Dr Fahd Rehman - The period of the ‘Great Moderation’ (1985-2007) was mainly based on efficient market hypothesis which means that there should be minimal intervention in the financial markets, manifested through a period of low volatility of business cycle and even less regulation. Therefore, the strategy of portfolio diversification was zealously pursued to increase the rewards which simply scatter the risk; however the systemic risk was ignored. The ignorance of ‘systemic risk’ resulted into global liquidity crises of 2007-08.

The liquidity crisis started from the credit card crunch in September 2007. The long period of the ‘Great Moderation’ made most of the economists, strategists, policymakers and regulators partly complacent. The complacency also led to ‘sub-prime’ mortgage crisis owing to excessive risk taking. In other words, the borrowers were able to get long term mortgage financing with ease due to complacency of regulators and long period of low interest rate environment after 2001. Since house acts as collateral for mortgage financing; massive default and foreclosure took place due to abrupt increase in interest rates during 2004-06. A wave of default and bankruptcy triggered a dramatic fall in the house prices which damaged the value of collateral i.e. house prices. These circumstances also dented the sentiments of the stock investors which made the stock markets reeling across the world. Owing to the integration of global financial system a domino effect took place which engulfed the whole world.

Being a regulator, the Federal Reserve [The Fed] responded a bit late on the presumption that the ‘sub-prime’ crisis was localized in the US and things would settle automatically. In addition, it is very difficult to gauge the timing of intervention. However, taking stock of the situation, the first reaction of the Fed came in the form of Quantitative Easing (Q.E) in December 2008. Similarly, Bank of England embarked more or less on a similar course in early 2009, followed by Bank of Japan, Switzerland and finally European Central Bank. The Fed has officially ended its Q.E program in October 2014 and Bank of England would follow suit soon. On the other hand, Bank of Japan and European Central Banks are still going on with their monetary stimulus to ward off deflation.

The primary purpose of the Q.E was to solve the global liquidity crises and the program revived the global house prices as well as refueled the stock markets. For example, the Dow Jones Index has already crossed 17500; the Japanese Nikkei-225 is around 17000- the highest since 2007. Similarly, the Hang Seng Index is around 24000; FTSE 100 is around 6600 and so on.  Similarly, Karachi Stock Exchange (KSE) in Pakistan is not an exception and is around 32000 since portfolio investment has come to Pakistan to some extent and more than $ 2 Billion of portfolio investment has been recorded during FY 2013-14. The Q.E has inflated asset bubbles in housing and stock markets across the globe and restored the confidence of investor to some extent in the US and the UK. However, there are certain ‘unintended consequences’ of this program for developing countries.

The Q.E brought global commodity inflation: hedge funds, commodity index and pension funds invested into commodity buying since they made commodities as an asset class. As a result, the prices of Gold, Copper, Aluminum, Iron Ore, Coal, Crude Oil, Cotton and Wheat skyrocketed during 2008-2012. Since these commodities are used as raw materials in manufacturing, the prices of finished manufactured goods also increased across the globe to some extent. The exports of developing countries are either raw and/ or low value added ones; these countries witnessed a slight increase in the value of merchandise exports during this period. However, the commodity prices have started to glide down with the winding back of the Q.E 3, which would translate into lower export value for the developing countries in future.  

On the other hand, the developing countries with low or minimum crude production were hit badly by the import prices of the petroleum products which increased due to exorbitant increase in crude oil prices. The prices of crude oil remained between $ 90 to $ 120 per barrel between 2008 and June 2014. These higher prices gobbled up a large chunk of low value added exports of developing countries. For instance, the imports of petroleum products consumed between 55-65 % of the value of exports during 2008-14 in Pakistan. This factor increased the trade deficit which translated into balance of payment crises manifested through fall in foreign exchange reserves twice in Pakistan.

Similarly, higher prices of petroleum products paved the way for power sector crisis in Pakistan. Since the power production is mainly done through thermal means: Gas, Diesel, and Furnace oil produces around 55 % of the total power. In the situation of scarcity of gas, the generation should shift to furnace oil. But higher international furnace oil and diesel prices constrained the generation of power plants to sub-optimal level. The higher electricity prices cannot be fully passed on to consumers. Although Government of Pakistan increased the electricity tariff around 35 % in the last one and half year, this higher adjustment has certain ‘unintended consequences’ such as theft manifested through bad revenue recovery in the distribution chain and recovery of electricity bills dropped from 90 % to 80 % during FY 2013-14.

In a nutshell, the period of ‘great moderation’ followed by a novel experiment of Q.E has just stopped. The winding back of QE would have serious consequences for the developed and developing countries at large, creating huge volatility in the stock and housing markets across the globe along with downturns; so one may expect a rocky road in future. However, this may bring positive supply shocks for the developing country like Pakistan. The first favorable supply shock has been received in the form of reduction in the petroleum prices of around 25% in Pakistan. Let’s see how things unfold and whether Islamabad brings other dividends for the masses especially in the form of reduction in electricity prices.

The writer is assistant professor of Economics at Suleman Dawood School of Business, LUMS, Lahore.