World financial crisis: reasons, trends, responses and perspectives

1. World financial crisis: reasons, trends, responses and perspectives Mojmir Mrak University of Ljubljana 2009

2. The structure of the presentation • I. Intensification of systemic risks in international finance • II. Immediate reasons for development and outbreak of the financial crisis • III. Key phases of the financial crisis • IV. Responses to the financial crisis • V. The impact of the financial crisis on the countries of Central and South-east Europe • VI. How to proceed?

3. I. Intensification of systemic risks in international finance • Instability of exchange rates • According to the BW system, we live in a system of flexible exchange rates, where coordination of exchange rate policies is of extreme importance • Coordination of exchange rate policies was conceptually recognized, but it is not operational in practice (the rising BP imbalances confirm this) • Strong US and EU pressure on the Chinese exchange rate policy • Oil countries and their exchange rate policies • Recent movements of exchange rates

4. I. Intensification of systemic risks in international finance (II) • Large balance of payments imbalances • During the last years, the BP imbalances have increased significantly • US have a huge BP deficit, Asia a great BP surplus, euro zone’s BP is around zero

5. I. Intensification of systemic risks in international finance (III) • Difficulties in providing international liquidity • Extremely strong trend of liberalization of capital flows in the last two decades • Balance of payments imbalances have been mainly financed by private capital marginalization of official capital flows • Frequent financial crisis, especially in EE, but also in some developed countries have disclosed problems

6. II. Immediate reasons for development and outbreak of the financial crisis • Long-term upward trend of real estate prices in the US

7. II. Immediate reasons for development and outbreak of the financial crisis (II) • Large liquidity in the world

8. II. Immediate reasons for development and outbreak of the financial crisis (III) • Problematic role of rating agencies in assessing the creditworthiness of complex financial instruments • Weaknesses in the supervision of some parts of the financial system • Agressive leadership model of financial institutions governance / management

9. III. Phases of the financial crisis • Outbreak of the crisis in the summer of 2007 • The financial crisis breaks out as a result of macroeconomic factors (such as the crises in 1980s and 1990s), or for reasons arising in the financial sector • The current crisis has occurred because of problems in the financial sector, specifically due to the plummeting of real estate prices (that hindered the servicing of debt) • The crisis began on the "sub-prime" segment of the US real estate market

10. III. Phases of the financial crisis (II) • Expansion of the crisis in the first period (autumn 2007 - August 2008) • Step one; Transfer of the crisis from the US to investors around the world • Step two; Transfer of the crisis from institutional investors to the interbank market • Step three; Crisis starts spreading from the financial sector to the real economy • Deepening of the crisis in the second period (from September 2008 onwards) • Systemic risk increased with Lehman Brothers’ • Stock markets plunge in all countries • Strong tightening of inter-bank market

11. IV. Responses to the financial crisis • Responses to the crisis in the first period (autumn 2007 – August 2008) • Providing liquidity by central banks and selectively reducing interest rates • Very limited and “case-by-case” usage of public funds for resolving the crisis • Short-term measures of regulators • Reporting banks’ / financial institutions’ losses • Deleveraging of banks / financial intermediaries • New business models in the financial sector • Self-regulation of certain subjects, such as rating agencies, “sovereign funds”

12. IV. Responses to the financial crisis (II) • General responses to the crisis in the second period (from September 2008 onwards) • Coordinated lowering of interest rates by key central banks • A more systemic approach of tackling the problem of financial institutions with public funds: • Ensuring the solvency of banks by nationalization (partial / comprehensive, capitalization and forced mergers of banks in trouble and healthy banks, with the participation of public funds) • Guarantees to unblock the interbank market • Guarantees to deposits (first limited, then overall)

13. IV. Responses to the financial crisis (III) • General responses to the crisis in the second period (from September 2008 onwards) (cont.) • Spreading of the crisis from the “Wall Street” to the “Main Street” • Economic growth in the world was drastically reduced in autumn • Forecasts for 2009 are bad (recession in US and EU) and only a bit better for 2010 • It has become more and more obvious that measures aimed solving financial sector would not be sufficient; what is also needed are fiscal packages aimed at increasing economic growth

14. IV. Responses to the financial crisis (IV) • EU specifics in responding to the crisis in the second period (from September 2008 onwards) • Some basic problems of the EU in responding to the financial and economic crisis • Institutional specifics of the EU vs USA • EU does not have a serious budget at the EU level • EU has strongly decentralised supervision of its financial sector • Until September 2008 EU member stated had responded to the crisis exclusively at a national level • Broadening of the crisis has forced EU member states and especially euro zone countries for more coordination • Irish precedence concerning deposit guarantees • European Commission considers today the state aid much more generously than only half a year ago

15. IV. Responses to the financial crisis (V) • EU specifics in responding to the crisis in the second period (from September 2008 onwards) • Key elements of the package adopted by the European Commission; the set of proposed measures included: • Fiscal impetus at a member states level equivalent to EUR 170 bn • Increase of targeted investment • Increase the guarantee potential for bank financing • Increase of safety net expenditures • Temporary reduction of certain taxes • Temporary reduction of contributions • Fiscal impetus at the EU level • EIB loans equivalent to EUR 30bn • Increase of advance payment for EU cohesion funds

16. IV. Responses to the financial crisis (V) • Implications of the crisis on EU economy (from September 2008 onwards) • Deficits in majority of EU member states will be over 3 % of GDP (over SGP treshhold); ratings of several eurozone members downgraded • Problems with raising funds on the international financial markets • Spreads over reference interest rates widened for many eurozone countries (discussion about “union bonds”) • Aceess limited to sovereign borrowers and borrowers with sovereign guarantees • Is it possible that an eurozone state defaults? • Real test for the euro • Increasing fear of protectionism (car industry)

