Third Quarter 2009 Point ofView · export revenue outlook, but credit will remain scarce as Russian banks are forced to delever-age. The refinancing rate was recently lowered to 12%,

Point ofViewOur Perspective on Issues Affecting Global Financial Markets

Third Quarter2009

PAGE1Emerging Markets and

Economic Recession – Last In – First Out? PA

GE6 Searching for Value in

Global Credit Markets

PAGE10 Regulatory Overhaul

in the Wake of the Financial Crisis PA

GE15 The Evolution of the Global

Auto IndustryIn this Issue »

Emerging Markets and Economic Recession – Last In–First Out?

The World Bank estimates that the global economy will contract 2.9% in 2009, its worst performance since the 1930s. The good news is that the pace of decline is already beginning to moderate and a global economic recovery is forecast to take hold in 2010.

Global investors are busy trying to gauge which economies will recover first in order to take advantage of investment opportunities in these financial markets.

There is a strong case to be made that some of the larger emerging market economies, includ-ing Brazil, China, and India, will lead the way out of the global recession. These countries have

sounder economic fundamentals than in the past and millions of domestic consumers to rely on in the face of weak foreign demand. This has sparked an impressive rebound in stock and sovereign bond prices in these na-tions. Indeed, the MSCI Emerging Market Stock Index is up more than 30% since the beginning of 2009. In this article, we will take a closer look at how emerging markets have managed to get through the worst of the glob-al credit crisis and what the prospects are for the future.

Weathering the Storm

Most emerging markets had little direct in-volvement in the global credit crisis that has consumed the industrialized world. This may explain why developing economies as a whole have managed to avoid an outright decline in economic activity. The World Bank is project-ing output in the developing world will expand by 1.6% this year versus a contraction of 4.5% in the industrialized world. The divergence in economic performance is of growing im-

portance since emerging markets account for an increasing share of world output. In fact, developing markets comprised 45% of world GDP in 2008 compared to 37% in 2000.

This is not meant to imply that emerging mar-kets were left unscathed by the events of the past year. Developing countries have suffered col-lateral damage in terms of falling exports, de-clining commodity prices, and reduced capital inflows as a result of the global credit crisis. In-deed, net flows of private capital to developing countries fell 41% to $707 billion last year and

-25

-20

-15

-10

-5

0

5

10

15

Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

G3 Economies

BRIC Economies

Sources: JP Morgan and Global InsightG3 include the United States, euro zone, and Japan; BRICs include Brazil, Russia, India, and China

Emerging Markets Expected to Lead Global Recovery

Industrial Production

Year

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ar P

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nt C

hang

e ForecastActual

Latin America and Asia, in particular, have been able to stimulate do-mestic growth through lower interest rates and increased government spending.

2 Payden & RygelQ3 2009

are projected to decline an additional 49% to $363 billion this year. Nevertheless, emerging markets were better prepared to weather the storm than they have been in the past. Flexible currency regimes, current account and budget surpluses, and large foreign exchange reserves have given most countries room to implement countercyclical policies during a crisis for the first time in recent history.

Latin America and Asia, in particular, have been able to stimulate domestic growth through lower interest rates and increased government spending. These regions have the added advantage of very low levels of debt in the household and banking sectors, which may help fuel an early revival of consumer spending and business investment. Unfortu-nately, this is not universally true for emerg-ing markets. Some countries in Central and Eastern European are plagued by excessive leverage in their financial systems in addition to fixed exchange rates and large current ac-count and budget deficits. Thus, while it may be helpful to lump emerging markets together for purposes of comparison with the industri-alized world, it is important to note that not all emerging markets are created equal from an investor perspective.

The Cream of the Crop

Within the Latin America and Asia regions, three countries appear best positioned to lead

the way in a global economic recovery. Brazil, India, and China have solid macroeconomic fundamentals as well as a couple of additional advantages. First, they were slower to liberal-ize their financial systems and therefore have been less affected by the collapse of global credit markets. Second, they rely less on ex-ports than the average emerging market and have the ability to turn inward because of their large domestic populations.

Many analysts group Brazil, Russia, India, and China, commonly referring to these countries as the BRICs. The BRICs comprised approxi-mately 22% of world GDP in 2008, up from 16% in 2000. They also accounted for roughly 30% of global growth over that time period. Their increasing importance in the world economy prompted the four countries to increase co-operation and organize their first summit in Yekaterinburg, Russia in mid-June. However, the Russian economy is not in the same class as the others primarily due to its dependence on oil and fragile banking system. While the others are poised to recover in 2009, the Rus-sian economy may struggle until 2010.

During and after the global economic recov-ery, we expect emerging markets to achieve much higher growth rates than developed countries which will continue to be pressured by deleveraging, increasing budget deficits, and higher debt burdens. From an investment perspective, it is difficult to say whether the re-cent run in stock and bond prices in any of these markets can be sustained in the short term given the volatility of financial markets. However, the long term prospects for these countries suggest they are worthy of a place in a well-diversified portfolio.

