Ana Costiuc

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Monetary and financial system crises in the context of globalization

and their impact on Republic of Moldova

Intoduction

CHAPTER 1. Conceptual issues in the context of globalization on

financial crisis

1.1 The concept of economic financial crisis in the economic schools vision 2

1.2 The causes and the impact of international financial crises in the context of

globalization 91.3 The role of international financial institutions in managing international

financial crises 17

CHAPTER 2. Current international financial crisis and management

practices

2.1 The impact of international financial crisis on international financial market

developments

2.2 The impaс of recent tinternational financial crisis on economic and social

issues in the world economy

2.3 The scenarios of international financial crisis management

CHAPTER 3. Moldova's development in the context of current

international financial crisis

3.1The place and the role of RM in the context of globalization processes

3.2The NBM actions in managing the financial crisis in Moldova

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3.3 Management recommendations on effective methods of international financial

crisis in Moldova 68

Conclusions

References

Appendices

ANA COSTIUC

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CHAPTER 1. Conceptual issues in the context of globalization

on financial crisis

§1.1 The concept of economic financial crisis

in the economic schools vision

There is a vast array of literature on financial crises based on historical case studies as

well as current economic conditions written by economist, financial theorist and by policy

analysts. Within this literature there is a number of “conclusions”, some of them are quite

contradictory and thereby inconclusive.

Every financial crisis is unique in its nature, forms, causes and consequences. However a

generalized theory can be used to explain the financial crisis. Depending on the time, location,

financial crises are very diverse in terms of timing, the source of monetary expansion and the

object of speculation. For instances, Kindleberger argues that “financial crises are associated

with the peaks of business cycle.” Before going to a deep analysis of financial crisis we would

like to recall the business cycle by which we can broadly analyze the financial crisis. Irving

Fisher 1 (1937) describes in his famous theory “Debt deflation Theory of great Depression”

about the business cycle. Schumpeter classifies the business cycle into four important parts-

Boom- Recession- Depression- Recovery. Starting from the mean, a boom is a rise which lasts

until the peak is reached; a business entity tries to stay as long as possible in the peak point. A

recession starts when business begins to fall from peak to the back again. When a business goes

down more from the mean then it is said depression. Again business starts to move upward then

it is called recovery period.

1 http://cepa.newschool.edu/het/essays/cycle/empirical.htm

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In a sense, any cycle of whatever duration can be described as going through these four

phases - otherwise the fluctuations cannot really be described as "cycles". In the 19th century,

business cycles were not thought of as cycle at all but rather as spells of "crises" interrupting the

smooth development of the economy. In later years, economists and non- economists alike began

believing in the regularity of such crises, analyzing how they were spaced apart and associated

with changing economic structures. Let`s define on the definition of financial crisis. Goldsmith`

s2 defined financial crisis - A sharp, brief, ultra cyclical deterioration of all or most of a group of

financial indicators- short term interest rates, asset (stock, real estate, land) prices, commercial

insolvencies and failures of financial institutions.”

Michael Bordo3 , a monetarist, defines financial crisis in terms of ten key elements or

links: a change in expectations, fear of insolvency of some financial institution, attempts to

convert real or illiquid assets into money and so on. Zavalaiii (2001) divided the financial crisis

into two major parts which are Currency crisis and Banking crisis. He defined Banking crisis -

Banking crises occur when a financial system become illiquid or insolvent. This type of crisis

refers to bank runs, closures, mergers, takeovers, or large-scale assistant by the government to a

group of banks or banking systems, should the crisis turn out to be systematic.

A recent approach to define financial crisis is in the view point of asymmetric

information problem. Mishkin defined financial crisis as follows “A financial crisis is a

disruption to financial markets in which adverse selection and moral hazard problems become

much worse, so that financial markets are unable to efficiently channel funds to those who have

the most productive investment opportunities”. Thus a financial crisis is a sharp deterioration of

a group of financial and economic indicators like economic growth, imbalance between money

supply and demand, declining asset prices, potentially also accompanied by failures of financial

institutions like bank, insurance and mutual funds and also non financial institutions. Since

bankruptcies increases, unemployment surges and it leads to slower economic growth.Asymmetric information problems increase between lender and borrower and it makes failure

the market.

Different theories have been developed regarding financial crises how it occurs and how

to recover the financial crisis. We analyzed four different approaches to describe financial crisis

and tried to find the gap among these theories.

