By E. J. Minja October 22, 2009 The financial crisis has been with us sufficiently long for even a non-sophisticated reader to grasp its basics. The initial signs originating from sub-prime mortgages prompted the question 'What is it?' This was soon followed by 'What is causing it?' Gradually we had the financial meltdown, and now we are grappling with the credit crunch and its contagion effects. The root of all these, as advanced here, is irresponsible borrowing and lending coupled with regulatory lapse in economies where economic agents overly rely on credit for both consumption and investment. Firstly, irresponsible borrowing and lending led to loans being made to borrowers with poor credit ratings, resulting in the explosion of the sub-prime credit market. Using the term 'irresponsible' may be taking an extreme position, but considering some of the credit products that were being offered, the presence of excess liquidity notwithstanding, it may not be that inappropriate. Secondly, a regulatory lapse allowed excessive creativity in engineering financial products whose quality proved extremely difficult to establish. Though the products originated in limited markets (mainly in the USA) they ended up being marketed, bought and insured by financial institutions and markets all over the world. One may also see a regulatory lapse in the regulators simply watching as borrowers and lenders engaged in irresponsible lending and borrowing. Finally, over-reliance on credit for both consumption and investment is both the source of the crisis and a fuel to the crisis that transmits the effects to the real sector. On the one hand, reliance on credit is what caused the explosion of the sub-prime credit. On the other, it is what is now being seen as the secondary or indirect effect which is proving both more damaging and difficult to handle. That is, lack of credit is putting serious dents on consumption and investments and consequently production and employment. The financial crisis is viewed as originating in the USA. Tighter monetary policy and upward adjustment of mortgage rates meant that financial institutions having exposure to the sub-prime market started experiencing delinquencies and foreclosures. The crisis has been highly contagious, with what was seen as a USA problem becoming a worldwide phenomenon. While the crisis has driven some of the affected economies into recession, the question of 'How safe is Tanzania?' is constantly in the minds of the public, policy makers and politicians. In this piece we attempt to present some implications of the financial crisis for the Tanzanian economy and what can be done to minimise the negative effects and capitalise on any positive effects. To do so we start by revisiting the causes of the crisis, and the channels through which it has been transmitted to other countries. This is followed by an analysis of the possible implications focusing on the nature, persistence and magnitude of the effects. Finally we end by pointing out what Tanzania needs to do to deal with the crisis. THE FINANCIAL CRISIS: THEN AND NOW The circular nature of the financial crisis means that one can start from any point in the cycle in explaining what it is all about. The story often starts with sub-prime mortgages in the US but we have to go back to the factors that were pushing these types of mortgages. The fall in stock prices that began in 2000 with the burst of the dot-com bubble and excessive liquidity associated with low interest rates in 2002-2004 period are two of the factors. The fall in stock prices had a flight-to-safety effect that had a bearing on both liquidity and housing prices. On the one hand, investors shunning the stock market held liquid assets while waiting for the market to turn around, or channelled their wealth into housing, thus fuelling the already rising house prices. On the other hand, liquidity also meant that lenders were eager to push funds into the hands of borrowers as investment vehicles were competing to turn out impressive numbers despite the low interest rates. The competition led to lenders pushing financial products to low quality borrowers - particularly credit cards and sub-prime mortgages - as well as engaging in financial engineering aimed at either hedging the risk exposure or transferring the risk altogether. One prevalent technique was the use of adjustable rates, which for mortgages, led to the now infamous ARMs - adjustable rate mortgages. Lenders were using introductory 'teaser' interest rates that typically started below the rates on comparable fixed-rate mortgages. However, after the introductory period, which could range from a few months to three years, the rate is adjusted upwards. While lenders were pushing sub-prime mortgages, borrowers also saw them as financial products worth acquiring. Firstly, appreciation in house values that was being experienced in the USA meant that it made more sense to use credit to finance home ownership rather than continuing renting. The mortgage monthly repayment may be slightly higher than the monthly rent, but ownership gives both shelter and equity in the property. Rapid increase in house prices also created speculation opportunities - people could use mortgages to acquire properties for renting out and benefiting from the appreciation of property value. Since not all aspiring home-owners qualify for typical mortgages some are willing to enter at 'lower' levels, hence the emergence of sub-prime borrowers in contrast to prime borrowers. A typical sub-prime borrower in the USA was not someone buying a house, but someone refinancing. A very basic form of financial engineering, refinancing was seen as the best way to replace a credit card burden with mortgage. The credit card burden itself originated from a push by lenders to get credit cards in the wallets of consumers that coincided with the generally low interest rates that were being experienced in the USA. Most credit cards pushed with low introductory 'teaser' interest rates soon turned into a burden as the rates were adjusted upwards. Consumers saddled with credit card debt found it sensible to refinance them with mortgages - which essentially involved mortgaging their houses in order to repay the credit card debts. Just like the credit cards, the mortgages also had introductory 'teaser' interest rates but more importantly they were carrying adjustable rates. Refinancing also involved attempts by home-owners to cash in on the appreciation of their homes to fund consumption or even to simply move to lower rate mortgages. If the value of a mortgaged property increases, the owner gains from the appreciation since the mortgage payments are not affected by the appreciation. Of course the opposite also happens with a decrease