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GLOBAL FINANCIAL Crisis

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Title: GLOBAL FINANCIAL Crisis


1
GLOBAL FINANCIAL Crisis
Why, What Happened, Whats Next?
  • 1978-2002, 117 Banking Crises in 93 economies.
  • 3rd Global Crisis in 3 decades
  • Latin America
  • East Asia/Russia/Brazil/Argentina/Turkey
  • Developed and Developing economies
  • But the first where US, UK, Euro economies and
    Japan are simultaneously in recession. IMF
    2009, 1st time since WWII developed economies
    will have negative growth.
  • Reinhart and Rogoff (2008) demonstrate, the
    antecedents and aftermath of banking crises in
    rich countries and emerging markets have a
    surprising amount in common. There are broadly
    similar patterns in housing and equity prices,
    unemployment, govt revenues and debt.

2
Unfolding Crisis JP Morgan Global Manufacturing
Index
Global Manufacturing PMI Summary Nov Dec
Change Summary Global PMI 36.5 33.2 Index at
series-record low Output 33.1 28.8 Index at
series-record low New Orders 29.8 25.3 Index at
series-record low Input Prices 36.2 31.3 Index
at series-record low Employment 39.6 36.7 Index
at series-record low Global manufacturing ended
2008 on an exceptionally weak footing with a 15
decline. Dec. PMI data pointed to series-record
contractions in output, new orders and employment
as companies continued to face weak market demand
resulting from the worldwide economic downturn
and ongoing crises in the financial and credit
markets. This was most striking in the US, where
production and new work received fell at the
fastest rates in the 61 year ISM survey. Almost
all of the national output and new orders indexes
for which Dec. figures were available were at
their lowest or second-lowest readings in their
respective series histories.
3
World-wide declines
  • Manufacturing surveys reflect simultaneous
    contraction in manufacturing throughout the G7
    and in key emerging markets like China, Brazil
    and Russia verifying the global recession that is
    well on course.  PMI and Industrial production is
    at least decade lows in key emerging markets and
    US and EU PMI surveys reflect the weakest levels
    in several decades
  • Merrill Industrial production, has absolutely
    collapsed everywhere, most notably in Asia. 
    Retail sales have been severely affected,
    particularly those of durable goods, such as
    autos, which have seen a plunge of 20-40 yoy
    globally,  creating severe downside risks for Q4
    GDP everywhere around the world. 
  • JPMorgan  The weakest performance was registered
    by Japan, whose output and new orders indexes
    fell to levels unprecedented in the histories of
    any of the national manufacturing. Employment
    also fell at series-record rates including all of
    the Eurozone nations, China and the UK. With the
    orders and inventory ratio falling further, an
    intense contraction phase in industry should
    remain in place for some months to come.
  • Chinese orders has been in contraction for five
    months and industrial production has been slowing
    sharply in many Asian countries as external and
    domestic demand weaken. Estimated 10,000 of
    60,000 Hong-Kong owned factories in southern
    China are in the process of closing, as exports
    have plunged 11 in December. Trade finance is
    collapsing. China in process of illegally
    encouraging trade thru tariffs subsidies, which
    will increase trade tensions.

