The world economy experienced a severe downturn following the emergence of global financial crisis that started with the burst of housing bubble in the United States in 2007. This bubble was formed due to the monetary policy which enabled the people to borrow at very low cost and it eventually led to excessive lending. Massive increases in subprime mortgages backed by securitization schemes were witnessed during this period. Subsequently, the home-owners were unable to meet financial commitments due to rising interest rates on newly-popular adjustable rate mortgages and declining property values. The result was emergence of the financial crisis. This article discusses the impact of financial crisis (2007-08) on the major domestic drivers of economic growth.
It is worth mentioning that not only the advanced economies suffered their worst economic downturn since World War II but economic growth in emerging market economies also dragged down significantly and the impact was almost similar. The World Bank in a 2011 report observed that the advanced economies experienced 7.5 per cent decline in real GDP during the last quarter of 2008, and output continued to fall quickly during the first quarter of 2009. Emerging economies as a whole contracted by 4 per cent in the last quarter of 2008, and this trend continued in the first quarter of 2009, while low-income countries felt limited direct impact, given the weaker linkages of these economies to the global economy.
A number of studies, theoretical and empirical ‘found the effect of the global financial crisis detrimental to economic growth in many advanced and emerging economies. The impact, however, varied widely among developing countries and regions. For instance, the aforementioned World Bank report reviewed that 29 developing countries suffered a severe impact with GDP growth rates fell on average of more than 5 percentage points, 36 countries suffered a moderate impact with 2 to 5 percentage points decline in GDP growth rates and 51 countries suffered a small impact with GDP growth reduction by 2 percentage points during the period from 2006-07 to 2008-09.
The crisis transmitted to the developing countries mainly through three channels viz., reduction in remittances, deterioration in external capital flows and increased trade deficits.
Pakistan falls within the category of lower-middle income countries. The country’s debt-driven and consumption-led growth is vulnerable to the credit crunch. Foreign capital inflows are an important determinant of economic growth, which are likely to be reduced significantly following the financial crisis. As the United States and the European Union are the major destinations of Pakistani exports, it is believed that Pakistani exports may be hit severely due to recession in the Western world. Pakistan is particularly vulnerable to the global financial crunch due to high fiscal and current account deficits, rapid inflation, low reserves, a weak currency and deep political instability.
Pakistan’s economy heavily depends on remittances sent by overseas Pakistanis living in Europe, the Middle East and the United States, to name some. These remittances also play a key role for stability in the balance of payments and mitigating unemployment problems. The financial crisis is likely to have strong reducing impact on the size of remittances.
1. Impact on Private Consumption
The growth of private consumption expenditure (PCE) increased significantly following the financial crisis as depicted in Figure 1. The private consumption expenditure increased from 14.4 per cent in 2006-07 to 20 per cent in 2007-08 followed by 30 per cent increase in 2008-09. On average, the private consumption expenditure recorded a growth of 20 per cent during the period 2009-10 to 2012-13. Empirically, there is a strong, positive impact of the financial crisis on the growth of the private consumption expenditure. Increase in household consumption might be fuelled by significant increase in workers’ remittances and decline in international commodity prices following the crisis.
2. Impact on Government Consumption Expenditure
The government consumption expenditure (GCE) also increased following the global financial crisis as shown in Figure 2. The government consumption expenditure witnessed 61 per cent increase in 2007-08 over the previous year, largely due to subsidies in the power sector. On average, the government consumption expenditure increased by 19 per cent during the period 2009-10 to 2011-12.
3. Impact on Private Fixed Investment
The private fixed investment (PFI) ‘one of the major drivers of economic growth’ contracted significantly following the crisis as shown in the Figure 3. On average, the private fixed investment increased by only 4 per cent during 2007-08 to 2011-12 as compared to 23 per cent increase during 2002-03 to 2006-07. Empirically, the impact is negative and significant. The State Bank of Pakistan (SBP) observed that decline in the private fixed investment in the country was due to reluctance of foreign investors to invest in Pakistan due to negative country image, domestic banks invested more in government papers, and uncertainties regarding strength of global recovery, etc.
4. Impact on Foreign Direct Investment
Figure 4 depicts the sharp decline in the foreign direct investment (FDI) in Pakistan following the financial crisis. On average, there was 28 per cent contraction in the foreign direct investment during 2007-08 to 2011-12 as against the average growth of 29 per cent during 2002-03 to 2006-07. Empirically, the impact is strong and negative on the foreign direct investment.
5. Impact on Inflation
Rising domestic demand pressures eventually translated into escalating inflation (INF). There were double-digit inflation rates following the financial crisis. Weaker domestic production coupled with strong domestic demand and commodity prices shocks led directly to rising inflationary pressures. The SBP observed that a widening current account deficit, declining foreign exchange reserves, rising public debt, a depreciating rupee, etc. were other reasons for inflationary trends following the global financial crisis. Furthermore, the bank observed that stubbornly high inflation rapidly eroded the purchasing power, which seriously impinges on real economy.
6. Impact on Domestic Debt
Figure 6 shows sharp rise in the government domestic debt growth (DDG) after the global financial crisis (FC). The government domestic debt increased from 11 per cent in 2006-07 to 25 per cent in 2007-08. The average growth of domestic debt was 24 per cent during the period from 2008-09 to 2011-12. The strong growth in the stock of domestic debt reflects that imbalances in the overall fiscal account as well as the country’s current account are large.