2 E. Philip Davis “ Debt financial fragility and systematic risk” ( Clarendon Press, 1995)3 Jorge Gallardo- Zavala “ Understanding Financial Crisis: A non technical Approach” ( Universidad Del

Pacifco, 2001)

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1.1 a Monetarist Approach for financial crisis

Banking panics have been identified as a sign of financial crisis by monetarist. This

theory focuses on only banking panics and banking crises. For example, Friedman and Schwartz

(1963) noted that of six major contraction in the US over 1867-1960, four were associated with

major banking or monetary disturbances. This is because public loss of confidence in Bank`s

abilities to convert deposits into currency. When an important institution fails in the market,

public confidence on bank became less and that helps to develop the crisis.

Moreover, they view the banking panics was a major sources of contraction in the money

supply which led to a severe contraction in the aggregate economic activity of the economy.

Monetarists do not consider the declining the asset price, failures of business as a cause of

financial crisis because it does not create banking panic and also does not hamper in money

supply.

In another approach macroeconomic causes like inflation have been identified as a

financial crisis. According to Schwartz (1987), financial instability tends to arise from inflation.

Inflation is highly related with the interest rate as well as money supply and an increase in

inflation leads to an increase in interest rate. This makes trouble for the bank specially if the

bank is engaged in fixed rate investment project or if bank lends in a fixed rate, even this instable

price level may lead to insolvencies of the bank. In another study by Lindgen, Garcia, and Saal

(1996)4 found that in weak banking systems, external shocks that affects terms of trade influence

bank`s viability. In this study, some of the indicators used by the authors to determine bank

unsoundness and its implications are: the money multiplier, claims on the private sector to GDP,

interest rates, impact on the real sector, fiscal implication and exchange rate valuatio

Monetarists do not see a necessary connection between business cycle and crisis and

they do not rule out asset price bubble. They ignore the loss of wealth associated with capital

market crashes, non financial bankruptcies, and failures of individual banks are financial crashes.

Rather, in monetarist view “` financial crisis` is to be said a reserved for a shift to money that

leads to widespread run on Banks. More specifically, Banking crises occur when financial

systems become illiquid. This types of financial crisis refers to bank runs, closures, mergers,

takeovers, or large scale assistant by the government to a group of banks or to the banking

systems, should the crisis turn out to be systemic

1.1b Uncertainty and financial crisis

4 Understanding Financial crises- a non technical approach- Jorge Gallardo-zavala

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The dictionary meaning of “Uncertain” is “not certain” or “doubtful”. Statistics shows

there is a misunderstanding between the word “risk” and “uncertainty”. The dictionary meaning

of “Risk” is “Possibility of Loss or Injury”. It is very important to understand the difference

between risk and uncertainty. Uncertainty nothing says about loss or risk of injury but

uncertainty is a source of risk. Risk is usually can be quantified but uncertainty can not be

quantified. Moreover, uncertainty can be added in order to minimize the risk. Knight (1921)

suggested the economic uncertainty as opposed to risk. Meltzer (1982) pointed out its

importance in understanding financial crisis. The study of “economic uncertainty” can be divided

into two main schools- (1) Mainstream (Keynesian) school and (2) the subjectivitist (Austrian

School).

In general, the mainstream defines uncertainty in the same manner as probabilists, that is

uncertainty can be measured by assessing the probabilities, the associated risks, and the benefits

of all possible outcomes. But Austrian school of Economics denied this definition saying “future

is not knowable either precisely or probabilistically (inferring from past data) rather uncertainty

applies to events whose implications resist purely objective analysis, such as wars, major

changes in policy regime, financial crises etc.

There is much need of uncertainty in the economy. According to Austrian economics

school “uncertainty is the market main source of stability and Innovation… evolution and the

creative process- also have a high need of uncertainty in order togenerate innovation.” In terms

of opportunity for profit, uncertainty rooted in change was suggested by Knight to be a main

source of competitive markets. If all probabilities were known and risk diversified, there would

be no extra profit and entrepreneur will not be motivated anymore to make new business. Profits

are earned by innovating and seeking opportunities where there is uneven information and

uncertainty. This process of innovation which termed as “creative destruction of innovation” by

Economist Joshep Schumpeter is taking place in the financial market. The innovation will be acreative destruction if the present business entity can cope with this new innovation, if risks are

correctly priced and if can make profit. But it will not be, if financial intermediary fails to

understand the properties of financial innovations by under pricing the risks.

