Transcript Financial Crisis . ppt

Globalization and the Financial
Crisis in Southeast Asia
Nov. 15, 2005
The Global Financial Crisis
and Developing Countries
Valpy FitzGerald
Oxford Department of
International Development
UNDP HDR Course, St
Catherine’s College, Oxford
22 September 2008
Three FAQs
1.
2.
3.
What is happening on global financial
markets?
What does it mean for developing
countries?
What can be done from a human
development perspective?
FAQ 1
What is happening on global
financial markets?
Origins of current financial crisis




Since 1990s deregulation of financial markets: risk pricing
replaces prudential supervision. Rise of derivative “assets”
with opaque markets and few players. Bank loans replaced
by bonds etc.
Huge US fiscal deficit, monetary expansion (“Greenspan
put”), low savings led to a US mortgage boom/bust (non
traded sector) and a huge current account deficit (traded
sector).
Mortgage bubbles (e.g. 1992 in UK) are familiar with
obvious political costs; join recurrent bubbles in past
decade (dotcoms, LTCM, Tequila etc);
But this is by far the most serious systemically because it
threatens the global banking system itself as creditor, and
whole US electorate as debtor.
“the elephant in the room”
Sub-prime lending


Sub-prime lending had spread from inner-city areas
right across the US by 2005. By then, one in five
mortgages were sub-prime, and they were particularly
popular among recent immigrants trying to buy a
home for the first time, and the poor.
House prices were high, and it was difficult to
become an owner-occupier. But these mortgages had
a much higher rate of repossession than conventional
mortgages (and thus much riskier) because they were
adjustable rate mortgages (ARMs). Payments were
fixed for two years, and then became higher and
linked to Fed interest rates, which also rose
substantially.
Subprime 2


A wave of repossessions is sweeping America
as many of these mortgages reset to higher
rates. By late 2007, one in ten homes in
Cleveland had been repossessed and
Deutsche Bank Trust, acting for of
bondholders, was the largest property owner
in the city.
As many as two million families will be
evicted from their homes as their cases make
their way through the courts. The Bush
administration is pushing the industry to
renegotiate, but mortgage companies are
being overwhelmed by a tidal wave of cases.
Scale and Spread



Collapse of the government backed mortgage
system in the USA (Fannie and Freddie)
followed by meltdown of major investment
banks (Lehman, Bear, Merrill) exposed to
mortgage market
Mark-to-market asset pricing effects on balance
sheets and cumulative liquidity retraction due to
rising risk aversion;
Now affecting Insurance (AIG) ; and pensions
funds next?
Global mortgage boom and bust
The end of the stock market boom
Financial Times, 20 Sept 2008



“…bank boards and bank executives have failed to
understand complex mortgage-backed banking
products, as have central bankers, regulators and
credit rating agencies.”
“…a reward system that has granted huge bonuses
to those who peddled toxic mortgage-related
products….”
“Almost as absurd has been the degree of leverage
racked up by investment banks.”
Policy reactions



“There are no atheists in foxholes and no ideologues in
financial crises,” Mr. Bernanke told colleagues…(NYT
21.09.08)
Freddie Mae and Freddie Mac (re)nationalised; Merrill sold
to BankAmerica; Lehman to Barclays; Goldman and
Morgan become banks again; US govt $700bn purchase of
bad debt; G3 central banks support world banking.
Expansionary monetary policy (to avoid recession like
1930s) and scale of US Govt (and G3) bailouts will have
large repercussions, yet to be evaluated [lessons of Mexico
etc?]
Scale of the potential bailout (already
up to $850bn)
FAQ 2
What does it mean for
developing countries?
Growth and trade



World GDP growth already projected by IMF to slow
down by 2 % points (from 5 to 3 for 2008 and 09);
probably more. So with 2% world growth; global GDP
per capita falls
Asia probably most resilient (though exports to US will
fall); LA will slow down, Africa recession?
Commodity prices declining already; volumes too.
Natural resource exporters will be hit; food and oil
importers to benefit.
World growth will slow, reducing
trade expansion etc.
An end to the commodity boom?
Investment and aid



International investment (bonds, FDI) will slow
down; as will emerging market stocks; as global
confidence declines
Sovereign spreads will rise due to rising risk
premium (default probability x risk aversion):
already up to 4%.
Aid flows already under pressure; will be hurt by
fiscal overload in G3.
S&P 500 vs Emerging Markets Index
Unsurprisingly, G3 market
expectations are bad
US now HIRC?
Recent ODA rise will be difficult to
sustain
Poverty and human development




MDG goals even less likely to be met (growth
and aid are main drivers)
Limitations of family support (Asia), few
universal benefits (LA) and narrow safety nets
(Africa): effect on poor
Previous crises increased inequality, which
remains even when growth recovers
Commodity price reverse will change lottery of
winners and losers
FAQ 3
What can be done from a
human development
perspective?
Proactive macroeconomic policy



Countercyclical monetary policy and real exchange rate
management (inc. capital controls) necessary:
 MICs with forex reserves already do this;
 but LICs constrained by IMF.
Support domestic banks (esp for agriculture and
SMEs), underwrite longterm investment lending; keep
real interest rates low.
Raise tax pressure (not rates) to maintain fiscal balance
and reduce public borrowing.
HD strategy for difficult times



Evidence (UNICEF) that for children employment
stability more important than wages; implications
for e.g. inflation policy
Essential to ringfence budgets (in real terms) for
education and health; extend schemes for (simple)
universal benefits.
Focus on inequality (especially horizontal) rather
than just poverty; to reduce conflict and increase
social cohesion.



International action and the “duty to
protect”
Essential to moderate G8 policy shifts (e.g. bank
regulation, interest rates, exchange rates) from
viewpoint of impact on world poor.
Need for UN to speak in a clear, timely and credible
fashion on these issues (TDR08 good, UN/DESA
etc silent)
Regional arrangements for mutual currency support
etc are vital (Asia progressing; LA talking; Africa
nothing). Role for sovereign wealth funds?
Study Questions







What are the new challenges for SE Asia in the world of global
finance?* Are they more structural or more relevant to some
actors?
What were the internal and external causes of the Financial
Crisis?*
What are the roles of int’l institutions in SE Asia after the crisis,
esp. the IMF?*
Do you think it is fair to criticize ASEAN as not doing enough
in the crisis?* If so, what do you expect ASEAN to do? Is it
feasible in reality or not?*
What are the constraints preventing ASEAN from doing more
during and after the crisis?*
What are domestic consequences of the crisis in the hard hit
countries?*
What are the consequences of the crisis to IR b/w SE Asia and
Japan, China, and the U.S.?
31
What are the new challenges for SE
Asia in the world of global finance?
Globalization: massive increase of trade and capital
flows with the rise of information and communication
technology
 Global capital: availability and willing to take risk in
fast-growing economies, but volatile and unstable.
 Neo-liberal Agenda – Washington Consensus (1989):
liberalization of trade/finance/(foreign) investment,
privatization, deregulation, etc.
 Structural challenges and opportunities for emerging
economies

32
Backgrounds for Growth





From ISI (Import Substitute Industrialization)
to EOI (Export-Oriented Industrialization)
The Four Dragons – NICs (Newly
Industrialized Countries): Korea, Hong Kong,
Taiwan, Singapore
The New Tigers: Malaysia, Thailand, Indonesia,
the Philippines
FDI from Japan after 1985 Plaza Accord
Results: around 10% of growth (1986-95)
33
What were the causes of the
Financial Crisis?
4 views
 Macroeconomic mismanagement (esp. exchange
rates)
 Regulatory and structural problems (esp. in the
financial sector)
 Volatility of int’l financial markets*
 Political uncertainty (esp. on govt. policy and
regime change)
34
Int’l Contexts before the Crisis



Chinese devaluation in 1994  the full rise of
Chinese export  compete w/ SE Asia
Prolonged economic recession in Japan  lower
capacity to absorb SE Asian export
Collapse of semiconductor prices  hurt Korea
and Malaysia
35
Towards the Financial Crisis
East Asian economic model: debt-financing
(bank loan) > equity (stock market)
 Availability of global capital = cheap money for
Asian businesses  capital liberalization (esp.
offshore banking)
 rapid increase of private short-term loans
 Pegged exchange rates to US$ = guarantee for
unhedged loans and reassurance against currency
for investors

36
Why Thailand?





Weak financial supervision after liberalization  too many
unproductive/speculative loans, esp. in real estate and stock
market
Also unhealthy corporate governance and indecisive govt.
Worsening macroeconomic situations: deficit in Balance of
Payment, Trade Balance  investors began to call back loans
Unlikely to keep pegged exchange rate  hedge funds’
speculative currency attack
Devaluation (July 2, 1997)  skyrocketing import bills/debtservicing costs  scarce capitals  heightened interest rates 
liquidity problem  bankruptcies “chain reaction”
37
The Effects




Contagion to other countries, esp. Korea,
Malaysia, and Indonesia
Economies with high foreign reserves (HK) and
also with open exchange-rate regime (Singapore)
were able to largely escape the crisis.
Social effects: hundreds of thousands of workers
lost jobs, even millions in Indonesia
Political unrest and regime changes in Indonesia
and Thailand
38
What are the roles of int’l institutions
(IMF, ADB) after the crisis?



