Monetary Policies performance through 2007 economic

crisis

Ahmad Bader
Student ID 201002680

What are the principal tools of monetary policy? Have they been effective in
the current financial crisis? Illustrate your answer with examples from Saudi
Arabia and a developed economy.

Dr. Mohammad Ramady

ECON 501
KFUPM

January 9th, 2011

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 2
Preface

Monetary policy is as unique as a countries national dish. Each nation has its
own givens and its people work together to achieve a national aspiration. As
they put the tools of monetary policy to use and add their own twist, the
number of unique possibilities is endless and so are the possible outcomes.
The 2007 global economic crisis naturally affected each country differently.

Writing the following paragraphs to discuss Monetary Policy tools and their
effectiveness in the USA and Saudi Arabia, I founded it beneficial to cite
examples from some other economies in the world to illustrate similarities
and differences and to give a little more of the global perspective on the
crisis.

Monetary policy: tools & objectives

The central bank is the arm conducting a government’s monetary policy. In

fulfilling its role as banker to the government, the central bank works to
maintain economic stability and a moderate growth rate by regulating the
supply of money available and the cost of the money made available to the
market or the interest rate. Stable prices, maximum employment, favored
exchange rate and moderate long-term interest rates are chief amongst
monetary policy objectives.

Elements of economic stability are interconnected and affect each other on

the short and long run. Low unemployment, a sign of good economic times, if
continued for example, will lead to sustained economic growth and an
increase in the Gross National Product, GDP. In turn, this will lead to
increased inflation. While moderate inflation is desirable, a continued larger
than desirable increase will have a negative effect on price stability and
ultimately threaten economic stability. Dramatic effects of excessive inflation
will sometimes surface sooner than anticipated. In such cause-effect
relationship of compound factors, a high level of finesse is paramount to
maintaining economic stability.

Central banks employ three main tools to achieving sustainable economic

growth and stable prices. Through Open Market Operations, a central bank
buys and sells government securities on the open market. Hence, decides on
the money supply and the interest rate. When the central bank buys
securities already on the market, the money paid increases the selling
bank’s cash flow. Some or all of this increased liquidity will then be loaned
out to consumers and investors. In other words, the central bank increased
the money supply available on the market. Government securities can be
short, medium or long-term debt obligations at an interest rate specified at
the time of the transaction.

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 3
Central banks also determine the minimum percentage of deposits a bank
should keep in reserve. The Required Reserve Ratio (RRR) is another tool by
which central banks establish monetary supply into the market. A lower RRR
means more funds are available for loans to individual and corporate
consumers. A higher Reserve Ratio on the other hand, decreases the funds
available for lending. For example, “In 2008, the Fed, the US central Bank,
required banks to hold minimum reserves equal to 3 percent of checking
deposits between $10.3 million and $44.4 million and 10 percent of these
deposits in excess of $44.4 million. The required reserves on other types of
deposits are zero.” (Parkin)

When a distressed bank is in need of funds, it turns to the central bank to

secure a loan, making room for another monetary policy tool. The rate at
which banks acquire a Last Resort Loan is the Discount Rate. By fulfilling this
role, the central bank acts as a safety net to prevent bank failures and the
most likely accompanying depositors’ panic, which can lead to catastrophic
national or even global outcomes, as we will see later. Saved for times of
crisis, this vital tool is used to send messages of reassurance to otherwise
anxious consumers, not the least of which about the safety of their deposits.

A leading economy in crises

Central bank managers around the world utilize the tools described above on
daily basis. Following the technology bubble of 2000, the US economy, the
largest in the world, showed signs of recovery that would last until the end of
2007. During that period, inflation rate was in favorable range between 2
and 3%, unemployment was low, and consumer confidence was high.
Investors, looking for opportunities away from stocks and new technology
company start-ups, found their opportunity in the real estate market. The
low interest rates and sub-prime lending facilities to otherwise unqualified
borrowers, helped speed up a real estate boom. Some economists were
starting to worry that things were too good.