According to Davis “Adverse surprise, given uncertainty and imperfect information may

trigger shifts in confidence and hence runs which affect markets more tan appears warranted nu

their intrinsic significance, because they lead to rethinking of decision process as well as to

decisions themselves. This helps explain the wide variety of proximate causes of financial crisis”

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While uncertainty is important for innovation, on the other hand if uncertainty runs in a

high level in the market, it may lead to a loss of confidence. Loss of confidence may lead runs

and panics on financial institution or collapse of liquidity in securities market and lead to

financial crisis.

1.1cAsymmetric information problem and financial crisis

A number of researches have been done on asymmetric information problem and its

relation with financial crisis. Simply, asymmetric information problem means the unavailability

of information among the entities in the financial market. In the financial market, the two most

important entities are borrowers and lenders and asymmetric information problem might exist in

the financial contract between lender and borrower.

Borrower has better information than lender about the borrower`s return on project, risk

associated with that project while lender misses those information. In that case lender has to raise

the interest rate which excludes some high quality borrower or lender may choose credit

rationing rather than raise interest rates, in order to avoid adverse selection (Stiglitz and Weiss

1981).

Asymmetric information creates the problem in financial structure in two ways- before

the transaction entered into (Adverse Selection) and after the transaction entered into (Moral

Hazard). Mishkin defined the adverse selection as follows “ Adverse selection occurs when the

potential borrowers who are the most likely to produce an undersirable outcomes- the bad credit

risks- are the ones most likely to be selected.” (1991. Page 3 ).The lender can not determine the

credit risk accurately and therefore indifferent in lending money or alternatively charging an

average interest rate from every borrowers. This action prevents some good borrowers taking

loan and will encourage the risky borrower to take loan more which creates the market more

sensitive and fragile.

Moral hazard is the end result of asymmetric information which emerges after the

transaction occurs. The lender runs the risk that the borrower will engage in activities that are

undesirable in from the lender points of view because they make it more likely that the loan will

be paid back. Moral hazard occurs because the borrowers have the incentives to invest in project

in high risk in which the borrower does well if project succeeds but the lender bears most of the

loss if the project fails. Moreover, borrowers may misallocate the funds in his personal use, toshirk and just not work hard or to undertake the investment in unprofitable projects. The conflict

of interest between borrower and lender sing from moral hazard at many lenders will not be

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willing to make loan which makes an imbalance between savings and investment in the real

world.

Mishkin (1991) identified five most important reasons for financial crisis- (1) increases in

interest rate (2) stock market declines (3) increase uncertainty (4) bank panics and (5) an

unanticipated declines in aggregate price level. He pointed that these five reasons of financial

crisis are the result of asymmetric information problem. Increase in uncertainty, or an increase in

interest rates and the stock market crash increased the severity of adverse selection problems in

the credit market, while the decline in net worth of stemming from stock market crash increased

in moral hazard which help lead to a crisis eventually.

This theory of financial crisis explains the causes of financial crisis but does not explain

how it develops and what are those signs of financial crisis? Moreover, asymmetric information

problem is not the only cause of financial crisis. The role of government or the failure of

government policy is not considered in this theory.

1.1d Financial Fragility Hypothesis

The opposite theory of financial crisis of monetarist approach is “Financial fragility

hypothesis” a concept developed by Minsky to theorize the financial crisis. Minsky (1977, 1982)

elaborated Fisher`s approach and introduced the concept of `fragility` to attempt to clarify the

problem of over indebtedness during an upswing. This Fragility depends on; first, the mix of

hedge, speculative and ponji finance; second, the liquidity of portfolios; third, the extent to

which ongoing investment is debt financed. Hedge finance states that investor’s cash inflows

cover interest and principal payments for borrowers who obtains a debt to buy an asset. These

are the safest investors. Speculative phase is the combination of safety and risky investment. In

this phase, cash inflows cover only interest payments, but may not cover to amortize the

principal. If the interest rate goes up and value of collateral goes down the speculator will be

more risky and even might not cover the interest payment also. Ponji phase is the most risky

phase in the crisis. in this phase, cash flows cover neither interest rate nor principal. Moreover

Ponji borrowers depend only on the rising price of asset. Let’s analyze how this mechanism

operates.

