Should We Expect A Decrease in Unemployment and Poverty?

August 24, 2011

I wrote this article for Positive Money. It was first published on the Positive Money Website on August 24, 2011You can also read it on I am publishing this on my blog so that people who access to my blog read this as well.

Poverty is one of the most prominent problems of the entire world. Numerous measures have been taken world wide to reduce poverty but it is still a burning issue. It is particularly much discussed in the post financial crisis period because an economic slowdown affects businesses, who cut back on production and costs, which in turn leads to an increase in unemployment. Unemployment is the main cause of poverty with other factors such as higher indirect taxes, high inflation that take higher percentage of low income group leading to low disposable income.

The unemployment rate of UK over the last seventeen (17) years was highest in early 1990s.  The unemployment rate in early 1990s was around 12 percent in Inner London, 10 percent in London, 9 percent in Outer London and 7 percent in the rest of England.

Unemployment rate started to decrease due to expansion of financial sector as banks had excess liquidity and these banks lent to health sector, construction, education, real estate, public administration and defense (but predominantly real estate and property). These sectors contribute more than 58 percent of GDP. Over the last decade these sectors also expanded due to excessive credit extension (i.e. too much lending) leading to decrease in unemployment.

During the financial crisis when the entire economy collapsed the unemployment rate rose significantly in the entire UK. The following graph shows the unemployment rate during the financial crisis.

Unemployment, Inner, Outer, London and rest of England

Labour Force Survey stated that in 2007 due to economic breakdown the unemployment rate in Inner London was 6 percent, and 5 percent in Outer London. In 2009 unemployment rate for Inner London and Outer London both were around 7 percent. It is important point to note  that the unemployment rate gap was wider between London and the rest of England from early 1990s till 2007 but it was nearly equal in 2009 which means that due to financial crisis increase in unemployment was witnessed in entire UK.

The number of part time workers also grew by 8 percent from 760,000 in 2007 to 825,000 in 2009. The increase in part time workers was due to the fact that they were not able to find full time jobs.

The increase in unemployment also leads to increase in Job Seekers’ Allowance, which is a drag on public finance (although a very small proportion of government revenue goes towards job seekers’ allowance). The following figure shows the increase in job seekers allowance payment. The highest increase was in the West Midlands and North East.

The high inflation rate is also pushing low income households in poverty by decreasing their purchasing power. Inflation rate in the UK is 4.4 percent against a target inflation rate of 2 percent.

The UK economy recorded a growth of only 0.2 percent in the second quarter and with lending cut by banks means that there will be negligible growth of the economy as eight largest sectors, which contribute around 58 percent of economic output, are dependent on private borrowing. This means that we should expect further increases in unemployment and higher levels of poverty going forwards.


The Future of Basel III

August 22, 2011

The financial crisis called for reforms and revision of regulations and supervision on international and national basis. The regulatory standards in the economies were strengthened through the adoption of Basel II Capital Standards and the Basel Core Principles for Effective Bank Supervision (BCPs). Despite this the crisis emerged in the economies where the regulations and supervision were thought to be the best in the world. This crisis exposed the weaknesses in regulatory and supervisory frameworks and provided the basis of debate about the roles these have played in causing and aggravating the crisis. So this is the top priority for decision and policy makers and many countries are working to upgrade their regulatory and supervisory frameworks, although inevitably this has to be a multilateral arrangement if it is to succeed.

The latest Basel III proposals from the Basel Committee have been put forward to strengthen the banking system and to reduce risk of future financial crises. These proposals require the banking sector to raise far more capital in response to the global financial crisis. Under the new proposals the banks will have to maintain core capital ratio of 6 percent (formerly 2 percent before). Now the question arises would the increase in capital ratio would prevent financial crisis in future? Is the current crisis due to decrease in core capital ratio? 

The key areas covered by the Basel III proposals are Tier I Capital Base, Minimum Liquidity Standards, Leverage Ratios, Counterparty Credit Risk – Derivatives, Repos and Securities and Countercyclical Capital Buffers. The Committee intends to raise therefore both the quantity and the quality of the capital base to enable banks to absorb losses in crisis period. It also introduces a minimum liquidity standard for banks to meet their liquidity requirements for 30 days under any ‘acute’ liquidity situation. Under these proposals leverage ratio introduces additional safeguard against risk and measurement error. The committee also proposed to strengthen capital requirements for counter party credit risk exposures arising from derivatives, repos and securities financing activities. It also proposed building up capital buffers in good times that can be drawn down in periods of stress.