IMF bailout package of $120 billion to Thailand,
Indonesia, Korea and the Philippines
Restrictive conditions – keep interest rates high,
restrictive bank loans  severe liquidity
problem  more bankruptcies
And even more neo-liberal agenda –
privatization, deregulation, liberalization of
foreign investment  massive asset sell-off to
foreign companies
39
Criticism against IMF


Wrong prescriptions
- too restrictive
- same prescriptions to all countries
- gave priority to investor protection
the Wall St-Treasury-IMF Complex
40
ASEAN and the Crisis






ASEAN financial ministers started to talk in early 1997,
but too optimistic.
Later on emphasize macroeconomic coordination and
financial supervisory mechanisms also through peer
review, but ASEAN lacks capability and the norm of
non-interference
Need to get help from Japan and China
ASEAN+3
The Chiang Mai Initiative (for swap arrangement)
Asia Bonds
41
Japan, China, the U.S. and the Crisis




Japan proposed AMF (Asian Monetary Fund),
but was shot down by the U.S.
Then substituted with a moderate “Miyazawa
Fund”
China loaned some money to SE Asia during the
crisis, but more importantly not to devalue its
currency.
The U.S. offered only moral support and urged
for reforms.
42
Consequences in IR





The U.S. reputation was tarnished by predatory
practices of takeover and the Wall St-Treasury-IMF
Complex.
Compared to friendly supports from Japanese
companies.
The growth of nationalism and Islamic activism in SE
Asia
More regionalism in East Asia (i.e. ASEAN+3) with
Japan and China playing key roles (stemmed from anger
+ anxiety)
China and Japan compete for leadership in East Asia.
43
The Current Financial
Crisis and its Impact
on Emerging Markets
LILIANA ROJAS-SUÁREZ
Interamerican Development Bank
Washington DC, May 2008
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.
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.
The Crisis: Policies and Incentives
Japan Overnight Call Rate (%)
Euro Area Main Refinancing Rate (%)
0
0.2
-2
0
0
-4
-0.2
-1
Source: IFS-IMF and FED.
Nominal
Real
Nominal
Real
Source: IFS-FMI and
European Central Bank.
Nominal
Excepting the period 2005-2006, monetary policy has
remained expansive in industrial countries (with periods of
negative real interest rates).
May-08
2007Q4
2007Q3
2007Q2
2007Q1
2006
2005
2004
2003
May-08
2007Q4
2007Q3
2007Q2
2007Q1
2006
2005
2004
2003
2002
2001
Source: IFS-IMF and
Central Bank of Japan.
2001
1
c
2000
May-08
2
2007Q4
0.4
2007Q3
2
2007Q2
3
2007Q1
0.6
2006
4
2005
4
2004
0.8
2003
6
2002
5
2001
1
2000
8
2002
US Fed Funds Rate (%)
Real
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.
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.
GDP, Consumption and Investment Growth (% )
8
6
4
2
0
-2
-4
1998
1999
2000
2001
Source: Bureau of Economic Analysis
2002
2003
Consumption
2004
2005
2006
Investment
GDP
2007
2008
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.
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 highyield 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.
The Crisis: Policies and Incentives
The Mortgage Loans Expansion in the Industrial World
Before:
Traditional Relationship between Borrower an
Bank
- Lends money
- Manages
delinquencies
- Pays interest and
principal
Borrowe
r
The Crisis: Policies and Incentives
The Mortgage Loans Expansion in the Industrial World
Now:
Mortgage
Broker
Creditors:
Loan
Borrower
Banks and others
Loan
Cash
Servicer
Monthly payments
Monthly payments
Issuer of Structured
Products -securities- (SIV)
Cash
Securities Monthly payments
Trustee
Underwriter
Rating Agencies
Insurers (monolines)
Investors (investment banks,
hedge funds, pension funds,
mutual funds, etc.)
Fuente: Shéila Bair, FDIC
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 system’s vulnerabilities:




Market participants that work for fees (mortgage brokers, payments
receivers) don’t 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).
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.
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.
And Moving Forward?
Under current circumstances, when the value of the
fundamentals is adjusting (the decrease in housing prices)…
CME Housing Prices Futures
(contract mid price)
Housing Prices (% annual change in S&P
- Case Shiller Index)
20
190
15
180
10
170
5
160
0
-5
150
-10
140
2003
2004
2005
Source: Thomson Datastream
2006
2007
2012
2011
2010
2009
2008
Source: Chicago Merchantile Exchange; Bloomberg
And Moving Forward?
… The system’s equilibrium involves a lower size of the
banking system (according to the available capital)…
Market Capitalization ($bn)
HSBC
Santander
UniCredit
Intesa Sanpaolo
BNP Paribas
BBVA
Sberbank
RBS
UBS
Société Générale
Deutsche Bank
Barclays
0
50
Source: Thomson Datastream
100
Mar 5 2008
… And that’s already happening.
150
Jan 1 2007
200
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.
University of Michigan Consumer Confidence Index
120
110
100
90
80
70
60
50
Source: University of Michigan
Consumer confidence is at levels of past recessions.
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
40
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
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.
Czech Republic
Chile
China
8%
9%
9%
7%
8%
8%
7%
7%
6%
6%
6%
5%
5%
5%
4%
4%
4%
3%
3%
3%
2%
2%
2%
1%
1%
1%
%
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
P o licy rate
Inflatio n
Colombia
P o licy rate
Inflatio n
South Africa
10%
12%
9%
11%
P o licy rate
South Korea
6%
5%
10%
8%
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
9%
7%
8%
6%
7%
4%
3%
6%
5%
5%
4%
4%
3%
3%
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n
P o licy rate
2%
1%
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n
P o licy rate
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n
P o licy rate
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…
Interest Rates Forecasts
Inflation
6%
4%
5%
3%
4%
3%
2%
2%
1%
1%
%
%
2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4
US
Euro Area
Source: Market Forecasts
2007
2008F
Japan
US Fed Funds Rate
ECB Refinance Rate
Source: Market Forecasts
… in spite of expectations of higher inflation.
Bank of Japan Call Rate
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.
The External Risks affecting Emerging Markets
US Recession / Banking Crisis
1.


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.
The External Risks affecting Emerging Markets
US Recession / Banking Crisis
1.

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.
Global Foreign Direct Investment
(as % of GDP)
12%
10%
8%
6%
4%
2%
0%
-2%
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: IFS - IMF.
Foreign direct investment tend to decline sharply in the face of
global slowdowns.
The External Risks affecting Emerging Markets
US Recession / Banking Crisis
1.

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).
Global Real GDP and Merchandise Export Volume
(Annual % change)
15
10
5
0
-5
1980
1982
Source: WEO - IMF.

1984
1986
1988
1990
1992
Real GDP
1994
1996
1998
2000
2002
2004
2006
2008
Merchandise Export Volume
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.
The External Risks affecting Emerging Markets
The Costs of Preventing a US Financial Meltdown: Inflation
2.

Concerns about inflation are keeping long-term interest rates high.
Fed Funds Target Rate and Corporate BAA Rated
8%
7%
6%
5%
4%
3%
2%
1%
Jan-07
Source: FED


Mar-07
May-07
Jul-07
Sep-07
Federal Funds Target Rate
Nov-07
Jan-08
Mar-08
May-08
Corporate BAA Rated
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.
The External Risks affecting Emerging Markets
3.
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:
A.
Cyclical
Nominal Dollar Broad Index (traded weighted) and CRB
Commodities Index
140
550
130
500
450
120
400
110
350
100
300
250
90
80
Jan-01


200
150
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Index
Commodities
Source: FED correlation
and CRB.
There is an inverse
between theDollar
value
of theCRBdollar
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.
The External Risks affecting Emerging Markets
A Decline in Commodity Prices?
3.
A.
Cyclical
JPY per USD: Spots and Forwards
140
130
120
110
100
Forw ards
90
80
2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: JP Morgan

… 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.
The External Risks affecting Emerging Markets
A Decline in Commodity Prices?
3.
B.



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 Africa’s power crisis (SA
produces 69% of platinum, 30% of palladium and 18% of
world’s supply of gold). Supply problems of aluminum are also
large.
Land and water constraints supporting high prices for
agricultural commodities.
The External Risks affecting Emerging Markets
A Decline in Commodity Prices?
3.
B.
Structural Factors
Aluminum prices: Spots and Futures
Gold prices: Spots and Futures
3000
1200
2800
2600
USD per metric ton
USD per troy ounce
1000
2400
800
2200
2000
600
1800
Futures
Futures
1600
400
1400
200
2002 2003
2004
Source: IFS-IMF and NYMEX

2005
2006
2007
2008
2009
2010
1200
2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: IFS-IMF and LME
And the markets are forecasting a continuation in the upward
trend of major commodities prices.
The External Risks affecting Emerging Markets
A Decline in Commodity Prices?
Also oil prices will remain high, supported by: (a) China’s strong
demand, (b) ageing infrastructure leading to unplanned outages and
(c) climate change leading to extreme weather conditions.
Oil Prices: Spots and Futures
140
120
100
USD per barrel
3.
80
60
40
20
0
2002
2003
Spot
2004
2005
Future Sep-04
2006
2007
Future Apr-05
2008
Future Oct-07
2009
2010
Future May-08
Source: IFS-IMF and NYMEX
Future prices anticipate a modest decline, but these prices have not
been effective predictors of oil returns in the past.
In Conclusion
• Prospects in the industrial economies (especially in
the US) aren’t 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.
The Financial Crisis
and its learning's:
Theoretical and Policyoriented
Jacques SAPIR, PhD.
Professor of Economics,
EHESS-Paris
Director CEMI-EHESS -Paris
[email protected]
I. The creeping financial world crisis

The US “Subprime” crisis.
 The banking crisis.
 The Currency crisis
I.I. The “Subprime” crisis

I. Subprime and Subprime-ARM:



II. Alt “A”:


Mortgages where the debt to income ratio is over 55% (highly
indebted households) or mortgages where the loan to good value is
over 85% (high leverage loans).
ARM: Adjustable Rates Mortgage.
Debt to income ratio or loan to value ratio are under Subprime
thresholds but documentation incomplete (so-called “fast track
loans”).
III. Jumbos:

Loans of over 417,000 USD.
What’s the Subprime relevance



Subprime and Alt “A” have a relatively low share in the
US Mortgage market (around 15% each). The traditionally
subsidised mortgage brokers Fanny Mae and Freddie Mac
where making more than 55% of mortgages.
But Subprime and other “specials” developed fast since
1998. Subprime loans were over 1300 billions USD by
March 2007. They were at 150 Billions in 2001 and 600
Billions in 2005…..
And they were backed by a powerful string of financial
derivatives. It is the “collateralization” process which gave
Subprime mortgages their relevance.
The development of Mortgage Based Securities





Credit Default Swaps (CDS).
Collateralized Debt Obligations (CDO).
Collateralized Loan Obligations (CLO).
“Selling” risk on financial markets: MBS are actually a
kind of insurance system for the emitter and they are
attractive bonds for buyers till the default rate is low
(usually 0.5%).
But MBS have spread the risk throughout the financial
system and everybody can become an insurance company
if it buy a CDS or a CDO….
MBS: an industry which grew too fast...



