How financial crises give birth to food crises? 1


NAJEEB REHMAN BHUTTO

All which we know as a monstrous food crises faced by the world today, that has pushed millions of people to starvation, has its roots in the US substandard mortgages market ie the “Subprime” Market. This may look awkward, as how the financial crises can lead to food crises? But in the next lines we shall understand how they are linked with each other.United States mortgages market is one of the most developed and sophisticated network of financial intermediaries in the world, a trillion dollar business, with government related and sponsored entities, investment funds, servicers of the MBS (Mortgage Backed Security), thrifts and big banks being its stakeholders.

The receivables of mortgages are securitized, thousands mortgages are pooled and then Mortgage Pass-through Securities (MPS) are sold to investors containing prorate share according to their principal in each mortgage. There are senior subordinate tranche structures, planned amortisation classes to manage the contraction and extension (prepayment) risk. The US mortgages market is widely bifurcated into two types of mortgages ie prime and subprime mortgages.

Prime mortgages are the ones which are guaranteed by federally related and sponsored entities like Gannie Mae, Fannie Mae & Freddie Mac ie these agencies guarantee the principal of Investors of MPS, if while extending the mortgage to a customer, certain bench mark criteria related to the income and leverage ratios of buyer of the mortgage loan are met.

Another type of mortgage market is the subprime mortgage market, the buyers who are being denied by the agency mortgage financing, because they do not meet the criteria of agency mortgages, acquire mortgage financing in the subprime market. The risk factors are high, so are the interest rates as compared to prime agency mortgage market.

In the modern society as general and in American way of life in particular, we find a rising trend of acquiring long term personal assets on credit ie one can see cars leased, homes mortgaged, home appliance based consumer durables acquired on credit, student mortgage loan associations and last but not the least credit cards through which many types of payments are made.

The current world recession emerged from the US housing market and growing appetite for energy in the emerging markets. The ever increasing appetite of emerging economies like India and China for energy needs heightened the current energy crises, as India and China are flexing their muscles towards the process of industrialisation and increased production; their hunger for energy has caused the world over scarcities and shortages.

US economy was in recession from the past few years. War in Iraq has further deteriorated the situation. This war, coupled with Opec decision to reduce oil supply, boosted the oil prices, on the other hand mounting expenditure of US war against terrorism caused US dollar to depreciate, which further soared the prices of oil because oil contracts around the world are traded in US dollars.

As the dollar depreciated, oil became more and more costlier in dollar terms. Now one question arises “What the mortgage market like subprime has any thing to do with, Iraqi war and oil prices?” The answer is simple: cause and effect relationship ie the war caused oil price hike.

As the US housing sector was expanding, increased oil price and resulting scarcity of energy, caused cost of heating the houses in winter or cooling them in summer unaffordable day by day. This factor, coupled with the increased interest rates by FED to check the core inflation and excess demand in the economy at that time (the FED is currently applying policy of decreasing the FED Funds Target Rate), deteriorated the purchasing power of the people and as a result most of the Housing loans began to default.

The situation was worsening for the banks because due to defaults there were excess houses available to be sold than the buyers to buy them. This factor reduced the prices of those houses radically. Mortgaged houses were the only collateral banks had in hand, along with it the lack of liquidity in the financial system to support these securities caused the banks and financial institutions to book huge losses against these receivables in their financial statements.

This crisis further expended from housing sector to the corporate sector. Short-term liquidity needs of the corporate sector in US is mainly fulfilled by means of commercial papers on a rollover basis. In a climate in which the investor was shy and confidence index was dropping, US corporate sector had a tough time in the subscription of commercial papers, for which the investor was requiring higher yields to compensate the risk.

At this point one can ask “How this financial crisis is causing commodities price hike?” The answer to this question lies in the business life cycle analysis of the US economy. The scarcity of oil and its momentous effects on essential food commodities due to their use as bio fuel was spotted on by the speculators. Hence, as the stocks of banks and commercial organisations were dropping, hot money started pouring into commodities.

