Tuesday, 7 July 2009
Ladies and Gentlemen,
This conference is devoted to the discussion of a topic, which already has become a hot topic. Before assessing the impact of the global financial economic crisis on a country’s economy, first of all one should understand precisely the pre crisis developments taking place in the economy in a global context. This will help us to understand correctly the lessons learned and to construct a new behavior.
The features of the time before the financial crisis
It is not a secret, that pre financial crisis period was featured by monetary expansion, which was accompanied by formation of low interest rate. This policy caused an increase of demand on real estate, which gradually turned into bubbles. The real estate prices through income and wealth effect stimulated the increase of consumption, resulting huge current account deficit of the balance of payments, which in its turn caused big inflow of US dollar into other developed and developing countries. From the other hand, to mitigate the speed of appreciation of the local currency vis-à-vis US dollar, those countries started to intervene heavily in the foreign exchange markets, which resulted to the replenishment of net foreign assets and supporting the financing of the US budget and current account huge deficits.
The above mentioned macro environment in US caused the US dollar to depreciate in the world and forced the rest of developed countries to lower the interest rates in order to soften the appreciation of their currency vis-à-vis US dollar. Those activities resulted in similar situations in the real estate markets in these countries: increase of demand and formation of «bubbles» in the real estate prices.
As a result, the huge public deficit in the USA, the high level of real estate prices and almost the similar situations in other developed countries resulted in high speeds of income and consumption increase of the developed world globally.
As a result the prices of raw materials increased, which significantly contributed to the increase of the export of developing countries, who has such exportable goods. From the other hand, the low level of interest rate in international markets stimulated the increase of direct investments from developed countries to developing countries. The favorable environment of economic activity and high rates of income growth encouraged also the increase of speed of credit expansion in developing countries. As a result, the developing countries in pre-crisis period had unprecedent high growth rates. The consequence of all of this was reflected in the real estate market, when the continuously growing demand resulted in a high prices on real estate and created «bubbles».
An important factor in this regard was the robust growth of financial innovations as a result of which world financial flows and credit volumes accelarated. Moreover, even since 2004, when in many countries the inflationary pressures began to take place and to address this issue countries started to conduct contractionary policy, e.g. increasing Central Bank interest rates and gradually reducing public deficit, the undertaken actions did not have significant effect on evolving overheating environment. In addition, in the state of overheating, the financial system institutions underestimated the future risks and even in condition of increasing interest rates continued to carry out credit expansion through various financial tools.
The macroeconomic environment created in developing countries was almost similarly repeated in the Republic of Armenia. The export growth rate in 2004-2007, in the condition of continuing appreciation of the national currency, was 15 %, the share of net direct investments in GDP increased from 4,6 in 2003 to 8,0 in 2008, the average annual growth rate of private investments was 28 % in 2004-2007, the average annual growth rates of the credit to economy and money supply were 46,3% and 45,0% respectively. Moreover, the link between diaspora and domestic economy had an additional and essential impact on the formation of macroeconomic environment in Armenia in face of private transfers sent to Armenia. The results of analysis on the state and influence of private transfers on our economy, conducted by the Central Bank of RA evidenced that along with altruistic motives for sending private transfers to the Republic of Armenia, there was also the investment motives, and the latter, according to the theory and empirical evidences, has a pro-cyclical nature. This means, that the high economic growth stimulated the acceleration of private transfer growth rates and vice versa. As a result, a 40 % growth of private transfers’ inflow has been registered since 2004.
Like in the rest of the world, in Armenia similarly, the above-mentioned macroeconomic developments led to overheating, which also entailed unprecedented growth of demand on the real estate market, and, consequently, the prices for real estate increased 26,6% on average in 2004-2007.
The huge foreign currency inflows and high rates of income growth created inflation/exchange rate dilemma. The Central Bank gave priority to the targeted inflation allowing nominal exchange rate to appreciate, which continued almost from 2004 to 2007. This means that the real exchange rate has appreciated due to the sharp appreciation of the nominal exchange rate. Moreover, since 2004 the speed of appreciation of the real exchange rate - 7,8 % on annual bases and around 40 % cumulativly –, is an evidence of quite a high speed of movement of the economy towards the overheating. It is important to emphasize here some important issues related to the structure of the economy, which aggravated overheating: first there was a well articulated price rigidities in the economy, second- there was a low level of production factors mobility in the economy and therefore clear wage rigidities, and third, the existence of market structure and non-competitive market. Those factors stimulated the overheating of the economy in the past, and currently they support the opposite process: the economic recession, which I am going to discuss later.