4
Long recession since Great Depression
At the end of 2008, Consumer confidence new
orders lowest ever. Manufacturing and home
constructions lowest levels in decades. Home
prices decline nationwide largest on record.
Factory sales fall off cliff, plunging 5.3 in
November, the biggest drop on record. Loan
losses for U.S. banks are expected to rise to 3
by the end of 2010, from 1.5 in 3rd Q 2008, hurt
by an increased percentage of bad loans, greater
consumer leverage and faster problem recognition
by banks, Deutsche Bank said, and Loan losses
might even surpass the 3.4 loss levels reached
in 1934 during the Great Depression. 200,000
retailers and 3000 malls and outlets may declare
bankruptcy.
5
Background
  • The global imbalances probably represent the
    single largest current threat to the continued
    growth and stability of the US and world
    economies (Bergsten, 07)
  • U.S. CA deficit as a sword of Damocles hanging
    over the global economy (Rogoff 07).
  • The first major financial crisis of the 21st
    century involves esoteric instruments, unaware
    regulators, and skittish investors. It also
    follows a well-trodden path laid down by
    centuries of financial folly. Is the special
    problem of sub-prime mortgages this time really
    different? …standard indicators for the US, such
    as asset price inflation, rising leverage, large
    sustained CA deficits, and a slowing trajectory
    of economic growth, exhibited virtually all the
    signs of a country on the verge of a financial
    crisis indeed, a severe one
  • Examination of 100s currency debt crises finds
    stunning qualitative and quantitative parallels
    across a number of standard financial crisis
    indicators. US buildup up debt is less, the
    pattern of US CA deficits is markedly worse. The
    aftermath of other episodes suggests that the
    strains can be quite severe, typically leading to
    fall of GDP by 2 and a prolonged 2-year
    slowdown.
  • Starting in the summer of 2007, the US
    experienced a striking contraction in wealth,
    increase in risk spreads, and deterioration in
    credit market functioning. The US sub-prime
    crisis, of course, has it roots in falling
    housing prices, which have in turn led to higher
    default levels particularly among less
    credit-worthy borrowers. The impact of these
    defaults on the financial sector has been greatly
    magnified due to the complex bundling of
    obligations that was thought to spread risk
    efficiently. Unfortunately, that innovation also
    made the resulting instruments extremely
    nontransparent and illiquid in the face of
    falling house… (Reinhart and Rogoff, 08)

6
A Crisis like no Other?
  • Tolstoy famously begins his classic novel Anna
    Karenina with Every happy family is alike, but
    every unhappy family is unhappy in their own
    way. While each financial crisis no doubt is
    distinct, they also share striking similarities,
    in the run-up of asset prices, in debt
    accumulation, in growth patterns, and in current
    account deficits. The majority of historical
    crises are preceded by financial liberalization,
    as documented in Kaminsky and Reinhart (1999).
    While in the case of the US, there has been no
    striking de jure liberalization, there certainly
    has been a de facto liberalization. New
    unregulated, or lightly regulated, financial
    entities have come to play a much larger role in
    the financial system, undoubtedly enhancing
    stability against some kinds of shocks, but
    possibly increasing vulnerabilities against
    others. An examination of the aftermath of severe
    financial crises shows deep and lasting effects
    on asset prices, output and employment.
  • 1) Real housing price declines average over 35
    over a six year period. Note in other crises,
    residential real estate was not necessarily a
    focus of the bubble. Even excluding Japan (which
    has suffered a 17 year housing price decline) the
    average is over 5 years. 2) Equity prices fall
    55 over three and a half years. 3) GDP fall an
    average of 9 4) Unemployment increases 7 over
    previous norms. 5) Government debt "explodes",
    increasing an average of 86, but the cause is
    typically not a banking industry
    recapitalization, but maintaining services in the
    face of collapsing tax revenues and
    countercyclical measure ex financial system
    measures.
  • Perhaps the US will prove a different kind of
    happy family. Despite many superficial
    similarities to a typical crisis country, it may
    yet suffer a growth lapse comparable only to the
    mildest cases. Perhaps this time will be
    different as so many argue. Nevertheless, the
    quantitative and qualitative parallels in run-ups
    to earlier postwar industrialized-country
    financial crises are worthy of note.

7
A Crisis waiting to happen
  • These global imbalances are unsustainable for
    both international financial and US domestic
    political reasons. On the intl side, the US must
    now attract 8 billion of capital from the rest
    of the world every working day to finance the US
    CA deficit and foreign investment outflows. Even
    a modest reduction of this inflow, let alone its
    cessation or a sell-off from the 14 trillion of
    dollar claims on the US now held around the
    world, could initiate a precipitous decline in
    the . This could, in turn, sharply increase US
    inflation and interest rates, severely affecting
    the equity and housing markets and potentially
    triggering a recession. Fred Bergsten May 07
  • The world economy faces an acute policy dilemma
    that, if mishandled, could bring on the mother of
    all monetary crises. Many dollar holders,
    including central banks and sovereign wealth
    funds as well as private investors, clearly want
    to diversify into other currencies. Even a modest
    realization of these desires could produce a free
    fall of the US currency and huge disruptions to
    markets and the world economy. Fears of such an
    outcome have risen sharply in both official
    circles and the markets. Bergsten Dec 07.
  • If only Asia would save less, spend more and so
    import more from America, it is argued, the
    deficit would simply vanish. The problem is that
    America's imports are 50 larger than its
    exports, so if both simply grow at the same pace,
    the CA automatically widens. If imports rise by
    10, then exports need to grow by 15 just to
    prevent the deficit from widening. This means
    that while stronger foreign demand would
    undoubtedly help, the US cant reduce the deficit
    by exporting its way out.
  • China says US should put its own house in order
    save moreand stop blaming others for its
    problems.