in values. In case of appreciation, the homeowner does not need to sell the property to realise the appreciation; s/he just takes a second mortgage based on the higher value and uses the proceeds to repay the earlier mortgage while still remaining with an amount accruing from the appreciation. The end result was homeowners who had very little equity in their properties and whose mortgage servicing obligations could push their cash flows to the limit as the rates were adjusted upwards. Although upward adjustment of mortgage rates was expected, tight credit ended up magnifying its damaging effects. For most of the sub-prime borrowers, the upward adjustment led to mortgages that they could not service. Generally higher interest rates were also pushing housing prices, whose growth had since slowed, downward. A crisis involving sub-prime mortgages would have only affected mortgage providers, were it not for complex financial engineering that came with it. This ranged from simple collateralisation to complicated securitisation, tranching, credit default swaps and insurance. Most mortgage originators did not wish to hold the assets in their balance sheets. Repackaging and selling the mortgages meant that they were not only able to get the mortgages off their balance sheets but also they could originate more mortgages. Most of the processes started with collateralisation and securitisation - that is, packaging mortgages into a pool of assets based on which standardised debt instruments are issued and sold to other financial institutions and the general public. The problem was that the process was not a simple 'pass-through' securitisation. For example, to make the mortgage pool more appealing for issuing debt securities, financial institutions threw into it both prime and sub-prime mortgages and even some synthetically created assets. Then they engaged in credit tranching, by creating multiple classes (or 'tranches') of securities, each of which had a different seniority relative to the others. The key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral pool or to create rated securities from a pool of unrated assets. This is accomplished through the use of credit support (enhancement), such as prioritisation of payments to the different tranches. The financial institutions then de-linked the credit risk of the collateral mortgage pool from their own credit risk, hence making it possible to create securities that had a higher rating than their own. In some cases this involved the use of finite-lived, stand alone special purpose vehicles (SPV). Throw in credit rating agencies that had lost direction and you end up with massive volumes of securities that were continuously being created, marketed and insured worldwide, whose value and risk were very difficult to establish. This web is what led to the financial crisis being very contagious. Fast forward and the financial crisis turns into a credit crunch. Banks and other financial institutions - both those that have been affected by the crisis as well as those that have not - become unwilling to lend. Some are trying to sort out their positions while others are playing the wait-and-see game. Most of them will only put their funds in 'absolute safe' assets. Foreclosure, high interest rates and the fact that there are very few qualified mortgage borrowers have sent house prices on a downward spiral. Finally, consumers are not spending especially on items whose purchase can be delayed, forcing producers to cut production and lay off employees. WHAT ARE THE EFFECTS ON TANZANIA'S ECONOMY? The effect of the crisis on the Tanzanian economy can be viewed in a number of ways and dimensions. We discuss three of them here: The nature of the effect, which may be direct or indirect; the persistence of the effect, from short-term to long term; and the magnitude (scale/size) of the effect. Direct effects depend on the links between the Tanzanian financial sector and the affected financial institutions and stock markets. The links can exist in the form of having deposits in the affected institutions, holding their shares or debt instruments and holding toxic financial assets most of which have indirect links with the affected institutions. Worldwide, most of the effects of this nature have so far been established, although the quantum may be unravelling as institutions take stock of their holdings. Affected stock markets are also bottoming-up. Direct effects to the Tanzanian financial sector are likely to be minimal for a number of reasons. First, the financial sector is regulated in a number of areas that would have established the damaging link. Foreign banks operating in the country are governed by laws that treat them as independent banks rather than branches of the foreign banks. As a result, while some multinational financial institutions such as Citibank and Barclays Bank have been affected, their Tanzanian operations have not. Further, the strength of bank regulation and supervision as per the Bank and Financial Institutions Act (2006) has led to a limited number of foreign resources in the local commercial banks - currently standing at 11 per cent - and so far not showing any holding of the toxic assets. It is worth pointing out that one of the causes of the financial crisis is poor corporate governance in the financial sector, which entertained massive creation of off-balance sheet assets most of which turned out to be toxic. So far Tanzanian financial supervision and regulatory system has managed to limit damage from this side. Some financial institutions may take a more cautious stance when advancing credit as they reflect on the consequences of irresponsible lending and financial engineering. Recently, there has been a large increase in the number of foreigners participating in financial markets in developing economies in the quest for higher yields. Flight to safety prompted by the financial crisis is causing investors to sell their assets in those economies which are considered the riskiest. Our stock market, which is relatively new and highly inactive in trading in securities, is shielded from the crisis through an unliberalised capital account that limits direct and legal participation of foreigners. Thus while other stock markets, including Nairobi and Johannesburg, have been affected by the financial crisis, the effect on the Dar es Salaam Stock Exchange (DSE) has been minimal because of the few foreign investors. Tanzania also has some exchange controls that restrict the flow of international capital thus limiting the contagion effect from foreign financial markets. Indirect effects are not directly connected to the financial sector but more related to links among economies and sectors. The links between Tanzania and the