Capital standards designed to fortify the global financial crisis are eroding due to the debt crisis in the Euro zone, and the US. The U.S.economic growth for the first quarter was revised down to 0.4 percent, while the second quarter’s initial figure was 1.3 percent. In Europe, gross domestic product fell from 0.8 percent in the first three months of the year to 0.2 percent in the second quarter. . Concerns about   payments, and debt problems of Italy and Spain also darkened the prospects of Basel III. European Commission estimated that European Banks will have to raise about $500 billion in new capital to meet new capital rules that will hamper their ability to lend. The cost will be borne mostly by the relatively undercapitalized banks in Germany, France, Spain and Greece.

The European banks cannot raise required capital as required by Basel III and the US banks have also reversed course. Another question is regarding the quality of capital that would the quality of capital be able to meet the basic objectives of the implementation of Basel III to reduce the risk of future crisis. EU’s implementation proposals allowed the inclusion of securities (such as hybrid securities), if they meet specific criteria, in the calculation of capital ratios.

Bloomberg reported that At Landesbank Hessen-Thueringen, a state-owned lender based in Frankfurt known as Helaba, silent participations account for more than 50 percent of the bank’s 6 billion euros ($8.6 billion) of capital. Helaba withdrew from the Europe-wide stress tests in July after regulators refused to count some of those hybrid instruments as capital.  

Another issue is the double counting of capital in the insurance subsidiaries in European economies. The proposed rules do not require banks to deduct investments in these subsidiaries from capital. The EU proposals are also lenient on the liquidity standards tha require banks to hold enough cash or easily sellable assets to meet short- and long- term liability. It  modifies the rule covering debt payments coming in next twelve (12) months for thirty (30) days to allow counting covered bonds as liquid assets. Denmark, Sweden and Spain supported this as their banks have large holdings of the bonds that are backed by the cash flows from pool of mortgage loans.

With the current international economic condition it is highly difficult for banks to raise the required capital as per required by Basel III. Also the flaws in the Basel III need to be looked into and revised before proper implementation of Basel III. Central banks should also tightly monitor and supervise the banks’ credit activities to reduce the risk of future crisis.

Turmoil to Continue in Global Financial Markets

August 20, 2011

Investors’ Losing Confidence on Future Growth

This week was very important for the investors and private companies as they waited to see the forecast of world economic growth to make investment decisions. Last week witnessed turmoil in the international financial markets. This started at the end of July when the US economy recorded flat line growth in the first quarter and 1.3 percent growth in the second quarter. On the other hand Euro zone and the UK just recorded a GDP growth rate of 0.2 percent.

Things are not gloomy for third quarter as well, with the contraction of the US economy, financial distress on the UK households’ and the sovereign debt crisis in the Euro zone leading to uncertainty in the global financial markets.

Private companies are facing output and profits cuts due to decrease in the households’ consumption. With the ‘air of fear for future growth’, the companies are cutting their investment plans and households’ are deferring their spending decisions.

In the Euro zone, European banks are cutting their lending due to high cost of funding that will drag down the economic growth. European banks are finding it difficult to obtain overnight funding as the banks prefer to deposit their liquidity with the Central Banks rather than lending it to other banks due to counter party risk. Financial Times reported that the foreign bank branches in the US  increased their cash assets from $758 billion for the week ending August 3 to $813 billion.

Banks are finding difficulty in obtaining finance from the wholesale market and commercial paper issuance by the financial group decreased by 16 percent from mid June. If the contraction in the credit in the financial market continues and banks’ cut their lending further, we will not be witnessing increase in growth rate in the US, the UK and the Euro zone despite the European temporary bank funding guarantee scheme and ECB’s overnight “deposit facility”.

The Consequences of UK Household Debt

August 20, 2011

I wrote this article for Positive Money. It was first published on the Positive Money Website on August 20, 2011 (at 7.00 a.m.). You can also read it on I am publishing this on my blog so that people who access to my blog read this as well.

The financial sector is an effective tool that can contribute to the economic development of the country. It can help in the expansion of business, assist in the expansion of the productive sector of the economy that contribute more to GDP growth and reduce poverty in the economy. Banks are important part of the financial sector that can have a significant influence on the economic growth. Over the last two decades banking sector grew phenomenally and accounted for an increased share of GDP, of corporate profits, and of stock market capitalization.

In theory, banks are the channel through which savings are channeled into the productive activities that are crucial for growth and general welfare. Households and firms provide their savings to the banks and banks act as intermediaries to supply funds from lenders to the ultimate borrowers which are mainly firms, governments and households. If the banks are making productive investments it will lead to sustainable growth of the economy. But since last decade banks have been making speculative and non-productive investments that led us to the financial crisis.