MBS have
developed
extremely fast in 8
years.
Risk has been
spread-out among
Banks and HedgeFunds through
“obligations
baskets” sold by
SPV working from
off-shore zones.
Weak
collateralization
could induce a
major liquidity
crunch.
50
45
40
35
30
MBS
volume (in
Trillion
USD)
25
20
15
10
5
0
1998 2002 2004 2005 2006 2007
US Household indebtedness in GDP %
The current crisis compared to 40 years of
indebtedness cycles
Mortgaged loans have been made so easy that they
had been used as a proxy for an income policy.

The US economy paradox: Fast growth but an
impoverished middle-class.





From 2000 to 2006 if the average income increased by 3% a year, the
median income has been stable.
Lower income households have lost ground. From 1997 to 2004 the 2nd
lowest decile lost 12% when the 2nd best decile gained 10%.
Poverty is gaining ground: in the USA 20% of children are under the
poverty line against 16% in GB and 7% in France and Germany.
The 0.1% wealthiest part of the population is accumulating 7% of the
national income against 2% in France and Germany.
As a result indebtedness has been used to maintain consumption. The
average household debt ratio is 120% of the yearly income and
households saving ratio was 1.5% of GDP in 2006.
I.II. The Banking crisis




Banks have been the main user of MBS (40% of
cumulative total).
Strong competition in a deregulated market has made
Subprime-ARM based CDS attractive to boost Banks
profit rates.
The use of SPV and SPV-based Securities-baskets by
banks has decreased transparency.
New accounting rules (“Mark to Market”) have increased
Banks and Insurance companies vulnerability to financial
market fluctuations.
The Body Count…(early December 2007).




Total losses in real-estate
properties is 107 Billions
USD.
Total financial losses is
around 400 Billions USD.
Banks are accounting for at
least 50% of losses.
But…nobody knows
precisely how much has
been lost. Confidence has
been broken and the interbank monetary market has
collapsed.

Requiescat in Pace.
 New Century Financial
(Subprime lender)
 American Home
Mortgage (Subprime
lender).
 Ameriquest (Subprime
lender)
 Netbank (Internet
Bank)
 NorthernRock (Bank)
Who’s next?

Known losses.







Citigroup, investment Bank, USD 11.0 Bln.
Merry Lynch, investment bank, USD 12.5 Bln (and may be 15.0…)
Morgan Stanley, investment bank, USD 3.7 Bln.
HSBC, bank, USD 3.4 Bln.
Freddie Mac, Mortgage Lender, USD 3.7 Bln.
UBS-AG Investment bank, USD 3.6 Bln.
Propagation into Europe.



The German Banking System is highly vulnerable. Deutsche Bank
acknowledge a loss of Euro 2.2 Bln.
The Spanish Banking System: dead on Arrival?
Insurance Companies: Swiss-Re acknowledge for more than USD 1,1 Bln
of losses.
I.III. The Currency Crisis

The banking crisis raises the ghost of a generalized “Credit
Crunch”.

Central Banks are reacting by injecting liquidity.

But the US Economy is so much indebted that the value of
the USD is in doubt.

Currency change rates are now extremely volatile.

A major crisis is possible in 2008 when we will reach the
peak of the Subprime crisis (March-April 2008).
The US Debt is increasing fast.
Is the US Dollar to spin down?

NO




The US Treasury needs to
keep the USD attractive to
sell T-Bonds.
East-Asian countries want
to defend their
competitiveness and would
try to prop-up the USD.
The ECB is pouring as
much money as it can to
prevent a bank crisis.
A brutal fall of the USD
could have widespread
political implications.

Yes




The US Government can’t
afford a recession in an
electoral year and any
increase of interest rates
would have devastating
effects.
The FED is to bail-out US
Banks.
Commodity exporters are
beginning to use other
currencies.
The wealth risk on USD
denominated Funds is too
high. A flight from the USD
is to happen.
II. Theoretical and
Political lessons
II.I. The current crisis validates some important theoretical
findings.







(A): Moral Hazard and Adverse Selection have been
proeminent in the Subprime crisis.
(B) The “Herd Mentality” validates Herbert Simon’s
theory of Bounded Rationality.
(C) Markets are not spontaneously information-efficient
(Stiglitz).
(D) Uncertainty and Surprise are shaping decision-makers
preferences.
(E) Rationality is context-dependent.
(F) Institution matters.
(G) Market-value is not the value….
II.II. Keynes is back…..
(and so are Minsky and Shackle)





(A) When uncertainty is prevalent credit is crunching: this
is the preference for liquidity.
(B) Agents are reacting not to what happens but to how
they understand other agents reaction to the new situation:
this is the “Beauty Pageant” metaphor.
(C) When a surprise comes from the “Unexpected” it can
have disastrous consequences.
(D) Money-managers are not stabilizing but de-stabilizing
the economy.
(E) A market does not generate institutions it needs.
II.III. Policy implications.





Central Banks need to be reactive and not bounded by a
single target. They have to interact with governments. Full
independence is not workable.
Financial markets need regulations and supervision.
Regulation can’t be fully “market based”.
Wealth redistribution is to be consistent with the
accumulation process.
There can’t be good finance where the real sector is not
working well.
Change rates in a fully liberalised financial environment
doesn’t reflect actual economic performances.
The New Financial
Order and the Current
Financial Crisis
Robert J. Shiller
Professor of Economics, Yale University
Co-Founder and Chief Economist, MacroMarkets LLC
New Economic School, Moscow
March 14, 2008
New Financial Order




Advances in mathematical finance
Advances in behavioral finance
Advances in information technology
Democratization of finance
Books
Discussing the need and history of financial
innovation in risk management
Macro Markets,
1993
The New Financial Order, 2003
New Markets in Progress




Home price markets
Oil price markets
Natural gas markets
Components of consumer price index





Medical costs
Education costs
Personal income risks
GDP
Longevity
Current Financial Crisis




International Stock market boom 1990s,
collapse 2000-2003
International housing market boom Late 1990s2000s
Collapse of housing boom in US since 2006,
following in other countries
US Subprime crisis leads to freeze up of
financial markets, systemic effects
Spread of Crisis to Europe



IKB Deutsche Industriebank AG, and
SachsenLB Bank in Germany
Funds sponsored by BNP Paribas in France
Northern Rock Building Society in the United
Kingdom
The Crisis as Opportunity




Example of stock market crash of 1929
US Reaction in 1930s: financial progress: creation of
Securities and Exchange Commission, Federal Deposit
Insurance Corporation, Fannie Mae, Homeowners
Loan Corporation, Federal Home Loan Bank System,
Federal Housing Administration
European reaction: not so congenial to markets
The current crisis should be dealt with with financial
progress again
450
1800
400
1600
350
1400
300
1200
250
1000
Price
200
800
150
600
Earnings
400
50
200
0
1860
100
0
1880
1900
1920
1940
Year
1960
1980
2000
2020
Real S&P Composite Earnings
2000
Real S&P Composite Stock Price Index
Real S&P500 Price and Earnings
January 1871 to February 2008
P/E10 and Nominal Long Rate
As of Today
50
20
2000
1981
Price-Earnings Ratio
40
16
1929
35
14
30
25
12
Price-Earnings Ratio
1901
1966
10
20
8
15
6
1921
10
5
0
1860
18
Long-Term Interest Rates
45
4
Long-Term Interest Rates
1880
1900
2
1920
1940
Year
1960
1980
2000
0
2020
Real Home Prices, Building Costs,
Population, Interest Rates
As of 2007-IV
1000
200
900
700
150
600
Home Prices
500
100
400
300
Building Costs
Population
50
200
Interest Rates
0
1880
1900
1920
1940
1960
Year
1980
2000
100
0
2020
Population in Millions
Index or Interest Rate
800
Comparing Real Home Prices in
Greater London and Greater Boston
1983-2007
400
350
Real Price Index
300
250
Gr. London
200
150
Gr. Boston
100
50
0
1980
1985
1990
1995
Date
2000
2005
2010
Moscow Apartment Prices
1999-2008 $/Square Meter
Fig. 4 Real Home Prices Netherlands,
Norway, USA 1890 to 2004-5-7
Real Home Price Index, 1890=100
350
300
250
Netherlands
200
Norway
150
100
USA
50
0
1890
1910
1930
1950
Year
1970
1990
2010
Fig. 1 US Real Price, Rent and Building
Costs Quarterly 1987-I to 2007-II
180
Real Price
160
Index 1987-I=100
140
Real Rent
120
100
80
Real Building Costs
60
40
20
0
1985
1990
1995
2000
Date
2005
2010
Home Prices a Massive World
Speculative Bubble




Gold rush mentality
Stories of the rapidly growing “BRICs” (Brazil,
Russia, India, China) have the whole world
spooked
Widespread anxieties about how to fit in to the
new capitalist world
A popular view that property investments are
the best way to secure one’s future, same
phenomenon over much of world
The Behavioral Finance Revolution
Terms “Behavioral Finance” & “Efficient Markets”
in News Media from 1981 to 2006
0 .9
0 .8
0 .7
0 .6
" Effic ient M arkets"
0 .5
0 .4
0 .3
0 .2
" Behavio ral Financ e"
0 .1
0
19 75
19 8 0
19 8 5
19 9 0
19 9 5
2000
2005
2 0 10
Wishful Thinking Bias


People exaggerate probability that their team will
win.
People exaggerate probability that the candidate
they favor will win.
Attention Anomalies




Attention is fundamental aspect of human
intelligence and its limits
Social basis for attention
Inability to account for one’s attention
“No arbitrage assumption” of financial theory:
No ten-dollar bills lying around. Does not
require everyone is paying attention.
Culture and Social Contagion