8
Falling Savings…
  • US personal savings rate have fallen from 10 to
    0. Credit Card debt is approaching 10,000
    household, home foreclosures have soared. We
    borrow from other economies - 8 billion a day,
    70 of the worlds savings. US Current Account
    Deficits have reached 600-800 billion for years.
    14 years of 4 real consumer growth likely to
    slow 1-2 for 3-5 years. UNSUSTAINABLE.
  • Current Account Deficits are appropriate for
    emerging countries that need investment whereas,
    US is borrowing for Wars, Consumption
    Housing.
  • Wall Street responsible for facilitating the
    financing of Asian/Oil Exporters to
    over-leveraged consumers.
  • The world economy faces an acute policy dilemma
    that, if mishandled, could bring on the mother of
    all monetary crises. Many dollar holders,
    including central banks and sovereign wealth
    funds as well as private investors, clearly want
    to diversify into other currencies. Even a modest
    realization of these desires could produce a free
    fall of the US currency and huge disruptions to
    markets and the world economy. Fears of such an
    outcome have risen sharply in both official
    circles and the markets. Bergsten Dec 07.

9
Impact on US Ownership
  • Foreigners account for about 2.2 trillion, or a
    little over half, of the outstanding total of
    4.3 trillion of US Treasury securities held by
    the public. Official institutions, mainly central
    banks, account for about 60 percent of this
    total. In addition, foreigners as a whole
    probably hold close to 1 trillion, or about 15,
    of US government agency securities. These totals
    and ratios have risen rapidly over the past 20
    years. From 1985-06, foreigners acquired almost
    75 percent of the overall increase in outstanding
    treasuries. From 1995-06, domestic holdings
    actually fell while foreign holdings grew by
    twice the aggregate increase. Since 2001, foreign
    purchases of treasuries have accounted for nearly
    all of the rise in the total outstanding debt.
  • Hence, the CA is now being financed by short-term
    money and by central banks, which is
    unprecedented. FX reserves (65 in ) have risen
    by 1 trillion in just 18 months. The previous
    addition of 1 trillion to official reserves took
    a decade. These purchases of have nothing to do
    with the prospective returns in the US, but are
    aimed at holding down the currencies of the
    purchasing countries.
  • Worse still, in recent years capital inflows into
    America have been financing not productive
    investment (which would boost future income) but
    a consumer-spending binge and a growing budget
    deficit. A CA deficit that reflects a lack of
    saving is hardly a sign of strength.
  • Debt is 11 times export earnings and comparable
    to crisis victims such as Argentina and Brazil

