Global impact of the crisis

Contagion

Terms

Recoupling Decoupling Contagion Deleveraging Mark to market

Events a year after the subprime crisis

the seizure of Fannie Mae and Freddie Mac by their regulator (state),

bankruptcy of Lehman Brothers (and the sale of its capital-markets arm to Barclays),

Merrill Lynch’s shotgun (forced) marriage to Bank of America

the government takeover of the insurance company American International Group (AIG).

on Thursday September 18th

Central banks pumped $180 billion of short-term liquidity into the markets.

HBOS, Britain’s biggest mortgage lender, also sold itself to Lloyds TSB, a major British bank.

Two days before that,Reserve Primary, a money-market fund, froze withdrawals for a week.

End of September 2008

Germany: Hypo Real Estate Belgium, Luxembourg and the Netherlands :

Fortis Britain nationalised Bradford & Bingley; Belgium, France and Luxembourg saved

Dexia; Iceland rescued Glitnir. Ireland (€400 billion) stood behind the

deposits and debts of its six large banks and building societies.

Shortage of money (dollar)

European banks are involved:

they generally do not have dollar deposits and rely largely on money and capital markets to fund their investment banks.

Among those affected are Barclays, Royal Bank of Scotland, Deutsche Bank and UBS, all of which saw huge jumps in the price of insuring their debt against default.

There was also the worry that they face losses on loans and derivatives contracts with firms that are either bankrupt, such as Lehman, or suddenly less than creditworthy, such as AIG.

European banks are involved:

three-headed monster—solvency, funding and liquidity,

Almost every country’s banking system is stricken with three interrelated problems:

1. having taken huge losses, the banks need capital;

2. because they cannot borrow in the longer-term paper markets, they are short of the funds they need to finance the share of their assets not covered by their deposits;

3. and because the short-term money markets are closed, the banks are cut off from their main source of liquidity.

Policy response to the three-headed monster

1. the banks need capital; recapitalization and purchase of toxic assets

2. they are short of the funds they need to finance the share of their assets not covered by their deposits; quantitative easing

3. because the short-term money markets are closed, the banks are cut off from their main source of liquidity: liquidity injection

4.

results

low yields on liquid government securities an evaporation of wholesale funding that

triggered disorderly deleveraging cascading across the rest of the global financial system

Liquid assets were sold at fire-sale prices, credit lines to hedge funds and other

leveraged financial intermediaries in the shadow banking system were slashed.

results

High-grade, high-yield corporate bond spreads increased,

trade finance and working capital was disrupted,

banks tightened lending standards equity prices fell

IMF WEO April 2009

Channels affecting the global economy

The credit crunch hurt even the most highly rated private borrowers.

Sharp falls in equity markets as well as continuing deflation of housing bubbles led to a loss of household wealth.

These may be considered as corrections, but that had drastic consequences.

Channels affecting the global economy

The consequeces of corrections were transmitted to all sectors and countries of the global economy by:

rising doubts about economic prospects

uncertainty about policy responses of governments

results

Industrial production and merchandise trade decreased in the fourth quarter of 2008 and continued to fall in early 2009

purchases of investment goods and consumer durables were affected by credit disruptions and loss in confidence.

Financial sector worries

bank credit growth falling bank wholesale funding in mature

markets dependent on government guarantees,

securitization markets not functioning

Financial sector worries

uncertainty about valuation of bad assets (mark to market)

problems in reestablishing liquid markets in these assets

little progress in reducing bank exposure to fluctuations in their value.

Channels of Crisis Contagion

Financial contagion (with financial globalization)

1. Ownership of US assets

2. Credit crunch affecting everyone

3. Similar practices Contagion to the real economy Trade links

Why should the US affect the rest of the world?

US GDP is more than 25% of world GDP

US consumer expenditures $9trl. When this decreases, there is nothing to compensate

US dominates world financial flows

Global Financial Assets (2006)

Nominal global GDP: $48.3 trl

McKinsey Global Institute, Fourth Annual Report, Jan2008

Bank deposits 45

Government debt securities

26

Private debt securities

43

Equity securities 54

Global Financial Assets (2007)

Nominal global GDP: $55 trl

McKinsey Global Institute, Fifth Annual Report, Dec2008

Bank deposits 53

Government debt securities

28

Private debt securities

51

Equity securities 65

Private debt from 2006 to 2007

Private debt is comprised of corporate bonds, commercial paper, securitized debt instruments

It increased from $43trl in 2006 to $51trl in 2007. However, this happenned in the first half of 2007.

Financial Assets by Region (2006) trillion dollars

US 56.1 Japan 19.5

Eurozone 37.6 China 8.1

UK 10.0 Emerging Asia

4.3

Europe 53.2 Total 167

Cross Border Capital Flows

FDI Purchases of foreign equity and debt

securities Cross border lending Cross border deposits These flows were $8.3trl in 2006 and

$11.2trl in 2007. 17.2% of global GDP in 2006

Cross Border Capital Flows

Cross border capital flows to emerging markets in 2006: $700bil

But, flows from emerging markets to developed markets exceeded that

Cross Border Investments

Foreign ownership of total assets in 2006: $74.5trl

1 in every 3 government bonds 1 in every 4 equity 1 in every 5 debt security

is held by a foreign investor

Cross Border Investments

Lending and deposits is the fastest growing component in the five years leading to 2007.