After a failed weekend of negotiations for a Last Resort Loan, early on

Monday morning on September 15, 2008, Lehman Brothers Bank filed for the
biggest bankruptcy ever in the history of
the United States. As it turns out, that
would become the tipping point that set
the US and global economy into a sharp
downward spiral as the shockwave
quickly traveled through domestic and
global markets. In the year to follow,
more than 120 US banks follow suit and
either filed for bankruptcy protection or
sold out according to the list published on

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 4
the Federal Reserve Bank website. Real estate property value was dropping
quickly, more than half in some states. Companies registered lower future
orders and resorted to laying off employees as a cost cutting measure.
Unemployment rose from the normal 5% to 10.1% in October of 2009 (US
Bureau of Labor Statistics). Many economist argued that the befallen
economic crisis to be worse than 1930s depression.

This, at a time of increasing military spending on simultaneous military

campaigns in Iraq and Afghanistan at a staggering cost o $141.7 billion in
2008 (US Department of Defense website), and an accumulating national Figure 1
debt of historic proportions totaling more than $14 trillion today. In a letter
laying the grounds for a US Treasury request for an increase of the deficit
limit, US Treasury Secretary Timothy Gartner wrote on January 6, 2011 to the
US Senate Majority Leader, the Honorable Harry Reid, to inform him that he
expects the current $14.29 trillion debt limit to be reached in March 2011.
The growing US external annual deficit is closing up on to the US annual GDP
of $14.6 trillion.

Since the signing of the Plaza Accord in 1985 between the G5 nations;
France, West Germany, Japan, the United States, and the United Kingdom, to
depreciate the U.S. dollar at the Plaza Hotel in New York City the value of the
dollar1:continues
Figure to Public
Outstanding US declineDebtagainst other world currencies. While this decline
in value can lead to increase in exports, it also means an increase in the cost
of imported goods. Currently, the US is running an export deficit, and the
long run of the devaluing dollar may have adverse effect on inflation rate
amongst other economic indicators. Some of the signees to the accord are
shifting positions as the expressed concern Just days before the G20 summit
meeting held in Seoul in November 2010, about the US announced plan to
pump $600 billion dollars into the market would further weaken the dollar
and saw the move as taking part in a currency war.

On the other side of the Pacific, some European banks and governments
investments were exposed to the real estate risk in the US and in Europe.
Consequently, the crisis affected those banks financial standing and
eventually contributed to the bankruptcy of Ireland and Greece. Other debt-
ridden countries are facing similar financial threat. The European Union
established the European Financial Stability Facility, a bailout program for
bankrupt governments. The other union members moved toward adopting
conservative policies and curbed expenditure to avoid a similar fate. The
French government raised retirement age from 60 to 62 in a move to save
pension funds. England announced a shrinking fiscal budget, and similar
economic measures were announced throughout the EU countries.
Europeans took to the streets rallying, protesting, and in some cases rioting
against the announced plans.

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 5
Although the crisis could not be averted in the US, that does not mean the
monetary policy failed completely, or that recovery is unfeasible. In our
dynamic globalised environment, countries are assessing the success or
failure of past economic plans and making adjustments based on available
resources and revised priorities. Taking note of old miscalculations is
necessary to moving forward in a prosperous direction. There is little doubt
that the US economy will recover, the speed and level of recovery however
will depend on the combination of US performance based on measures it
takes and the performance of other countries, especially the emerging power
economies like China and India.

Emerging economies

While a housing bubble was swelling in the US, the economy in China was
gaining momentum as exports of its manufactured goods were reaching new
highs. According to World Bank published statistics, China’s Real GDP
jumped from 8.4% in 2000 to 14.2% in 2007(IMF). China's total import and
export volume amounted to $1.76 trillion in 2006, maintaining its position as
the world’s third-largest trading nation (Ying, 2007). According to a report by
CNN on January 15, 2009 titled
“China passes Germany in
economic ranking” China had
become the third largest
economy in the world after the
US and Japan. The 2007 revised
GDP figures released by China
put it ahead of Germany based
on World Bank estimates.
China’s reserves also grew
substantially as illustrated in
Figure 2.
Figure 2
With the second largest
population, India also emerged
as a powerful economy with
strong indicators its growing
GDP could surpass some Figure 2