Social cognition,
collective memory
A global culture in
today’s world
S&P/Case-Shiller® Home Price MacroShares®
CME Housing Futures and Options
On May 22, 2006, The Chicago Mercantile Exchange launched the first successful futures and options market for
home prices. The contracts currently settle on 11 different S&P/Case-Shiller® Home Price Indices. The combined
cumulative notional value traded in the CME housing products (both futures and options) in the first year
exceeded $500mm, a period over which these products were limited to a maximum one-year term. On
September 17, 2007, the CME began listing longer-dated contracts (up to 5 years) to meet market demand for
greater product utility.
“Financial Engineering comes to
real estate at last, and the housing
market will never be the same.”
-Barron’s 5.15.06
C um ula tive C M E H o using Future s N o tio na l Tra d e d
(Sinc e Inc e p tio n, M a y 2 0 0 6 )
$350
$300
$200
$ 15 0
UPDATE THIS
$ 10 0
7/ 13/ 2007
7/ 03/ 2007
6/ 13/ 2007
6/ 22/ 2007
6/ 04/ 2007
5/ 14/ 2007
5/ 23/ 2007
5/ 03/ 2007
4/ 13/ 2007
4/ 24/ 2007
4/ 03/ 2007
3/ 14/ 2007
3/ 23/ 2007
3/ 05/ 2007
2/ 12/ 2007
2/ 22/ 2007
2/ 01/ 2007
1/ 11/ 2007
1/ 23/ 2007
12/ 19/ 2006
12/ 29/ 2006
12/ 08/ 2006
11/ 17/ 2006
11/ 29/ 2006
11/ 08/ 2006
10/ 19/ 2006
10/ 30/ 2006
9/ 29/ 2006
10/ 10/ 2006
9/ 11/ 2006
9/ 20/ 2006
8/ 21/ 2006
8/ 30/ 2006
8/ 10/ 2006
8/ 01/ 2006
7/ 21/ 2006
7/ 12/ 2006
6/ 21/ 2006
6/ 30/ 2006
6/ 12/ 2006
$0
6/ 01/ 2006
$50
5/ 22/ 2006
$ in M illio n s
$250
2/
6/ 200
12 6
/
6/ 200
30 6
/
7/ 200
21 6
/
8/ 200
10 6
/
8/ 200
30 6
/
9/ 200
20 6
10 /20
/1 06
0
10 /20
/3 0 6
0
11 /20
/1 0 6
7
12 /20
/0 0 6
8
12 /20
/2 0 6
9/
1/ 200
23 6
/
2/ 200
12 7
/
3/ 200
05 7
/
3/ 200
23 7
/
4/ 200
13 7
/
5/ 200
03 7
/
5/ 200
23 7
/
6/ 200
13 7
/
7/ 200
03 7
/
7/ 200
24 7
/
8/ 200
13 7
/
8/ 200
31 7
/
9/ 200
21 7
10 /20
/1 07
1
10 /20
/3 0 7
1
11 /20
/2 0 7
0/
20
07
5/
2
Problems Getting Market Started
Open Interest May 2006 to Nov 2007
$120,000,000
$100,000,000
$80,000,000
$60,000,000
$40,000,000
$20,000,000
$0
Home Price Futures
Percent Discount of CME Housing Futures from S&P/Case-Shiller HPI Levels – as of
January 3rd, 2008.
% d isc o unt v. S&P/ C a se - Shille r H o m e Pric e Ind e x
0%
Bo sto n
-5%
Chic ag o
Denver
- 10 %
LV
LA
- 15 %
M iam i
NY
-20%
SD
SF
-25%
W ash DC
Co m p - 10
-30%
-35%
Fe b - 0 8
M a y- 0 8
Aug - 0 8
N o v- 0 8
Fe b - 0 9
M a y- 0 9
N o v- 0 9
C M E Fu tu re s C o n tra c t Ex p ira tio n
M a y- 10
N o v- 10
N o v- 11
N o v- 12
Futures Price and Latest Home Price
Index
Daily, May 2006 – February 2008
S&P/Case-Shiller Composite- 10: Expected Change Within One Year, by Trading Day:
Through February 14, 2008
260
250
CME Composite-10 Futures
S&P/CSI Composite-10 Index
240
230
220
210
200
190
180
5/19/2006
8/1/2006
10/11/2006 12/21/2006
3/7/2007
5/17/07
7/30/07
10/09/2007 12/19/2007
*Data derived from the asking price of the long-dated CME futures contract and prevailing S&P/Case-Shiller Home Price Incex level on each trading day.
Efficient Portfolio Frontier
Effic ie n t P o r tfo lio F r o n tie r W ith a n d W ith o u t O il
Ex p e c t e d An n u a l R e t u r n
16 %
28% Up O il M ACRO s hares , 115% Sto c k s , - 44% B o nd s
15 %
W it h Oil
14 %
21% Up O il M ACRO s hares , 79% Sto c k s , 0% B o nd s
100% Sto c k s
13 %
W / O Oil
12 %
15% Up O il M ACRO s hares , 53% Sto c k s , 32% B o nd s
50% Sto c k s , 50% B o nd s
11%
9% Up O il M ACRO s hares , 27% Sto c k s , 64% B o nd s
25% Sto c k s , 75% B o nd s
10 %
100% B o nd s
9%
8%
5%
7%
9%
11%
13 %
15 %
S t a n d a r d D e v ia t io n o f An n u a l R e t u r n
17%
19 %
The MACROSHARES Structure
A Vision Becomes a Reality
On November 30th, 2006:
MacroMarkets LLC launched
MACROSHARES Oil Up and MACROSHARES Oil Down are listed on the American
Stock Exchange.
These securities track the performance (and inverse performance) of
West Texas Intermediate Crude Oil.
Ticker Symbols:
AMEX: UCR
AMEX: DCR
MACROSHARES
MACROSHARES
Oil Up
Oil Down
10/18/2007
10/4/2007
9/20/2007
9/6/2007
8/23/2007
8/9/2007
7/26/2007
7/12/2007
6/28/2007
6/14/2007
5/31/2007
CL1
5/17/2007
75
5/3/2007
CL12
4/19/2007
80
4/5/2007
CL60
3/22/2007
85
3/8/2007
UCR
2/22/2007
90
2/8/2007
1/25/2007
1/11/2007
12/28/2006
12/14/2006
11/30/2006
NYMEX Oil Futures Prices to 60 Months and UCR
Price Daily Nov 30 2006- Oct 28 2007
70
65
60
55
50
Spread Between Front-Month and 60-Month Futures
and Spread Between UCR and Front-Month Futures,
Daily Nov 30 2006-Oct 28, 2007
-10%
-15%
-20%
(CL60-CL1)/ CL1
(UCR-CL1)/CL1
9/30/2007
-5%
8/30/2007
0%
7/30/2007
0%
6/30/2007
5%
5/30/2007
5%
4/30/2007
10%
3/30/2007
10%
2/28/2007
15%
1/30/2007
15%
12/30/2006
20%
11/30/2006
20%
-5%
-10%
-15%
-20%
Pensions and the Risk of Outliving
One’s Wealth

Life annuities are an excellent old idea, rarely embraced by the
public

Wishful thinking bias, mental framing

Public pension funds

Private annuities

Problem: annuity providers have to manage aggregate longevity
risk
U.S. Life Expectancy, 1900-2001
90
80
Ag e at D e ath
70
Fe m a le
60
M a le
50
40
30
20
10
0
18 8 0
19 0 0
19 2 0
19 4 0
19 6 0
19 8 0
2000
2020
Problems Inhibiting Longevity
Bonds



EIB Bonds were nominal bonds, should be real
UK Issuers of life annuities were not seriously
enough interested in this small issue to take fast
action
Those who would take other side are not easily
found, need to look at prices in an established
market
Efforts to Create Markets for
Longevity Risk

Swiss Re longevity bond, 2003

European Investment Bank-BNP Paribas longevity bond 2004

Swiss Re, takes on £1.7 billion of longevity from Friends Provident in UK
JP Morgan Launches International Longevity and Mortality Index – LifeMetrics Index,
March 2007
Goldman Sachs Launches Tradeable Index for Longevity and Mortality Risks Dec.
2007


To date the longevity risk market is still struggling to gain a foothold
Personal Income Risk Markets


Subprime crisis could have been averted with
income-linked (and real estate price linked)
mortgages
Such retail products require the creation of
markets
GDP Linked Securities



Governments could sell shares in their GDP
One “trill” is a trillionth of a nation’s GDP
Precursors: Bulgaria GDP warrants, 1993,
Argentina GDP warrants, 2005
Summary
There is enormous potential for improvement in human welfare
from radical financial innovation in the area of energy,, real
estate, longevity and multiple risks we still cannot immunize
ourselves from today. The subprime crisis is evidence of the
need to improve our markets
The Financial Crisis :
Some Causes and Consequences
Keith Wade
Chief Economist
The financial crisis: macro consequences
– A re-assessment of risk
– De-leveraging
– History lessons
Macro Consequences
US monetary policy will be easing, or easy until 2010
Fed funds target rate
%
10
9
8
7
6
5
4
3
2
1
0
2007
2008
Current cycle
Source: Thomson Datastream, Schroders
2009
2010
Jan 2001-2006
2011
2012
June 1989 - 1994
Market Consequences
Some implications for investors
– Persistent weakness in USD and GBP
– Loose monetary policy in Emerging markets
– Continued flows into commodities
– Bubble risk
– Persistent inflation worries
– The return of fiscal activism
Causes: How did we get into this mess?
Market Behaviour Cycle
New opportunity
Increased credit
Speculation
Excessive gearing
Financial distress
Credit crunch
Not the last crisis
Challenges for the authorities
–
Saving the banks from themselves
–
Macro stability and risk appetite
The Financial Crisis :
Some Causes and Consequences
Keith Wade
Chief Economist
Euroland and
the global
financial
crisis
May 2008
Thomas Mayer
Co-head of Global Economics
& Chief European Economist
[email protected]
(+44) 20 7547 2884
IMPORTANT: All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
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do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could
affect the objectivity of this report. Investors should consider this report as only a single factor in making their in-vestment decision. Independent,
third-party research (IR) on certain companies covered by DBSI's research is available to customers of DBSI in the United States at no cost. Customers
can access this IR at http://gm.db.com, or call 1-877-208-6300 to request that a copy of the IR be sent to them. DISCLOSURES AND ANALYST
CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
Main points

The US real estate market downturn, the
associated global financial crisis, and the surge in
commodity prices has pushed the probability of
a world economic recession to its highest level
since 2001.

