Literature Review

2.1 Introduction

Definition of Financial Crisis

2.3 Origin of Financial Crisis

• How the 2008 Financial Crisis Spread in Developing Countries
• The Impact of the 2008 Financial Crisis on small Island State like Mauritius
• Effects on the Tourism sector worldwide
• Effects on the Tourism sector in Mauritian economy

Introduction

The events of 2008 have already passed into history, but they still have the power to take our breath away. Over a matter of months, a succession of earthquakes struck the world’s financial system – the sort of events that might normally happen only once in a century.

In reality, the warning signs were already there in 2007, when severe pressure began building in the subprime securities market.

Then, in March 2008, the investment bank and brokerage Bear Stearns collapsed. More was to come. Early in September, the US government announced it was taking control of Fannie Mae and Freddie Mac, two huge entities that underpin mortgage lending in the United States. Then, in the middle of that month, came news of the collapse of investment bank Lehman Brothers. A fixture on Wall Street, Lehman had been a home to the sort of traders and dealers that novelist Tom Wolfe once dubbed “masters of the universe”. Around the same time, another of Wall Street’s legends, Merrill Lynch, avoided Lehman’s fate only by selling itself to the Bank of America.

It wasn’t just investment banks that found themselves in trouble. The biggest insurer in the US, American Insurance Group (AIG), teetered on the brink of failure due to bad bets it had made on insuring complex financial securities. It survived only after billions of dollars of bailouts from Washington.

Definition of Financial Crisis

A collapse of the US subprime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. The Global Financial Crisis which started to show its effects in the middle of 2007 and into 2008 in the US, was the sequel of excessive credit lines given to companies and individuals to boost the housing bubble, according to Yilmaz (2008). Following high market volatility with prices of stocks going more and more speculative, banks, mortgage companies and insurances were unable to pay back their debts. The problem was so large that banks even with large capital reserves ran out. This chain effect of insolvency, lead to the collapse of even the wealthiest economies which had to come up with rescue packages to bail out their financial systems (Moshirian,2009).

For Chan Lau (2008), the financial quake made the ailing US economy tremble and run the risk of a major bankruptcy. European economies which were well aligned with their American counterparts in the form of overseas subsidiaries and affiliates, were eventually threatened by the crisis and it was foreseen that emerging economies in the developing world would also suffer.

It is difficult to quantify the effect the financial crisis in the summer of 2007 had on the recession that started in December 2007 and is working its way through 2009. This is especially true given that a large number of households lost a majority of their wealth when housing prices started their steep downward trend in 2006. In other words, the recession may well have occurred even if the financial crisis had not taken root. But most would agree that the near collapse of the financial system in the fall of 2008 has had severe consequences for the economy.

The losses that highly leveraged financial institutions faced led to a significant credit crunch that exacerbated the asset price deflation and led to lower real spending on capital goods—consumer durables and investment goods—that has triggered the overall economic contraction. It is, however, a vicious circle. Deleveraging and credit crunches have both financial and real consequences: They trigger financial losses and they can trigger an economic recession that worsens financial losses for debtors and creditors, and so on.

Origin of Financial Crisis

The main cause was an easy access to cheap borrowing. This resulted from low interest rates in key economies like Japan and the United States and what amounted to huge support for US finances from China. This idea of a supply of easy money might seem rather abstract, but it had a real impact on everyday life. For example, low inflation helped by the huge supply of goods coming out of Asia, low US interest rates and Asian investment in US Treasury securities made mortgages cheap, encouraging buyers to get into the market, fuelling a bubble in house prices. Other assets, like shares, also rose to levels that were going to be hard to sustain over the long term.

In the financial world, however, the channels only contributed to the problems. These channels were poor regulation, which created incentives for money-making activities that were dangerous and not always well understood. The result was that banks and other financial institutions suffered huge losses on financial gambles that wiped out their capital.

Lehman was perhaps the most notable collapse, but in reality the problems had been brewing for years. A year earlier, in autumn 2007, for instance, Northern Rock became the first British bank in a century and a half to experience a “run” – where fearful depositors race to retrieve their money. The “Rock” had grown quickly to become one of the country’s top mortgage lenders, relying on short-term borrowings, and not its customers’ deposits, to finance its lending. Around the same time, a number of banks in Germany also received emergency state support. But perhaps it took the collapse of Lehman to really thrust the full scale of the looming crisis into the public’s consciousness. Subsequently, the crisis moved far beyond Wall Street and affected economies around the world.

2.4 How the Financial Crisis spread in Developing Countries

There are mainly three mechanisms that play a key role in spreading the consequences of the financial crisis to developing world. We have remittances, capital flows and trade.

One of the key channels for transmission of the crisis from developed to developing countries has been via private capital flows though the impact of this has been more severe for emerging markets than for low-income countries, there has been a massive reversal of currency positions out of high-yielding assets in emerging economies into developed countries currency with a negative impact on the exchange rates o developing countries, even in the countries with significant current account surpluses.

The main channel of transmission of the crisis to exporters of manufactures and services is through a decline in trade volumes; while exporters of primary goods have been more affected by declining prices. Falling energy prices will benefit energy importing countries but they will also lead to reduced investment and economic activity in commodity-dependent developing countries, particularly in Africa, the Middle East and North Africa, and Latin America. For these countries, a major opportunity ahead is to redesign their trade strategy to reduce their commodity dependence.