affected economies range from simple trade, investment, aid, grants and remittance flows to complex price discovery for financial and non-financial products. The bottom line is, if the US, with a 25 per cent share of global GDP, slows down, it will definitely have an impact on the entire global economy, including Tanzania. For Tanzania, the national budget, which has substantial donor finance, will be affected if donors' commitments are not fully met. Faced with the need to commit financial resources to bail out affected entities in their domestic economies, some countries may be forced to cut down aid and grants to Tanzania. However, this effect is likely to be felt in the long run rather than in the short run, especially if the crisis persists, as aid and grants commitments are often decided well in advance. As far as donor funding is concerned, civil society and non-governmental organisations (NGOs), whose budgets depend on foreign donors, are definitely going to bear the brunt of the financial crisis. The effect will be felt even in the short run as the financial crisis affects the wealth of the donors - both individuals and charity organisations. It is important to note that most endowments that donate to the civil society and NGOs hold their wealth in financial assets, most of which have experienced substantial fall in their value. Reduction in foreign direct investment (FDI) is likely to be experienced both in the short and long runs, since foreign investors acquire resources from banks and financial institutions as well as venture capital funds. Most of these sources have been affected by the financial crisis either directly or indirectly through their connection with the financial markets. Reduction in FDI will also be aggravated by the fact that most FDI to Tanzania flows to activities that are of a capital intensive nature - mining, oil and gas exploration - and that are also risky. Some firms will also be focussing on their internal problems, thus limiting expansion activities to foreign countries including Tanzania. Other negative effects will be in terms of flows from tourism, remittances from Tanzanians living in the affected economies and exports. A fall in wealth and aggregate income - the latter due to high unemployment and low bonuses - as well as difficulties in securing credit will directly affect the flow of tourists and their cash into Tanzania. The same factors will affect remittances to Tanzania, which, of late, have increased, though not to the same significant extent as in other countries including neighbouring Kenya and Uganda. Tanzania's exports, especially the non-traditional items such as flowers and other horticultural products, have started feeling the effects of the credit crunch, with a decline in both prices and volumes of exports. The effects on tourism and exports are the most worrisome for Tanzania, considering the prominence these sectors have been given in the recent past. The tourism sector, especially, has established strong links with other sectors and the hospitality industry is a major employer in areas with touristic attractions such as Arusha and Zanzibar. Not all effects of the financial crisis will be negative to Tanzania. The price of oil has declined sharply from the highs observed in mid-2008 due to a decline in demand in the affected economies that also caused a reduction in the level of speculation in the commodity. Some commodities - especially gold - have experienced increased prices that are now viewed as a safe haven for investors attempting to protect their wealth. Combined reduction in employment is expected in the tourism industry and the horticulture sector. Foreign currency flow effects will have a bearing on the value of the Tanzanian shilling which has not only depreciated recently but has also experienced some volatility. Tanzania's lower external debt, better external reserve levels, prudent fiscal management and debt markets with an investor base whose dependence on foreign investors is minimal, will help minimise the effects of the financial crisis on her financial system. Limited effects on the different sectors translate into a limited effect on the overall economy. The effects on the overall economy are also unlikely to last long as economic agents make adjustments and the affected economies start to pick up. LESSONS AND WHAT NEEDS TO BE DONE Domestic factors are critical determinants of the persistence and magnitude of the effects - particularly those affecting the financial sector directly. First, it is information symmetry and how economic agents perceive the effects of the crisis. Information asymmetry may throw firms and individuals into a panic mode, with consequences such as a flight to currencies perceived as safe or even a run on banks. Further, lessons from the crisis are useful in gauging how the economy is perceived to exhibit features that led to the financial crisis. For example, the effects may be amplified by overvalued housing markets, explosive credit expansion by commercial banks or even political uncertainty. With the credit crunch, it would not be wise to expect many new investors from abroad and therefore taking care of the existing ones is essential. Limiting the effects on the economy is critical in sending a message that Tanzania should be viewed as a safe haven for attracting more foreign investments. Finally, care has to be taken with the property formalisation programme (MKURABITA). One idea of the programme is that formalised properties will serve as collateral in assessing credit. While formalisation of properties is undoubtedly important, mortgaging the formalised property can easily spiral to irresponsible lending and borrowing. E. J. Minja is in the department of Finance at the University of Dar es Salaam Business School. NOTES  I use 'sub-prime credit market' rather than the now famous 'sub-prime mortgage market' because irresponsible borrowing and lending was initially responsible for expansion of credit card loans that was a precursor to, as well as a source of, the expansion of the sub-prime mortgage market.  One mortgage provider in the USA, whose motto was 'Home of the 'no doc' loan', had a product called the NINJA loan which stood for No Income, No Job (and) no Assets.  In some cases the rate is also adjusted upward as general interest rates change.  Collateralisation means that the underlying mortgages and their cash flows were effectively the collateral of the created securities  The word 'tranche' comes from the French word for slice. In collateralisation, the terms 'tranche' and 'class' are synonymous.  China, which sells a fifth of its exports to the USA, estimates that a 1 per cent drop in US economic growth will translate into a 6 per cent drop in its exports.