Impact of Credit Crisis on International Business
This paper tries to study the impact of credit crisis on international business. The relation between international business and financial crisis is two sided i.e. both the phenomena impact each other, The financial crisis of this scale could not have been a possibility if economies had not been coupled and secondly the impact of the crisis flew to other developing economies, those which did not have any direct exposure to these toxic assets through the financial integration only. The contagion which is being witnessed across stock markets is a clear evidence of it. In turn, the crisis also determines the fate of international business. This is what we set out to study. In this paper we try to study the impact of recent credit crisis of 2008, which originated from America, on the International Business at global level. We propose to study the impact of the crisis on the international business under various heads i.e. factors that determine the international business like International Trade (Exports and Imports), Foreign Direct Investment ( both M&A and green field), Foreign Trade Policies etc. Since these factors in turn are affected by Credit availability, GDP growth, Investment opportunities, Business confidence etc. The motivation behind such study is to be able to gauge how such crises determine the International business. A manager in International business will be highly helped, if he is able to predict and prepare for what challenges are ahead in the international business arena, after such crisis has passed. Those who are better prepared will be able to whether the financial storm of this scale if not fully but predictably. Though, the scars of the crisis have been severe on the face of globalization as many countries have realized that their Exports, imports, Foreign direct Investment, Indirect investments like portfolio investments, integration with cross border businesses have been severely affected, but it has would have taught many lessons to policy makers and businesses.
Structure of the Paper
The paper would first define “credit crisis”, after which a brief history of similar crises will be detailed, entailing some of the plausible causes of such financial. Then we will delve deeper in to the causes behind “The Great Credit Crisis” as it's been called. Further we will compare the current crisis and its predecessors. We will also highlight on the argument “that this crisis was unprecedented and did not have much in common with earlier crises”. Then we will discuss the impact of the financial crisis on International Trade, Foreign Direct Investment (FDI), Business Cycles and International trade Policies respectively. After which the brief conclusion will be offered followed by detailed reference list.
Credit crisis can be defined as a situation where in businesses and households though otherwise able to obtain credit normally for capital formation and purchasing consumer durables find it very difficult or sometimes impossible to obtain credit.
“Investopeadia” defines credit crisis as “crisisthat occurs when several financial institutions issue orare sold high-risk loans that start to default. As borrowers default on their loans, the financial institutionsthat issued the loans stop receiving payments.This isfollowed bya period in which financial institutions redefine the riskiness of borrowers, making it difficult for debtors to find creditors.”
History of Financial Crises
Though world history is awash with financial upheavals not all of them can be termed as crisis as severity of some of them was less than others and thus some economists choose to term them as “Credit crunch” rather than crisis. One of the earliest and noticed financial crises was “Dutch Tulip craze”. An artificial bubble got created around Tulip prices in 1960's; as Tulips were highly sought after for their beauty and their unique colours. The bubble finally got burst when some traders started booking profits and the prices finally came down steeply and people lost their money. In 1857 the Civil War led US to a credit crisis which crashed equity prices and nations that traded with the US were severely affected. Another significant event in global financial history was the US stock market crash in 1929 which was a result of stock speculation during 1920's and when the economy started to slow down the market came down and the day 29th October in 1929 is remembered as the “Black Tuesday”. After recovering from “The great depression” The US enjoyed great economic development with increased government intervention as prescribed by “John Maynard Keyenes” in his economic theory. But again in 1966 the US slipped in to recession following a credit crisis and resulting deflation and huge economic slump. 1982 also witnessed a credit crisis that swept itself across developing countries and prevented them from paying their debts. Russia defaulted on its payments obligations in 1998 caused by financial crisis. In 2001 Argentina government defaulted on its payment obligations reflecting an economic crisis in the country. We cannot ignore what happened recently in Zimbabwe, where the economy got crippled in to hyperinflation.
