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The Current Financial Crisis and its Impact on Emerging Markets

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Title: The Current Financial Crisis and its Impact on Emerging Markets


1
The Current Financial Crisis and its Impact on
Emerging Markets
LILIANA ROJAS-SUÁREZ Interamerican Development
Bank Washington DC, May 2008
2
Hypotheses about the Origin of the Current
Financial Turmoil
  • Highly expansive monetary policy in industrial
    countries.
  • The persistence of global macroeconomic
    imbalances.
  • Technological developments in financial markets,
    which led to the creation of complex instruments.
  • Insufficient transparency of non-bank entities
    operations and off-balance sheet bank operations.
  • Inadequate regulation for the current
    sophisticated financial and equity markets.

3
Hypotheses about the Origin of the Current
Financial Turmoil
  • ALL the advanced hypotheses are part of the
    problem.
  • But there is one more
  • A not-yet learned lesson capital markets
    complement, not substitute the banking system.

All financial crisis are characterized by the
presence of incentives for excessive risk taking.
4
The Crisis Policies and Incentives
  • Excepting the period 2005-2006, monetary policy
    has remained expansive in industrial countries
    (with periods of negative real interest rates).

5
The Crisis Policies and Incentives
  • The main reasons that prevented a restrictive
    monetary policy in the US
  • The vulnerability of the economic recovery after
    the 2001 recession, especially in the context of
    geopolitical risks.
  • Low inflation expectations.

6
The Crisis Policies and Incentives
  • Despite the stock markets crash in 2001, monetary
    policy stabilized real consumption growth in the
    period 2000-2006, through its effects on the
    consumers wealth. This was possible because of
    the large increase in housing prices associated
    with low interest rates.
  • Over the last decade, consumption has offset
    declines in investments. This responds to the
    consumers perception of greater wealth, through
    the value of stocks at first and then through the
    value of real state.

7
The Crisis Policies and Incentives
  • The large global liquidity (low interest rates)
    created incentives for
  • The aggressive expansion of financial non-bank
    intermediaries (mortgage lenders, hedge funds)
    with increasing demand for high-yield assets.
  • The use of financial products that saved
    capital for banks through securitization.
    (Under Basel I, mortgages held on banks balance
    sheets are subject to a 50 capital charge. There
    is no capital charge when mortgages are sold to a
    SIV.)
  • The use of housing equity to get individual
    funding (home equity loans).

In contrast to the 2001 crisis, in 2008 the
American consumer is highly indebted.
8
The Crisis Policies and Incentives
  • The Mortgage Loans Expansion in the Industrial
    World
  • Before

Traditional Relationship between Borrower and
Creditor
Bank
- Pays interest and principal
- Lends money - Manages delinquencies
Borrower
9
The Crisis Policies and Incentives
  • The Mortgage Loans Expansion in the Industrial
    World
  • Now

Mortgage Broker
Creditors Banks and others
Loan
Borrower
Monthly payments
Servicer
Loan
Cash
Monthly payments
Issuer of Structured Products -securities- (SIV)
Trustee
Underwriter
Rating Agencies
Cash
Securities
Monthly payments
Insurers (monolines)
Investors (investment banks, hedge funds,
pension funds, mutual funds, etc.)
Fuente Shéila Bair, FDIC
10
The Crisis Policies and Incentives
  • The system, though complex, can work if risks are
    correctly assessed.
  • The problem is that under conditions of large
    liquidity, the quest for returns encourages
    excessive risk taking and exposes the systems
    vulnerabilities
  • Market participants that work for fees (mortgage
    brokers, payments receivers) dont have
    incentives to monitor the quality of loans, only
    to increase the quantity of loans.
  • The same thing happens with the credit rating
    agencies which supply ratings for the
    structured products and do not face any financial
    responsibility to cover losses from their
    mistakes.
  • Regulatory Arbitrage different financial
    institutions undertaking similar activities face
    different regulations (especially capital
    requirements).
  • Principal-Agent Problem huge disparity in
    traders maximum loss (zero bonus) vs. investors
    losses (the full capital invested).

11
The Crisis Policies and Incentives
  • But the largest problem is that, if an adverse
    shock to the system occurs (in this case, the
    generalized fall of housing prices), all the
    involved financial institutions lose capital.
  • Because banks provide liquidity to capital
    markets and hold structured products as assets, a
    complex system in crisis might collapse to the
    simple system bank-borrower.
  • This trend is already happening
  • Banks have absorbed many SIVs into their books.
  • Banks faced pressures from authorities to finance
    insurers (monolines).
  • Many mortgage brokers have declared bankruptcy.

12
Would Basel II Helped Prevent the Crisis?
  • Most likely not!
  • Under the Standardized Approach Basel II
    emphasizes the reliance on external credit
    ratings. The current crisis has seriously
    questioned the credibility of these agencies for
    the adequate assessment of risks.
  • For large and sophisticated banks, Basel II
    relies on the banks internal risk models for
    assessing credit risk. During the current crisis,
    large banks were heavily affected using their own
    internal models!
  • Because of the large demand from investors for
    mortgage-backed structured products, a reduction
    in capital charges (from 50 to 35 percent in
    Basel II for mortgage held on banks balance
    sheets) would not have prevented excessive
    securitization.
  • Basel II does not properly take into account
    liquidity risk. Funding for SIVs collapsed when
    doubts about the quality of their assets emerged.
    Under huge liquidity constraints, many SIVs were
    forced to sell their assets at very low prices.

13
And Moving Forward?
  • Under current circumstances, when the value of
    the fundamentals is adjusting (the decrease in
    housing prices)

14
And Moving Forward?
  • The systems equilibrium involves a lower size
    of the banking system (according to the available
    capital)
  • And thats already happening.