Works Cited:

1. "BRICs, Emerging Markets and the World Economy: Not Just Straw Men." The Economist.June 20, 2009.

Brazil, Russia, India, and China comprised approximately 22% of world GDP in 2008, up from 16% in 2000.

3Payden & Rygel Q3 2009

Russia’s growth in recent years was fueled by strong export revenues coupled with rapidly expanding lending. Russian banks borrowed in the international capital markets to finance booming local demand for credit. As a result, household debt/GDP ratios rose significantly. Oil prices at $70/barrel improve the country’s export revenue outlook, but credit will remain scarce as Russian banks are forced to delever-age. The refinancing rate was recently lowered to 12%, and there is still room for further cuts in Russia. Growth indicators have surprised on the downside this year and we expect Russia’s economic recovery to lag that of its BRIC coun-terparts, mainly due to its fragile banking sec-tor. The forecast for Russia’s recovery improves significantly if the current rally in commodities is sustained.

Russia - 2009 ForecastNominal GDP (US$ bn) 1,317Population (million) 141Real GDP growth -6.3%Fiscal stimulus (% GDP) 4.4%Benchmark interest rate 11.00% (refinancing rate) FX Reserves (US$ bn) 394

Sources: Credit Suisse and Payden & Rygel Estimates

Brazil - 2009 Forecast

Nominal GDP (US$ bn) 1,465Population (million) 191Real GDP growth -1.0%Fiscal stimulus (% GDP) 1.5%Benchmark interest rate (SELIC) 8.75%FX Reserves (US$ bn) 212


Brazil’s diversified export structure, which in-cludes a wide array of commodities (soy, sugar, iron ore, steel, and hydrocarbons), was hurt by the end of the commodity boom. However, its economy contracted at a slower pace than ex-pected in the first quarter of 2009 as household consumption increased from the prior quarter. Political and economic stability achieved during President Lula’s Administration has allowed the Central Bank of Brazil to gain control over infla-tion and cut interest rates sharply in the current easing cycle. With interest rates at historically low levels and bank lending expected to pick up, consumers should become a much larger contributor to economic growth this year and lead the way out of the recession. More reforms are needed to boost long-term competitiveness, but the government’s agenda is very light this year given presidential elections in 2010.

Year-end Economic Outlooks


China’s growth is driven by government spend-ing and investment in infrastructure and other public projects. At CNY 4 trillion (US$ 586 bil-lion), China’s fiscal stimulus package for 2009 and 2010 is the largest in emerging markets and will likely ensure the government’s 8% long-term economic growth target is achieved. However, there is some concern that a portion of stimulus funds are being allocated toward projects that have little economic value. De-spite deteriorating export performance in May, Chinese economic data suggests the recovery is gaining momentum with industrial produc-tion up by 8.9% year-over-year and retail sales growth continuing to accelerate to 15.2% year-over-year. The manufacturing Purchasing Man-agers Index (PMI), which leads output by two months, rose above 50 this year, indicating that the manufacturing sector is expanding and that improvement in industrial production should continue in the following months.

The positive parliamentary election results this May, which gave the United Progressive Alliance (UPA) a clear mandate, are paving the way for reforms that will sustain India's rapid growth. The new government’s first 100-day program is likely to focus on legislative reforms, including the pension bill and increased foreign invest-ment in the insurance sector. Financial liberal-ization and labor market and land acquisition reforms will take more time to be approved. In-dia’s fiscal stimulus package of 5% of GDP is the second largest in emerging markets. While In-dia has less flexibility than China given its worse fiscal position, aggressive monetary easing and lower inflation should lead to a pick-up in pri-vate consumption, which accounts for 55% of India’s GDP. Despite relatively weak private con-sumption growth so far this year, we expect a significant improvement in the second half. In-frastructure development remains a top govern-ment priority and one of the main engines of growth.

India - 2009 Forecast

Nominal GDP (US$ bn) 1,232Population (million) 1,189Real GDP growth 6.2%Fiscal stimulus (% GDP) 5.0%Benchmark interest rate 4.75% (repo rate) FX Reserves (US$ bn) 270


China - 2009 ForecastNominal GDP (US$ bn) 4,893Population (million) 1,336Real GDP growth 8.0%Fiscal stimulus (% GDP) 6.0%*Benchmark interest rate 5.31%FX Reserves (US$ bn) 2,317

Sources: Credit Suisse and Payden & Rygel Estimates*Assumes half of the US $586 billion fiscal stimulus will be spent in 2009.


The growth of the European corporate bond market as an alternative and com-plement to the US market has been one of the most important developments in global credit markets over the past de-cade. For investors, a diversified portfolio of corporate bonds that has exposure to both regions is likely to enhance returns and reduce risk. Below we will compare and contrast the two markets and discuss the best ways to realize the benefits of-fered by both.

