Financial Innovations Reduce Volatility Selected Macroeconomic Volatility Before and After FI Period

1
Joel Kurtzman Chairman, Kurtzman Group Senior
Fellow, Milken Institute
Global Edge Risk and the world economy
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Global Edge Risk and the World Economy

• The Current Situation

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Overall, the global economy appears to be holding
up
GDP
Source IMF, Eurostat, The Conference Board
4
Financial depth increasing
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All regions show resilience

• LEI Leading Economic Indicators
• Note Shaded areas represent U.S. recessions
• Source The Conference Board

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Capital outflows continue to be strong
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US consumers are wary but optimistic
Unemployment rate Actual Bureau of Labor
Statistics Consumer confidence Conference
Board Monthly survey of consumer confidence self
stated by household

• Sources The Conference Board, TNS NFO, BLS

8
Manufactured goods still dominate trade
Source World Trade Organization
9
Three continental exportersWestern Europe a
dominant player (US billions)
Source World Trade Organization
10
Global exports 1999-2005US trillions
Source World Trade Organization
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Manufactured goods as percent of total exports
Source World Trade Organization
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Asian logistics costlier than Europes
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Logistics and Outsourcing
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Logistical operations
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Growth in logistics
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Capital is plentiful

• There may be a credit crunch,
• but there is no capital crunch

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Large pools of capital seeking opportunities
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Wealth funds contribute to global growth
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Petro dollars will continue to increase
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SWFs Largest and smallest(In Billions)
Source Sovereign Wealth Funds Institute
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SWFs 95 of Middle East Foreign Assets
Sovereign Wealth Funds 96 of Middle East
Countries Foreign Assets
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Growth is strong, orientation is long
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Greatest concentration in Middle East
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Sovereign wealth fund market by country
Source Sovereign Wealth Fund Institute
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Mr. Mrs. Asia

• Asian region integrates globally,
• and prepares for the future

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Mr. Mrs. Asia
After-School Educational Activities
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China is spending big on education

• In China, parents spend an average of 15 on
  their childrens education and only 10 on
  housing.
• 55 of parents in China send their children for
  extra lessons in English.

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Spending on early-childhood andpost-secondary
education
Early Childhood Post-Secondary Education Educati
on
U.S. 3,900 14,200 China 6,000 -
10,000 1,200 - 1,500
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Source Knowledge Universe Education
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The flat world is getting flatter
English texts are now the fastest-growing sector
of education books in China. Xin
GuangweiPublishing in China
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Source The Financial Times 4/13/05
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Education remains a high priority
After-School Educational Activities
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India leads in educational aspirations
In India

• Extracurricular activities consisted of academic
  coaching in 95 of the households.
• 43 of parents want their children to get a
  Masters degree 29 want them to get a PhD.

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South Korea sees US as a second home
South Korea

• Spend more on education (22) than housing (13)
• 70 of Korean parents expect their children to
  work overseas, of which more than half expect
  their children to work in the US.

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Long-term trend, a less populous Asia
Fertility Rates
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Mr. Mrs. America

• A few stumbles along
• an otherwise upbeat trail

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Despite problems, US economy remains vibrant
Source International Monetary Fund
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A US recession is not a certainty
Sources Economy.com, Milken Institute, 2005
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US high tech and VC investment remains strong
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Existing home sales are down and falling
Sources National Association of Realtors,
Moodys Economy.com
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New home sales are down and falling
Sources US Census, Moodys Economy.com
40
Dont write off securitization -- US home
ownership rates
Sources US Census, Moodys Economy.com
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Subprime and prime mortgages outstanding
Subprime
Prime
Source Mortgage Banker Assocation
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Subprime write offs total 185 billion, in line
with Feds predictions
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Subprime Share of Securitized Purchase Mortgage
Originations
Sources Loan Performance, Credit Suisse
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Subprime loan originations are down
Sources Inside Mortgage Finance Statistic
Annual, Credit Suisse
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Impact of 10 Percent Decline in Housing
Sales Impact over Next Four Quarters
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Current Path Credit Crunch Impact over Next Four
Quarters
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Current Path 100 Oil Impact over Next Four
Quarters
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Current Path Housing, Oil, and Credit Crunch
Impact over Next Four Quarters
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Global Edge global risk

• The opacity index and
• global risk management

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Business risks
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Labor risk
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Supply chain risks
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Risk management
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Most companies manage risks informally
55
Management of supply chain risks lags
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No common risk standards
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Opacity Risk A new approach

• Todays hypercompetition changes the old view of
  what makes countries successful
• Old view Countries compete on labor costs and
  raw material endowments
• New view countries compete on a range of issues
  including
• Access to capital
• Social systems and costs
• Stability
• Overall levels of risk
• Opacity/transparency

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Markets and countriesincluded in the Opacity
Index
Austria Belgium Czech Rep. Denmark
Finland France Germany Greece
Hungary Ireland Italy Netherlands Norway
Poland Portugal
Russia Spain Sweden Switzerland Turkey United
Kingdom
Canada United States
Pakistan Philippines Singapore South Korea
Taiwan Thailand
China India Hong Kong Indonesia Japan Malaysia
Egypt Israel Kuwait Lebanon Nigeria Saudi Arabia
Argentina Brazil Chile Colombia Ecuador Mexico V
enezuela
South Africa
Australia
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Two types of global risks

• Large-Scale, Low-Frequency Risk
• Large-scale risks (earthquakes, revolutions,
  nationalizations) are dramatic and rare but
  capture attention.
• Small-Scale, High-Frequency Risk
• Small-scale risks are everyday occurrences and
  are the real bane of business. For business, this
  is where the real costs lie.