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12
Record Financial Losses
  • It has been a year of record misery the largest
    bankruptcy, bank failure and Ponzi scheme in U.S.
    history 720 billion in writedowns and losses by
    financial institutions 30.1 trillion in market
    valuation wiped out including 7 trillion in the
    US
  • The biggest loss and the hardest thing to
    recover, though, may be something that cant be
    precisely measured -- confidence in the markets
    and the firms that rely on them. Lehman with
    assets of 639 billion, filed the largest
    bankruptcy in U.S. history on Sept. 15. Its
    creditors lost 75 billion. Financial companies
    tumbled the most among the 10 main industries in
    the SP 500 this year, falling 57 percent. The
    SP 500s 38 decline in 2008 was the first that
    exceeded 30 since the 39 percent plunge in 1937.
    In, 2002, 1974, the SP was down 23 29.7, the
    following year there were annual gains of 26 and
    32 respectively.
  • In the largest U.S. bank failure, WAMU collapsed
    in September with 307 billion in assets (more
    than last six year combined). There were 25 bank
    failures in 2008, the most in 15 years. The wave
    of writedowns and losses that swamped financial
    institutions around the world reached 720
    billion this year. It also eroded employment
    250000 in financial services.
  • Wall Street bonuses became so rich in recent
    years that 1 million was referred to as a buck.
    The U.S. government was forced to rescue the
    worlds largest insurance company, AIG with a
    152.5 billion package of investments, loans and
    capital infusions.
  • Overall, the Govt has committed 8.5 trillion in
    trying to jumpstart a shrinking economy.
  • The paralysis of credit markets sent ripples
    through many of the businesses that had flooded
    Wall Street with profits over the past decade.
    Corporate profits have declined for seven
    straight quarters. Should earnings fall through
    the first half of 2009, as analysts expect that
    would be the longest stretch of decreases since
    the government started tracking quarterly data in
    1947.

13
Causes Litany of Errors
  • Financial Liberalization coupled with poor
    regulation, enforcement, lax underwriting bond
    ratings, skewed incentives in the financial
    sector. Greed ignorance by Wall Street and
    Main Street with Govt indifference. Capitalism
    went from a referred boxing match to a bar room
    brawl with no bouncer and rules. Reinhart Banana
    republic approach of supervision no one seems to
    know who is responsible for what. "Received
    wisdom was that such supervisory disarray could
    only happen in an emerging market - we now know
    better.
  • Global Imbalances caused by falling US savings
    rates, and Mercantilism (structural or exchange
    rate manipulated) leading to a Savings Glut by
    other economies. US China in financial embrace
    addicted to cheap goods credit (US) export
    growth and financial stability (China)
  • Borrowing good to finance investment. In 1800s,
    we borrowed from British to build railroads. But
    in past 8 years, government borrowed for Iraq
    consumer for SUVs, houses
  • Monetary Glut Serial Bubble Economy, Interest
    Rates too low, too long record low 2002-2004,
    leading to housing boom bust. Tremendous
    increase in liquidity and growth in the
    nonbanking/shadow banking sector.
  • Perception of Risk and disregard of history
    This time is different. However, 1.2 trillion in
    bad debt, and may reach 2 trillion. The most
    expensive financial crisis in history.

14
Causes Financial regulations
  • Financial crises have accelerated across the
    world during Financial Globalization Deregulation
    (pushed by US) , increased Financial Flows,
    Loosening of Capital Capital Controls at the
    heart of over 100 crisis including the Asian and
    Latin American financial crises of the 1990s
    foreshadowed the current situation and argues
    that the rise of unregulated financial
    institutions--or "shadow banks"--since then has
    been the real problem
  • Banks and other Financial institutions are
    inherently instable due to very high leverage
    ratios Gross capital flows into the United States
    totaled 7.8 trillion over the five years from
    2003 through 2007, increasing each year to reach
    2.1 trillion in 2007.1 bursting of the
    debt-fueled property bubble and the crippling
    losses suffered by banks,
  • The principal instruments were MBSs (mortgage
    backed securities), CDOs (collateralized debt
    obligations) and CDSs (credit default swaps),
    which were a form of insurance against default.
    These depended on the liquidity and solvency of
    the insurer, for example the huge insurance
    company AIG which the government had to take
    over. Derivatives, securitization, deregulation,
    greedy bankers, overpaid traders, fraudulent
    behavior
  • Another example is the hands-off attitude that
    was taken toward hedge funds, even as they became
    a larger and larger part of the financial system,
    and even after the crisis caused by the
    near-collapse of Long-Term Capital Management in
    1998. Grew 1.8 trillion
  • All told, the non-bank financial system grew to
    be very large (10.5 trillion)