Evolution of US and European Credit Markets

Within the global corporate bond market, the US market remains the largest as measured by the amount of debt outstanding. Broad mar-ket index providers, such as Barclays Capital, estimate that the aggregate amount of US in-vestment grade (rated BBB-/Baa3 or above) corporate debt outstanding is in excess of $2.27 trillion. The US market has a relatively long history of helping fund large-scale infra-structure projects, from railroads in the late

1800s to present day mergers and acquisitions (M&A). The US market is also relatively diverse in terms of issuer credit quality, as evidenced by the amount of high-yield (rated below BBB-/Baa3) issuance, which has grown to approxi-mately 20% to 25% of the overall US corporate bond market. Today, US corporate bond issu-ers still include mature industrial sectors and companies, such as CSX (freight transporta-tion), but also corporations ranging from Mi-crosoft (software) to Neiman Marcus (retail) to Disney (entertainment). The size, maturity, and diversity of the US corporate bond market have appealed to global investors.

Conditions in global credit markets have improved dramatically since policymakers stepped in to stabi-

lize financial markets following Lehman Brothers’ bankruptcy last fall. No longer faced with the prospect of a systemic melt-down, both corporate bond issuers and investors have adopted a cautiously opti-mistic outlook. Although corporate bond yields have dipped, yield spreads above government bonds remain at historically high levels, and therefore continue to of-fer compelling value.

Searching for Value in Global Credit Markets


Compared to its US counterpart, the Europe-an corporate bond market (which consists of a sterling currency and a larger euro currency component) did not fully develop until the ar-rival of the single European currency in 1999. Cases of European companies issuing non-domestic currency bonds designed to appeal to international investors prior to this date ap-pear to be the exception rather than the rule. For the most part, European companies were dependent on bank loan financing; bond is-suance was rare and mostly geared toward the domestic audience. France and Germany even had regulations until the 1980s and 1990s pro-hibiting a company from issuing short term debt in the public markets. Over the past de-cade many of these impediments have disap-peared.

Europe's economic unification hastened this shift. The euro, initially adopted by 12 mem-ber states of the European Union, allowed for greater transparency of security prices in member countries. It also removed the need

for currency hedging among euro-zone inves-tors, reducing barriers to investing. Equally significant, the EU simultaneously underwent a greater degree of market liberalization that allowed for companies to engage in cross-bor-der mergers and acquisitions in order to gain economies of scale and more effectively com-pete on a global basis. As a result, companies not only gained greater visibility outside their home markets, but also had an impetus to is-sue bonds (to help fund their M&A activity), thereby aiding the demand and supply of this asset class.

Despite its slow start, the European corpo-rate bond market has grown rapidly in recent years. Investment grade European corporate bonds outstanding were approximately 58% the size of the US market in 1999, whereas today they are approximately 92%. As of May 2009, the amount of debt outstanding neared $2.1 trillion (80% of which is euro-denomi-nated bonds, and 20% sterling-denominated bonds). Current European issuers include

0

500

1,000

1,500

2,000

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Dollar-Denominated

Euro-Denominated

Sterling-Denominated

European Credit Markets are Gaining on the US

Source: Barclays Capital

US$

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such diverse names and sectors as Enel (Ital-ian utilities), Marks & Spencer (UK retail), Ericsson (Swedish telecommunications), and Nestle (Swiss consumer goods). However, the European market has thus far developed with a higher quality bias. In contrast to the US, where high yield issues account for one quar-ter of all corporate bonds, in Europe they are less than 10%.

Enhancing Returns through Diversification

While the European corporate bond market is more homogenous and less mature than its American counterpart, its recent growth and absolute size provide a unique investment op-portunity. For the globally-oriented investor, exposure to both US and European markets offers higher risk-adjusted returns than lim-iting exposure to only one region. Modern portfolio theory offers two main rationales

for such action. First, adding two distinct asset classes together has the potential to enhance returns. Second, even if additional returns are not forthcoming, combining two asset classes should provide benefits in the form of diver-sification, thereby decreasing risk in the port-folio.

The potential for heightened returns can be seen by comparing both current yields as well as total returns for the regions over time. As the table (Sterling Investment Grade Corpo-rates Are Attractive) on the right indicates, in-vestors are currently offered higher yields on sterling-denominated versus US dollar-denom-inated corporate bonds both in absolute terms (yield) as well as on an excess spread basis. Fur-thermore, from 1999 to 2008, no single market generated consistently higher total returns. In-stead, using broad market indices as a proxy, the US corporate bond market outperformed from 2000 to 2003, and then again in 2006 and 2007. However, in 1999, 2004, and 2005, both sterling and euro-denominated corporate

12 Month Total Annual Returns on Investment Grade Bonds

-15%

-10%

-5%

0%

5%

10%

15%

Dollar-Denominated

Euro-Denominated

Sterling-Denominated

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Different Markets Outperform at Different Times

Source: Barclays Capital Aggregate USD, EUR and GBP Corporate Indices2009 is Year-To-Date Total Annual Return to June 26, 2009

Tota

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bonds delivered higher returns. In 2008, euro-denominated corporate bonds outperformed both US dollar and sterling corporate bonds. More recently, the US corporate bond market outperformed the euro and sterling markets from January to June 2009. Thus, an investor limiting their portfolio to any single market would have missed out on the opportunity for higher returns in other markets during this time frame.

