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Understanding the Global Economic Crisis Presentation by Heiner Flassbeck Director, Division on Globalization and Development Strategies Geneva, 3 April 2009 Outline • First session The global economic crisis : what went wrong • Second session Systemic failures and multilateral remedies Reference text: “The Global Economic Crisis: Systemic Failures and Multilateral Remedies” Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation First Session The global economic crisis : what went wrong Understanding the Globalized Economy When there is a mouse trap in the house, the whole farmyard is at risk Understanding the Globalized Economy Commodity Market Stock Market Currency Market Unwinding of speculative flows Subprime Credit Collapse The subprime credit collapse highlighted the exposure to risk in many areas and triggered the sudden unwinding of speculative positions in different markets Starting point… The fact that the global financial crisis originated in a relatively obscure corner of the United States housing credit system means that it cannot be analysed adequately by just looking at this segment of the market while ignoring the huge asset-price bubbles that arose elsewhere seemingly independently Causes of the Crisis What really went wrong: The blind faith in the efficiency of financial markets What made it worse: Global imbalances Absence of a regulatory scheme Causes of the Crisis • There are no simplistic explanations: – “too much liquidity”, – saving glut in China – individual misbehavior • The drivers of the crisis are more complex and the analysis needs to entail three specific areas in which the global economy experienced systemic failures: Financial market Commodities market Currency market FINANCIAL MARKETS Financial Markets Fundamental misconceptions: • Assumption that “markets know best” • Regulators should not play an active role • More financial innovation would always be beneficial from society’s point of view Implications: • Poorly designed regulation can backfire and lead to regulatory arbitrage →This is what happened with banking regulation Arbitrage as a Result of the Regulatory Framework Figure 2.1 LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR 30 Leverage 25 20 15 10 Banks Financial services Life insurance 5 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream. Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average. The decrease in the leverage ratio of commercial banks was accompanied by an increase in the leverage ratios of nonbank financial institutions Financial Innovation and the Shadow Banking System Figure 2.2 THE SHADOW BANKING SYSTEM, 2007, Q2 18 instrument for shifting leverage 16 14 $ trillion 12 • Financial Innovation as an Government sponsored enterprises 7.7 10 8 6 Finance companies 1.9 Brokers and dealers 2.9 Commercial banks 10.1 4 2 Asset backed securities issuers 4.1 0 Market based Savings institutions 1.9 Credit unions 0.8 • The shadow banking system in the United States held assets of more than $16 trillion Bank based Source: Shin (2009). While regulation focused on banks, it was the collapse of the shadow banking system which kick-started the current crisis. Financial Regulation • Wrong belief that securitization had contributed to both diversifying and allocating risk to sophisticated economic agents who could bear such risk • Regulators assumed that, unlike deposit taking banks, the collapse of large non-bank institutions would not have systemic implications BUT IT HAD COMMODITY MARKETS Commodity Markets and the Financial Crisis The build-up and eruption of crisis in the financial system was paralleled by an unusually sharp increase and subsequent strong reversal of the prices of internationally traded primary commodities Commodity Price Index (S&P GSCI) 1000.00 900.00 700.00 600.00 500.00 400.00 300.00 03.12.2008 03.11.2008 03.10.2008 03.09.2008 03.08.2008 03.07.2008 03.06.2008 03.05.2008 03.04.2008 03.02.2008 03.03.2008 03.01.2008 03.12.2007 03.11.2007 03.10.2007 03.09.2007 03.08.2007 03.07.2007 03.06.2007 03.05.2007 03.04.2007 03.02.2007 03.03.2007 200.00 03.01.2007 Index Number 800.00 The Growing Presence of Financial Investors in Commodity Markets Figure 3.2 FUTURES AND OPTIONS CONTRACTS