Global impact of the crisis

1. Global impact of the crisis Contagion

2. Terms • Recoupling • Decoupling • Contagion • Deleveraging • Mark to market

3. 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).

4. 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.

5. 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.

6. Shortage of money (dollar)

7. 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.

8. European banks are involved: • 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.

9. three-headed monster—solvency, funding and liquidity, • Almost every country’s banking system is stricken with three interrelated problems: • having taken huge losses, the banks need capital; • 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; • and because the short-term money markets are closed, the banks are cut off from their main source of liquidity.

10. Policy response to the three-headed monster • the banks need capital; recapitalization and purchase of toxic assets • they are short of the funds they need to finance the share of their assets not covered by their deposits; quantitative easing • because the short-term money markets are closed, the banks are cut off from their main source of liquidity: liquidity injection

11. results • low yields on liquid government securities • an evaporation of wholesale fundingthat triggered disorderly deleveraging cascading across the rest of the global financialsystem • Liquid assets were sold atfire-sale prices, • credit lines to hedge fundsand other leveraged financial intermediariesin the shadow banking system wereslashed.

13. results • High-grade, high-yield corporatebond spreads increased, • trade finance and working capital was disrupted, • banks tightened lending standards • equity prices fell

14. IMF WEO April 2009

18. Channels affecting the global economy • Thecredit crunch hurt even the most highly rated privateborrowers. • Sharp falls in equity markets as wellas continuing deflation of housing bubblesled to a loss of household wealth. • These may be considered as corrections, but that had drastic consequences.

19. Channels affecting the global economy • The consequeces of corrections were transmitted to all sectorsand countries of the global economy by: • rising doubts abouteconomic prospects • uncertaintyabout policy responses of governments

20. results • Industrial production and merchandisetrade decreased in the fourthquarter of 2008 and continued to fall inearly 2009 • purchases of investmentgoods and consumer durables were affected by credit disruptionsand loss in confidence.

25. Financial sector worries • bank credit growth falling • bank wholesale fundingin mature markets dependent on government guarantees, • securitizationmarkets not functioning

26. Financial sector worries • uncertaintyabout valuation of bad assets (mark to market) • problems in reestablishingliquidmarkets in these assets • littleprogress in reducing bankexposure tofluctuations in their value.

27. Channels of Crisis Contagion • Financial contagion (with financial globalization) • Ownership of US assets • Credit crunch affecting everyone • Similar practices • Contagion to the real economy • Trade links

28. 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

29. Global Financial Assets (2006) • Nominal global GDP: $48.3 trl • McKinsey Global Institute, Fourth Annual Report, Jan2008

30. Global Financial Assets (2007) • Nominal global GDP: $55 trl • McKinsey Global Institute, Fifth Annual Report, Dec2008

31. 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.

32. Financial Assets by Region (2006) trillion dollars

33. 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

34. Cross Border Capital Flows • Cross border capital flows to emerging markets in 2006: $700bil • But, flows from emerging markets to developed markets exceeded that

35. 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

36. 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.

37. Cross Border Investments • 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.

38. 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.

39. 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.

40. 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.

41. Financial contagion • 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.

42. 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.

43. 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.

44. 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.

45. China Japan Korea Singapore Hong Kong Malaysia Phlippines Thailand Canada Mexico Major exporters to the US

46. Real GDP and trade growth of OECD countries (% y-y) Real GDP and trade growth of OECD countries, 2007-2008% change on a year to year basis

47. Growth in the volume of merchandise trade (%)

48. World Exports ($ billion) • Trade worsened in 2008 Q4. • 20.4% decrease over 2008 Q3. • 10.5% decrese over 2007 Q4.

49. 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

50. 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 notless vulnerable to economic turmoil in developed countries.