It is the norm of the US investors, that in times of recession they play in safe niches like T-Bills and Commodities and the situation is vice versa in boom ie Stocks and interest oriented scrips are heavily traded in the boom arena. The proof of which could be found in declining share price indices and skyrocketing commodities in the current recessionary phase.

Now, as a consequential effect, investment avenues for investors have been confined to the commodities’ speculations. One can imagine, what could happen to prices of those commodities, if bulk of the wealth of financial super power of the world is invested in those commodities. This fact has been acknowledged by the top executives of World Bank, accepting that this food crisis faced by the humanity today is manmade, not natural.

Again a question arises “Why US crisis is taking the entire world under its effect?” There are two elements involved in it. First is that almost all of the developed financial markets of the world have heavily invested in US financial markets and vice versa, for the purpose of global diversification benefits and to get the prospects of investment in the US blue chips of global repute. So the downturn of the US stock markets is translating into the downturn of stock exchanges around the world.

Second is that oil being major driver of inflation shocks in economies, is eradicating the purchasing power of common man as well as incentives for businesses around the world. Emerging markets are characterised by the ones that have come into sight in terms of accelerated growth in GDP, enlarged production and increased trading volume. This situation has also severely affected the emerging markets; inflation shock from supply input side due to fuel and energy crises has wiped out the incentive for producers and has reduced the growth potential of these economies.

Even with these pessimistic gestures in the emerging markets, when compared with US and Euro zones, they are better off. Emerging markets are still a region where there is hope of rebound, keeping in view the accelerated growth potential concentrated in these economies.

The main challenge faced by these emerging markets, is the search of energy sources to fulfil their growth needs. Crude oil and its produce are getting more and more costly than ever. World economies are now moving towards the alternative energy resources, like ethanol which takes agriculture produce as their major input. In this process, major agricultural commodities are getting out of the reach of the poor masses.

IMPLICATIONS FOR PAKISTAN

 

 As compared with peer emerging markets, the scenario is worst in Pakistan, economy which is tumbled by the political crisis, leading to flight of capital, resulting in devaluation of the rupee, which is further resulting in mounting oil bill. Indeed the import bill as a whole is causing balance of payment deficit, which further weakens the currency and increases foreign debt burden in rupee terms.

One could argue “Why being an agrarian economy, the wound of commodity price hike of such a severe intensity to a country like Pakistan.” The increases in prices of commodities internationally have increased the incentives to smuggle these grains from countries like Pakistan.

Along with this, the unreliable statistics of food grains produced within the country and inefficient strategy by the government to export food commodities like wheat when their prices are relatively low in international markets and importing them when their prices are high, has also contributed a lot to the increase in commodity prices in Pakistan. In addition to this, our investment in the agriculture sector since about a decade has been insignificant; the results of which are now visible.

The country’s growth fundamentals, like other emerging markets, are still intact. Our performance in exports this year is a great proof of it, but there are deficiencies on strategic economic management front and the economy’s heavy reliance on oil as a source of energy generation and industrial production has put inflationary pressures on the economy.

The government is currently handling this matter by passing on inflation effect to the consumers, but this situation may not last very long, as it will push more and more people of the country down the poverty line. Like other emerging markets, Pakistan will have to find out alternative energy resources eg utilising the gigantic coal mines which it has, for industrial and power generation purposes. This would reduce the reliance on oil being the most sensitive element in CPI and would further control its passon effects on the price rise of other commodities.

IN ADDITION TO THIS, THE GOVERNMENT NEEDS TO EMPHASIZE ON THE FOLLOWING FRONTS:

 

a) proper check on the demand and supply of the food grains within the country,

 b) deployment of the government machinery to collect accurate and proper record of all the food grains produced within the country;

 c) exporting the surplus commodities only,

 d) exporting the commodities at the right time ie when their prices are relatively higher in international market.

Also the political elites have to take actions to impede the smuggling of food grains, to protect the society from poverty and starvation which is already vulnerable to many of the evils.

Courtesy: Business Recorder, 21/8/2008


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