European countries like France

and Italy by 2020. Between 2000 and 2007, India’s Real GDP climbed from
4.4% to 9.9%. (IMF) An outstanding economic come back by all measures.
Back in June 1991, this poverty-stricken Asian country had almost defaulted
on its debts had it not been for an IMF agreement and serious economic
reforms efforts by the government. (Ghosh)

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 6
Figure 3: Data generated by the IMF Data Mapper, a tool available in the IMF website give a Historic
perspective of Real GDP figures. For our comparison, values for USA, Germany, China, and India are
combined in one graph.
How did it happen in the US?

Associated Press reported on Oct. 23, 2008 that Allen Greenspan, the then
former US Federal Reserve Chairman, admitted during a hearing in front of
the House Oversight Committee that misestimates and misjudgments were
made by economic leadership including himself in the months leading up to
the crises. He also proposed the government should consider tougher
regulations including requiring firms that package mortgages into securities
to keep a portion as a check on quality.

In an ever-dynamic economic environment, financial innovation is an

essential driving force that cannot be discounted. In the years leading up to
the crisis however, financial instruments were growing in complexity;
financial products, access intermediaries, integrated markets around the
world, and so on. (Moskow) It may be reasonable to think that consumers
may take some time before they appreciate new instruments, but when
experts, especially in leadership position, find themselves overwhelmed by
the complexity, the government and financial regulators bear the
responsibility to ensure quality measures and regulations are in place to
protect not only consumers, but also the economy as a whole. Corporate
accounting and auditing rules, rating agencies practices are also other areas

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 7
that can benefit from further scrutiny. The fall of Enron is still on our fresh
memories. Maintaining consumer confidence will require a more proactive
approach.

Straying away from fundamentals also played a key role in where we are
today. Banks gave loans to consumers the bank knew were not credit worthy
and were likely to default on payments. Credit card companies issued cards
to minors and in some cases to pets. Investment companies bought
derivatives for which they could not accurately calculate risk. Investors
invested in stocks on hopes they would ride a wave not necessarily on
performance and company fundamentals. And regulators did not listen to
warnings from economists during times of “irrational exuberance”.

Saudi Arabia during the crises

SAMA, The Saudi Arabian Monetary Agency, the central bank of the kingdom
was established in 1952. After serving as Vice-Governor of SAMA for fourteen
years, in early 2009 Dr. Mohammad Al-Jasser was named governor by royal
degree.

According to published World Bank GDP figures, Saudi Arabia is the largest
market amongst Arab countries. Oil exports comprise the main source of
revenue for the kingdom. However, serious economic diversification efforts
have been underway. Despite the global financial crisis, gradual, but yet
sizable increase in the share of non-oil revenues is reported in 2007 and
2009 as reported in Table 1 below. Due to high increase in oil prices in 2008,
the share of non-oil revenue shows a decline from the previous year, yet the
amount of non-oil income increased by 37 billion riyals as reported by SAMA
in it’s annul report below. Nonetheless, of the ongoing promising
diversification and foreign investments attraction efforts, the supply of
money is still dependant on an annual budget financed mainly by oil exports.

Table 1: Actual Oil and Non-oil Revenues, Source SAMA 2010 Annual Report

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 8
 Interest Rates on Saudi Riyals and US Dollar deposits
While working to absorb the shock of the global financial crisis, SAMA was
concurrently working to balance
the pressure from rising inflation
due to a sharp rise in oil prices in
2008, and a devaluing US dollar,
to which the Saudi Riyal value has
been pegged since 1981. The
fixed exchange rate constitutes a
restraint on monetary policy
flexibility on one hand and
provides economic security and
stability to investors on the other
hand. A fixed exchange rate is
also more convenient for
governmental agencies fiscal
planning and budgeting. In spite
of the high opportunity cost, the
peg to the US dollar was unchanged and the Saudi Riyal interest rate was
continuously adjusted close to the US Dollar. “In terms of economic policy,
this means that in Saudi Arabia, fiscal, not monetary, policy is the primary
instrument for economic growth management.” (Ramady)