While analysing the pre-crisis developments in Armenia, it is important to examine the structure of the economy, i.e. what structure of economy we inherited after the crisis. In 2004-2007 the average economic growth of 13,0% was secured by the following sectors: capital construction, which contributed 4.6 percentage points of the GDP growth, and this branch was mainly conditioned by the increase of the demand in the result of financial inflow. Second – the mining industry, which was directly linked with the unprecedented growth of commodity prices in the international markets. and which had significantly contribution to the export . From another hand export ensured additional financial inflow to the economy. The third branch, which is partly conditioned to the developments of the first two, as well as to some extent is based on the financial inflow to the country is the service sector. This sector had contributed 4.5 percentage points of the GDP growth. It’s obvious that the economic growth of the country was driven mainly by non-tradable sector, which mostly depend on external factors. This was also evidenced through the Ballassa-Samuelson effect, assessed for the economy of Armenia, which indicated that only a small portion of real exchange rate appreciation was conditioned by the factor, increasing the “immunity” of the economy, i.e. productivity. This means, that the main portion of appreciation was the result of financial inflow and positive terms of trade shock.
The features of post-crisis period
The boom of the economic activity could not continue for a very long time. As in case of an ordinary business cycle, the deceleration of the rates of economic growth and even contraction of economy were expected. However, there were no precise predictions and perceptions on initial period of economic contraction, extent and speed of decline. The first signs were observed in mid-2007 on the real estate market of the United States, when the price “bubbles” blew up, the losses then spread on insurance companies, banks and on other participants of the financial market. The collapse of the US financial market and continued economic decline spread all over the world. As it was mentioned, the real estate price “bubbles” had evolved almost in all countries, hence the developments of the US economy were noticed both in developed, and developing countries. This means, sharp decline of real estate prices, drastic deterioration of the portfolios of the financial market participants, sharp decrease of the credit volumes and naturally – creation of expectations of economic downturn. All the mentioned, by spreading all around the world entailed the drastic decrease of demand for investments by firms and consumption rates by consumers. In the world commodity markets dramatic price decrease for the raw materials was observed, which caused those raw material exporting country’s exports to dampen significantly.
In sum, the macroeconomic phenomena evidenced during the years of economic growth started to be expressed on the opposite direction, moreover - in a very short period of time.
Small open economies, such as the Republic of Armenia, first of all drastic fall of export rates was observed – in 2008 – 6.1 %, and in the first five months of 2009 – 47.8% . From the income generation side a 35.3 % decrease was observed in the indicators of remittances, during the first five months of 2009. The expectation of decline by the firms and consumers, in the conditions of income decrease, resulted in high rates of decrease of private investments and consumption.
During the growth phase of economic activity, as it was already stated, the construction became the main driver for ensuring high rates of the economic growth. As it could be expected, construction sector must be the first to be affected by the financial crisis, which was actually observed. During the first five months the decline in construction went up to 56.1%: The sharp decline commodity prices on international markets directly influenced the volumes of production of those goods in Armenia, consequently the mining industry contracted by 10%.
The productions of the other branches of economy were followed by the deteriorations in these sectors.
The banking system was not left apart from these developments. On the other hand the fact that the banking system of Armenia is comparatively small (compared with developed countries) was a supporting factor for avoiding big losses in this system, and from the retrospective influence of the system on the real economy, on the other hand. However, the decline of real-estate prices, the phenomenon of the economic downturn significantly decreased the indicators of profitability of banks, but has not created serious problems for the system yet. From the other hand, the banking system made the lending conditions more rigid, taking into account the possibility of forthcoming risks. This kind of banks’ behavior, as it has been evidenced by numerous crisis episodes in the world economy, is rather rational from perspective of a single bank, but irrational from the perspective of the whole system, because the volume of lending remained almost the same and it become an additional factor suppressing the demand. And this will impact the banks retrospectively: by increasing the volume of non-performing loans.
Dollarization is another factor that must be discussed from the prospective of lending volumes decrease . From the very beginning of the financial crisis the economic agents had Armenian Dram depreciation expectations. In addition to the existing savings, the phenomenon of economic decline caused demand for money to decrease and formation of excess dram liquidity in the economy. The expectations of Armenian Dram depreciation resulted in exchange of huge amount of dram assets into foreign currency assets. Despite banking system confronted to this additional negative shock due to the heavy interventions by the Central Bank, however the widespread shrinkage of dram resources in the banking system became an additional factor for the reduction of dram lending. From the other hand, although the banks were suggesting credits in foreign currency, however the expectations for depreciation of Armenian Dram suppressed the demand for dram term credits significantly.
