Fixing Global Finance

Fixing Global FinanceMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

Leverhulme Centre for Research on Globalisationand Economic Policy and School of Economics, Nottingham University

October 13th 2008

2

Fixing Global Finance

“Things that can’t go on forever, don’t”Herbert Stein

3


“The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war.” Alan Greenspan, Financial Times, March 16th 2008

4


“Asia has become the source of finance, the source of savings. It now has the human capital to manage that well. Why doesn't it take the advantage of that opportunity to try and create financial markets that work better for the people of Asia?” Joseph Stiglitz.

5


• Outline of the argument:1. The emerging market crises showed the danger of foreign currency

borrowing

2. Many emerging economies decided to self-insure and become creditor nations

3. The US and a few other high-income countries became borrowers of last resort

4. This created twin economic risks: external and internal

5. The internal risks have proved dominant, but this saga is not over

6. More emerging economies will now move into current account deficit

7. This means we need a much stronger system of global finance

6

1. Emerging market crises

• In the 1980s and 1990s, emerging market economies suffered a series of shattering foreign currency and banking crises

• These culminated in the Asian crises of 1997-98, the Russian and Brazilian crises of 1998-99 and the Argentine crisis

• A central feature of many of these crises was current account deficits, financed by short-term foreign currency borrowing

• When the crises hit, the currencies collapsed and the currency mismatches created mass bankruptcies

7


VALUE AGAINST THE US DOLLAR: EAST ASIA(January 1996 = 100)

0.0

20.0

40.0

60.0

80.0

100.0

120.008

/03/

1996

08/0

7/19

96

08/1

1/19

96

08/0

3/19

97

08/0

7/19

97

08/1

1/19

97

08/0

3/19

98

08/0

7/19

98

08/1

1/19

98

08/0

3/19

99

08/0

7/19

99

08/1

1/19

99

08/0

3/20

00

08/0

7/20

00

08/1

1/20

00

08/0

3/20

01

08/0

7/20

01

08/1

1/20

01

08/0

3/20

02

08/0

7/20

02

08/1

1/20

02

08/0

3/20

03

08/0

7/20

03

08/1

1/20

03

08/0

3/20

04

08/0

7/20

04

08/1

1/20

04

08/0

3/20

05

08/0

7/20

05

08/1

1/20

05

08/0

3/20

06

SOUTH KOREAN WON MALAYSIAN RINGGIT PHILIPPINE PESOINDONESIAN RUPIAH THAI BAHT

CURRENCY COLLAPSES IN THE CRISES

8


FOREIGN CURRENCY LIABILITIES OF THE BANKING SYSTEM(per cent of GDP)

5.9% 5.6%4.8%

12.7%

6.2%

26.8%

17.2%

9.3% 9.2%

5.6%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Thailand Philippines South Korea Malaysia Indonesia

1992 1996

Source: Barry Eichengreen (2004)

DANGER OF FOREIGN CURRENCY LIABILITIES

9


THE MACROECONOMIC CONSEQUENCES OF THE ASIAN CRISIS(GDP in the year before a crisis and four subsequent years)

80.0

85.0

90.0

95.0

100.0

105.0

110.0

115.0

120.0

1 2 3 4 5 6

Indonesia 1996-2001 Korea 1996-2001Malaysia 1996-2001 Thailand 1996-2001

CONSEQUENT ECONOMIC COLLAPSES

10


FISCAL COST OF SOME OF THE BIG EMERGING MARKET CRISES(per cent of GDP)

55.0% 55.0%

42.0%

34.8%

30.5%28.0%

19.3%16.4%

7.0% 6.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Indonesia1997-

Argentina1980-82

Chile1981-86

Thailand1997-

Turkey2000-

SouthKorea1997-

Mexico1994-97

Malaysia1997-

Philippines1998-

Russia1998-99

Source: Caprio and Klingebiel

AND HUGE FISCAL LOSSES FOR BAIL-OUTS

11

2. Rise of emerging country surpluses

• In the 2000s the emerging world moved into massive current account surplus

• This was part of the explanation for the “savings glut”and low global real interest rates pointed to, correctly, by Alan Greenspan and Ben Bernanke

• Behind the emerging savings glut were three forces:– Cut-backs of investment in countries affected by financial

crises;

– Emergence of vast Chinese surpluses; and

– Emergence of the surpluses of oil exporting countries with high oil prices.

