Challenges in the Era of Globalization - iaabd

Proceedings of the 12th Annual Conference © 2011 IAABD
Four main transmission mechanisms of economic and financial crises from the developed economies to
the developing ones have been identified in the literature. These are the trade channel, capital market
channel, foreign aid channel and remittances (Balaskrishman et al 2009, frank and Hesse 2009, Roe 2009,
Odi 2009 and Gosh et al 2009). Although many extant studies have confirmed the transmission of
financial crisis and financial stress to developing countries and some have identified the channels of
transmission, none to the best of our knowledge has examine examining the mechanism from developed
countries to Nigeria. To fill this lacuna, this paper examines the impact of the global crisis on the Nigerian
capital market.
The paper is in five sections. Following this introductory section, the second section reviews the extant
literature on the subject matter. In the third section, we present the methodology while the fourth section
discusses the results of the exercise in section three. The fifth summarizes the findings and draws some
conclusions, while making recommendations to help policy makers.
Rreview of extant theoretical and empirical studies
The reasons for and effects of the current global economic and financial crisis have been well documented
in the literature. The crisis, which has its genesis in the U.S Subprime mortgages crisis in August 2007,
rapidly escalated and spilled over to financial markets and economies all over the world. Greenlaw et al.
(2008), Blanchard (2009) and Brunnermeier (2009), moreover, trace the roots of the financial crisis to the
preceding seven years of high global growth, low interest rates and limited volatility. The underestimation
of risks and over-optimism about the future, as a result of high growth/low volatility and low interest
rates, led to the creation and the purchase of riskier assets and ultimately asset price bubble. According to
Nadauld and Sherlund (2008) the bubble reached its peak in the U.S in 2006 and house prices there and
elsewhere started to fall. The fall in house prices led to a fall in the prices of securitized subprime
mortgages, affecting financial markets worldwide. The demise of Lehman Brothers in September 2008
forced markets to re-assess risk and this eventually led to massive investors’ withdrawal of funds from the
markets. This market illiquidity in turn resulted in massive decline in economic activity in the U.S. and
many other countries. In general, risk concentrations, market indiscipline and lax financial regulation and
supervision, among others, contributed in no small way to the crisis (Blanchard 2009).
Indeed, financial crises, characterized as currency crises and banking crises, have long been studied.
Krugman (1979) shows that currency crises occurs when deterioration in economic fundamentals leads to
a crisis in the external account while Obstfeld (1986) indicates that a “second-generation” model of
currency crises exists and occurs even in countries with sound fundamentals owing to self-fulfilling
expectations. In a world of “multiple equilibria,” countries with relatively sound fundamentals may end
up with a bad equilibrium; that is, a currency crisis. Banking crises on the other hand are associated with a
run on bank deposits and this can result from fundamental weaknesses of several commercial banks or
from self-fulfilling expectations (as modeled by Diamond and Dybvig, 1983). These “twin crises”
(currency and banking crises) tend to be associated with each other and often take place together.
Kaminsky and Reinhart (1999) show that currency crises can cause banking crises, banking crises can
cause currency crises, and currency and banking crises can result from common factors. When an
economic boom is financed by a surge both in large capital inflows and in bank credit, the end of the
boom tends to be accompanied by both currency and banking crises (McKinnon and Pill 1996). Before
the episodes of the 1990s, financial crises were, in principle, considered as events occurring in individual
countries. But the Mexican crisis of 1994–95, the East Asian crisis of 1997–98, and the Russian crisis of
1998 had strong contagion (or spillover) effects in other countries; that is a crisis in one country was
rapidly transmitted to the rest of the world.
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