15
Govt Promoted Free Market
  • Ed Gramlich, a Fed governor warned in 2000 that a
    fast-growing new breed of lenders was luring many
    people into risky mortgages they could not
    afford. But when Gramlich privately urged Fed
    examiners to investigate mortgage lenders
    affiliated with national banks, he was rebuffed
    by Greenspan. Mr. Gramlich asked. The question
    answers itself the least sophisticated
    borrowers are probably duped into taking these
    products.
  • In 2001, Bair (Treasury), tried to persuade
    subprime lenders to adopt a code of best
    practices and to let outside monitors verify
    their compliance. None of the lenders would agree
    to the monitors, and many rejected the code
    itself. Housing advocacy group in CA meeting with
    Greenspan in 2004, warned that deception was
    increasing and unscrupulous practices were
    spreading. However, Greenspan encouraged the use
    of flexible rate mortgages and new innovations.
  • Federal Govt stopped more than 30 states attempts
    to curb mortgage brokerage lenders bad behavior.
    Both the Fed and the Bush adm. placed a higher
    priority on promoting financial innovation and
    the ownership society. Further, the Fed
    counted on the housing boom to prop up the
    economy after the stock market collapsed in 2000.
  • Homeowners with subprime mortgages end up in
    foreclosure almost 20 of the time, or more than
    6 times as often as experiences that begin with
    prime mortgages. House price depreciation plays
    an important role in generating foreclosures, as
    subprime lending borrowers are particularly
    sensitive to falling house prices. By comparison,
    the success rate for borrowers who finance their
    home purchase with a prime mortgage is 97.

16
Housing is partially to blame
17
Impact on US Ownership
  • Foreigners account for about 2.2 trillion, or a
    little over half, of the outstanding total of
    4.3 trillion of US Treasury securities held by
    the public. Official institutions, mainly central
    banks, account for about 60 of this total. In
    addition, foreigners as a whole probably hold
    close to 1 trillion, or about 15, of US
    government agency securities. These totals and
    ratios have risen rapidly over the past 20 years.
    From 1985-06, foreigners acquired almost 75
    percent of the overall increase in outstanding
    treasuries. From 1995-06, domestic holdings
    actually fell while foreign holdings grew by
    twice the aggregate increase. Since 2001, foreign
    purchases of treasuries have accounted for most
    of the rise in the total outstanding debt.
  • Hence, the CA is now being financed by short-term
    money and by central banks, which is
    unprecedented. FX reserves (65 in ) have risen
    by 1 trillion in just 18 months. The previous
    addition of 1 trillion to official reserves took
    a decade. These purchases of have nothing to do
    with the prospective returns in the US, but are
    aimed at holding down the currencies of the
    purchasing countries by China, Japan, Hong Kong,
    Taiwan…
  • Worse still, in recent years capital inflows into
    America have been financing not productive
    investment (which would boost future income) but
    a consumer-spending binge and a growing budget
    deficit. A CA deficit that reflects a lack of
    saving is hardly a sign of strength.
  • Debt is 11 times export earnings and comparable
    to crisis victims such as Argentina and Brazil

18
Deleveraging
  • The U.S. and Western Europe is in the grip of a
    downward spiral that financial experts call
    deleveraging. Having accumulated debts beyond
    what's sustainable, households and financial
    institutions are being forced to reduce them. The
    pressure to do so results from a decline in the
    price of the assets they bought with the money
    they borrowed. It's a vicious feedback loop. When
    families and banks tip into bankruptcy, more
    assets get dumped on the market, driving prices
    down further and necessitating more deleveraging.
    This process now has momentum that even 700
    billion in taxpayers' money may not suffice to
    stop it.
  • In the case of households, debt rose from about
    50 of GDP in 1980 to a peak of 100 in 2006.
    Much of the increase in debt was used to invest
    in real estate. The result was a bubble at its
    peak, average U.S. house prices were rising at
    20 a year. Then as bubbles always do it
    burst.
  • Banks and other financial institutions are in
    worse shape their debts are accumulating even
    faster. By 2007 the financial sector's debt was
    equivalent to 116 of GDP, compared with a mere
    21 in 80. The banks net losses imply that they
    will need to shrink their balance sheets by 10
    times that figure almost a trillion dollars
    to maintain a constant ratio between their assets
    and capital. That suggests a drastic reduction of
    credit, since a bank's assets are its loans.
    Fewer loans mean tighter business conditions
    credit leading to layoffs.
  • The Wall Street crash lead to a U.S. stock market
    declined a staggering 89, reaching its nadir in
    July 1932. The index did not regain its 1929 peak
    until 1954. Yet the underlying cause of the Great
    Depression as Friedman and Schwartz argued was
    not the stock-market crash but a "great
    contraction" of credit due to an epidemic of bank
    failures. By 1932, 1,860 banks had failed.

