THE financial and economic crises that have already taken a heavy economic toll across the globe began more than a year ago in the United States.

They originated with the way the American banking system had lent to homeowners, often ignoring their capacity to service their loans.

Sometimes the banks enticed the homeowners to borrow by offering all kinds of sweeteners. These loans were then repackaged into new and fancy products and sold to the financial institutions that had the appetite for them. This process was called “spreading the risk”, a development much lauded by Alan Greenspan who served for almost two decades as Chairman of the US Federal Reserve, the American central bank.

Greenspan has now admitted that he did not fully appreciate that unregulated non-banking institutions could play havoc with the financial system.

When the initial sweeteners offered to homeowners by the banks ran out, those who had borrowed discovered that they did not have the capacity to repay the loans they had taken out. Most of the sweeteners were low interest rates for a few years after the loan was signed or no payments of principal for the first few years.

When the payments ballooned, defaults increased at an alarming rate and the quality of the assets on the books of the banks began to deteriorate. Since the banks had sold their loans to other financial institutions, the crisis spread to places other than the banks. Investment banks, hedge funds and pension funds got caught up in the spreading crisis.

For about a year, there was a strong belief that since the practices that produced the crises originated in the United States, that is where they will stay. That did not happen since many of the products developed in the United States were acquired by the banks in Europe. As the quality of these assets deteriorated the European banks were also caught in the web and have also suffered heavy losses. However, the emerging world was initially spared since its financial system was not closely integrated with that of the West.

Eventually, the shockwaves reached the shores of many developing countries through the capital markets. As the portfolio investors in developed countries had taken positions in the stock markets in many developing countries, Pakistan included, liquidation of their assets by them created chaos and the values of shares plummeted.

The departure of the western investor affected Pakistan. This was one reason – albeit not the only one – that resulted in the loss of so much value in the shares quoted on the Karachi stock market. The rot was prevented by the government by fixing a floor under the prices of the quoted scrips.

This was supposedly a temporary measure, taken in the hope that investment sentiment will somehow change and the downward pressure on the prices of stocks will ease. The floor was to be removed on October 27. That did not happen which, as I will discuss, below was a wise decision. Considerable amount of damage has been done to the markets around the globe by the loss of confidence in the working of the global financial global system. In this context, Pakistan had a lot of company.

I will mention some numbers in order to underscore the magnitude of the crisis and its global reach. Since September 1, about $16.3 trillion worth of the global stock market value has been erased. This is a loss of 34.7 per cent in the pre-crisis value of the global market. This is equivalent to 32.6 per cent of global gross domestic product of $50 trillion. Of this, the United States market lost $4.5 trillion, a decline of 29.4 per cent. In terms of the American GDP, this loss is equivalent to about 30 per cent. In other words, capital market losses were larger outside the United States, a fact not fully appreciated by those who comment on the crisis.

How did the countries deal with this financial tsunami? This was handled mostly by the infusion of public money to shore up the stressed system. The government led bail outs have amounted to this date to $4 trillion of which $2.7 trillion was in Europe and the Middle East, $1.2 trillion in the United States and only $181 billion in Asia. The Asian rescue effort was relatively small since the crisis was more contained in these countries than in other large economies.

There has been a severe impact on the value of the local currencies as capital flight took place across the globe. Pakistan was not the only country in which the domestic currency lost so much of its value. India’s rupee fell to a record low against the American currency reaching close to 50 to a dollar. The Polish zloty and the Hungarian forint had their biggest weekly declines last week. Mexico used $13.1 billion to support the local peso but the currency had its worst fall since the “tequila crisis” of 1994.

As indicated, Pakistan adopted an administrative rather than a financial approach to resolve the crisis in its capital market. This was for two reasons. One, the flight of capital that occurred began before the financial crisis developed in the West. It happened because of the sharp wakening in the economy since the beginning of 2007 and the prolonged political crisis from which the country is only now emerging. The second reason was that Pakistan did not have the financial flexibility that was available to other governments. It already had a large fiscal deficit and was already borrowing extensively from the central bank thus creating inflationary pressures. It therefore resorted to administrative means such as placing a floor under the prices of company stocks.

What will happen when the floor is removed? My guess is that the market will suffer a heavy loss as the investors, prevented from liquidating their assets, head for the door. When there is loss of confidence, there is little that prevents the herd instinct from doing damage. Investors are not likely to be deterred by the sharp fall in the price of the rupee.

Nervous investors, especially the few foreigners who are still invested in the market, will be prepared to take heavy losses in expectation of facing a total liquidation of their assets. I have seen this happen before in my career as a development economist.

I saw this kind of behavior in Argentina, Brazil, Chile and Mexico in 1994-94 when the economies of these countries came under pressure and the foreigners who had come to their markets left in droves. There was a repeat of this kind of behavior later at the time of what came to be called the Asian Financial Crisis.

Only two governments managed their escape well. They were Chile in Latin America and Malaysia in Asia. Both used capital controls of various kinds to make it very expensive for investors to quit the domestic market.

The Chileans imposed a heavy penalty on the quitters in the form of a tax on short-term capital movements. This stemmed the flight of capital. The Malaysians, much to the annoyance of the IMF and the western policymakers, used capital controls as well as exchange rate management to deal with the crisis. Both countries emerged stronger compared to their neighbours.

What are the lessons Islamabad (and, of course, Karachi since that is where the State Bank of Pakistan is located) should learn from the experience of other countries. Having used the administrative measure, it would be very costly to suddenly free trading in the stock market.

I would suggest the adoption of two safeguards before the markets are allowed to operate freely. It should create a stabilisation fund to inject capital into the enterprises that have been under stress. Some of the money the country is likely to receive as result of the rescue effort that has been launched, could be used for this purpose. Two, Islamabad should impose taxes on the movement of short-term capital.

The important point that I would like to underscore is that careful thought should be given before the next step is taken to stabilise the markets.