OUTSTANDING ON COMMODITY EXCHANGES, DECEMBER 1993–DECEMBER 2008 (Number of contracts, millions) Figure 3.3 NOTIONAL AMOUNT OF OUTSTANDING OVERTHE-COUNTER COMMODITY DERIVATIVES, DECEMBER 1998 – JUNE 2008 (Trillions of dollars) 50 14 45 12 40 10 35 30 8 25 6 20 15 Other commodities Other precious metals Gold 4 10 2 5 0 Dec. 1993 0 Dec. 1995 Dec. 1997 Dec. 1999 Dec. 2001 Dec. 2003 Dec. 2005 Dec. 2007 Source: BIS, Quarterly Review , March 2009, table 23B. Dec. 1998 Dec. 2000 Dec. 2002 Dec. 2004 Dec. 2006 June 2008 Source: BIS, Quarterly Review , December 2008, table 19. Trading volumes on commodity exchanges strongly increased during the recent period of substantial commodity price increases What Evidence for a Correlation between Speculative Position and Price Development ? Wheat Maize 250 1400 500 800 200 1200 400 700 150 1000 300 100 800 200 50 600 100 0 400 0 -50 200 -100 0 -200 600 500 400 -100 01/01/2002 06/01/2004 03/01/2006 01/01/2008 01/01/2002 Soybeans 300 200 100 0 06/01/2004 03/01/2006 01/01/2008 Soybean oil 250 1800 100 80 200 1600 80 70 60 60 40 50 20 40 600 0 30 400 -20 20 200 -40 10 0 -60 01/01/2002 1400 150 1200 100 1000 800 50 0 -50 -100 01/01/2002 06/01/2004 03/01/2006 01/01/2008 Net long non-commercial positions, '000 contracts, left scale Net long non-commercial positions excl. CIT, '000 contracts, left scale Net long CIT positions, '000 contracts, left scale Price, cents/bushel, right scale 0 06/01/2004 03/01/2006 01/01/2008 Net long non-commercial positions, '000 contracts, left scale Net long non-commercial positions excl. CIT, '000 contracts, left scale Net long CIT positions, '000 contracts, left scale Price, cents/lb, right scale Correlation between Speculative Position and Price Development (?) • The scepticism among economist is based on the efficient market hypothesis • However, – Short-term price elasticity of many commodities is low Position changes that are large relative to the size of the total market have a temporary, or even persistent, price impact – Changes in market positions may result from the behaviour of a certain group of market participants who respond to factors other than information about market fundamentals Correlations between the Exchange Rate of Selected Countries and Equity and Commodity Price Index BRAZILIAN REAL TO JAPANESE YEN June 2008–December 2008 • Strong correlation between the unwinding of speculation in different markets that should be uncorrelated • All participants react to the same kind of information NEW ZEALAND DOLLAR TO JAPANESE YEN Future and Options Market Positions Futures and options market positions, by trader group, selected agricultural commodities, January 2006 – December 2008 Average long position of index traders is very large, sometimes more than ten times the size of an average long position held by either commercial or noncommercial traders (Per cent and number of contracts) Long positions Average position size NonCommodity Maize Commercial Commercial Index 1134 1499 16260 Soybeans 590 1052 6024 Soybean oil 790 1719 4418 Wheat CBOT 553 964 8326 Wheat KCBOT 680 632 1816 Cotton 363 1010 4095 Live cattle 580 409 4743 Feeder cattle 258 162 469 Lean hogs 419 712 3983 • Positions of this order are likely to have sufficiently high financial power to drive prices • Speculative bubbles may form and price changes can no longer be interpreted as reflecting fundamental supply and demand signals Commodity futures exchanges do not function in accordance with the efficient market view CURRENCY MARKETS Currency Speculation and Financial Bubbles The uncertainty associated with the subprime crisis generated an unwinding of speculative currency positions - causing large depreciation of former high-hielding currencies 130 120 100 90 80 70 02 .0 1. 08 02 .0 2. 08 02 .0 3. 08 02 .0 4. 08 02 .0 5. 08 02 .0 6. 08 02 .0 7. 08 02 .0 8. 08 02 .0 9. 08 02 .1 0. 08 02 .1 1. 08 02 .1 2. 