19
Shadow Banks Securitization
  • It's started with the collapse of these 300-plus
    non-bank mortgage lenders. shadow banking
    system.  The non-bank mortgage lenders -the
    broker-dealers, the hedge funds, the private
    equity, the money market funds look like banks
    by borrowing short.  They're highly leveraged,
    more than banks.  They lend long and illiquid
    ways. 
  • The originators of the mortgages had little or no
    incentive to ensure that the mortgagees could
    afford to take out the mortgages without default.
    Only if they retained some of the loans or
    instruments would they have an incentive, This is
    very different from the old-fashioned way when
    local banks retained the risks and therefore made
    themselves adequately familiar with the
    mortgagees. It is not surprising that the new
    procedure is called the originate-to-distribute
    model. securitization
  • It became impossible for mortgagees to
    renegotiate the loans with the ultimate lenders,
    since the latter were effectively dispersed.
    Contrast this with the negotiations that took
    place in the 80s between the govt of developing
    countries and the intl banks in resolving the
    LDC debt crisis.
  • There was an effect that was fatal, and indeed
    set off the world credit crisis. Once the US
    housing market went into decline and a proportion
    of  sub-prime mortgagees defaulted there was a
    critical information problem. Holders of these
    instruments, which were composites of many
    different mortgages, did not know and could not
    know what risks they were running.  All they
    knew was that they could make big losses or
    they might not. As a result they wanted to get
    rid of them, and the market value of the
    instruments fell dramatically. A device which was
    meant to off-load and spread risk which indeed
    it did spread fear. And this led to the next
    step,  Panic

20
Lessons from Past events - IMF
  • Financial systemsboth financial institutions and
    the channels of intermediationhave historically
    been prone to periods of rapid expansion followed
    by corrections.
  • Episodes of financial turmoil characterized by
    banking distress are more often associated with
    severe and protracted downturns than episodes of
    stress centered mainly in securities or foreign
    exchange markets.
  • The likelihood that financial stress will be
    followed by recession is greater when a housing
    and credit bubble period precedes it. Moreover,
    greater reliance on external financing by
    households and nonfinancial firms coupled with
    leverage is associated with sharper downturns in
    the aftermath of financial stress.
  • The importance of core financial intermediaries
    in transmitting financial shocks to the real
    economy suggests that policies that help restore
    the capital base of these institutions within a
    strong framework of financial stability can help
    alleviate downturns.
  • The patterns of asset prices and aggregate
    credit in the US during the current episode of
    financial stress appear similar to those of
    previous episodes that were followed by
    recessions. In particular, changes in the pattern
    of household net borrowing closely track the
    trajectory of past recessions.
  • Nonfinancial firms entered the turmoil from a
    relatively strong position. Combined with the
    large losses sustained by core banking
    institutions, these factors suggest that the
    United States continues to face considerable
    recession risks.