12


SAVINGS, INVESTMENT AND CURRENT ACCOUNTS OF EMERGING MARKET AND OIL-PRODUCING COUNTRIES

(per cent of GDP)

-2-10123456789

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Current Account Saving Investment

Source: IMF, World Economic Outlook, April 2007

EMERGING ECONOMIES SHIFT INTO SURPLUS

13


THE GREAT IMBALANCES

RISE AND FALL OF THE GLOBAL IMBALANCES(per cent of world GDP)

-2

-1.5

-1

-0.5

0

0.5

1

1.5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

United States Euro Area Japan Emerging Asia Oil exporters

Source: IMF, World Economic Outlook April 2008

14


GLOBAL CURRENT ACCOUNT 2006 ($bn)

-$857

-$68

$131

$170

$239

$102

$511

$396

-$131

$19

-$1,000 -$800 -$600 -$400 -$200 $0 $200 $400 $600

US

UK

Western Europe, excluding UK

Japan

China

Rest of Asia

Total Asia

Fuel exporters

Rest of World

Discrepancy

Source: IMF, World Economic Outlook, April 2004, April 2007 and April 2007

Database.

US AS BORROWER OF LAST RESORT

15


SURPLUS COUNTRIES 2007 ($bn)

$512

$361

$213

$185

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

2007

Remaining Surplus Countries

Malaysia

Taiwan Province of China

Sweden

Singapore

Netherlands

Switzerland

Germany

Japan

China

Oil Exporters

GLOBAL SURPLUSES

16


GLOBAL DEFICITS

DEFICIT COUNTRIES 2007 ($bn)

-$739

-$146

-$136

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

Remaining Deficit CountriesRomaniaFranceTurkeyGreeceItalyAustraliaUnited KingdomSpainUnited States

17


RISE OF FOREIGN CURRENCY RESERVES

GROWTH OF FOREIGN CURRENCY RESERVES ($m)

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

$8,000,000

Jan-9

9May

-99Sep

-99Ja

n-00

May-00

Sep-00

Jan-0

1May

-01Sep

-01Ja

n-02

May-02

Sep-02

Jan-0

3May

-03Sep

-03Ja

n-04

May-04

Sep-04

Jan-0

5May

-05Sep

-05Ja

n-06

May-06

Sep-06

Jan-0

7May

-07Sep

-07Ja

n-08

May-08

Industrial Countries Asian Developing Countries Oil Exporting countries Other Developing Countries

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3. US becomes borrower of last resort

• US emerged as the principal borrower in the system

• This created external and internal financial deficits

• These were also promoted by the loose monetary policy, made partly in response to the savings glut

• The most important aspect of internal deficits was the huge financial deficits of US households

• These were sustained by the ability to borrow against rising housing wealth

19


• But the result was growing vulnerability of the US financial system to housing-related debt

• This was made worse by extremely poor regulation –indeed active encouragement of very bad lending

• It was the internal, not the external deficits, that proved the “killers”

20


US NET INTERNATIONAL INVESTMENT POSITION(as per cent of GDP)

-100.0%

-50.0%

0.0%

50.0%

100.0%

150.0%

200.0%

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

U.S.-owned assets abroad (with FDI valued at market prices)Foreign-owned assets in the U.S. (with FDI at market prices)Net International Investment Position Net International Investment Position (cumulative current account)

US “CHEATS” ITS CREDITORS

21


US DOMESTIC IMBALANCESFINANCIAL BALANCES IN THE US ECONOMY, SINCE 1990

(per cent of GDP)

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1990-I

199

0-IV

1991-I

II 199

2-II

1993-I

199

3-IV

1994-I

II 199

5-II

1996-I

199

6-IV

1997-I

II 199

8-II

1999-I

199

9-IV

2000-I

II 200

1-II

2002-I

200

2-IV

2003-I

II 200

4-II

2005-I

200

5-IV

2006-I

II 200

7-II

2008-I

Private Financial Balance Government Financial Balance Foreign Financial Balance

22


HOUSEHOLDS SPENT; COMPANIES DID NOTUS HOUSEHOLD AND BUSINESS FINANCIAL BALANCES

(as per cent of GDP)