Neither Europe nor Japan is in a position to fill
the gap left by weaker US demand. Moreover,
commodity exporting and emerging market
countries are likely to offset only part of the
effects of the US slowdown. Hence, global
136
Transatlantic recession risks: 1. A
real estate bubble
Housing prices adjusted for inflation
(GDP weighted averages for Euroland)
30
% deviation from trend
25
Euroland
US
20
15
10
5
0
-5
-10
-15
-20
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07
137
Source: OECD, DB Global Markets Research
Housing markets in the US and
Europe: some similarities in
valuation developments
Price-to-income ratio
Price-to-rent ratio
1.4
1.4
2000=1.0
1.3
2000=1.0
1.3
USA
1.2
USA
euro area
1.2
euro area
1.1
1.1
1
1
0.9
0.9
0.8
1996:1 1997:4 1999:3 2001:2 2003:1 2004:4 2006:3
0.8
1970:1 1975:1 1980:1 1985:1 1990:1 1995:1 2000:1 2005:1
Source: OECD, DB Global Markets Research
138
Euroland’s key housing markets:
Hot, except in Germany
Housing prices adjusted for inflation
80
% deviation from trend
60
France
Italy
Spain
40
Germany
20
0
-20
-40
-60
71 74 77 80 83 86 89 92 95 98 01 04 07
Source: OECD, DB Global Markets Research
139
Adjustment is under way
House prices adjusted for inflation
15
10
% yoy
UShp
EURhp
5
0
-5
-10
71 74 77 80 83 86 89 92 95 98 01 04 07
Source: OECD, DB Global Markets Research
140
The cooling real estate market is likely to exert a drag on
construction investment and consumption
The power of real estate
140
consumption
(% 98-06)
60
Residential housing permits, sa, 2000=100
130
50
Euroland
120
40
110
100
30
90
20
E
S
2
R = 0.6523
FIN
F
NL
80
D
70
60
1995
141
IRE
10
I
house prices (% )
0
1997
1999
2001
2003
2005
2007
-50
0
Source: ECB, Haver, DB Global Markets Research
50
100
150
Swing factor Spain
30
Euroland
France
Spain
%
20
Germany*
Italy
Spain’s share in EMU4 GDP = 14.9%
10
0
-10
-20
-30
-40
-50
Based on EM U 4
Residential construction
sector confidence, net
% balance of opinion
-60
Jan-06
Jul-06
Jan-07
Cont ribut ion
Cont ribut ion
2006
t o grow t h
at t ribut able
%
p.p.
t o Spain
%
Jul-07
GDP
2.7
---
19.0
Private Consumption
5.2
1.1
23.6
Total investment
spending
5.3
0.3
24.2
-- Housing investment
3.9
0.2
29.4
-- Other construction
investment
5.2
1.1
23.6
Source: Deutsche Bank, Eurostat
142
Grow t h
Source: ECB, Haver, DB Global Markets Research
Transatlantic recession risks: 2.
Financial
crisis
A stubborn risk premium on banks…
120
100
80
2.00
bp
US Basisswap
1.80
1.60
3mo EURIBOREONIA swap
1.40
1.20
60
1.00
0.80
40
0.60
0.40
20
0
01/01/2007 01/05/2007 01/09/2007 01/01/2008 01/05/2008
143
bp
"TED spread"
US
Euro area
0.20
0.00
Jan2005
Jul2005
Jan2006
Source: Bloomberg, DB Global Markets Research
Jul2006
Jan2007
Jul2007
Jan2008
Transatlantic recession risks: 2.
Financial crisis
…and credit…
175
bp Credit default sw ap spreads in Europe bp
600
155
135
650
investment grade
550
high yield (rhs)
500
Agency AAA
Muni
High grade
Agency MBS
3.0
1.5
1.0
1.0
0.5
0.5
250
0.0
0.0
200
-0.5
-0.5
150
-1.0
Jan-07
350
300
35
20/07/2007
20/11/2007
20/03/2008
2.5
1.5
400
55
3.0
2.0
95
75
%
3.5
2.0
450
144
Credit spreads relative to US Treasuries
2.5
115
15
20/03/2007
%
3.5
-1.0
Apr-07
Source: Bloomberg, DB Global Markets Research
Jul-07
Oct-07
Jan-08
Apr-08
Transatlantic recession risks: 2.
Financial crisis
…leading to a tightening of lending standards…
100
%
FRB senior officers survey: tightening of
mortgage lending standards
80
70
%
housing loans
60
consumer loans
50
60
40
20
All
40
Prime
30
Sub-prime
20
enterprises
tighter
10
0
0
-10
-20
-20
-40
90
92
94
96
98
00
02
04
06
Sources: Fed, ECB, GM Research
145
-30
2003
2004
2005
2006
2007
2008
Transatlantic recession risks: 2.
Financial crisis
…and in Euroland to an increase in bank lending rates
Lending rates on new loans with 1-5 year fixed rates
Feb 07 –
Feb 08
Consumer
credit
Mortgages
Small
corporations
Large
corporations
+0.38bp
+0.25bp
+0.41
+0.77
Sources: ECB, GM Research
146
Transatlantic recession risks: 2.
Financial crisis
Hunt for collateral widens Euroland sovereign spreads…
70
bp
Austria
France
60
Greece
Spain
50
Italy
40
30
20
10
0
Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar07 07 07
07 07
07 07
08
08 08
147
Source: Bloomberg, DB Global Markets Research
Transatlantic recession risks: 2.
Financial crisis
…while policy divergence is creating exchange rate tensions
Index
Broad TWI: US (ls)
Index
DB's Broad TWI: Euro area (rs)
110
142
108
138
106
104
134
102
130
100
98
126
96
94
Jan-2007
148
122
Apr-2007
Jul-2007
Oct-2007
Jan-2008
Source: Bloomberg, DB Global Markets Research
Europe as vulnerable to the
financial crisis as US
Table 1. A scorecard for count ries' vulnerabilit y t o t he financial crises
Spain
UK
France
US
Canada
Italy
Japan
Germany
India
Brazil
Russia
China
Stocks*
146.7
67.7
97.6
68.4
110.2
84.0
111.4
176.8
Score
7
1
4
2
5
3
6
8
293.3
394.7
340.9
187.4
2
4
3
1
Housing*
76.3
46.4
67.4
45.6
46.1
37.1
-17.2
9.3
Current
Score account* *
8
-9.8
6
-2.9
7
-1.3
4
-5.6
5
1.9
3
-2.0
1
4.7
2
6.0
-2.1
0.8
5.9
11.7
Score
8
6
4
7
3
5
2
1
4
3
2
1
Household
debt* * *
Score
8
****
30.6
7
14.0
5
25.9
6
5.4
3
10.5
4
-2.1
2
-7.2
1
Equity
capital* *
96.9
151.4
104.0
115.2
128.6
52.6
95.4
65.4
Score
4
8
5
6
7
1
3
2
Total
Score
35
28
25
25
23
16
14
14
147.2
120.5
88.6
127.9
4
2
1
3
10
9
6
5
* % change end 2002 to mid-2007
* * 2007
* * * Change betw een 2002 and 2006
* * * * We did not find comparable household debt ratios for Spain, but available indicators pointed to an increase even greater
than in the UK.
Source: OECD, Haver, DB Global M arkets Research
149
Credit and banking crisis likely to
dampen business investment
growth
Despite rising profits, firms need credit to fund their growth
7
% yoy
% of GDP
0.0
-0.5
6
-1.0
5
-1.5
4
-2.0
3
-2.5
2
Profits (gross operating surplus) (lhs)
-3.0
-3.5
Non-financial
corprate
sector
financial
1
-4.0
balance (- means net borrower) (rhs)
0
-4.5
2000 2001 2002 2003 2004 2005 2006 2007
150
Source: Haver, Bloomberg, DB Global Markets Research
Investment has benefited from buoyant export growth
16
14
12
% yoy
Real exports
Real investment
Real op.surplus
10
8
6
4
2
0
-2
-4
1999 2000 2001 2002 2003 2004 2005 2006 2007
151
Source: Eurostat, Haver, DB Global Markets Research
Rise of the euro to slow export
growth, reinforcing the
dampening effect from tighter
credit on business investment
16
14
12
% yoy
exports
% yoy
reer (rhs)
-15
-10
10
-5
8
0
Export elasticities*
Activity
Exchange rate
US
1.9
-0.4
Euroland
1.1
-0.5
* Lo ng-term values (mean lag US=1.9qu., Euro land=1.4qu.
Source: DB Global Markets Research
Recursive eur regressions suggest no major changes in
coefficient
6
5
4
0
2
0
-2
-4
96 97 98 99 00 01 02 03 04 05 06 07
10
-0.2
15
-0.4
20
-0.6
s.t.coeff.
-0.8
+2 s.e.
-1
-2 s.e.
-1.2
98
152
99
00
Source: Eurostat, Haver, DB Global Markets Research
01
02
03
04
05
06
07
Investment growth to be
squeezed
3.0
Real, % qoq
Construction
2.5
Equipment
2.0
Total investment
1.5
1.0
0.5
0.0
-0.5
Forecasts
-1.0
-1.5
2006
153
2007
2008
Source: ECB, Haver, DB Global Markets Research
2009
Transatlantic recession risk: 3.
Rising
oil
and
commodity
prices
First-round impact on trade balance of the oil price surge since September 2007
Great losers (trade balance w orsening greater than by 1% of GDP)
Small losers (trade balance w orsening less than by 1% of GDP)
Small gainers (trade balance improving by less than by 1% of GDP)
Big gainers (trade balance improving by greater than by 1% of GDP)
154
No data Sources: IMF, DB Global Markets Research
Transatlantic recession risk: 3.
Rising oil and commodity prices
Falling terms of trade hurting consumer
2000=100
130
US
Euroland
120
Japan
110
100
90
80
70
60
98
155
99
00
01
Source: Haver, DB Global Markets Research
02
03
04
05
06
07
08
Euroland consumption growth
has been sluggish
Sluggish consumption growth…
7
6.5
6
%
yoy
consumption
disposable income
15.0
%
14.8
savings ratio
14.6
5.5
14.4
5
14.2
4.5
14.0
4
13.8
3.5
13.6
3
13.4
2.5
13.2
2
1999 2000 2001 2002 2003 2004 2005 2006 2007
156
…despite a lower savings ratio
13.0
1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: ECB, Haver, DB Global Markets Research
Employment growth has not
helped disposable income growth
very much
7
6.5
6
5.5
5
%
yoy
disposable income
%
yo
y
employment (rhs)
3
2.5
2
1.5
4.5
4
1
3.5
3
0.5
2.5
2
1999 2000 2001 2002 2003 2004 2005 2006 2007
157
Source: ECB, Haver, DB Global Markets Research
0
Consumers retrenching
Retail sales plunge as surging food and energy prices tax consumers
4.5
Retail sales (smoothed)
%
yoy
4
PCE
3.5
5.0
3.5
0.0
3
consumer confidence (rhs)
-1
% yoy
0
smoothed
1
2.5
-5.0
3
2
2
2.5
-10.0
2
-15.0
1.5
3
1.5
4
1
5
Retail sales
1
-20.0
0.5
-25.0
0
98
158
% yoy
% yoy
99
00
01
02
03
04
05
06
07
08
0.5
6
Food & energy prices (rhs)
0
7
-0.5
8
98
99
00
Source: Haver, DB Global Markets Research
01
02
03
04
05
06
07
08
No signs of “decoupling” from
the US
OECD leading economic indicators pointing down
15
10
% 6-month
annualised
change
Euro area
US
5
0
-5
-10
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: OECD
159
Euroland not contributing to
global rebalancing…
Imports weakening more than exports
exports of goods
% yoy
imports of goods
13
8
3
-2
-7
98
160
99
00
01
02
03
04
05
06
Source: ECB, Haver, DB Global Markets Research
07
…as past reliance on the US
“locomotive” is likely to continue
170
US consumer confidence (conf board)
5.0
Euroland GDP, % yoy (rhs)
150
4.0
130
3.0
110
2.0
90
161
70
1.0
50
1996
0.0
1998
2000
2002
2004
Source: Haver, DB Global Markets Research
2006
2008
Fiscal policy is likely to be
broadly neutral…
0.80
% of GDP
0.60
f'cast
tightening
0.40
0.20
0.00
-0.20
-0.40
easing
-0.60
fiscal impulse (=
change in
cyclically adjusted
budget balance)
-0.80
1999
162
2001
2003
2005
2007
Source: OECD, Haver, DB Global Markets Research
2009
…while monetary conditions
tighten to record levels
DB Euroland MCI
120
%
ECB refi rate (rhs)
115
5.5
5.0
4.5
110
4.0
105
3.5
100
3.0
95
2.5
90
2.0
MCI base = sample mean
85
1.5
99
163
00
01
02
03
04
05
06
07
08
Source: ECB, Haver, DB Global Markets Research
Based on our simple MCI we
estimate that monetary
conditions have tightened by
about 120bp since last July.
Of this, 50bp are due to the
rise in money market rates
and 70bp reflect the 7% rise
of the trade-weighted euro
exchange rate
The ECB remains hawkish
PMI composite output index
ECB rate changes, bps (rhs)
65
5
62
hawkish
60
4
60
3
58 55
2
56
1
52
Hawkometer (lhs)
-2
dovish
-3
2002
2003
164
50
PMI composite index (rhs)
2004
2005
2006
2007
2008
0.2
50
45
-1
0.4
Highest level o f P M I
fo r a rate cut
54
0
40
48 35
0.6
0.0
level o f P M I when
rates first cut in 2001
M edian level o f P M I
fo r a rate cut
-0.2
-0.4
-0.6
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: ECB, NTC, DB Global Markets Research
Is the ECB too optimistic about
growth?
Evolution of 2008 GDP growth forecasts since Jan'07, %
2.6
2.4
2.2
2.0
1.8
1.6
Consensus
1.4
DB
1.2
ECB
1.0
J
F M
A M
J
J
A
S O N
2007
Sources: ECB, Consensus Economics, Deutsche Bank
165
D
J
F M
2008
ECB will probably only
reluctantly follow the Fed
7
%
f'cast
ECB refi rate
Fed funds rate
BoJ call rate
6
5
4
3
2
1
0
99
166
00
01
02
03
Source: Haver, DB Global Markets Research
04
05
06
07
08
09
Credit-sensitive growth to weaken
most in 2008-09
4.5
4.0
3.5
3.0
2.5
Contributions to real annual GDP grow th, pp
Consumption
Investment
Net trade
Government
Stocks
GDP
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
forecast
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
167
Source: Haver, DB Global Markets Research
Slower growth likely to reduce
inflationary pressures
Wage inflation remaining contained
Headline inflation boosted by food and energy
4.0
% yoy
HICP
3.5
forecast
3.0
% yoy
%
2.8
core
3.0
2.6
2.5
2.0
output gap (-1y) (rhs)
1.5
2.4
1.5
2.2
0.5
0.0
-0.5
1.0
-1.0
2.0
-1.5
0.5
168
2.5
contract wages
1.0
2.0
0.0
1998
3.0
2000
2002
2004
2006
2008
1.8
1999
-2.0
2001
2003
Source: ECB, OECD, Haver, DB Global Markets Research
2005
2007
2009
Conclusion: a cooler world
economy…
US
Japan
Euroland
GDP grow th, %
2007 2008F 2009F
2.2
1.2
1.3
2.0
1.1
1.8
2.6
1.7
1.1
G7
Asia
(ex Japan)
EMEA
Latam
2.2
1.3
1.5
2.2
2.9
2.0
9.4
6.7
5.4
7.5
6.0
4.8
7.5
6.2
4.2
4.3
10.5
6.8
6.3
9.7
7.0
4.1
7.4
7.3
Global
4.7
3.6
3.7
3.6
4.5
3.4
Source: DB Global Markets Research
169
CPI inflation, %
2007 2008F 2009F
2.9
3.7
2.5
0.0
0.6
0.3
2.1
3.3
2.1
…and shifting sources of growth
6.00
Global GDP
% yoy
f'cast
IC ontr.(pp)
5.00
EM contr. (pp)
4.00
3.00
2.00
1.00
0.00
-1.00
1980
1984
1988
Source: DB Global Markets Research
170
1992
1996
2000
2004
2008
Appendix
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive
any compensation for providing a specific recommendation or view in this report. Thomas Mayer
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03/2007
172
Macroeconomic Issues and
Vulnerabilities in the US
and Global Economy
by
Nouriel Roubini
Stern School of Business, NYU
and
Roubini Global Economics
(www.rgemonitor.com)
August 2008
The current major global
concerns are over several “E”s