While today's' financial crisis is more severe in its impact than the mentioned crises except “The great depression”. In fact there have been a lot of studies around comparison of these two great events in the history of the world economy “The Great Depression” and “The Great Credit Crisis”. One thing is very common to both of them they both originated from the USA and swept the entire world influencing most of the developed and developing economies. However the Impact of “The great credit crisis” should be more global because of increased integration of different economies in 2008 when compared to 1929. The impact of the current crisis on the trade would be different from the one of 1929 in one way i.e. way back in 1930's the industrial production was concentrated in North America and Europe while Latin American and Asian countries were more dependent on primary productions like agriculture and thus were more stable during “The great depression”, and the North American and European countries were hurt badly. While today, since the industrial production is spread throughout the world the impact of the current crisis is fairly spread over various parts of the world, though its impact had been initially, in 2008, slower in the developing countries than the developed ones, but came 2009 and the impact had been clearly visible on developing countries too. A few countries, with highly regulated financial systems like banks with tighter following tighter monetary policies, have been speared a bit due to their limited exposure.
The Causes behind the Current Crisis
After seeing the fall of big invest banks during 1930's and its impact on investors' confidence and the overall market an act known as “The Glass-Steaglle” act was passed which prohibited investment banks to operate as commercial banks also i.e. a commercial bank and an investment have to be two separate entities and a bank can't work as both commercial bank, offering risk free deposits, to general public, and an investment bank that serves corporate and government for their capital raising by issuing securities, trading in securities and facilitating Mergers and Acquisitions. The commercial bank model is low profit model in comparison to investment banking model, but off late due to increased competition profitability in investment bank also started getting thinner and thus these investment banks started innovating new products to earn higher income. The Glass- Steaglle act was also repealed in 1999 through another act i.e. “Gramm–Leach–Bliley Act”. Thus theses investment banks were allowed to convert themselves in to universal banks which had both the businesses combined that of commercial as well as investment bank. When the housing market was experiencing fast growth, before 2006, these banks started offering loans to people who were not credit worthy, i.e. sub prime loans, thinking that, even if these people default, increased prices of their properties that they would seize by foreclosure, would compensate for the losses on account non payment of the interest and principal repayment. Lending to the people with less or no credibility allowed these financial innovators to charge higher interest rates, which was a great incentive for other banks, institutions and hedge funds, as they were able to earn higher return on their investment. The problem of poor credibility was dealt with, with the introduction of credit default swaps (CDS) by AIG, which acted as the insurer against any default arising out of these subprime loans and was also able to hide the true risk of investing in these sub-prime loans. They were able hide the true risk inherent in the toxic assets by combining them with prime securities and then slicing them. And with AIG as the insurer against any default they were able to get “AA” or even “AAA” rating fir these assets. Thus the investment banks connived to repackage their risky securities with some risk free securities to obtain good ratings and keeping their investors from knowing how much real risk investing in these collateralized debt would mean. Thus banks, world over, invested heavily to make quick money for their clients and themselves. And as “The Glass Steaglle” act had already been repealed in 1999, the money of the retail investors was also pumped in to these risky (read CDO's) assets. Everything remained undercover as long as the basic premise on which fate of such an arrangement rested, i.e. Housing prices would rise and thus any default (foreclosure) would not mean any loss as the price of the property would have risen from the purchase price. But the safe haven of housing prices appreciating at a fast pace proved short lived and when the housing bubble busted, the default started and losses increased and housing prices kept falling further, compelling to otherwise credible borrowers to default as they found out the property rates have cooled off and they are paying much more for a house than its current market price and this entire episode brought down first the investment banks and then their investors which ranged from banks, hedge funds to other institutions across the world economies. The world's financial system nearly collapsed on account of it.
Crisis and International Trade
International Trade can be defined “as exchange of capital goods and services between countries”. This is the phenomenon which connects various countries in to a business relation and thus is responsible for globalization. It is the international trade that today determines the fate of most of the developed and developing countries. A country's balance of payment which is net of exports (what a country give to other countries) and imports (what a country receives from other countries) determines it dominance in the global economy.
International Trade is significant for both developed and developing countries. As for developing countries it affords them access to latest technology and newer products and for developed ones it affords them the market to sell their new products and services.