Average private borrowing by banks from 2003 till 2010 increased at 11.2 percent of GDP but it decreased to £16 billion in 2008-09 from £114 billion in 2007-08 due to the financial crisis. This had a significant impact on the economic growth since the eight largest economic sectors of the UK are dependent upon borrowing.

Household debt was one of the major concerns during the financial crisis. During the last decade banks lending to households in the form of secured (mortgage) and unsecured (credit cards, overdrafts etc) increased more than 50 percent. The households’ debt stood at over £1.4 trillion at the end of 2010. Out of total debt of £1.4 trillion in 2010, £1.24 trillion (85 percent) accounted for secured debt (mortgages) and £216 billion (15 percent) accounted for unsecured debt.

The average house price grew from £40,000 in 1987 to over £170,000 in 2006. The increase in housing prices increased the consumption of households’ as they borrowed against the increase in home equity due to the easy availability of credit. During 2007 the consumption fell sharply due to credit crunch. Total household resources and household final consumption expenditure was negative in Q3 of 2008 and Q1 of 2009.

This decrease in household consumption affected the GDP growth of UK as private consumption is an important contributing factor in the GDP growth of the economy. In the UK 60 percent of consumption is by the household sector. The household sector alone has a direct impact on the economic growth of UK. As long as households were able to obtain debt finance their consumption could grow but as soon as banks stopped lending, their consumption decreased and so did economic growth.

High household debt accumulation decreased the purchasing power of the households. Bank of England estimates that 13 percent of households spend more than 35 percent of their income on debt repayments and 18 percent of households with unsecured debt spend more than one-fifth of their income servicing unsecured debt payments.  One fifth of the households with mortgages spend 20 percent of their gross income on mortgage repayments, 13 percent are spend more than 35 percent on debt repayment cost and 6 percent of households have debt repayment ratio greater than 50 percent.

Monthly average budget (income receipts minus expenditures) position of the low income group households declined from £51 in 2005 to -£450 in 2010.Many households are breakeven and even a slight increase in their expenditure will tip them into indebtedness unless they have any other source of saving. This means that households will have to borrow more in order to maintain their consumption levels which will further decrease their purchasing power as they will allocate large proportion of their disposable income for repayment of debt, leading to further decrease in their monthly budget position.

Saving ratio (proportion of disposable income not contributed for final consumption) also declined during the last decade due to increase in final consumption. The saving ratio declined to -0.7 percent in 2008. It increased to 8.4 percent in 2009 due to households response to uncertain economic conditions and holding of liquid assets. The large difference between property income receipts and property income payments also contributed to increase in saving ratio as many homeowners exploited the financing  by banks by obtaining ‘buy to let’ mortgages.

Office for Budget Responsibility (OBR) projected that debt will rise to 175 percent of household income by 2015 compared with 160 percent in 2010. OBR estimated that households debt will rise over £1,700 billion by 2012 and £2,100 billion by 2015.  This will have a drag on households personal finances and their ability to save for future that will lead to financial vulnerability.

Currently 29 percent of households with no savings have debt to income ratio of more than 60 percent. If this level of debt is made available in the economy by the banks, this means further increase in credit in the economy, asset prices boom and another financial crisis.

If UK banks continue to lend to make speculative and non- productive investments, particularly mortgages, we will be facing another crisis in near future because UK economy needs more debt to sustain growth and prevent a depression. More debt means more interest and more interest payments means less purchasing power. This means that we need more debt to service and this cycle continues until we enter into another recession when this cycle breaks down.

Bank Capital Requirements

August 19, 2011

Bank capital requirements will play an important part in the global economic recovery since banks do not have sufficient liquidity to lend to the private sector that is hampering the economic growth. The total credit to GDP ratio is an important indicator over or under supply of the lending in the economy. This ratio has decreased markedly after 2007.

The figure shows that credit to GDP ratio as per Bank of England calculation has decreased in  2010.  The credit growth in the economy has been low in 2010 particularly to small and medium business that do not have access to capital markets unlike their large counterparts.

 The capital requirements of banks might hamper the economic growth more as the current international and domestic conditions suggest that contraction in the lending will continue in near future. Considering the current economic conditions, should the regulators relax the capital requirements in the short term enabling the economic to recover?

Poland’s Exceptional Case During Financial Crisis

August 19, 2011

Eastern European economies were significantly affected during the financial crisis due to their integration with rest of the world in term of Foreign Direct Investment (FDIs) and Exports. With the exception of Poland all the Eastern Europe(EE) economies recorded negative growth with some of the economies recorded double digit negative growth as well.Poland recorded 1.2 percent of growth in the year 2009.