$6trl in 2007 (Total in 2007 is $11trl) Banks account for 80% of this. They fund

their liquidity needs through global markets. The rest: hedge funds, private equity funds,

insurance companies.

Cross border lending and deposits is the most volatile form of capital inflows.

65% have maturities for less than 1 yr They can be withdrawn very easily in the

case of liquidity problems or sensing of increasing risk

Channel for financial contagion in global markets.

Cross Border Investments

Global Derivatives Market

Equities, debt securities and bank deposits represent financial claims against future earnings by companies and households.

Derivatives are risk shifting agreements by financial market participants.

The above figures do not include derivatives.

Global Derivatives Market

In 2006, the total notional value of derivatives amounted to $477trl.

Notional value of an asset backed security (eg CDO) is the value of the underlying asset (eg house).

But when defaults started to happen, notional value did not mean much.

Financial contagion

The source of the collapse in financial markets were residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).

These were not only sold to US investors but were sold to investors all around the world.

As mortgages default, investors all over the world feel this.

European firms depend on bank lending more than US.

Liquidity and credit crunch in Europe and elsewhere hurts firms because banks’ ability to give credit is limited.

Financial contagion

Losses in the banking and financial system, and of investors increase as the real economies slow down and firms face financial distress and defaults.

Thus, the financial and real sector performance feed each other.

Financial contagion

Contagion occurs through stock markets. When investors lose in one market they pull

out of other markets. Investors are risk averse and they want to

dump their risky assets when there is turmoil and volatility.

When they get signals of bad economic news from one market, it carries over to other markets.

Financial contagion

Direct trade links

Real economic contagion occurs via direct trade links.

Fall in US expenditures causes a decrease in US imports and hence a decrease in exports to US

US trade deficit is huge. This means that the impact will be even larger.

Major exporters to the US

China Japan Korea Singapore Hong Kong Malaysia

Phlippines Thailand Canada Mexico

Real GDP and trade growth of OECD countries, 2007-2008% change on a year to year basis

                                                                                                       

Real GDP and trade growth of OECD countries (% y-y)

Growth in the volume of merchandise trade (%)

World Exports ($ billion)

Trade worsened in 2008 Q4.

20.4% decrease over 2008 Q3.

10.5% decrese over 2007 Q4.

2007 Q1 3133

2007 Q2 3377

2007 Q3 3488

2007 Q4 3834

2008 Q1 3400

2008 Q2 4309

2008 Q3 4309

2008 Q4 3431

Effect on world trade

World trade grew by 2% in volume terms in 2008 and was well down on the 6% volume increase in 2007.

WTO estimates a 9% global trade decline in volume in 2009 as recession strikes

This is the biggest such contraction since the Second World War

Recoupling

Monthly exports and imports of major developed and developing economies have been falling in unison since September 2008

Growing share of developing countries’ trade in the total, and increased geographical diversification of trade flows, created an expectation of “decoupling” effect.

This has not turned out to be the case. Developing countries are not less vulnerable to economic turmoil in developed countries.

WTO

For the last 30 years trade is an increasing part of economic activity, with trade growth often exceeding output growth.

Production for many products is sourced around the world so there is a multiplier effect — as demand falls sharply overall, trade will fall even further.

The depleted pool of funds available for trade finance has contributed to the significant decline in trade flows, in particular in developing countries

WTO

Many thousands of trade related jobs are being lost.

There is the danger of implementing protectionist trade policies.

This would make this bad situation worse with the loss of more jobs.

Reasons for the sharp drop in trade

all regions of the world economy are slowing at once

increasing presence of global supply chains in total trade.

Trade contraction or expansion is no longer simply a question of changes in trade flows between a producing country and a consuming country — goods cross many frontiers during the production process and components in the final product are counted every time they cross a frontier.

Reasons for the sharp drop in trade

protectionism Any rises in protection will threaten the

prospects for recovery and prolong the downturn.

The risk of aggravated protectionism is rightly a source of concern

Indirect trade links

Demand for intermediate inputs by exporting nations

Dependence on US jointly by Asian economies

Effects on commodity prices

Oil Energy Food Minerals

Energy, metal and food prices

Energy, metal and food prices

Prices for primary commodities were highly volatile in 2008,

This is one of the main reasons why trade performance in the second half of the year was so different from the first half.

Prices steadily rising throughout 2007 energy prices hit record highs at over $140 a barrel by

mid-year, afterwards they crashed to the lowest level since early

2005 due to weakening demand in oil importing countries.

Between January 2007 and July 2008 fuel prices rose 144%, more than doubling. But from July until the end of 2008 they fell 63%

Commodity prices

Prices for other primary products, including metals and food, have also fallen from their peaks earlier in 2008.

Inflationary pressures remain in check in most countries due to weaker demand for goods worldwide, and deflation may be a greater risk in some countries in the short term