Diversification is another benefit of interna-tional investing. A portfolio benefits from di-versification any time two non-perfectly corre-lated assets are combined. Correlation refers to the degree of movement in one variable given a move in another and can range from -1 (perfect negative correlation) to 1 (per-fect correlation). When two variables which are not perfectly correlated are combined to-gether, the probability of extreme outcomes (risk) is reduced since any movement in one variable will be slightly offset by movement in the second variable. A simple regression of the annualized total returns for the period 1999 to 2008 shows that the correlation of returns between US dollar and euro-denominated cor-porate bonds is 0.87, US dollar and sterling- denominated corporate bonds is 0.82, and euro-denominated and sterling-denominated corporate bonds is 0.91. It would be extremely difficult to find two assets with exact perfect

or exact perfect negative correlation. The relatively high number suggests diversification benefits from investing across the US and European markets would be limited. However, even this small benefit is preferable to none, which would be the case with a single market allocation.

Global Allocation to Corporate Bonds Remains Attractive

For the corporate bond investor re-flecting on the recent market rally, it is

therefore important to keep in mind a few key points. First, corporate bonds still offer attrac-tive yields above those offered by government issued debt. Second, the development of the European corporate bond market and its char-acteristics relative to the US market provide in-vestors with an increased menu of options with respect to investment regions and currencies. Third, the optimal allocation is likely not one that is restricted to either market, but rather a portfolio exposed to both markets, enabling higher returns and reduced risk.

Works Cited:

1. Emily Bowen, ed. “International Debt Capital Markets Handbook.” Euromoney. 2007 Edition.

Sterling Investment Grade Corporates Are Attractive

Spread Over Investment Grade Corporates Yields Government Bond Yields

Euro Corporate Bonds 5.44% 2.90%

Sterling Corporate Bonds 7.64% 4.12%

US Dollar Corporate Bonds 6.01% 3.11%

Source: Barclays CapitalAs of June 26, 2009


US Treasury Secretary Timothy Geithner may have summed it up best in his testimony before the House Financial Services Committee in March 2009 when he said that financial sector “failures have caused a great loss of confidence in the basic fabric of our financial system, a sys-tem that over time has been a tremendous as-set for the American economy. To address this will require comprehensive reform. Not mod-est repairs at the margin, but new rules of the game.” While disagreements abound as to its form, few contest that a new global regulatory architecture is desperately needed to prevent a repeat of the far-reaching financial melt-down that paralyzed credit markets, wreaking financial devastation from Wall Street to Main Street.

Innovation Outpaces Regulation

Financial innovation has outstripped regula-tory modernization, allowing a risky financial order to emerge outside the boundaries of traditional bank regulation. There are at least four areas that need to be addressed in any comprehensive financial reform legislation:

1) Uniform and consolidated regulation: Large financial companies are free to “cherry pick”

their regulator by simply changing their char-ter. A hodgepodge of regulatory agencies is re-sponsible for supervision of the financial sec-tor, creating gaps and overlaps.

2) Transparency in derivative markets: Complex financial products worth trillions of dollars are traded over the counter, leaving regulators and investors in the dark. The US Over-the-Coun-ter (OTC) derivative markets exceeded $590 trillion in notional amounts outstanding as of December 2008, over thirteen times the size of the capital markets at nearly $43.3 trillion, yet exist in the shadows.

3) Systemic risk management: A consolidated fi-nancial services industry dominated by a few powerful firms makes some firms “too big to fail,” posing a systemic risk. The financial services industry has undergone a transfor-mation, as tremendous growth in non-bank financial services has accompanied radical consolidation of financial firms. The number of banking institutions in the US declined by 50% while the number of big bank offices in-creased by 42% since 1989.

4) Resolution mechanisms for insolvent systemically-important financial institutions: While the Feder-al Deposit Insurance Corporation (FDIC) can

T he global financial crisis has called at-tention to the need to modernize the international financial regulatory archi-

tecture for the 21st century. American and Eu-ropean regulators currently face similar issues of fragmented regulation, opaque markets, and highly consolidated financial institutions whose failure would destabilize the entire system. Con-sequently, historic reforms are necessary on both sides of the Atlantic to combat the systemic risk endemic to a highly complex and intercon-nected financial services industry.

