latin American economy Europe seems to have it much worse. The first materialization of the crisis in Europe was the banks themselves. Unlike Latin America a long list of failed banks in Europe had to be bailed out. The damage to the financial institutions would have been tremendous if the governments did not support these banks. As banks began to fail investor became less confident and it became very difficult for the banks to raise capital in the form of shares (Directorate-General for Economic and Financial Affairs of the European Commission, 2009). Institution had to therefore put a cap on lending and started selling assets. This caused a feedback loop as the capital of similar assets began to fall further reducing lending. The main response to this came from the central banks in the form of interest rate reduction so that banks can have new sources of funding. In addition to this they also provided liquidity against collateral to ensure that financial institutions didn’t need to sell anymore assets. This was however not as a successful as the measure that were put in place in Latin America. Governments found that by simply providing liquidity the restoration of the banking system couldn’t be achieved. They then initialized a system of toxic asset purchasing where the bank can sell it to the government at a good price. (Directorate-General for Economic and Financial Affairs of the European Commission, 2009)

The impact of the crisis has 2 modes of transmission in Europe and they were both different from Latin America. The financial system itself was the main mode of transmission in Europe as losses originating in the United States were felt by sister organizations in Europe. Banks trying to deleverage drastically reduced their contact with new market which caused a snowball effect as emerging economies within Europe were beginning to feel the repercussions. In Latin America we find that the major brunt of the crisis was transmitted through the depreciation of international trade and receiving less remittance money from emigrants. The second mode of transmission is closely connected to the first. As lending’s subsided people began to lose their wealth and started buying less consumer durables (such as cars) and assets (houses etc.). People began to save more and invest less. This created a loop in the financial market as inventories built up and production had to cut (Directorate-General for Economic and Financial Affairs of the European Commission, 2009).

A common mode of transmission between Latin America and Europe is the depreciation of international trade. In Europe however this was not the major cause of turmoil.

One sector of economics that has been affected regardless of region is the labor market. As in the case with Latin America, unemployment has gone up by 2 percent in Europe. In Europe the socio-economic group that has felt the major impact of the force is the low and medium skilled workers (Directorate-General for Economic and Financial Affairs of the European Commission, 2009). Comparatively unemployment t in Latin America has focused on middle class skilled technologically advanced workers. The challenge in both these regions is that unemployment will not easily go back to its original pre-crisis low.

The crisis policy framework for Europe is different from that of Latin America as it draws more on the framework of longevity. While Latin America instigates short term fiscal and monetary policies with reducing social impact as a primary concern, the European policies are more long term and are made to help stabilize the entire financial system. There are three main stages in the European policy framework.

The crisis prevention stage is the first stage of the framework. At this stage policies are created to regulate and supervise financial markets so that crisis conditions do not build up. To ensure strong macroeconomic fundamentals these policies concentrate on achieving robust growth and flexibility in the market (Directorate-General for Economic and Financial Affairs of the European Commission, 2009).

The second stage of policies will be based on crisis mitigation. If crisis prevention fails then this stage would ensure that the effects on the economy are minimized. These policies concentrate on monetary and fiscal stimulus. By intervening in product and labor markets these policies avoid hardship and loss of human capital (Directorate-General for Economic and Financial Affairs of the European Commission, 2009).

In the third and final phase of the policy framework crisis resolution is given primary importance. A complete plan on how to exit from all the different downfalls is devised in this stage. This includes macro and micro economics of a country unlike Latin America where the recovery plans usually concentrate on the macroeconomic policies of the region (Directorate-General for Economic and Financial Affairs of the European Commission, 2009).

Conclusion

The Global economic crisis which began in 2007 has affected many countries but all in different ways. It began in The United States of America with the collapse of the housing bubble and was transmitted to Europe first because of the financial ties between institutions in both these regions. This caused a worldwide catastrophe as the collapse of financial and consumer markets in both these regions meant that countries which have their main income through international trade had just lost their grasp over two major markets. One such region that came under this influence is Latin America. However unlike the other regions Latin America did not face extreme adversity. The reason for this was that they had experienced many recessions in the past 40 years and had learnt to develop their macroeconomic policies for their advantage. In addition to this the preceding years of growth and international reserves due to surplus gave Latin America an advantage as it entered the crisis with enough liquid assets to support the financial structure. Last but not the least the crisis mode of transmission into Latin America was solely through trade unlike Europe which was affected by the collapse of financial institutions themselves.

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