Polish Financial Supervision Authority played an important role during the crisis period and guided the Polish banks’ in managing risk particularly risks related to investment in derivative contracts and foreign currency related transaction.

Poland did not experience the problem of toxic asset in the year 2008-09 due to Polish banks’ conservative credit policy and good quality of mortgage portfolio. Ludwik Kotecki, the Polish Vice-Minister of Finance reported that bad assets accounted for only 0.2 percent of the total financial sector assets in Poland.

However, it is important to note that the companies involved in foreign exports and transaction in foreign currency options did record losses due to international financial meltdown. Polish Financial Supervision Authority estimated that negative valuation of currency option recorded by businesses exceeded US$ 3.5 billion (PLN 9 billion).

Decrease in international demand also did not markedly impact the Polish economy as Polish exports were 34 percent of GDP in 2009 (compared with exports of rest of the EE economies which was more than 100 percent of GDP).  Central Statistical Office,Warsaw, reported a decline in exports from US$ 171,859.9 million in 2008 to US$ 136,641.3 million in 2009. Interestingly, the share of high-processed electric and machinery goods increased by 2 percent in 2009 to 44.8 percent.

The affect of decrease in exports ofPolandwas offset by performance of Small and Medium Enterprises (SMEs) sector that contributed 46.9 percent in the GDP growth in 2008. Polish Agency for Enterprise Development reported that in 2009 around 4 million businesses were registered, 94 percent of them were micro businesses (employing upto 8 persons), 4.4 percent are small enterprises and 0.8 percent are medium sized while large organisations (employing more than 249 person) accounted for only 0.17 percent. It also revealed that seven out of ten workers were employed in small businesses.

Positive growth of Polish economy during the financial crisis proves that if banks do not make speculative investments, do not investment in risky mortgages and invest in productive sector of the economy, the risk of future crisis could be avoided because investment in productive sectors leads to job creation, increase in purchasing power of households, increase in saving ratio and increase domestic demand and prevent the country from global financial vulnerabilities.

Islamic Finance and Financial Crisis – Analysis

August 19, 2011

Much has been written about the current financial crisis. The current crisis not only impacted the US and the UK but it affected the global economy. The crisis was due to excess leverage of financial institutions, revaluation of assets, financial innovation, investments in speculative and uncertain investment. This revealed the need for financial system that prevents all these factors that led to financial crisis. This is where an Islamic Financial System can play an important part.

Islamic Finance Industry during the last decade grew at 15 – 20 percent per annum. The growth in Sharia Compliant assets amounted to 29.7 percent during the last decade. In 2008, Dow Jones Islamic Financial Index showed a decline of 7 percent as compare to 38.5 percent and 33.8 percent in S&P 500 index and Dow Jones Industrial Index respectively.

The basic principles of Islamic Economics System are Justice, Equity, and Welfare. Islamic economic system aims to develop an economic system with full employment and sustainable rate of economic growth. It is based on set of values such as honesty, credibility, transparency and co-operation. These values ensure stability and security for all those parties who are involved in the financial system. It prohibits such financial transactions that involve interest, lying, gambling, cheating, gharar (risk and uncertainty), monopoly, exploitation, greed, and unfairness.

One of the important aspects of Islamic Finance transactions is that banks act as venture capital firm and share in profit / loss in their investment so the banks are prudent in making their investments and do not make investment just to make profit. Also money is fully asset backed (tied to an identified tangible asset) and is traded at par. Islamic Economic System does not allow credit expansion (creation of money through fractional reserve banking) and wealth expansion at the expense of society.

Sharia Laws also impose ban on uncertainty investments unless all the terms and conditions of risk are clearly understood. Islamic banks appeared to be more resilient in the international financial crisis than conventional banks because they avoided speculative investment such as derivatives which is one of the causes of financial crisis. During the financial crisis Islamic banks were less exposed to sub prime mortgage fiasco, as they require greater initial deposits thus automatically restricting the exposure to sub prime borrowers.  

Islamic banks cannot sell something that they do not own and cannot sell products and services that they are not in a position to deliver. Due to this reason they did not invest in derivatives and conventional future contracts. The price and nature of goods are also determined at the time of transaction that restrains gambling.

The performance of the Islamic Banks’ during the financial crisis justifies that the factors that caused and fuelled the crisis could be avoided if Islamic Sharia Compliant principles are adopted. The adoption of Islamic Finance principles could prevent excess credit creation, speculative and uncertain investment (such as derivatives and future contracts), sub prime mortgage financing and will channeled the money in the productive sector of the economy. This will lead to stable long-term growth of the economy benefiting the entire society.