These E’s are as follows:
Economy
 Energy
 Exchange Rates and External imbalances
 Europe/Euro/ECB
 Emerging market economies
 East as in Middle East
 East as in Far East
 Earnings/Equity markets

Economy






How hard will be the US hard landing (recession)? The debate is
no longer about soft landing versus hard landing
The housing recession is worsening rather than bottoming out
Spillovers of the housing recession to other sectors of the
economy (autos, manufacturing, consumer durables)
The US consumers (consumption is 70% of aggregate demand)
are shopped-out, saving-less and debt-burdened
They are now buffeted by a number of negative shocks: falling
home prices, falling stock prices, falling home equity withdrawal,
credit crunch in mortgage markets, high oil prices, falling
employment
The credit crunch started in the sub-prime mortgage market; but
this is not just a sub-prime problem
Economy






Spillovers from the sub-prime crisis to other credit markets.
Significant financial markets turmoil and volatility since summer
of 2007.
This is both a liquidity crunch and a credit crunch driven by
serious solvency problems
A severe banking and financial crisis in underway
Headline inflation is rising with stagflationary risks.
What will the Fed do next? Hike, stay on hold or cut further?
Fed Funds already cut from 5.25% to 2%
Will the rest of the world growth “decouple” from the US hard
landing? It depends on how hard is the US hard landing
Energy





US/global recessions have been associated with oil price spikes
(1973-74, 1979-80, 1990-91, 2000-2001).
After the 2003 Iraq war was oil prices remained high and they
spiked in 2004-05 because of high demand (especially from
China and the U.S.), low global spare production and refining
capacity, concerns that terrorism will lead to supply shortages
(“fear premium”) and supply concerns about Russia, Venezuela
and Nigeria.
The spike in the price of oil and energy since 2004-05 led to
concerns about stagflation (low growth plus inflation) as oil
prices have remained around $70 a barrel or above for several
months now.
Why didn’t the 2004-2005 oil shock lead to an economic
slowdown? It was driven by high demand rather than
stagflationary supply shocks
Will the recent high oil prices contribute to a global recession in
2008-09? Oil prices are now starting to fall
Exchange rates and External
imbalances





The strength of the U.S. in the 1990s relative to Euro, Yen and
other currencies led to a large a growing current account deficit
in the US as the US lost competitiveness
After 2000, the US current account deficit worsened further as
the fiscal deficits mushroomed (“twin deficits”) and as the
private savings rate sank close to zero
Is this current account deficit sustainable or is going to lead to a
crash in the value of the US dollar and/or a spike in US interest
rates (dollar hard landing)?
The dollar started to decline in 2002-2004, especially relative to
the Euro, but then it sharply appreciated again in 2005 as interest
rates and real growth differentials favored the $ relative to the
euro and the yen.
But the dollar resumed its fall in 2006-08 when the US had a
growth slump, a financial crisis, and the Fed stopped raising the
Fed Funds rate and then cut it starting in the fall of 2007
Exchange rates and External
imbalances






Will the U.S. dollar continue its fall in 2008 and beyond or is it
starting to bottom out as other regions are entering a recession?
Will the adjustment of global current account imbalances be
orderly or disorderly?
How will the Euro perform during the rest of 2008 and in 2009?
Will the yen weaken or strengthen? Will the “yen carry trades”
unravel?
Will China let its currency revalue at a faster rate as in recent
months or keep on accumulating reserves to prevent such a fast
appreciation?
Will other Asian economies keep on aggressively intervening –
like China - in the forex market to prevent the appreciation of
their currencies relative to the US dollar?
Europe/Euro/ECB