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

1990

-I 19

90-IV

19

91-III

19

92-II

1993

-I 19

93-IV

19

94-III

19

95-II

1996

-I 19

96-IV

19

97-III

19

98-II

1999

-I 19

99-IV

20

00-III

20

01-II

2002

-I 20

02-IV

20

03-III

20

04-II

2005

-I 20

05-IV

20

06-III

20

07-II

2008

-I

Business Financial Balance Household Financial Balance

23


GREAT HOUSEHOLD SPENDING BOOMPERSONAL SAVINGS AND INVESTMENT

(as per cent of GDP)

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

199

0-I

199

0-III

199

1-I

199

1-III

199

2-I

199

2-III

199

3-I

199

3-III

199

4-I

199

4-III

199

5-I

199

5-III

199

6-I

199

6-III

199

7-I

199

7-III

199

8-I

199

8-III

199

9-I

199

9-III

200

0-I

200

0-III

200

1-I

200

1-III

200

2-I

200

2-III

200

3-I

200

3-III

200

4-I

200

4-III

200

5-I

200

5-III

200

6-I

200

6-III

200

7-I

200

7-III

200

8-I

Gross Personal saving Gross Residential Investment Household Financial Balance

24


AND MASSIVELY INCREASED OVERALL DEBT

SECTORAL RATIOS OF US DEBT TO GDP

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Q2

Households Non-financial Business All Government Financial Sectors

25


AND MASSIVELY INCREASED HOUSEHOLD DEBTHOUSEHOLD DEBT AND DEBT SERVICE

(as per cent of disposable incomes)

40.0

60.0

80.0

100.0

120.0

140.0

160.0

Q180

Q181

Q182

Q183

Q184

Q185

Q186

Q187

Q188

Q189

Q190

Q191

Q192

Q193

Q194

Q195

Q196

Q197

Q198

Q199

Q100

Q101

Q102

Q103

Q104

Q105

Q106

Q107

Q108

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

14.0

14.5

15.0

US Household Debt US Household Debt Payments

26


AND MASSIVELY INCREASED HOUSEHOLD DEBT

HOUSEHOLD LIABILITIES(as per cent of disposable income)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

United Kingdom United States Japan Canada Germany France Italy

1996 2006 2007

OECD Economic Outlook

27

4. Implications of the “subprime crisis”

• This episode is now at an end, as:– US house prices fall;

– housing-related debt deteriorates in quality; and

– the financial system becomes de-capitalised

• So the US is moving into export-led growth

28


BURST HOUSING BUBBLEHOUSE PRICES IN THE US (Case-Shiller 10-City Index)

0

50

100

150

200

250

Jan-8

8Ja

n-89

Jan-9

0Ja

n-91

Jan-9

2Ja

n-93

Jan-9

4Ja

n-95

Jan-9

6Ja

n-97

Jan-9

8Ja

n-99

Jan-0

0Ja

n-01

Jan-0

2Ja

n-03

Jan-0

4Ja

n-05

Jan-0

6Ja

n-07

Jan-0

8

-25

-20

-15

-10

-5

0

5

10

15

20

Real House Prices Change in Real House Prices

29


CREDIT SHOCK IN THE USDISAPPEARANCE OF THE COMMERCIAL PAPER MARKET

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

30/0

8/20

06

30/0

9/20

06

30/1

0/20

06

30/1

1/20

06

30/1

2/20

06

30/0

1/20

07

28/0

2/20

07

30/0

3/20

07

30/0

4/20

07

30/0

5/20

07

30/0

6/20

07

30/0

7/20

07

30/0

8/20

07

30/0

9/20

07

30/1

0/20

07

30/1

1/20

07

30/1

2/20

07

30/0

1/20

08

29/0

2/20

08

30/0

3/20

08

30/0

4/20

08

30/0

5/20

08

30/0

6/20

08

30/0

7/20

08

Asset-backed Commercial Paper Financial Commercial Paper OutstandingNonfinancial Commercial Paper Outstanding

30


CREDIT SHOCK IN THE US

SPREADS BETWEEN TREASURY BILL AND COMMERCIAL PAPER RATES IN THE US

(percentage points)