In this theory Minsky divides the crisis into five main phases like business cycle-

Displacement, Euphoria, Peak and Panic. According to Minsky, events up to a crisis start with a“displacement” some exogenous, outside shock like outbreak or end of a war or any significant

invention to the macroeconomic system. Displacement will increase more profit opportunities at

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least in one sector of the economy. As a result, business enterprise and individual invest more

and more on that sector and because of that investment increases and so as production which will

lead the economy in ` Euphoric` stage. In this stage bank will expand its credit expecting more

profit from that particular sector and thinking this sector as a safe sector. As investment increases

more and more it will lead to price increase which will create more profit opportunities which is

termed as `peak`. As stated earlier, Ponji borrowers invest expecting an increase of price of

particular asset. An artificial price increase is happened in this stage. Investors earn their

maximum profit in this phase. Small price variation in the peak level because of government

policy change or any other change like interest rate rise will lead to Fisher`s `distress selling`

which follows the “crisis”. In this stage bankruptcies surge, economic activity slows, and

unemployment increases

1.1 Rationality of choosing Minsky`s financial fragility hypothesis

No financial crises theory explains a crisis in a perfect way. Monetarists emphasize only

on banking panic and do not rule out asset price bubble, although they do not see a necessary

connection with the business cycle. Monetarist theory does not consider loss of wealth, non

financial bankruptcies, and failures of individual bank are the causes of financial crises but

reality reveals different information. Uncertainty is a source of innovation at the same time a

source of financial crisis. This theory promotes the competition in the market in a high level to

get the innovation in the market but can not analyze in what level of competition leads to crisis

and what should be the role o institution to limit the competition.

Asymmetric information problem is one of the most crucial problems for making

financial crisis which exists in the financial system but there is no proper incentive to reduce this

problem. all of these theories does not identify the foundation of the crisis and can’t explain

broadly how it develops.

Among the financial crisis theories that we analyzed here, “Financial Fragility Theory”

which is known as `Minsky`s financial crisis theory is the most useful to analyze the financial

crisis. This theory broadly analyzes how a crisis happens explicitly and specially dividing the

phase of the crisis cycle. To attain the goal of this thesis, we think this theory is useful as it is

widely accepted to the economist as well as financial theorist.

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§ 1.2 The causes and the impact of international financial crises in the context

of globalization

Although his place in a dictionary (Webster)5 6 early decade of the last century, globalization

requires conceptual '90s, the work of many foreign academics.

5

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Globalization is one of the most common terms used in particular in the last few decades.

The idea of globalization one can find many programs on radio and television across the globe, a

lot of web-sites of various companies, politicians in speeches, in meetings of national and

international organizations, let alone hundreds or even thousands The pages are presented all

sorts of views on the causes and effects of this phenomenon in particular. Various aspects and

connections of this concept has been expanded and continues to develop in an extremely fast.

The idea of globalization is present in all areas of life: science, art, culture, morality, the

technique in sitemele financial, transport and communication facilities, in technology, military

affairs, the environment, S. of. Each makes its own act of charge if used in everyday language,

this notion had some courtesy such as the global economy, global market global financial

system, global crisis and other supporting raliendu this is the phenomenon or the they fight.

What is particularly interesting and still unexplained once, is that after so many years from theemergence and development of this concept so widespread in all areas of life, not yet found a

simple, clear and complex once all that is widely recognized. In the opinion of specialists in

linguistics, verb globalize; was first certified by the Merriam Webster Dictionary in 1944. Some

historians, linguists, but believes that this word can be found in some writings dating from the

late fourteenth century, or even before. After some economists view globalization theorists was

;invented; in the '80s, but recognize that the conceptual point of view, it existed long before.

Personally, my opinion after that globalization rally began with the Renaissance era, there has

been a real explosion of science and technology, when there were a lot of inventions and

developed banking system. This was the period in which they were created and expanded a lot of

links between countries in Europe, Asia and America.

After World War I, globalization has seen an even broader expansion. In a broader sense

and including a wider range of activities and fields of application was observed after the second

world war and subsequent settlement after the Cold War competition between the two systems,

capitalist and socialist. With the advent and expansion of the use of computers and satellites

artificali then, the explosion of this phenomenon could not be controlled. He took the true

meaning of world natural proportions. In an objective can be considered as we are witnessing a

new revolution and global users. Of all fields of application, and most often discussed by the

phenomenon of economic globalization which in turn has a broad spectrum of manufacturing

acivitatea event in the entire financial system and especially investment in international trade

labor migration, tourism and other sectors. If some 50 years ago a form of globalization appear

so-called Americanization, now she has a totally different look and a totally different meaning.