Regulatory Overhaul in the Wake of the Financial Crisis


orderly dismantle a failed bank, the Treasury Department has no mechanism to unwind an interconnected non-bank financial giant with-out destabilizing domestic and international financial markets.

The Alphabet Soup of Regulation

Current US regulations create significant vari-ation in how financial products and institu-tions are regulated. Banks are subject to the most stringent restrictions. The Bank Holding Act of 1956 gave the Federal Reserve author-ity to register and regulate bank holding com-panies, putting in place stricter regulations of operations, capital requirements, and merger and acquisition activity in exchange for great-er flexibility in raising capital. Morgan Stanley

and Goldman Sachs converted to bank hold-ing companies in September 2008 after the collapse of Lehman Brothers brought the in-vestment banking industry to its knees. Howev-er, equally large and interconnected financial institutions like insurance companies, invest-ment banks, and private funds are subject to limited consolidated oversight.

The “boundary issue” is central to the prob-lem of decentralized and inconsistent regula-tory authority. At the most basic level, effective regulation penalizes the regulated and rewards those just outside its reach, causing a shift to-ward the unregulated industries. The result is a system like that which exists today, where much of the country’s financial activity takes place outside of traditionally-regulated banks.

*As of December 31, 2008**Sources: Federal Reserve, U.S. Treasury, Federal Agencies, Thomson Financial, Bank of International Settlements, Securities Industry and Financial Markets Association, Payden & Rygel Estimates1 Other: Money Market, Municipal, Federal Agency, Asset-backed Securities2 Other: Equity-linked Contracts, Commodity Contracts, Unallocated

US Relative Market Size

Opaque OTC Derivative MarketsTransparent Capital Markets

Capital MarketsMarket Value Outstanding

OTC Derivative MarketsNotional Amounts Outstanding

$592

$43.30

100

200

300

400

500

600

700

32% Equity

71% Interest

Rate Contracts

14% Other2

8% Foreign Exchange Contracts

7% Credit Default Swaps

29%OtherDebt110% Treasury Debt

13% Corporate Debt

16% Mortgage Related Debt

US

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When looking at international financial reg-ulation, the “boundary issue” is literal. Al-though financial institutions operate around the globe, regulations differ by country of ori-gin and operation. Just as inconsistent regula-tion causes substitution toward unregulated financial instruments, inconsistent national standards shift opportunities for greater prof-its toward less regulated national markets. Eu-ropean Central Bank (ECB) Executive Board Member Gertrude Tumpel-Gugerell argued in June 2009 that “effective coordination of all policy initiatives is key for ensuring global consistency and success; but financial stability ultimately depends on the implementation of global initiatives at the local level.” Standard-ized financial regulation is important, but the greatest transnational regulatory challenge lies in uniform implementation.

Similar problems exist at the national level. The current US regulatory regime is overly complex and fragmented. The Federal Re-serve, Securities & Exchange Commission (SEC), Federal Deposit Insurance Corpora-tion (FDIC), Office of the Comptroller of the Currency (OCC), Commodity Futures Trading Commission (CFTC), Office of Thrift Supervi-sion (OTS), and the National Credit Union Administration (NCUA) share responsibility for monitoring the financial sector. Each has limited authority and no agency has systemic oversight. The alphabet soup of regulators creates gaps and turf wars that allow extraor-dinary risks, and in some cases even fraud, to go undetected.

Consolidating regulators and bolstering the Federal Reserve’s authority may eliminate some of the bureaucracy that inhibits effective supervision. President Barack Obama has pro-posed putting the OTS on the chopping block, though the Administration has shied away from the aggressive agency streamlining that many have deemed necessary. Others have called for combining the SEC and CFTC, which monitor similar activities in the equities and derivatives

markets. Central to the debate is where con-solidated systemic regulatory authority should lie. Empowering the Fed to act as the United States’ leading macro-prudential regulator is gaining support, arousing a backlash from op-ponents who seek to limit its power by putting in place stricter auditing requirements.

Macro-prudential regulation is equally vital to European financial reform efforts. In June, European Union leaders proposed the “Eu-ropean Systemic Risk Board (ESRB)”, a new body to monitor EU-wide risk, uniting leaders from the ECB, the Bank of England (BOE), and other national central banks. This move is highly controversial, particularly within the UK, as it threatens to subject Britain to greater oversight from Brussels. EU leaders also pro-posed creating the “European System of Fi-nancial Supervisors”, a board designed to seek convergence and resolve differences in nation-al financial regulation.

Transparency Is Key

Increasing transparency is another critical area for improvement. Even looking beyond moral considerations of fair play and practical con-cerns of risk management, transparency is vital for free markets to operate efficiently. Paul Vol-cker notes in the Group of 30’s Framework for Financial Stability that “the more opaque are the risks being taken, the more difficult it is for stakeholders to ascertain if there is reasonable balance between risks and expected rewards.” As financial innovators came up with increas-ingly complex financial instruments to sell to investors, the costs and risks of those invest-ments became increasingly obscured.