15
And Moving Forward?
  • With a lower lending capacity to corporations
    (affecting investment) and with a poorer consumer
    (decrease in wealth), the chances of a prolonged
    US slowdown or recession are very high.
  • Consumer confidence is at levels of past
    recessions.

16
Effects of the Current Financial Turmoil on
Emerging Markets
  • Up to now, the effects of the financial turmoil
    in industrial countries on emerging markets have
    been
  • Mild and mostly limited to financial variables
  • Different between regions and between countries
  • HAVE NOT BEEN AN OBSTACLE TO THE CONDUCT OF
    FISCAL AND MONETARY POLICY

17
Effects of the Current Financial Turmoil on
Emerging Markets
  • A most important current feature of many emerging
    markets is their ability to tighten monetary
    policy -increase interest rates- in the presence
    of inflationary pressures.

Source Central Banks and IFS-IMF
18
Effects of the Current Financial Turmoil on
Emerging Markets
  • This contrasts with monetary policy in
    industrialized countries where fears of a
    significant slowdown in economic growth are
    keeping interest rates low and decreasing
  • in spite of expectations of
    higher inflation.

19
What Factors might weaken the Performance of
Emerging Markets?
  • Severe and protracted recession in the US /
    Banking crisis (a mild recession is already
    priced in).
  • High inflation leading to increases in industrial
    countries interest rates (more relevant in 2009).
  • The China factor and the sustainability of high
    commodity prices.

20
The External Risks affecting Emerging Markets
  • US Recession / Banking Crisis
  • Without doubt the worst case scenario for global
    growth and emerging markets performance is a
    systemic banking crisis in the US.
  • This worst case scenario can only materialize if
    the US enters in a vicious circle where
  • severe decline in the value of banks assets
    loss of bank capital
  • credit crunch financing problems
    in corporations and non-bank
  • financial institutions recession
    increase in severity of bad
  • banks assets banking crisis
    prolonged recession
  • This is still a relatively low probability
    scenario, however, because the Fed and the
    Treasury are currently aligned to prevent its
    occurrence.

21
The External Risks affecting Emerging Markets
  • US Recession / Banking Crisis
  • While a mild US recession would find emerging
    markets in good standing, a severe and prolonged
    recession would increase risk aversion, hurting
    investment inflows to emerging markets.
  • Foreign direct investment tend to decline
    sharply in the face of global slowdowns.

22
The External Risks affecting Emerging Markets
  • US Recession / Banking Crisis
  • Trade flows would also be affected, especially if
    the US financial troubles expand to other
    industrial countries, particularly Europe (some
    markets estimations calculate that UK residential
    properties are 30 overvalued).
  • Export growth has suffered the most in
    periods of global slowdowns.
  • Re-emerging calls for trade protectionism in the
    US exports are also a potential threat for
    emerging markets exports.

23
The External Risks affecting Emerging Markets
  • The Costs of Preventing a US Financial Meltdown
    Inflation
  • Concerns about inflation are keeping long-term
    interest rates high.
  • A medium-term risk (2009 onwards) is a sudden
    increase in interest rates in industrial
    countries to contain inflation.
  • This risk, which will affect emerging markets
    financing costs, has a low probability under
    current circumstances, when fears of a prolonged
    recession in the US is the main driver of
    monetary policy.

24
The External Risks affecting Emerging Markets
  • A Decline in Commodity Prices?
  • Although, as stated before, global exports
    are at risk in the face of a US-led global
    slowdown, the sustainability of high commodity
    prices is less risky in the short and medium-term
    due to two factors
  • Cyclical
  • There is an inverse correlation between the value
    of the dollar and the price of commodities.
  • This is because commodities (especially oil and
    gold and food, more recently) are perceived as a
    hedge against dollar weakness and the risk of
    inflation.

25
The External Risks affecting Emerging Markets
  • A Decline in Commodity Prices?
  • Cyclical
  • and the dollar is expected to depreciate
    further, especially with respect to Asian
    currencies. Recent policy signals by the Chinese
    authorities to control inflation point towards
    further increases in interest rates in China and
    further appreciation of the RMB against the US
    dollar.

26
The External Risks affecting Emerging Markets
  • A Decline in Commodity Prices?
  • Structural Factors
  • China, a major importer of many commodities
    -second importer of oil-, will continue a strong
    path of growth in the coming years.
  • Supply problems in the precious and industrial
    metals are a long-term issue, especially given
    South Africas power crisis (SA produces 69 of
    platinum, 30 of palladium and 18 of worlds
    supply of gold). Supply problems of aluminum are
    also large.
  • Land and water constraints supporting high prices
    for agricultural commodities.

27
The External Risks affecting Emerging Markets
  • A Decline in Commodity Prices?
  • Structural Factors
  • And the markets are forecasting a continuation
    in the upward trend of major commodities prices.

28
The External Risks affecting Emerging Markets
  • A Decline in Commodity Prices?
  • Also oil prices will remain high, supported by
    (a) Chinas strong demand, (b) ageing
    infrastructure leading to unplanned outages and
    (c) climate change leading to extreme weather
    conditions.
  • Future prices anticipate a modest decline, but
    these prices have not been effective predictors
    of oil returns in the past.

29
In Conclusion
  • Prospects in the industrial economies (especially
    in the US) arent encouraging in the short-term.
  • The good news is that, at least in the
    short-term, investors are increasing their
    investments in commodities and emerging markets.
  • The bad news is that if the financial problems
    remain severe and prolonged, there will be
    adverse effects on the sustainability of growth
    in emerging markets.
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