Credit Derivatives : financial impact on the UK and America

Cycles of economic boom and bust are regular features of market economies. The global recession that set in during 2008 is the most recent episode of this phenomenon and is likely to be repeated in the future as well. Although the scale and magnitude of these crises have somewhat reduced in the period after the Second World War, they have been big enough to be termed critical policy failures of governments across the world. And in the neo-liberal economic order of the world today, national economies are ever more intertwined, making it impossible for any one nation to insulate itself and its people from the effects of the crisis. This is most obvious when we take a look at the data pertaining to the recent global economic recession, precipitated by the collapse of credit derivatives. (Weale, 2008)

Since many of the leading economies in the world are in North America and Europe, these regions are the worst hit. East Asian economic giant Japan seems not to have been impacted. Emerging economic superpowers in the form of China and India have shown stable credit markets too. (Barrell & Hurst, 2008) As the U.S. financial markets are most closely linked to that of Europe in general and the UK in particular, the effect of the credit crisis is most acute on the latter. If the total losses induced by the current economic recession crosses $1000, then this will constitute a 7.4 percent contraction in US GDP. But other countries such as the UK will also be affected by this contraction since their banking institutions have invested in US mortgages. This means that other countries such as the UK are adversely affected as well. In the UK, although the losses have not measured accurately so far, it is a fair estimate that losses of 2-3 per cent of GDP have been incurred.

But even before the credit derivatives crisis took hold, the IMF gave out warnings through its World Economic Outlook reports. The report also made obvious that any crisis in the U.S. financial markets would have a cascade effect on the UK and beyond. For example, in the report released in 2008, months before the outbreak of the credit crisis, it stated that

It is possible that falling house prices could induce US consumers to default on prime loans issued to good creditors with significant housing equity. It is also possible that default rates on credit cards and car loans could rise, but perhaps this is less likely as the short-term costs are perhaps higher. In addition it is possible that borrowers with negative equity in the UK and elsewhere might choose to default on their loans when house prices are falling and, if they did, banking sector losses could mount.” (Barrell & Liadze, 2009)

Just as the recession was taking hold in the US, analysts predicted that there would be spill over effects on the rest of the world, including the UK. And so far, those predictions have proven to be true. The crisis triggered by the failure of credit derivatives in the US would affect other countries depending on which areas the losses affected and their impact on the banking system. At a time when the effects of global recession was on an ascendency, scholars Ray Barrell and Ian Hurst, noted that “if we spread the losses evenly then growth in the UK would also slow, this year and next, and we might see growth as low as 1.4 per cent this year and marginally lower than 1 per cent next year. On the same basis Euro Area growth might slow to around 1.2 per cent in each year. These falls could be compounded if there were domestic problems in these countries as well as in the US”. (Barrell & Hurst, 2008) And economic data for 2009 and 2010 has vindicated their predictions, further underlying the fact that the UK economy is highly dependent on the fortunes and fluctuations of the American economy.

During the first phase of the recession, it is natural to see an increase in bank borrowing, as business corporations seek to utilize additional credit to manage the crisis. But, during this period lending to UK businesses has been declining, which indicates lending by UK and foreign banks to non-bank businesses. Financial analysts reason that the decline has been induced by a “reduction of lending by foreign banks. However, sterling lending by UK banks continued to rise. Thus the first phase of the crisis associated with the failures of Northern Rock and Bradford and Bingley had no real effect on lending to businesses”. (Weale, 2009)

The real interdependencies between the US and the UK financial markets came to light only when large financial institutions such as Lehman Brothers went bankrupt. Since Lehman Brothers filed for bankruptcy in September of 2008, banks in the UK have grown cautious too. This is reflected in the monthly data available on lending by monetary sector (M4) institutions in the UK till December of 2008. The data indicates that during last quarter of 2008 outstanding loans to UK business corporations by UK banks declined. It further shows “falling secured mortgage lending and unsecured consumer credit lending to individuals falling more sharply, while lending to small businesses has stagnated. Thus, in the second phase of the crisis, the problems began to affect UK banks’ willingness to lend to British businesses” (Barrell & Liadze, 2009). This result more than anything else, points to the dependency of the UK financial market on that in the US. And by extension, the success or failure of complex financial products such as credit derivatives can have world-wide implications.

Now that the strong relation between financial markets across the Atlantic is established, it is obvious that the recovery should also happen in unison. For example, in order to improve the effectiveness of fiscal policy stimuli devised by the US and UK governments, it is essential that their implementation is well coordinated. Further,

the fiscal policy impact will be strengthened by spill over effects as rising GDPs will, via international trade linkages, stimulate exports of each country’s trade partners. The effects of coordinated fiscal policy actions undertaken by all economies at the same time would normally be greater than those materializing in case of policies conducted in isolation.” (Hawser, 2009)

References

Barrell, R., Fic, T., & Liadze, I. (2009). Fiscal Policy Effectiveness in the Banking Crisis. National Institute Economic Review, (207), 43+.

Barrell, R., & Hurst, I. (2008). Financial Crises and the Prospects for Recession. National Institute Economic Review, (204), 33+.

Decomposing the Global Recession. (2008). National Institute Economic Review, (206), 74+.

Hawser, A. (2009, May). Countries Count Cost of Credit Crisis. Global Finance, 23, 8.

Recession in the Euro Area. (2009). National Institute Economic Review, (209), 22+.

Weale, M. (2008). Commentary: The Banking Crisis and the Economy. National Institute Economic Review, (204), 4+.

Weale, M. (2009). Data on the Credit Crunch. National Institute Economic Review, (207), 71+.