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24
Why have they lent US
  • Gross capital flows into the United States
    totaled 7.8 trillion over the five years from
    2003 through 2007, increasing each year to reach
    2.1 trillion in 2007.1
  • Why are foreigners willing to invest an average
    of over 5 billion every day in the USespecially
    given relatively low returns relative to
    comparable investments in other countries and a
    widespread expectation of continued dollar
    depreciation? Forbes Foreigners investing in
    U.S. equity and bond markets have earned lower
    returns over the past five years than if they had
    invested in the same asset classes in their own
    countries, and the advantages of the US are
    diminishing honest, highly developed liquid
    market that is uncorrelated with their own
    market. ever, as developing financial markets
    (especially in low-income countries) is a
    prolonged process. If countries with less
    developed financial markets begin to question the
    relative advantages of U.S. financial markets,
    this could lead to a more rapid adjustment in
    U.S. capital inflows, global imbalances and asset
    prices.
  • NY Times (Jan 08) China Losing Taste for US
    Debt. China has bought more than 1 trillion of
    American debt, but as the global downturn has
    intensified, Beijing is starting to keep more of
    its money at home, a move that could have painful
    effects for American borrowers. I Past five
    years, China has spent as much as 1/7 of its
    entire economic output buying foreign debt,
    mostly American. In September, it surpassed Japan
    as the largest overseas holder of Treasuries.
    Last year, China spent 415 billion, while this
    year it is expected 177 billion as deficit
    soars. Chinas voracious demand for American
    bonds has helped keep interest rates low for
    borrowers ranging from the US Govt to home
    buyers. Reduced Chinese enthusiasm for buying
    American bonds will reduce this dampening effect.

25
Potential instability
  • Economist America's policies are putting at
    risk the dollar's role as the world's dominant
    intl currency.
  • IMF - With its rising budget deficit and
    ballooning trade imbalance, the US is running up
    a foreign debt of such record-breaking
    proportions that it threatens the financial
    stability of the global economy. IMF reported
    sounded a loud alarm about the shaky fiscal
    foundation of the US, questioning the wisdom of
    the Bush adm. tax cuts and warning that large
    budget deficits pose "significant risks" not just
    for the US but for the rest of the world. The
    report warns that the US' net financial
    obligations to the rest of the world could be
    equal to 40 percent of its total economy within
    a few years "an unprecedented level of external
    debt for a large industrial country, that could
    play havoc with the value of the dollar and intl
    exchange rates.
  • The danger, according to the report, is that the
    United States' voracious appetite for borrowing
    could push up global interest rates and thus slow
    global investment and economic growth.
  • "Higher borrowing costs abroad would mean that
    the adverse effects of U.S. fiscal deficits would
    spill over into global investment and output,"
  • The I.M.F. is right," said C. Fred Bergsten,
    director of the Institute for International
    Economics in Wash. "If those twin deficits of
    the federal budget and the trade deficit
    continue to grow you are increasing the risk of a
    day of reckoning when things can get pretty
    nasty."

26
Myths Lessons
  • Lower macroeconomic risk the Great Moderation.
  • Lower financial risk due to financial innovations
    (increased systematic risk)
  • Lower risk due to efficient, nonfailing markets
  • Lead to increased leverage
  • Decoupling lead to believe that emerging markets
    were no longer tied to US but we are
    interconnected via trade in goods, services,
    assets and institutions.
  • US is a different type of borrower than emerging
    economies
  • Global imbalances and the US consumers can
    continue to borrow forever
  • International financial integration like
    international trade produces more winners than
    losers
  • Government is bad No, government is critical
    for establishing honest, transparent markets and
    enforcing contracts, free flow of information and
    protecting private property. Capitalism can not
    work with markets, there are to many
    externalities, and free riders. Reliable
    information needs government enforcement, not
    voluntary private enforcement.
  • Lessons Confidence, like reputation, is a
    fragile commodity hard to earn, easy to lose.
    Once it is shattered, mistrust and caution will
    prevail for awhile, putting back the pieces takes
    time and faith.