To address the repercussions of the global financial crisis at the end of the
last year, SAMA continued in 2009 to pursue an accommodative monetary
policy aimed at achieving stability in the financial sector and strengthening
the domestic economy through enhancing the liquidity position of banks to
encourage credit to the private sector in the context of the decline in
inflationary pressures to 5.1 percent in 2009 from 9.9 percent in 2008.
(SAMA)

Cash Reserve Ratio (CRR) is one tool SAMA used to influence the supply of
money on the market following the crisis. “In 1980 SAMA reduced the CRR to
7% on current accounts and 2% on deposit accounts, but 28 years later it
reversed policy by dramatically raising the CRR to 13% on current accounts
and 4% on deposit accounts ... By the end of 2008, the CRR on current
accounts had been reduced to 7%, but SAMA’s intentions were taken on
board by Saudi Banks” (Ramady) During 2008, SAMA also announced a drop
in the overnight Repo rate twice to boost market liquidity in response to
record inflation that year. Repos and Reverse Repos are purchase and
reverse purchase agreements executed by SAMA to facilitate the trade of
government bonds and securities and have been increasingly utilized to
conduct its Open Market Operations.

Some countries in the region did not withstand the crisis and suffered a slow
down, even a halt in some, state projects, drop in foreign investment,

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 9
accumulation of deficits, and high inflation. With its conservative economic
policy, Saudi Arabia withered the worst of the global economic crisis while
maintaining relative economic stability and moderate economic growth.
Inflation was contained, employment amongst Saudi national males was up
in 2009 (ILO) and state construction projects of major Industrial and
Economic Cities, and Universities are still underway, some have even
completed. In addition, in an impressive accomplishment, Saudi Arabia
moved up from 67th place in 2005 to 11th place in 2010 on the list of “easiest
countries to do business” by The International Finance Corporation, a
member of the World Bank Group.

Conclusion

Monetary policy remains a key factor of national growth. Built on sound

fundamentals, it can also ease the blow of an economic crisis. A few people
would have believed that European countries would be in debt to the point of
bailout, or that the US would not be able to maintain its nuclear power plant
and let them shut down instead. Each country has its unique situation of
labor force, natural resources, geographical location, etc. to consider when
formulating a monetary policy. Short term planning between crises alone can
bring devastating results. However, a sound long-term incremental growth
policy built on fundamentals, despite some hardship along the way, proves
to be a winning paradigm.

Monetary Policy performance through 2007 economic crisis, AB 2011, KFUPM, ECON 501 10
References:

1. Ghosh, Arunabha. "India's Pathway through economic crisis." 1 06 2004.

http://www.globaleconomicgovernance.org. 2 12 2010
http://www.globaleconomicgovernance.org/wp-content/uploads/Ghosh%20-%20India.pdf.
2. ILO, International Labor Office. "G20 Statistical Update: Saudi Arabia." 2009.
http://www.dol.gov/ilab/media/events/G20_ministersmeeting/G20-SaudiArabia-stats.pdf.
3. Moskow, M., President and Chief Executive Officer Federal Reserve Bank of Chicago.
"Current Policy Issues: Judging Sustainable Growth and Facing Financial Market
Complexity." 17 7 2007. Federal Reserve Bank of Chicago. 5 12 2010
http://www.chicagofed.org/webpages/publications/speeches/2007/07.19_GIC_remarks.cfm.
4. Parkin, Michael. Economics. Pearson, 2010.
5. Ramady, Mohamed. The Saudi Arabian Economy. Second edition. Springer, 2010.
6. SAMA. "Forty Sixth Annual Report." 2010.
7. Ying, Diao. China's trade to reach $2 trillion in 2007. 18 May 2007.
http://www.chinadaily.com.cn/china/2007-05/18/content_875677.htm.

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