If some of the BRICs can be said to have had a “good” recession, the situation is less clear for developing economies. Even though banks in many of these countries had little or no exposure to the toxic debt of banks in the OECD area, their economies were still hit by the slowdown, although the extent to which this happened varied greatly.

For example, the developing countries of Europe and Central Asia were particularly hard hit, in part because of problems that existed even before the crisis. According to the World Bank, the region’s GDP fell by more than 6% in 2009, and looks set for only a very feeble recovery.

Much of Africa managed to avoid falling into actual recession: according to the African Development Bank only six countries saw a contraction in GDP in 2009. However, many more saw growth rates slow, putting at risk some of the progress African countries have made in recent years, especially in sub-Saharan Africa. According to AfDB economists, GDP overall in Africa probably grew by only 2% in 2009, a sharp decline on the annual pace of 6% seen in the seven or eight years before the crisis. The AfDB also forecast that during 2009, the continent would see its first decline in real GDP per capita in almost a decade.

The crisis made its way to developing countries through a number of routes. For example, as the crisis began to bite in late 2008, prices fell sharply for such commodities as food, metals and minerals (although there was a recovery in 2009). Emerging and developing countries were also hit by the wider slowdown in global trade, especially a slowdown in imports to OECD countries as consumers in the zone tightened their belts and businesses reduced output. As financial markets froze up, importers and exporters also found it increasingly hard to access various forms of trade credit, which, in simple terms, is credit to bridge the gap between when goods are delivered and when they’re paid for.

Developing economies also saw a substantial drop in financial flows from abroad. The World Bank estimates that FDI – foreign direct investment – in 2009 stood at $385 billion, just 30% of levels in the previous year. Foreign aid has also been hit as governments in developed countries come under pressure to sort out their own countries’ problems. Although it’s forecast to reach record levels in 2010 in dollar terms, official development assistance will be well down from what developing countries were expecting.

And developing countries were hit by a drop in remittances, the money sent back home by emigrants. This can play an important role in easing poverty in some of the world’s poorest countries, allowing families to eat better, build homes and even start small businesses. During previous recessions, remittances have sometimes remained surprisingly resilient; however, the scale of this slowdown and the fact that it has affected so many of the world’s economies means they have come under pressure. According to the World Bank, recorded remittances to developing countries were worth $388 billion in 2008, a new record that continued the strong growth seen in recent years. In 2009, however, they are estimated to have fallen by 6.1% and look unlikely to return to 2008 levels even by 2011.

2.5 The Impact of the 2008 Financial Crisis on Mauritius

In Mauritius, the GDP growth rate for 2009 is estimated by the Central Statistics Office at 4 per cent, lower than the 5.2 per cent growth registered in 2008. There are already indications that the global financial crisis and economic downturn are impacting negatively on the textile and tourism sectors. The risks for a further deterioration in the trade balance and current account balance have increased, with potential downward pressures on the exchange rate of the rupee and the level of foreign exchange reserves.

In the conduct of monetary policy in 2008, the Bank was confronted with the combined challenge of combating inflation and preserving the competitiveness of the export-oriented sectors. Conducting monetary policy against the backdrop of the global financial crisis and economic slowdown is indeed a challenging task for central banks, particularly in small open economies like Mauritius. Inflation is still a source of concern in Mauritius. Headline inflation rate stood at 9.7 per cent at the end of December 2008, compared to 8.8 per cent at the end of 2007. However, on a year-onyear basis, CPI inflation has declined to 6.7 per cent in December 2008 from 8.7 per cent in December 2007. Recent declines in food and energy prices, if sustained, and sluggish real economic activity abroad, hold out some prospects of a reduction in the inflation rate.

The global financial and economic crisis has also brought about a high level of coordination between the Bank and the Ministry of Finance and Economic Empowerment, recognizing the fact that the monetary tool kit alone is inadequate for dealing with the emerging problems. The Bank has provided inputs in the Additional

Stimulus Package of Rs10.4 billion, equivalent to 3.8 per cent of GDP, unveiled in mid-December 2008 by the Government to shore up the economic performance of the economy. Normal conditions continue to prevail in the domestic money market. There is no credit crunch in Mauritius. No sector is being starved of credit.

The global financial crisis has brought financial stability issues to the forefront of policy considerations. The crisis highlights the need for strengthening financial sector regulation to ensure stability. All the banks operating in Mauritius have, so far, shown considerable resilience in terms of capital adequacy, balance sheet growth, profitability and loan delinquencies. The system has not witnessed any serious liquidity crunch either. Banks in Mauritius had an estimated average capital adequacy ratio of 15.8 per cent at the end of December 2008 against the regulatory minimum of 10 per cent. There are no indications that the Mauritian banking sector has any direct exposure to the toxic debt that has affected global financial markets, and banking soundness indicators are healthy. The banks in Mauritius do not have significant exposure to equities either by way of their investments or loans against the collateral of shares. As macroeconomic risks increase, financial strains, associated with an increase in credit risks and reduced risk appetite of banks, are likely t