Growth was sluggish in Europe in the 1990s relative to the U.S.
given structural impediments to growth; and the Euro showed
significant weakness relative to the US dollar until mid 2002.
The Euro then sharply appreciated until the end of 2004 (by
about 40%), and again in 2006-07 (after a brief dollar rally in
2005)
European growth in 2002-2003 was dismal compared to the US
moderate growth recovery, in part because the ECB did not ease
as much as the Fed (EU policy rate down to 2%).
Eurozone growth recovered in 2004 but it remained substandard
(about 2%) and it relapsed further in 2005 to 1.2% following the
strength of the Euro in 2004.
Eurozone growth recovered above 2% since 2006 and was
higher than US growth in last few quarters
Europe/Euro/ECB






What now sharp growth slowdown in Europe and actual signs of a Eurozone
wide recession (negative growth in Q2 of 2008)
What will the ECB policy be in 2008-2009? The ECB started raising policy
rate in 2006 all the way to 4%; then recently hiked to 4.25% out of fear of
inflation
Are ECB’s concerns about inflation valid? Will it cut rate now that there are
recession risks?
How much further will European growth weaken given that the Euro
strengthened relative to the dollar?
What are the prospects for further structural economic reforms in Europe?
Will the Euro further strengthen or weaken relative to the US dollar as both
economies are entering a recession?
Emerging market economies




Emerging market (EM) economies experienced many economic
and financial crises in the 1994-2002 period
2001 was a dismal year for emerging market (EM) economies.
The slowdown of growth in US and G7, the tech bust and the
reduction of flows of capital to emerging markets led to a sharp
slowdown of growth in many emerging markets.
Outright currency and financial crises emerged in Turkey
(February 2001) and Argentina (December 2001). In 2002, severe
pressures mounted in Uruguay and Brazil; Uruguay experienced
a severe financial crisis in 2002; Brazil barely escaped a financial
crisis as elections loomed in late 2002 but then it recovered after
Lula followed moderate policies.
2003 was also a poor year for emerging markets (especially Latin
America) as the global economy did not recover fast enough.
Emerging market economies





Emerging market (EM) economies’ growth recovered sharply in 2004,
especially in Asia but also in Latin America. Important role of macro and
financial reforms after the EM crises in this growth recovery
2004-2007 were excellent years for EMs as global conditions were ideal:
global growth was high, global interest rates were low, commodity prices were
high and global investors’ risk aversion low (search for yield).
The turmoil in emerging markets in May-June 2006 was a signal that rougher
times may be ahead, especially for EMs with greater macro and financial
vulnerabilities.
Will the US hard landing hurt emerging market economies and how much?
Decoupling or recoupling?
Which EM economies could get into financial trouble and distress?
East as in Middle East




Further turmoil in the Middle East (the Iraqi security situation;
further terrorist attacks in Saudi Arabia or the Gulf; tensions
between Israel and its neighbors; the risk of a military
confrontation between Israel and Iran on the nuclear issue) will
affect oil prices that may increase further.
Also, such oil market turmoil affects skittish investors’ mood and
consumer confidence as it increases uncertainty and reduces real
incomes.
The Middle East and oil prices are a major source of geopolitical tension on global markets.
Previous US and global recessions have been associated with
staglationary oil price shocks
East as in East Asia





After excessive growth overheating in 2003 and early 2004,
China tried a soft landing of its economy via policy tightening
measures in 2004; but the economy did not experience any
serious slowdown.
In 2005-07 the economy actually accelerated leading to a serious
risk of overheating with concerns about inflation. But now the
US recession is leading to downside growth risks in China.
India is at the center of the debate on offshore outsourcing.
Dynamism of the IT sector in India contributed to high growth
in the last years. But India faces severe fiscal problems and the
need for major structural economic reforms.
Will East Asia be hurt by the coming US slowdown? Can Asia
decouple from the US?
Will Japan end up in a recession again?
Earnings/Equity markets








Equity markets in the US and globally did well in the 2006-2007
given high global economic growth
High earnings growth, much improved corporate balance sheets,
easy monetary conditions supported equities
Profits sharply increased as a share of GDP
The recent market turmoil and volatility in financial markets
challenged equity markets leading to a bear market in equities in
the US and abroad
Will this turmoil continue or are we close to the bottom for
equity markets?
Much depends on how hard is the US and global hard landing
How will equity markets perform in the rest of 2008 and 2009?
Is the stock market overvalued based on historical cyclically
adjusted P/E ratios?
Earnings/Equity markets
Background on US equity markets in the 2000-2007 period:

The U.S. and global economic slowdown in 2001 led to a sharp slowdown of earnings and
underperformance of equity markets (on top of the dotcom bust and Nasdaq collapse in 2000).

Equity markets also underperformed in 2002 as the stock market rally after the 9/11 drop was
excessive and based on overoptimistic expectations of growth.

Stock markets slumped again in the first quarter of 2003 as the concerns about a war with Iraq led
to renewed risk aversion.

But they then recovered sharply after the war in 2003 as markets started to expect a sustained
economic recovery and a sharp pick-up in profits and earnings.

But stock indexes remained mostly flat on average in 2004 and even in 2005 and 2006 (with only a
modest uptrend since 2004) even if corporate balance sheets have improved sharply (with debt
de-leveraging) and earnings growth has been sustained in 2004-2006.

Equity markets – in the US and abroad – rallied sharply in 2006-2007

Bear market in equities starting with the financial turmoil in the summer and fall of 2007
U.S. economy vulnerabilities







Housing bubble that has now turned into a bust: severe housing recession and
first fall in home prices since the 1930s
Large current account deficit and a dollar that needs to fall even more to
reduce this imbalance; risk of hard landing for the dollar and/or for US
interest rates
Low private savings rate; negative household savings
High levels of household indebtedness (mortgages, consumer credit, etc.)
with debt service costs now rising because of credit crunch and reset of
ARMs
Severe financial crisis leading to a credit crunch
Vulnerability to further oil shocks and risk that oil well above $100 will be a
tipping point for the economy
Political risk from global security/military developments (Iraq, Iran, Mid-East,
etc.)
U.S. economy vulnerabilities





Weak labor market with employment falling for seven months
now
Risk of a fall of private consumption especially as the housing
bubble has burst, the credit crunch spreads, oil prices stay high
and employment keep on falling
Limited role for further fiscal policy easing as large structural
fiscal deficits have emerged in the 2000s
Risk of a systemic financial crisis (as in the 1994 bond rout or
1998 LTCM crisis) if the current financial markets turmoil and
volatility persist and worsens
A combination of excessive liquidity, low interest rates, high
leverage, poor risk management, excessive risk- taking had
possibly led to bubbles in many asset prices (housing, bonds,
commodities, emerging market debt, equities). Under-pricing of
risk until re-pricing in 2007.
IMF forecasts for US and global
growth


The latest IMF forecasts suggest a sharp US and global
slowdown with a possibility of a global recession
(defined as global growth below 2.5%)
The new IMF forecasts will be out in October when
new IMF’s World Economic Outlook (WEO) will be
out
Main risk factors for
the continuation of global growth







US and other G7 hard landing (recession) leading to a sharp
global economic slowdown (no decoupling)
Bursting of housing bubbles in the US and other countries (UK,
Spain, Ireland, Italy, Iceland, Australia, New Zealand, etc.)
Financial markets turmoil spreading around the world
Still high oil and commodity prices leading to a global slowdown
Geo-strategic risks (terrorism, Iraq, Middle East, Iran)
Large and unsustainable US current account deficit and risk of a
hard landing of the US dollar
How will the global economy perform in H2:2008 and 2009 as
clouds are gathering around the US and other advanced
economies, financial markets are in turmoil, global imbalances
are still large and oil prices still high?
Linkages between the U.S. and the rest of the
world occur via various channels








Trade
Capital flows and FDI (Europe, Japan, Emerging
markets)
Value of the US dollar
US monetary and fiscal policy
Global stock markets and financial links
Developments in oil and commodity markets
Political shocks and risks
Global investors and corporate confidence
Fed policy since 2001




The Fed reduced the Fed Funds rates 11 times in 2001, by
475pbs to a rate of 1.75%.
The Fed was expected to reverse course and increase the Fed
Funds rate in early 2002 as the economy recovered. But the
faltering in the US recovery in the fall of 2002 and the risk of a
double dip recession led the Fed to reduce the Fed Funds again,
down to 1.25% in November 2002 and down to 1% in June
2003 as a jobless recovery emerged during and after the war with
Iraq.
In 2004, as growth of output and jobs picked up and inflation
started to increase, the Fed started to increase the Fed Funds rate
in 17 consecutive steps bringing it to 5.25% by June 2006 and
then pausing in August 2006.
The risk of a US hard landing and the market turmoil in the
summer of 2007 led the Fed to cut rates starting in the fall of
2007 from 5.25% to 2% in the spring of 2008
US fiscal policy






What will be the stance of fiscal policy in the U.S. in 2008-09?
Fiscal stimulus package in 2008 as the economy risked a
recession
The improvement in the fiscal balance in 2005-07 was partly
driven by temporary factors that are unraveling
The US has a structural budget deficit (due to rising entitlement
costs)
Can the US afford the 2001 and 2003 tax cuts and make them
permanent?
A fiscal bailout of the housing and financial crisis is adding
sharply to the fiscal deficit
Global current account imbalances






Are the global current account imbalances (large deficit in the US, large
surpluses in Europe, Japan, China and most emerging market economies)
sustainable over time?
Is the US current account deficit and external debt accumulation sustainable?
It is shrinking with a weak $ but too slowly.
Will the adjustment of global imbalances be orderly or disorderly?
What are the implications of this deficit for the value of the US dollar in the
future?
How will the major currencies ($, Yen and Euro) perform in 2008-2009? Will
the dollar weaken further? Is there a risk of a hard landing of the US dollar?
Will Asian countries (China, Korea, etc.) allow their currency to appreciate
relative to the US $) or will they keep on aggressively intervening to prevent
such appreciation?
Global inflation
and commodity prices