Current regulation allows for a dangerous lack of transparency that contributed to the finan-cial crisis. There are few disclosure require-ments in place for hedge funds and complex OTC derivative transactions like credit default swaps, despite their magnitude and signifi-


cance. Hedge funds accounted for assets of be-tween $1.25 and $2.48 trillion as of late 2007, and the credit default swap market neared $42 trillion. Investors, regulators, and even the firms involved did not understand the ex-tent of risk on their balance sheets. Mortgage-backed securities provide an excellent exam-ple of the dangers of opaque markets, as the companies that originated the bad loans sold them off their books, and investors who pur-chased high-rated residential mortgages, the “safest” tranches of packaged debt, had little knowledge of the underlying loans, and sub-sequently little understanding of the true de-fault risk.

Incentives must be modified to ensure prudent risk-taking. One frequent suggestion is to cre-ate a “skin in the game” requirement, where originators of loans would be obligated to hold a financial stake in them, rather than selling them entirely to investors. This would protect against the reckless issue of loans to unquali-fied buyers. Similarly, executive compensa-tion should be tied to long term performance rather than short term gains, in order to better align employee, shareholder, and bondholder interests.

Tranparency is also an issue in the credit de-fault swap (CDS) market. CDS brought about massive losses that may have been minimized had all parties involved had an accurate ac-counting and understanding of the true risks firms like American International Group (AIG) had taken on. One proposal that is gain-ing traction is to create a common exchange for derivatives to supplant the murky over-the- counter market. Loose requirements for hedge fund disclosure allowed for fraud to be perpe-trated without intervention, such as Bernard Madoff’s $50 billion Ponzi scheme. Increasing transparency will boost efficiency and prevent against systemic breakdown.

Reducing Systemic Risk

The overarching aim of regulatory reforms is to reduce systemic risk. To accomplish this, regulators must be equipped to take a system-wide perspective, looking beyond the level of individual firms or sectors. The consolidation and diversification of financial services players fostered the “too big to fail” phenomenon, as evidenced by the global implications of the Le-hman Brothers bankruptcy.

Fed Chairman Ben Bernanke has argued for especially close supervisory oversight of firms whose failure would risk systemic meltdown, including holding them to high capital and liquidity standards. Ironically, the financial crisis produced greater consolidation of finan-cial firms, as Wachovia, Merrill Lynch, Bear Stearns, Lehman Brothers, and Washington Mutual have been absorbed by more stable rivals, creating even greater systemic stress should any major player fail.

The revised regulatory regime must recognize the interconnectivity of global financial mar-kets in its efforts to mitigate systemic risk. As major financial institutions have global reach, US regulators must work with international regulators to craft a system to ensure global financial stability. The Group of 30 has advo-cated enhancing international financial data collection and promoting implementation and enforcement of international standards abroad in order to make the job of regulators a little easier.

While it is important to prevent one intercon-nected firm’s failure from dragging down the entire market, regulators cannot overlook the perils of keeping failing banks afloat simply because they are “too big to fail.” Some have warned that such a long-term approach is anti-competitive, allowing poorly run companies to stay afloat, creating artificial incentives for firms to grow to reach too-big-to-fail status, and forging barriers to entry for smaller firms


that will have a harder time raising capital than large competitors with implicit government support.

Consequently, a mechanism should be put in place to unwind large, interconnected, highly complex non-bank financial institutions with-out disrupting global financial markets. The Savings and Loan Crisis of the 1980s resulted in the creation of the Resolution Trust Corpo-ration in 1989, responsible for managing the closures of insolvent thrifts. The new system should work similarly to the conservatorship system employed for failed banks. Bankruptcy court is effective for most companies on the verge of collapse, but special treatment should be accorded to the most interconnected finan-cial firms.

Regulatory Reform Must Take Center Stage

In March 2009, Fed Chairman Ben Bernanke correctly asserted that “until we stabilize the fi-nancial system, a sustainable economic recov-ery will remain out of reach.” Actions taken by both the central bank and the Treasury seem to have succeeded in halting the free fall in financial markets. Now the focus is shifting toward regulatory reform to help prevent fu-ture fiscal crises on the same scale. President Obama has argued that we must act now, be-fore we lose the impetus for radical reform. The same sense of urgency is felt across the At-lantic. ECB Executive Board Member Lorenzo Bini Smaghi lamented in June 2009 that “the forces pushing towards maintaining the status quo are gaining strength. If these forces are not firmly counteracted, this crisis could turn out to have been a wasted opportunity. And the next crisis could move closer.”