0

1

2

3

4

5

6

7

01/0

9/20

06

01/1

0/20

06

01/1

1/20

06

01/1

2/20

06

01/0

1/20

07

01/0

2/20

07

01/0

3/20

07

01/0

4/20

07

01/0

5/20

07

01/0

6/20

07

01/0

7/20

07

01/0

8/20

07

01/0

9/20

07

01/1

0/20

07

01/1

1/20

07

01/1

2/20

07

01/0

1/20

08

01/0

2/20

08

01/0

3/20

08

01/0

4/20

08

01/0

5/20

08

01/0

6/20

08

01/0

7/20

08

01/0

8/20

08

01/0

9/20

08

US 3 mth Treasury bill yield (%) US A2/P2 non-financial 90 day yield (%) Spread

31


RISK SPREADS ON US CORPORATE BONDS(percentage points over Treasuries)

0

500

1000

1500

2000

2500

3000

30/0

9/20

02

30/1

2/20

02

30/0

3/20

03

30/0

6/20

03

30/0

9/20

03

30/1

2/20

03

30/0

3/20

04

30/0

6/20

04

30/0

9/20

04

30/1

2/20

04

30/0

3/20

05

30/0

6/20

05

30/0

9/20

05

30/1

2/20

05

30/0

3/20

06

30/0

6/20

06

30/0

9/20

06

30/1

2/20

06

30/0

3/20

07

30/0

6/20

07

30/0

9/20

07

30/1

2/20

07

30/0

3/20

08

30/0

6/20

08

30/0

9/20

08

BBB rated B rated C rated

RISE OF RISK PERCEPTIONS

32


DEMAND DRIVERS OF US GROWTH

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Q1 01

Q3 01

Q1 02

Q3 02

Q1 03

Q3 03

Q1 04

Q3 04

Q1 05

Q3 05

Q1 06

Q3 06

Q1 07

Q3 07

Q1 08

Domestic demand Net exports GDP (yoy%)

US EXPORT-LED GROWTH

33


• At present the risk is almost entirely on the internal side, which the US can manage, because it borrows in its own currency

• But there is also a risk on the external side:– What if creditors decide they are losing too much?

– What if there is a panic sale of dollars

• Then the US may only be able rescue the financial system by an inflationary default and possible collapse of the dollar standard

• So external vulnerability is also an issue

34


FALLING REAL EXCHANGE RATE FOR THE US

60

70

80

90

100

110

120

130

Jan-

70

Jan-

72

Jan-

74

Jan-

76

Jan-

78

Jan-

80

Jan-

82

Jan-

84

Jan-

86

Jan-

88

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Jan-

98

Jan-

00

Jan-

02

Jan-

04

Jan-

06

Jan-

08

IT’S MANAGEABLE – SO FAR

35

5. Need for adjustment in emerging economies

• This big US adjustment is compatible with global growth only if other countries have smaller surpluses or bigger deficits

• Oil exporters have a good reason to run big surpluses, because they are shifting one asset into another, though the IMF does expect them to spend more

• But non-oil exporters also need to reduce current account surpluses or increase deficits

• This means they must spend more relative to incomes

• China is the most important single case

36

6. Role of reforms in global finance

• So how are emerging countries to run current account deficits safely?

• The answer is that the external finance must itself be relatively stable

• There are three solutions:`– Equity investment (FDI and portfolio);

– Local currency bonds; or

– More collective insurance – e.g. via the IMF

• The development of local-currency bond markets shifts a potentially lethal risk onto foreign investors

37


• Of course, the development of local currency finance also depends on:– A sustainable fiscal position

– A sound currency

– A well-regulated financial system

– Openness to foreign investors

• Without these qualities local currency finance will fail, for both domestic residents and foreigners

• Countries that cannot generate such conditions need exchange controls

38


EMERGING MARKET BONDS OUTSTANDING ($bn)

$287$498 $618

$534

$1,312

$43

$369

$875

$2,640

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

1995 2000 2005

International Domestic Public Domestic Private

Source: "Financial stability and local currency bond markets", BIS, June 2007

RISE OF DOMESTIC CURRENCY FINANCING

39

7. Conclusion

• The financial crisis is far worse than I had expected

• Moreover, interestingly, it is far more related to internal, rather than external, imbalances

• This may not remain the case indefinitely, however

• The reduction in the internal imbalances depends on reducing the external imbalances, while maintaining global economic growth

• This depends on big changes in the rest of the world and reforms in the global financial system

40

7. Conclusion

• These changes include:– Much more local currency finance

– Bigger collective insurance systems

– More co-operative management of the system

Documents

Fixing Global Finance