Impact of Financial crisis on International trade has been seriously affected by the global financial crisis. Decelerating global demand caused by credit dry-up, increased uncertainty, severe financial loses, increased protectionism could be a few of the reasons behind this impact of global financial crisis on International trade.
Before the global crisis the world was growing strongly, but came end 2007, when the impact of the housing bubble seemed surfacing and world trade activity started slowing down the global trade had been gradually hurt. The dry-up of credit and confidence, after the failure of Lehman Brothers, led to cancelled or deferred purchases of consumer goods specifically durable goods, as people became jittery about future. This led to sharp decrease in demand which brought down global trade with it. In November and December 2008 world trade volume were down by 5.3% and 7.0% respectively. The quarter of 2008 witnessed overall 6.0% down fall in world trade figures on a quarter to quarter basis. The world Purchasing Manager Index (PMI) which reflects the demand and thus the output came down steeply in 2008 going much below the 50% level which is used as a line for demarcation for contraction and expansion, clearly sending the message that world output and trend have contracted. Though in February 2009 it had gained some momentum but still, remained below the contraction – expansion threshold. (Ion and Cornelia: 2009)
The IMF's expectation for world trade growth is that it will be down to 2.1% in 2009 in comparison to robust 9.3% growth in 2006. World Bank also shares a similar view that the world trade will stagnate due to financial crisis. While the actual impact of it on a country will be determined by direct and indirect linkages to different developed countries like the US and other affected countries, what is structure of trade like extent of exports and imports and how much do they depend on crisis struck countries for remittances and financial flows, and how their government responds with policy measures. One important reason for such a down turn in global trade is poor availability of trade finance, due to financial crisis. The same concern was voiced in the WTO meeting that took place in Geneva in the year 2008.
The Crisis and FDI
FDI stands for “Foreign Direct Investment” which is “the purchase of the “physical assets or a significant amount of ownership (stock) of a company in another country in order to gain a measure of management control.”(Richard J. Hunter, Jr., 2005:2).
Impact of the crisis on FDI
The FDI inflows generally tend to more stable than the other investments because of longer horizon, less reversibility, it results in ownership and operation of productive facilities. Moreover the purpose to invest incase through FDI could be having new markets, setting up production facility and other business interest which is absent in case of portfolio and other investments. However there has been considerable impact on FDI inflows and outflows on the crisis struck countries.
FDI may get affected by financial crisis on account of several reasons:
- Tighter Credit
- Profits generated by MNC's are flown back to save financially troubled parent companies in the parent country
- Decreased future expectations of appreciation in the currency of the host country
- Decreased business confidence
- Fear of Protectionism by the host country
As per the world investment report by The UN Conference on Trade and Development UNCTAD global FDI flows which was at US $2.0 trillion in 2007 fell down to US $ 1.7 trillion in 2008, a 14 % slide over last year. In the first quarter of 2009 the dip in FDI flows was by 44% when compared to same quarter 2008 figures. Globally, in 2008, the M&A sales decreased by around 40% while the same was 56% down for in Europe in the same year During 2008 FDI flows for developed countries dipped by 29% reflecting a sharp decline in M&A activities. It would be by 2011 only that the FDI flows figure would retreat to 2008 figures. In 2008, The United Kingdom was replaced by France as the highest receiver of FDI in Europe. The top position as both the receiver and the source of FDI was retained by the US in 2008 also followed by France. In fact, the year 2008 has been very fortunate for the developing countries as their contribution to global FDI increased to 43% but UNCTAD clearly warns for poor figures in 2009 as the contagion from the developed countries has reached to the developing countries now.
Looking industry wise there is some good news as, in 2009 the agricultural and extractive industries have been steady but manufacturing has underperformed due to more direct linkage with business cycles. As opposed to M&A, green field project remained very strong in 2008, but 2009 has rung well with them as the figures are down in 2009.
