Domino Effect: How Lehman's Failure marked the beginning of the End for the Dollar

The period before this crisis in America and in the Western World was considered to be the “Second Gilded Age.” Simply put, people were making a ton of money. In the financial sector, bonuses were robust, and that is putting it lightly. It was routine for one's bonus to be larger than their salaries. Loan requirements were relaxed. At the peak of this period in 2005, one would be able to take out a loan without providing proof of income. People rushed to take out mortgages and other loans, chasing the sought after American Dream[1]. It just seemed to good to be true. Unfortunately, it was too good to be true.  We could go into the how’s and why’s, but that is a discussion for another time. What is important is how it affected everyone’s confidence that the system was rock solid, confidence that to this day is not restored. Countries such as China and India, who have depended heavily on the western dominated financial system, began to have second thoughts.

 

 

Lehman Brothers CEO Dick Fuld at the Congressional Hearing examining the failure of Lehman Brothers. (Source: Wall Street Journal)

 

The reverberations from the failure of Lehman Brothers were felt all over the world, including the BRICS emerging markets economies. These governments felt that their large amounts of foreign reserves could help mitigate the effects of the crisis. Their foreign reserves helped up to a point. Yet, even after the usage of these foreign reserves to stimulate their ailing economies, emerging markets were still at a disadvantage[2]. Output slowed, and with it, so did economic growth. Even countries such as India suffered, who’s central bank held no mortgage-backed securities, had minimal off the books activities, and no securitized assets. So how did countries like India, which had limited exposure to the toxic assets that sparked the crisis, suffer from the bankruptcy of a bank on the other side of the world?  The answer can be encapsulated in one word: Globalization.

 

In India’s case, its rapid integration into the global financial system followed the 1998 financial crisis. It sought to raise its foreign reserves, as did every other emerging market affected by the crisis. So where was the problem? Well, The Indian corporate sector obtained external financing that accounted for close to half of their GDP growth from 1998 to 2008. This external financing made Indian corporations and businesses dependent on foreign financing, foreign financing that severely contracted following the credit crisis that was part of the Global Recession[3]. Luckily the Indian Reserve bank was able to increase the money supply by dropping interest rates, therefore mitigating much of the damage it incurred. Despite this, these events still made the Indian government doubt the strength and stability of the Global Financial System. The present numbers show that India is in a rapid recovery, arguably the fastest and  strongest recovery out of all BRICS countries. Yet it still criticizes the US and it's economy, focusing mainly on the US Governments reaction to the crisis. India has been pretty quiet about its views on the American Financial system, but it is situations like these where it reveals its true views on the matter. The other members of BRICS, such as Russia, have not been so reserved on the matter.

 

 

 

A Dow Trader holds his head in his hands as the DOW industrial average dropped below 9,000 for the first time since 2003. (Source: The Telegraph)

 

After the 1998 “Russian Flu” crisis, the Russian economy saw unprecedented growth.  Since 2000 GDP has gone up 70%, industrial growth was market at 75%, and investments increased by 125%. This unprecedented growth is partly due to the fact that Russia’s main exports are oil and natural gas products, which have been steadily rising in value during that period. The price of oil peaked at 147.27$ a barrel in July 2008, keeping the Russian economy healthy while American leaders were frantically looking for a solution to the Fannie Mae and Freddie Mac problem that was threatening to destabilize the housing market. It seemed as if Russia could bypass this crisis completely.

 

Yet, when Lehman filed for bankruptcy, the ensuing panic drove energy prices down to 60$ a barrel, essentially cutting Russian energy revenue in half. By November 2008 the Russian stock market was down 70% from spring levels. Capital outflow totaled to 50 billion dollars. Russian government projected that it would reach deficit spending if the price of oil fell below 70$. Unfortunately, it did.  Russia was stuck with a deficit in an economic downturn it took no part in instigating. Of course, the lessons learned from this crisis are still being developed into policies. Russia suffered from such an economic downturn because it has a commodities driven economy, it highly depends on the prices of gas and oil products[4]. The Russian economy has yet to diversify, which makes it vulnerable if there is another global economic downturn.

 

Russia has been expressing its dissatisfaction with the US dollar and the US dominated global financial system, and it’s easy to see why. Its economy, like India’s and China’s experienced a downturn due to the risk taking actions of banks based in the United States[5]. Of course, the slump can be attributed to the fact that Russia is a commodity driven economy and its economic health is pinned to the price of gas and oil, but the epicenter of the crisis lies within the enormous risk taking practices of investment banks that eventually led brought the shadow banking system to its knees, and with it, the entire global economy. Personally I believe that’s its easy to see why Russia wants to limit its exposure to the dollar and the US dominated financial system.

 

            With India and Russia covered, it is time to look back and see how China fared in this global recession. After the sub-prime mortgage crisis hit the United States, in the ensuing turmoil, China’s economic growth dropped from a double-digit growth rate of 14.2% in 2007 to 9.2% in 2009. Although it still maintained a steady and a strong growth rate through the crisis, it still had a 5% drop in growth, a drop that was felt throughout the economy. In November 2008, export growth slowed to  -2.2% from 20% in October. Exporters suffered substantially, and confidence in the system was decreasing rapidly.  Only after the State Council of China announced a whopping 4 trillion Yuan stimulus package in November of 2008 did the confidence return and the system stabilized. It is not surprising that even 6 years after these events, China still expresses its dissatisfaction with the global financial system. Considering that China was the country that arguably suffered the least from the Global Recession, it still suffered. The numbers may not show the whole picture but a 22.2% drop in export growth coupled with a 5% drop in economic growth, effects that the Chinese Government had to mitigate with a massive bailout package. China now still retains its position as the second largest economy[6]. The question is, if such a crisis were to happen again, would China be able to recover as quickly as it did in 2008? If we are asking these questions, it wouldn’t be too far fetched to infer that the Chinese leadership has been asking them too.

 

            What do these new attitudes mean for the dollar? Well, the dollar is the currency representing the strength of the United States economy, and its influence all over the world. The effects of the global recession in 2008 not only damaged economies and the livelihoods of people all over the world, but also the confidence in the system itself. The leaders of BRICS are now posed with questions doubting the stability and the reliability of the system. Recently, the leaders of the BRICS countries met in Brazil to establish the BRICS Development Bank, a counterpart to the IMF and the World Bank, specifically designed to increase the amount of money loaned to developing nations. The bank also was created with an emergency reserve fund, echoing the sentiments of the 1998 crisis, where developing nations and emerging markets suffered greatly from the lack of substantial reserves[7].

 

            This new bank is a step in the right direction for BRICS.  For the US, it is most certainly a cause for alarm. The countries that depend on the health and strength of the US economy are taking steps to turn away from it. These moves are all tied down to the effects of the Global Recession, which significantly damaged the worlds confidence in the strength and reliability of the US dominated Global Financial system.