17. IV. Responses to the financial crisis (VI)

18. V. Financial crisis and Central and South-east Europe • Why are the CE and SEE countries more hurt by the crisis than other emerging country regions • Characteristics of the financial systems of the CE and SEE countries • High dependence of domestic banks of the interbank market • A significant number of foreign banks and thus much financing from abroad; parent - daughter relations • Great credit expansion in the years before the outbreak of the crisis, much invested in real estate (due to cheap money and low indebtedness of population) • First signs of tightening conditions seen this spring; due to liquidity problems of mother banks • It meant reduced access to capital for domestic banks and a significant increase of its price • Additional problem was the price erosion of real estate

19. V. Financial crisis and Central and South-east Europe(II) • Why are the CE and SEE countries more hurt by the crisis than other emerging country regions (cont.) • The region has well defended itself against the financial crisis until September, despite • Higher price of money • Falling economic growth in partner countries; especially EU • Deepening of the crisis; after the collapse of Lehman Brothers the region got affected more than other regions; because of • Partner EU countries enteres into a strong recession • Significant dependence on the interbank market; which is blocked • Parent banks evaluate how to allocate available funds to its daughters (higher influence of “country risk”)

20. V. Financial crisis and Central and South-east Europe(III) • Impact of the crisis on different groups of countries in the region; Iceland has deepened the differenciation among countries in the region • The most affected are the countries with large balance of payment deficits and significant needs for foreign borrowing (the Baltic states, Hungary, Ukraine, Kazakhstan and Turkey and some of the SEE countries, especially Bulgaria and Romania) • Less risky are Central European countries, except Hungary, which are characterized by relatively lower dependence on the foreign interbank market (they have relatively more domestic deposits)

21. V. Financial crisis and Central and South-east Europe(IV)

22. V. Financial crisis and Central and South-east Europe(V)

23. V. Financial crisis and Central and South-east Europe(VI)

24. V. Financial crisis and Central and South-east Europe(VII) • Impact of the crisis on Western European banks and their states • Western banks have some 1,300 bn EUR of claims in the region; the most exposed Austria, followed by Belgium and Sweden • Banks have problems raising funds on the market; Moody’s recently downgraded some of them • CE in SEE countries have to repay or roll over for some 400 bn EUR of credits in 2009 • Due to the crisis, EBRD expects that some 10 % of loans will become non-performing • High exposure of banks and states to the crisis

25. V. Financial crisis and Central and South-east Europe(VIII)

26. V. Financial crisis and Central and South-east Europe(IX)

27. V. Financial crisis and Central and South-east Europe(X)

28. V. Financial crisis and Central and South-east Europe(XI)

29. V. Financial crisis and Central and South-east Europe(XII)

30. V. Financial crisis and Central and South-east Europe(XIII) • Management of the crisis for the region • In the early stage (by the end of 2008) case-by-case approach with arrangements done for Hungary, Latvia, Serbia and Ukraine; key role of the IMF in these arrangements • Later on (since January 2009) more talks about a rescue package for the region and for the western banks; amount between 150 – 250 bn EUR • Austrian proposal for an EU sponsore package • Proposal for an EIB sponsored package • Proposal for increasing the funding potential of the IMF • 24 bn EUR package by EBRD, EIB and WB

31. VI. How to proceed? • Complexity of the current crisis asks for complex answers as; in the following two directions: • Macroeconomic policy measures • Measures within the financial sector • Macroeconomic policy measures – how to make the crisis as short and shallow as possible • Monetary - further lowering of interest rates (FED vs. ECB) and maintaining liquidity (mistrust) • Fiscal - in addition to financial, also fiscal measures, to prevent the collapse of the "Main Street" and possibly of the "Wall Street" in the future • “Price” of these measures (worse fiscal position and less favourable ratings; pressure to make the GSP softer; pressure on ECB's independence)

32. IV. How to proceed? (II) • Measures within the financial sector – how to reestablish a healthy development "lifeblood" • Short-term – to “extinguish the fire” and to stabilize the sector • Measures to reestablish confidence (in terms of deposit savers, and interbank business – European specifics; problems with implementation) • Measures to ensure the solvency of banks (potentially negative impact to the real sector; moral hazard problem) • More complete disclosure of information about the complex financial instruments (to systematically tackle the problem, it is necessary to know its exact scope) • Assisting “emerging" countries without their own financial packages (pulled in the crisis, this time not by their own fault; IMF vs others)

33. IV . How to proceed? (III) • Measures within the financial sector (cont.) • Long-term – for systematic rehabilitation of national and international financial systems (globalization requires a new approach of global governance); two basic approaches: • Idealistic – establishment of a “new international financial architecture” in an multilateral world • A thorough institutional reform of the IMF with a substantially greater weight to ”emerging” countries in its decision making (elimination of the US veto power and “one voice” for the euro zone countries) • Establishment of a framework for effective coordination of exchange rates and elimination of balance of payments imbalances (the role of countries with large balance of payments surpluses - "sovereign wealth funds")

34. IV. How to proceed? (IV) • Measures within the financial sector (cont.) • Long-term – for systematic rehabilitation of the system • Realistic – approach that is based on a national / regional level and strengthened cooperation between national institutions • To substantially strengthen the regulation and control over the entire financial industry (end of "shadow banking”; cooperation of national structures, particularly in the EU, centralized control of large banks; central areas of regulation will be capital adequacy, liquidity, rewards; danger of too much regulation) • Harmonization of differences in accounting standards for banks, regarding the valuation of securities • Improvement of risk management in banks and elimination of conflict of interests between individual banking products • The reform of rating agencies (the elimination of conflict of interests; different views regarding regulation between the U.S. and EU)