08 Index Number 110 Hungarian Forint Brazilean Real Mexican Peso Czech Koruna The Carry Trade Phenomenon Currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate Yen Carry trade on the Icelandic Krona and the Brazilian Real Real 12 10 12 8 6 8 4 2 4 10 6 Per cent Per cent Krona 0 -2 2 0 -2 -4 -4 -6 -6 -8 -8 -10 -10 12345678910 11 212345678910 11 212345678910 11 2123456789 2005 2006 2007 Uncovered interest return Nominal exchange-rate change Interest rate differential 2008 12345678910 11 212345678910 11 212345678910 11 2123456789 2005 2006 2007 Uncovered interest return Nominal exchange-rate change Interest rate differential 2008 The Carry Trade Phenomenon • In this framework, nominal exchange rate movements are mainly driven by speculative flows, moving away from their “fundamentals” • Currency specualtion and currency crisis has brought a number of countries to the verge of default and dramatically fuelled the crisis • Risk exposure! Trade distortion effect! Exchange Rate Fluctuations and the Trade Distorsion Effect E m e rging m a rk e t ( no n- E uro pe ) E m e rging m a rk e t e c o no m ie s in E uro pe a nd o t he r t ra ns it io n e c o no m ie s E uro a re a 0.00040 0.00040 0.00040 P EER co ntributio n NEER co ntributio n VA R (REER gro wth) 0.00035 0.00030 P EER co ntributio n NEER co ntributio n VA R (REER gro wth) 0.00035 0.00030 0.00030 0.00025 0.00025 0.00025 0.00020 0.00020 0.00020 0.00015 0.00015 0.00015 0.00010 0.00010 0.00010 0.00005 0.00005 0.00005 0.00000 1993 0.00000 1996 1999 2002 2005 2008 1993 P EER co ntributio n NEER co ntributio n VA R (REER gro wth) 0.00035 0.00000 1996 1999 2002 2005 2008 1993 1996 1999 2002 2005 The real exchange rate is a measure of countries’ competitiveness Evidence shows that nominal exchange rate changes appear to explain most of the real exchange rate changes The present monetary chaos exerts a huge and distorting influence on the effectiveness of international trade 2008 Second session Systemic failures and multilateral remedies The Global and Systemic Crisis • The crisis dynamics reflect: failures in national and international financial deregulation, persistent global imbalances, absence of an international monetary system deep inconsistencies among global trading, financial and monetary policies The most important task is to break the spiral of falling asset prices and falling demand and to revive the financial sector’s ability to provide credit for productive investment The key objective of regulatory reform has to be devise a system that allows shutting down the casino and weeding out financial instruments with no social return The “money –for-nothing” mentality In 1983, the financial sector generated 5 per cent of the United States’ GDP and “statistically” accounted for 7.5 per cent of total corporate profits In 2007, the United States financial sector generated 8 per cent of GDP and “statistically” accounted for 40 per cent of total corporate profits Strong indications that this “industry” does not contribute much to overall productivity Financial Regulation: Policy Implications • Banks and the capital markets need to be regulated jointly and financial institutions should be supervised on a fully consolidated basis • Creating a clearinghouse that would net out the various positions could increase transparency • Micro-prudential regulation has to be complemented by macro-prudential regulation • Need of an international dimension to financial regulation and institution to take into account systemic risk Commodity Markets : Policy Implications Better regulation of these markets and direct intervention in case of destabilizing speculation is needed • Need to ensure that swap dealer positions do not lead to ‘excessive speculation’: key loopholes in regulation • regulators need access to more comprehensive trading data in order to be able to intervene • In addition to regulatory measures, international measures are needed: the world needs a new global institutional arrangement consisting of a minimum physical grain reserve to stabilize markets Currency Markets: Policy Implications Multilateral or even global exchange rate arragment are urgently needed for the stability of the financial system and a balanced international trade Only one exchange rate/price adjustment rule: nominal exchange rate changes should follow the difference in the price levels of the trading partners Conclusion The state is back but national action is not sufficient: • Preventing the competition of nations (a new code of conduct is needed) • Intervention in financial markets is indispensable • No “crisis solution” by markets Thank you for your attention [email protected]