The recent financial crisis revealed gaping holes in the financial regulatory system, and a broad array of reforms are on the table. In-

creased transparency is a must, as opaque deals create market inefficiencies and have the po-tential to expose companies to extraordinary risk. Incentives must be realigned and too-big-to-fail institutions must be monitored closely to mitigate systemic risk. Financial services are far too integrated and complex to regulate on an individual company basis. When complex financial giants do fail, there must be some mechanism for unwinding them to achieve minimum disruption to the global financial markets.

Regulatory reform is in many ways comparable to closing the barn door after the horse has bolted; however, playing catch-up to failure is better than taking no action at all. The great-est challenge in crafting effective regulatory reform is striking the necessary balance. How can we regulate without stifling those who in-novate? How can we reduce risk without elimi-nating the opportunity for reward?

Works Cited:

Timothy Geithner. “Overhauling Financial 1. Regulations; House Financial Services Committee.” Congressional Quarterly. March 26, 2009.

“Semiannual OTC derivative statistics at end-2. December 2008.” Bank for International Settlements.

Charles Goodhart. “The Boundary Problem 3. in Financial Regulation.” National Institute Economic Review. Volume 206/1. 2008.

“The Post-Crisis Financial Architecture.” Speech 4. by Gertrude Tumpel-Gugerell. Saint Petersburg International Economic Forum. June 6, 2009.

“Financial Reform: A Framework for Financial 5. Stability.” The Group of Thirty. January 15, 2009.

Alistair MacDonald and Margot Patrick. “Hedge 6. Funds: Leveraging the Numbers.” The Wall Street Journal. November 24, 2007.

“Going Forward: Regulation and Supervision 7. after the Financial Turmoil.” Speech by Lorenzo Bini Smaghi. Fourth International Conference of Financial Regulation and Supervision, Bocconi University, Milan, Italy. June 19, 2009.


During prior economic cycles, brands such as American Motors, Oldsmobile, and Stude-baker have come and gone. But today, rather than allowing capitalism to run its course, gov-ernments around the world are intervening in their local markets on an unprecedented scale. We attempt to put the crisis facing the global auto industry into perspective and dis-cuss some of the recent actions taken by both automakers and governments to help the in-dustry survive.

Putting the Decline into Perspective

The drop in global auto sales over the past two years has been extraordinary. According to R. L. Polk and Company, worldwide sales of cars and light-trucks will decline to 55.2 million units in 2009, down 23% from 71.9 million units in 2007. Much of the deterioration has occurred in the United States, where sales lev-els have fallen to their lowest point since World War II. Indeed, the recent US annualized sales rate of 9.3 million cars in May 2009 is roughly

The landscape of the global automotive industry is changing rapidly, as evidenced by the bankruptcy of two of the largest US carmakers – Chrysler and General Motors – in the spring of 2009. These struggling giants are the most recent victims of long-term structural

changes that are transforming the global auto industry. The process has accelerated over the past year due to the deep cyclical contraction in the world economy.

The Evolution of the Global Auto Industry


equivalent to levels seen during the late 1970s recession when the population of the US was about 225 million, 25% lower than today’s esti-mate of 305 million. The graph above (Ameri-cans Are Buying Fewer Cars) shows that, when adjusted for population growth, current car sales levels have experienced an even greater drop.

A large portion of the collapse in sales has been driven by cyclical forces associated with the global recession. This is evident in the fact that sales have fallen for all brands and across the price spectrum. During recent months, Japanese automakers have actually experi-enced more severe sales declines than their Detroit counterparts. Both Toyota and Honda suffered sales slumps of 30% or more on a year-over-year basis. These companies have healthy financial profiles including well-capitalized fi-nance arms and a high-quality product. Thus, the recent drop in sales likely has more to do with the collapse of consumer demand than the uncompetitive cost structures and signifi-cant healthcare and retirement legacy costs

that plague some of the US carmakers.

The downward trend in auto sales started in the US, but has spread in varying degrees throughout Europe and Asia. For many of the world’s largest automakers, the emerging mar-kets are still seen as the likely drivers of future growth. Auto sales in these markets are driven by consumers buying their first vehicles due to increased purchasing power, rather than by replacement demand. With countries such as Brazil, India, and China expected to lead the way in a global economic recovery, auto sales in these markets may recover sooner than in the industrialized world.

Government Involvement on the Rise

Global automakers and governments have taken drastic action in order to facilitate a re-covery in the global auto industry. Most manu-facturers have announced layoffs even if those only consisted of temporary workers, as in the case of Honda and Toyota. Roughly half

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1976 1980 1984 1988 1992 1996 2000 2004 2008

Americans Are Buying Fewer Cars

Population-Adjusted US Car Sales At Historical Lows

Source: Bloomberg

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of America's fifty-one light vehicle plants are projected to permanently close in the coming years, costing another 200,000 jobs in the sec-tor, on top of the 560,000 jobs already lost this decade.