FDI flows to developed countries plunged by 29% during 2008, reflecting a sharp reduction in merger and acquisition (M&A) activity. M&A sales were down 39% globally in 2008 and by as much as 56% in Europe. During 2010, a gradual recovery in overall FDI is expected to be under way, up to US$1.4 trillion, and only by 2011 are flows expected to have returned to 2008 levels. The United States continued to be the largest single recipient of FDI during 2008, followed by France, China, the United Kingdom (which lost its top spot in Europe), Russia and Spain. The biggest sources of outward flows were the United States, France, Germany, Japan and the United Kingdom. Japan, Switzerland and Canada were particularly notable for the growth of their outward investment in 2008. Countries suffering particularly sharp declines in inward investment included the United Kingdom, Italy and Germany. (IHS Global Insight: 2009)
Business Cycles and the Financial crisis
Business cycle refers to economy wide ups and downs in the economic activity and production, between periods of contraction and boom.
Impact of the crisis on Business Cycles
Businesscycles Prior to the recent crisis, there were strong arguments in favour of “decoupling of Business Cycles” between large emerging Asian and developed economies. The last two decades data had also supported the argument quite well. Many large transnational used Asian economies as their production hubs, still prior to the financial crisis of 2008 ther was low or negative correlation between most developed countries and Asian economic leaders like China and India, supporting the theory of decoupling of business cycles. But financial crisis has increased the co movement of business cycles of emerging and developed economies. In fact Business cycles of India and China (read Asian emerging market leaders) have started taking after OECD countries' business cycles. (Iikka and Jarko: 2009)
There will see a clear change in the way world economies relate with each other. There will be more interdependence between emerging and developed economy (The US rather than dependence of emerging economies on developed economies ((Iikka and Jarko: 2009)
Financial crisis and Foreign Trade Policies
Foreign Trade Policy is a set, of guidelines, which helps a government in deciding their response towards trade with other countries.
Impact of the Crisis on Foreign Trade Policy
After every crisis people start questioning the free market philosophy and, are generated arguments over whether government should intervene or let the free market determine the best interest of the society and support for “Protectionism” suddenly gathers decibel. As has happened in the past after every crisis governments in their rush to protect domestic economy go for Protectionist measures. But this crisis has not been followed by much Trade and Investment protectionism. As per UNCTAD's survey of Changes to National Laws and Regulations, 85, out of 110 new FDI related measures that were introduced, have been gauged to be favourable. The same survey also revealed that the number of bilateral treaties stands at 2676, with 59 of them concluded during 2008 only. So we can say that the trade policies have not been severely affected by the crisis (UNCTAD: 2008)
The current financial crisis that surfaced somewhere, in 2008 had been brewing for a long time. The main reasons behind the crisis were the same as with any other crisis i.e. Greed of people. The crisis has been the most severe after “The Great Depression”. The crisis has really impacted the world in many ways. Though the impact of the crisis has varied degree of impact on different countries, it certainly has been a global phenomenon. The significance of the crisis in world economic history would be very great as it has impacted the international business in great many ways. The developing countries, in though, not directly exposed, but felt the heat of the crisis, because of increased integrating with the global world.
The impact of the crisis on the international business has been significant. The international trade i.e. exports and imports have been severely affected for both developed and developing nations. Developing countries had a great time in 2008 with their share in global trade rising to 43% but overall the global economy faced a downturn in global trade at around 6% in the last quarter of 2008 on a quarter to quarter basis.
The impact on FDI has also been significant with global FDI flow declined by 14 % from US $2.0 trillion in 2007 to US $ 1.7 trillion in 2008. The first quarter of 2009 posted even more dismal figures with global FDI down by 44 % when compared to the first quarter of 2008.
The impact on business cycles has been mixed with both good and bad into it. While this crisis has actually proved the concept of decoupling of the business cycles between developing and developed nations, but at the same time it would also help bringing down the imbalances in the global trade by making Americans save more than earlier.
The best thing so far has been the way different governments have responded to the crisis with their foreign trade policy. There have been very limited instances of Protectionism, which proves that the world is really getting integrated and nations are realizing that for long term benefits they have to interdependent on each other. Thus a better integrated world should economy should prevail.
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