27
Surprise?
  • In 2003, Case Shiller wrote, The popular press
    is full of speculation that we are in a housing
    bubble that is about to burst. Barrons, Money
    Magazine and The Economist have all run recent
    feature stories about the irrational runup in
    prices and the potential for a crash in home
    prices. The Economist has had a series of
    articles with titles like Castles in Hot Air
    House of Cards Bubble Trouble, Betting the
    House. These accounts have necessarily raised a
    lot of concerns among the general public. But,
    how do we know if the housing market is in a
    bubble? there are elements of a speculative
    bubble in single family home prices in some
    cities the strong investment motive, the high
    expectations for future price increases and the
    strong word of mouthThe consequences of such a
    fall in home prices would be severe for some
    individuals. Given the high level of personal
    debt relative to personal income, an increase in
    bankruptcies is likely. Such an increase could
    potentially worsen consumer confidence, creating
    a renewed interest in replenishing savings.
    Personal consumption expenditure, which has
    driven the economy so far, may drop, stalling the
    current economic recovery.
  • Leamer in 2003 also warned of a housing bubble,
    but Greenspan argued that there really wasn't a
    single national market for housing, but rather a
    collection of many local markets. Even if a
    bubble emerged in one market, he said, there was
    no reason to think it would spill over into other
    markets. He dismissed the idea--or, for that
    matter, any comparison to the stock market, which
    had recently gone through a high-tech bubble--on
    the grounds that housing was different because of
    substantial transaction costs and more limited
    opportunities for speculation.
  • Paul Kaiser noted that 60 of banks' earning
    assets were mortgage-related--twice as much as
    was the case in 1986. If the housing market were
    to go bust, the banking system would suffer
    significant damage. And since the banking system
    is the transmission mechanism between the Fed and
    the economy, any serious downturn in that sector
    could make monetary policy impotent, thus pulling
    down the entire economy.

28
IMF Summary Forecast
  • 1) The world is heading into a severe slump, with
    declining output in the near term and no clear
    turnaround in sight.
  • 2) Consumers in the US and the nonfinancial
    corporate sector everywhere are trying to
    rebuild their balance sheets, which means they
    want to save more.
  • 3) Govts have only a limited ability to offset
    this increase in desired private sector savings
    through dissaving (i.e., increased budget
    deficits that result from fiscal stimulus). Even
    the most prudent govts in industrialized
    countries did not run sufficiently
    countercyclical fiscal policy in the boom time
    and now face balance sheet constraints.
  • 4) Compounding these problems is a serious test
    of the eurozone financial market pressure on
    Greece, Ireland and Italy is mounting Portugal
    and Spain are also likely to be affected. This
    will lead to another round of bailouts in Europe,
    this time for weaker sovereigns in the eurozone.
    As a result, fiscal policy will be even less
    countercyclical, i.e., Govts will feel the need
    to attempt precautionary austerity, which amounts
    to a further increase in savings.
  • 5) At the same time, the situation in emerging
    markets moves towards near-crisis, in which
    currency collapse and debt default is averted by
    fiscal austerity. The current IMF strategy is
    designed to limit the needed degree of
    contraction, but the IMF cannot raise enough
    resources to make a difference in global terms -
    largely because potential creditors do not
    believe that large borrowers from an augmented
    Fund will be responsible.

29
IMF Forecast
  • 6) The global situation is analogous to the
    problem of Japan in the 1990s, in which
    corporations tried to repair their balance sheets
    while consumers continued to save as before. The
    difference, of course, is that the external
    sector was able to grow and Japan could run a
    current account surplus this does not work at a
    global level. Global growth prospects are
    therefore no better than for Japan in the 1990s.
  • 7) A rapid return to growth requires more
    expansionary monetary policy, and to be led by
    the US.
  • 8) The push to re-regulate, which is the focus of
    the G20 intergovernmental process could lead to a
    potentially dangerous procyclical set of policies
    that can exacerbate the downturn and prolong the
    recovery. There is currently nothing on the G20
    agenda that will help slow the global decline and
    start a recovery.
  • 9) The most likely outcome is not a V-shaped
    recovery (which is the current official
    consensus) or a U-shaped recovery (which is
    closer to the private sector consensus), but
    rather an L, in which there is a steep fall and
    then a struggle to recover.

30
Links between Economies
  • Markets have entered a vici
  • Markets have entered a vicious cycle of asset
    deleveraging, price declines, and investor
    redemptions. Credit spreads spiked to distressed
    levels, and major equity indices dropped by about
    25 percent in Oct. Emerging markets came under
    even more severe pressure. Since Oct. spreads on
    sovereign debt doubled, returning to 2002 levels,
    with more than a third of the countries in the
    benchmark EMBIG index trading at spreads above
    1,000 basis points. Emerging equity markets lost
    about a third of their value in local currency
    terms and more than 40 percent of their value in
    U.S. dollar terms, owing to widespread currency
    depreciations.
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