Governments have responded in numerous ways. In February 2009, Germany enacted what has been called a “Cash for Clunkers” program which provides consumers with $3,320 to pur-chase a new car if they scrap a car over nine years old. The German program has helped drive sales of lower price models during the past couple of months. Total unit sales in Germany were up 18% in the four months to April versus a year earlier, helping offset a catastrophic 40% decline in export sales. Germany’s success with the program has prompted similar proposals in the United States, France, and the United Kingdom, as it serves to stimulate demand and remove the highest polluting vehicles from the streets. Indeed, Congress recently passed the “Car Allowance Rebate System (CARS),” offer-ing a $3,500 to $4,500 credit for replacing a car getting under 18 miles per gallon (mpg) with a more fuel efficient new model.

Of course, the most expensive intervention

has been the bailout of the automakers them-selves. While the bailouts of GM and Chrysler have received the most press, there have been a number of other rescue measures. GMAC, the independent auto finance company that had previously been owned by GM, is now con-trolled by the US Treasury following the infu-sion of more than $10 billion in new capital.

SAAB, the Swedish car brand owned by GM, is being sold to Swedish boutique sports-car com-pany Koenigsegg using $600 million of loan guarantees from the Swedish government. Koenigsegg is estimated to build only 20 cars a year and have annual revenue of less than $20 million. That such a small firm like Koenig-segg would be selected as the buyer points to the determination of the Swedish government to keep the SAAB brand in existence. The Ger-man and UK governments are similarly plan-ning to subsidize the purchase of Opel and Vauxhall, GM’s other European brands.

Strings Attached to Government Aid

With all of this governmental intervention, the question arises: what will the auto industry look like in the future? Most of the developed nations’ governments are making their wishes clear. They want their respective companies to build fuel efficient smaller cars (which also happen to be the least profitable product for the manufacturers). The Cash for Clunkers Program reflects this strategy. In May 2009, the Obama Administration announced that the Corporate Average Fuel Economy (CAFE) standards for auto manufacturers are set to in-crease at a much faster rate. Manufacturers will now need to have a fleet that gets an aver-age of 35.5 mpg by 2016, up significantly from 27.5 mpg in 2009.

The US government is helping automakers achieve these fuel efficiency goals through the Advanced Vehicle Technology Loan Program. The program will provide low cost loans to do-

Source: Automotive News

International Car Sales71.9 Million Vehicles Sold in 2007

28%North

America

30%Asia-Pacific

33%Europe

3%Middle East

6%Latin

America


mestic auto companies that develop hybrid, electric, and alternative fuel vehicles. While these loans have not been disbursed, it is clear that the US and other countries around the world see this as an opportunity to push through a high fuel efficient agenda. Addi-tionally, with gasoline prices back on the rise, fuel efficiency may again become paramount to consumers.

Balancing Supply and Demand

Global automakers have the capacity to build more than 90 million cars annually, yet con-sumer demand suggests they will sell no more than 55 million this year. The willingness of national governments to support their home-grown auto companies has thwarted con-solidation. Indeed, China alone has some 80 different small automakers. Government in-tervention raises the risk that the industry will continue to suffer from overinvestment.

However, positive signs do exist on the de-mand side. The Federal Reserve’s Term As-set Backed Loan Facility (TALF) program has been successful in restarting securitized auto lending. Several companies, including Nissan, VW, BMW, and Ford, have used TALF in recent

weeks. The re-establishment of this important source of consumer financing should support sales during the remainder of the year.

In addition, the scrappage rate of 5.6% of the 250 million vehicles in existence suggests 14 million were sent to the junkyard in 2008, far exceeding the annualized sales rate of 10.3 mil-lion. General population growth world-wide is enough to provide basic levels of auto de-mand in excess of the number of cars that get scrapped. Therefore, as the global economy stabilizes, sales should begin to recover. The rate of increase may even grow as the number of cars per family expands in developing na-tions around the world.

Two specific trends point to an improvement in the US market. Used car prices have started to rise off their lows, indicating that people are beginning to purchase cars. Historically, improvement in the used car market precedes growth in the new car market. Furthermore, miles driven per month by the US population is beginning to increase for the first time since 2007. Demand for automobiles typically grows as the number of miles driven increases.

Although a return to the pre-2008 heady days is unlikely, the global industry is poised to emerge from the current crisis stronger and more efficient. Higher fuel costs and govern-ment mandates suggest that surviving compa-nies will have to embrace high-quality, fuel ef-ficient cars tailored to the individual needs of the respective markets. Once the auto indus-try recovers, the question remains whether the government will take a back seat.

Works Cited:

1. Gunnar Gaedke, Ulrich Winzen and Thomas Mawick. “The Changing Automotive Industry.” R.L. Polk & Company. May 2009.

2. Jeff Rubin. “Wrong Turn.” StrategEcon. CIBC World Markets. Toronto Canada. March 2, 2009.


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