It is important to consider other issues as well mostly related to the real sector, which deepened the influence of the crisis on the economic activity and I have mentioned about them above. Those issues relate to the causes of real and nominal business cycles, which evolving at this stage deepened the phenomena of economic decline..
First of all let us refer to the issue of investments. As it is known from the theory, for the purpose of making necessary investments a timeframe is required (time to build – real business cycle theory), due to which productivity shocks create cyclical fluctuations of economic activity. Particularly, the decrease of commodity prices entailed decline of the marginal profitability of the mining industry, and in such conditions it was necessary to make additional investments to restore the productivity. However, in the real life, a time is needed for the realization of the investments, that is why entities of this sector in the initial period drastically decreased the volumes of production.
There is another issue concerning the investments. Again, starting the investments and finishing them requires some time. In this regard, , when the demand is growing continuously, the investments, which have been started but not finished yet during the growth phase of economic activity, were left unfinished when economic downturn lunched. The fast and drastic declines of external and internal demands, tightening lending conditions by the banks and negative expectations of the firms were the factors for the investments not to reach their end, which in its turn made those investments unproductive ones. It should be noticed that the above mentioned was more vividly evidenced in housing construction. The widespread housing construction which had begun years before and was not finished, stopped instantly because of the demand decline and low level of availability of investments resources.
Nominal rigidities of wages and prices are the next important reasons, from the point of view of aggravating economic downturn. The decline of the nominal wages in the labor market was necessary to compensate increased marginal expenses of firms and to minimize the unavoidable unemployment. However, the rigidity of wages in the labor market (the nominal wages on January-May of 2009 have increased by 13.4 % in comparison with the same period of the previous year) caused the undesirable reduction of employment and output (9.8 % and 15.7 % in the first five months of 2009).
From the other hand in order to restore real aggregate demand in some extent, the decrease in prices of goods was necessary, which would enable to increase the purchasing capacity in real terms. However in goods markets there are price adjustment rigidities as well, which are conditioned mainly by the existence of uncompetitive markets, in the result of which the prices did not decrease to an extent, which was needed for possibly smaller reduction of volumes of production.
The fact that during the growth phase a small number of branches become the drivers concerns a lot. As it was evidenced on the example of the Republic of Armenia, the amplitude of business cycle decline is more compared to those countries which have relatively diversified economies. In this regard, in the long term perspective it is necessary to lower the share of construction and related fields in GDP by increasing the shares of other sectors and branches of the economy. Particularly, the share of construction in GDP is 6-10% in the transitional countries of Eastern Europe, while it is 25% in Armenia.
Currently there are two concerns about the future, relative to the reduction of the impact of the financial-economic crisis on the economy of our country. We can divide them into short-term and long-term issues and solutions necessary for them. In Short term perspective it is important to soften the rate of economic decline. One of the above mentioned reasons was the sharp ceasing of the investments, which is partially connected with the time frame necessary for the realization of the investments and stopping the unfinished investments (mainly in the field of housing construction). To solve this issue, the necessary measures have been taken to support the two leading branches of the economy` capital construction and industry (particularly, mining). There is a mechanism of providing guarantees for supporting capital construction: for finishing up stopped capital construction. At the same time, financial assistance in the form of loans is being provided to the other important branch of the economy, such as mining industry.
To the long term measures we should relate the carrying out of aggressive economic reforms – directed towards diversification of the economy, formation of effective incentive structure for distribution of resources, strengthening the anti-monopoly policy, etc. There is also important to ensure effective mobility of the labor force in the labor market. The non-mobile labor market is the reason for not adjusting the wages enough to soften the fluctuation of business cycles.
It is also important to emphasize the role of the banking system in circle of development. The banking system of Armenia being a small one and being in a very strict area of regulation has not faced and has not caused serious problems. In this regard the expected serious reforms in the financial systems of the developed countries, which will presumably be directed at least to the prevention of economic crisis caused by the financial sector, will be taken into consideration by the Central Bank of Armenia as well. From the other hand the regulation and control of the banking system of Armenia based on the features of the Armenian banking system will continue to be deemed as important in long term perspective.
Bibliography
1. The Global Plan for Recovery and Reform. April 2009. The London Summit 2009.
2. Initial Lessons of the Crisis. Monetary and Capital Markets, and
Strategy, Policy Review, IMF Research Departments ,2009.
3. Lessons of the Global Crisis for Macroeconomic Policy. IMF Research Department, 2009.
4. The Implications of the Global Financial Crisis for Low-Income Countries. IMF March 2009.
5. Justin Yifu Lin “The Impact of the Financial Crisis on Developing Countries” Korea Development Institute, Seoul.
6. Edwards c. Prescott, Finn e. Kydland “Time to build and aggregate fluctuations”.