What are the risks of a resurgence of global inflation?
In 2007 deflation – the worry of the 2001-2003 period - was out; rather
worries about a resurgence of global inflation emerged
Spring of 2007: risks of a rising global inflation due to a “global reflation” and
high energy and commodity prices
Role of BRICs and emerging markets in pushing up commodity prices
The financial turmoil of the summer of 2007 partially reduced these global
inflation worries
But recent futher surge of oil, energy, food and other commodity prices in
2008 has led to serious concerns about stagflation.
30 emerging market economies had have double digit
A US recession would reduce global inflationary pressures via slack in goods
markets, slack in labor markets and fall in commodity price.
Some of the cutting edge issues (and jargon terminology
used) in international macro policy debates









Will the subprime crisis lead to a wider credit crunch?
Are we facing a liquidity crunch or a credit crunch/crisis?
What is the risk of a systemic crisis and what factors could trigger one?
What causes asset bubbles? What causes housing bubbles and bust?
How should monetary policy react to asset bubbles and asset bubbles bursting?
Should we worry about deflation or inflation?
Why have we had recently a bond conundrum?
Will we experience a yield curve inversion in the U.S. and what does such
inversion imply?
Are we back to a Bretton Woods Two regime of exchange rates on a global scale?
Some of the cutting edge issues in
international macro policy debates










Are we back to stagflationary shocks?
Are global external imbalances sustainable or not, and for how long?
Are the twin deficits sustainable?
Will global rebalancing be orderly or disorderly?
Should we worry about asset protectionism?
What is the future of offshore outsourcing?
Will the rest of the world decouple from a US slowdown? Will we experience a
rotation in global growth or a locomotive switch?
Is Doha as dead as Dodo?
Are target zones for major currencies necessary and/or desirable?
Is free trade compatible with flexible exchange rates or does greater trade
integration require managed or pegged exchange rates?
Some of the cutting edge issues in
international macro policy debates








What is the BBC (Basket, Band and Crawl) exchange rate regime allegedly
chosen by China?
Are highly-leveraged institutions and hedge funds a source of systemic risk?
Is offshore outsourcing a threat or a benefit for the global economy?
Will the BRICs dominate the world economy in the next decades?
Is the balance sheet approach the appropriate framework for thinking about
financial crises in emerging economies?
Are crises due to fundamentals or self-fulfilling liquidity runs?
What explains sudden stops and reversals of capital inflows?
What explains the joint eruption of currency, sovereign debt, systemic banking and
systemic corporate crises?
Some of the cutting edge issues in
international macro policy debates














What is the appropriate form of PSI/bail-in/burden-sharing in crisis resolution?
Do we need an international lender of last resort (ILOR)?
What explains international contagion, is it reduced lately and if so why?
How to deal with liability dollarization and original sin?
Is debt intolerance an endemic element of sovereign debt markets?
Do we need an international bankruptcy regime for sovereigns?
What is the most desirable sovereign debt restructuring mechanism?
Do emerging markets suffer of fear of floating and if so why?
Should the IFIs maintain their preferred creditor status?
Is unilateral dollarization the way of the future?
Are monetary unions feasible without political unions?
Is sterilization of excessive capital inflows feasible and desirable?
Is Asia on a new Dollar Standard?
What is the desirable reform of the international financial architecture?
Sources of International
Macroeconomic Interdependence
among Economies

“Macroeconomics” is “international” given the
increasing economic interdependence among countries
and the increased globalization of trade and finance.

Trade links:
 Income effects on imports and exports of goods and
services
 Direct and indirect trade links
 Exchange rate effects on trade
Financial channels of
interdependence

Assets/Liabilities traded internationally




Stocks
Bonds
Derivative instruments
International financial markets/intermediaries:




Banks
Capital markets (stock/bond/money markets)
Foreign exchange markets
Commodities markets
Interdependence channels via
common shocks and FDI/MNCs

Common sectoral/external shocks





Common oil shocks
Tech sector technology shock in the mid 1990s and bust in
2000-2001
Housing bubbles in the US and other countries; and their
bust in 2006-2008?
Global credit crunch
Foreign Direct Investment (FDI)/ Multinational
Corporations (MNCs):


Real investment (FDI, M&A)
Output/production location decisions
Interdependence via Policy Links



Domestic effects of macro policies
International effects of domestic policies if a country is
large (US, Europe, Japan)
International effects of domestic policies even if a
country is small (international contagion):





Mexico Tequila effect
The Asian fever/flu
The Russian virus (contagion to emerging markets – Brazil,
LatAm - and advanced markets – LTCM & US capital
markets)
The Turkish influenza in 2001
The modest contagion from Argentina in 2001-2002
Many Financial Crises in Emerging Markets
and G7 Economies in the last two decades

Currency/Financial Crises in Emerging Markets:
 1980s debt crisis in Latin America
 Mexico, East Asia, Russia, Brazil in the 1990s;
 Turkey and Argentina in 2001; Uruguay in 2002; Brazil minicrisis in 2002; Dominican Republic in 2003
 Market turmoil (mini-crisis) in EMs in May-June 2006
 Partial recent contagion of US sub-prime turmoil to emerging
markets’ equity markets
Crises and financial stresses in
Advanced/G7 Economies







S&L crisis in US in early 1990s
Corporate/Banking crisis in Japan in 1990s after bursting of the
1980s asset price bubble
European Monetary System (EMS) currency crisis in Europe in
1992-93 (Italy, UK, France, Sweden)
Banking crisis in Finland and Sweden in early 1990s
Bond market crash in the US in 1994 as the Fed unexpectedly
tightened monetary policy.
Sharp fall of the value of the US dollar in 1994-1995
LTCM crisis in 1998 and seizure of U.S. capital markets
Crises and financial stresses in
Advanced/G7 Economies







Bursting of the US asset price bubble in equity markets in 20002002; IT and dot.com crash.
US corporate and accounting scandals in 2002-2003 (Enron,
Sarbox legislation, etc.)
GM-Ford downgrade in 2005 and turmoil in credit derivatives
markets
Equity market turmoil in the spring of 2006 during the “inflation
scare”
Housing bust and sub-prime crisis in the US (2006-2008)
US and global financial markets turmoil and volatility starting in
the summer of 2007
Bearish global equity markets so far (-20% globally)
Major macro and financial events of the last 20 years:
Advanced Economies










1987: Greenspan becomes chairman of the Fed. Stock market crash in the US in 1987.
S&L (Saving and Loans) financial crisis in the late 1980s; evidence of a “credit crunch”
in the US.
US and global recession in 1990-91 during the Gulf War.
Persistent stagnation of Japanese economy in the 1990s (4 recessions in the 1990s
decade) after the bursting of the 1980s asset bubble
Currency crisis in the European Monetary System in1992-93
European Monetary Union (1999 introduction of Euro) and mediocre
economic/growth performance of Europe in the 1990s
Large swings in the value of G3 currencies ($, Yen, Euro)
Global financial crisis in 1998 following Russian crisis and LTCM collapse
“New Economy”, internet and technology boom: the U.S. boom years (1995-2000):
high growth, low inflation, high productivity growth, low unemployment rate, boom in
equity markets, budget surpluses, strong dollar, large current account deficits.
Bust of the IT bubble in 2000-2001; sharp fall of investment leading to economic
slowdown in the US.
Major macro and financial events of the last 20 years:
Advanced Economies
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The oil shock in 2000 contributing to the global slowdown
Fed tightening of monetary policy between mid 1999 and mid 2000 as the economy
was “overheating”.
US slowdown and recession and global slowdown in 2001; it started before 9/11 but
was exacerbated by it.
Third and final stage of EMU (“Euro” supplanting domestic currencies) started in
2002.
A de facto “Bretton Woods II” regime since 2001 as China and Asia effectively pegged
their exchange rates to the U.S. dollar through aggressive foreign exchange
intervention.
Tentative U.S. and global economic recovery in early 2002 that slowed down in the
spring and in the fall. Slow growth in H1-2003 (given Iraq war uncertainty); U.S. and
global recovery in second half of 2003 and Q1:2004 but with poor job growth
(“jobless recovery”). Higher US and global growth in 2005-2006
Evidence of a bursting of the US housing bubble and a housing bust since mid 2006.
Risk of a US hard landing
Sub-prime mortgage crisis in the US (2007)
US and global financial markets turmoil, volatility in starting in the summer of 2007
and continuing into 2008
Major macro and financial events of the last 20
years: Emerging markets
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Latin American debt crisis (in the 1980s) and its solution (Brady Bonds) in the late
1980s and early 1990s
Large capital flows to emerging markets in the 1990-95 period.
Transition to a market economy in Central and East European countries.
Mexican currency crisis in 1994-95
Asian currency and financial crisis (Thailand, Indonesia, Korea, Malaysia) in 1997-98
Russian financial and currency crisis (8/98) and its contagion to emerging markets and
advanced economies financial markets (LTCM)
Currency crisis in Brazil in 1/99
Financial turmoil and IMF rescue packages in Argentina and Turkey in NovemberDecember 2000
Sovereign debt restructurings after partial/full default in Ecuador, Russia, Ukraine and
Pakistan in 2000-2001
Turkish currency and financial crisis in February 2001
Major macro and financial events of the last 20
years: Emerging markets
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Argentina currency and financial crisis and default of 2001-2002
Financial/currency crisis in Uruguay in 2002
Risk of a financial crisis in Brazil as October 2002 elections were looming. Financial recovery
after the election. Weak economic performance of Latin America in 2003 with growth recovery in
2004-2005.
Accession of 10 emerging markets (mostly transition economies) to the European Union in 2004.
Rapid growth of emerging market economies in 2004-2006 on the back of macro/financial
reforms and benign global conditions (high global growth, high commodity prices, low G7
interest rates). International investors rediscover emerging markets.
Boom in commodity prices exported by EMs.
2006-2007: Africa as the new EMs growth story and asset class?
Turmoil in EM financial markets in May-June 2006, especially for countries with external
vulnerabilities
Bubbly equity markets in EM especially in China, India and Gulf states
Turmoil in global financial markets starting in the summer of 2007 with partial contagion to EMs
(especially equity markets).