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The impact of small-scale risks is big

• While all eyes focus on the large but rare risks,
  businesses must
• watch out for the real risks that cost money and
  time.
• Corruption
• Legal systems with limited protections
• Economic policies that hinder sustained growth
• Accounting and governance standards that make it
  difficult to see inside companies
• Regulatory systems that fail to protect investors
• These five (CLEAR) factors are sand in the gear
  of commerce. They are the everyday risks of
  being a global business.

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We call these small-scale risks Opacity

• What exactly is opacity?
• Opacity is the opposite of transparency. It is
  the lack of clear, accurate, easily discernible,
  and widely accepted practices governing the
  relationships among businesses, investors, and
  governments. Opacity acts as a brake on commerce,
  and its presence hampers the smooth operation of
  business transactions.
• Joel Kurtzman and Glenn Yago
• MIT Sloan Management Review
• October 2004

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The costs of small-scale risks can be measured

• Social scientists might call opacity negative
  social capital. Social capital includes
  institutions and agreements that keep a society
  functioning. It includes elements as diverse as
  laws, markets and educational institutions.
• Since opacity is a form of capital, it can be
  measured.
• Since opacity is a form of capital, its
  transformation from negative to positive can be
  noted and followed.
• Since opacity is a form of capital, its impact on
  business and growth can be plainly seen if
  leaders want to look!

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What can we do with Opacity?

• Understand the link between opacity and growth
• Understand price risk
• Measure global portfolio risk and balance
• Create country-based strategies
• Create new types of portfolios (green,
  sustainable, peace etc.)
• Comply with pension fund screens
• Forecast challenges/opportunities
• Compute minimum-required rates of return

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The Opacity Index scores
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The Opacity Index scores
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The Opacity Index scores
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The Opacity Index scores
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Behaviors have costs

• Every Additional Point on an Opacity Score
  Yields
• Lower average per capita income (-986)
• Lower net foreign direct investment as a percent
  of GDP (-1 percent)
• Lower Capital Access Index Score (-0.06 points)
• Lower bank assets as a percent of GDP (-4
  percent)
• Lower stock market capitalization as a percent of
  GDP (-0.9 percent)
• Lower stock market traded value as a percent of
  GDP (-0.9 percent)
• Increase average borrowing interest rate (57
  basis points)
• Increase inflation rate (0.46 percent)

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Complexity of legal systems

• Procedural Complexity Index
• Number of filings
• Duration
• Cost
• Employment Laws Index
• Flexibility of Hiring Index
• Conditions of Employment Index
• Flexibility of Firing Index
• Aggregate Complexity Index
• Average of Procedural Complexity and Employment
  Laws Index

Source World Bank, Doing Business
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Sources of data (general)
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Sources of data (economic and regulatory)
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Sources of data (economic and regulatory)
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Sources of data (economic and regulatory)
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Sources of data (economic and regulatory)
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U.S. GDP growth
Source International Financial Statistics
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A brief period of U.S. budget surplus
Surplus
Deficit
Source U.S. Department of the Treasury, Bureau
of the Public Debt
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Capital Access Index 2006 Gauging
entrepreneurial access to capital
Source Milken Institute
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Capital Access Index, 2006
Less access
More access
Sources World Economic Outlook, Milken Institute
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Factors affecting financial market development

• Level of institutional development, including law
  and regulation (Boyd and Smith, 1996 Gurley and
  Shaw, 1955)
• Legal origin, shareholder rights and creditor
  rights (La Porta et al, 1998)
• Laws and regulations (Levine, 2002 World Bank,
  2001)
• Demographics and human capital (Black, 2002)

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Improved capital access can add billions to
emerging economies
Source Authors Calculation based upon Triphon
Phumiwasana, (2003)
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Representative costs of Opacity expressed in
percent

• Finland -1.83
• UK -0.44
• Sweden -0.31
• U.S. 0.00
• Switzerland 0.40
• Belgium 0.42
• Germany 0.86
• Ireland 1.03
• Japan 1.51

• Brazil 4.29
• Czech Rep 4.56
• Turkey 4.95
• Mexico 5.01
• Saudi Arabia 5.52
• Russia 5.64
• China 6.49
• Venezuela 6.56
• Indonesia 8.54

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Opportunity map

• Size of each bubble represents relative GDP
• Vertical (Y) location of the bubble indicates
  rate of growth
• Horizontal (X) location illustrates increasing
  procedural complexity

Opportunity is defined here as a countrys legal
and procedural complexity, relative to its
overall market size and rate of growth

• Right side of the chart correlateswith higher
  levels of opportunity

GDP GROWTH RATE ()
Source CIA World Factbook World Bank, Doing
Business The Economist World in Figures 2002
INCREASING LEGAL COMPLEXITY
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Forgone finance, forgone growth

• Recent empirical estimates suggest that
• Doubling bank credit to the private sector as a
  percent of GDP in emerging markets could increase
  annual GDP growth by almost 3 percent.
• Doubling the trading volume of the stock market
  in an emerging market could increase annual GDP
  growth by almost 2 percent.

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Thank you

• Joel Kurtzman