Originally it referred specifically to foreign investment in stocks, in bonds in international trade

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stimulated by reducing tariffs. Initially mainly export American cars in Europe instead importing

clothing and all sorts of exotic products from different countries.

Globalization is a considerable amount of effects, positive and negative. As positive

elements, the highlights: amplification and trade liberalization, investment and financial flows,

expansion of democratic values, individual identity protection, environmental protection, but

also ;freedom movement; security. Must agree with the analyst Hans Blommestein, that for the

first time in history, today, a global technology transforms the world financial market, the

business, political and psychological, making them unrecognizable. From the perspective of free

market, globalization will bring unprecedented prosperity, as more and more nations will

participate in the global economy and technological and financial flows from developed

countries to less developed countries will lead to an equalization of wealth and development of

the whole world. John Gray emphasizes that globalization, which he sees as a supportedinterconnect technology between the political, economic, cultural world has, in the latter area,

the effect of hybridization of cultures, preservation, renovation and development of cultural

identities.

Phenomenon of globalization is marked by an integration of the economies of various

countries, that changes the entire quality of the various scaffold structures of national economies.

Referring specifically to economic development in different countries based on the continuous

development of science and technology and supported by socio-political concepts of democracy,

globalization is a natural way a truly revolutionary trajectory.

But globalization also has negative effects, such as lowering safety to all indicators,

chronic local and regional phenomena of globalization, the globalization of major organized

crime (trafficking in weapons, drugs, people), the radicalization of ethnic and religious

fanaticism, terrorism. In economic terms, globalization leads, for example, economic chaos and

environmental havoc in many parts of the world. Basically, through globalization, there is a

deterioration of income distribution, financial and economic crises are multiplying, with large

effects on social and political. .Moreover, globalization makes economic and social structures

that do not adjust quickly to the extreme strain, can cause major conflicts.

In fact, in the opinion of those who are against the globalization phenomenon and should

be seen and understood in terms of how ;try; to ensure so-called consumer gain. By submitting a

demand for abroad (in countries such as China, Malaysia, Philippines, India, Mexico ), To

remove an enormously large number of jobs in local businesses. A lot of workers, technicians,

engineers and other trades and professions lose their jobs. The loss of these jobs is assessed by

experts in the field of labor organization is not temporary but permanent.

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Currently due to the economic crisis is discussed on a number of unemployed, which

exceeds U.S. 12 million people. Elimination of labor entails loss of certain monthly income or

temporary limitation of these revenues (by providing unemployment benefits) for those who are

removed from an activity that carried. Thus was purchased them drastically reduced income and

therefore buying opportunities of consumer goods and services procurement. On the other hand

removed from the work process to get out of the ranks of middle class population among the

poor îngroşând. We must not forget that the middle class who formed the company, is the

company that provides revenue because it represents the majority population. The percentage

reduction of this social class, and entails many financial problems for the country.

The whole world is currently experiencing the effects of a strong economic crisis.

Opinion of many economists in different countries is that the crisis began in the United States

and the effects of globalization are felt in all developed countries, developing and third worldcountries. United States initially entered formally into recession two years ago and none of the

leaders of government departments did not want to formally recognize this state of affairs. In

many applications of the media, the answers were very evasive or false, that sustaining the

American economy is robust financial system and inflation was under total control and as such

everyone be quiet. If these elected representatives, senators and congressmen would have warned

people of the United States and other countries about the risks of this economic mess, he might

have taken early measures which reduced the overall impact. Causes of that economic crisis has

far exceeded that of the years 1929-1933, are multiple and have accumulated huge budget

spending due to undue the large-scale financial fraud and controlled us, granting huge loans

without kind of coverage, a weakening dollar in the various economic transactions, extending

Outsourcing process to obtain large profits for private companies and stock holders of these

companies and much more. Media seeking for months as a radar situation presents continuous

stock exchange volatility stocks and falling gradually from the values of some special. high

(hundreds of dollars) to the ridiculous amount of fractions. Enormous expenditure incurred in

recent years affected and continues to affect the U.S. budget in general and each state in

particular. From the positive values that the U.S. budget was eight years ago, it was a huge

budget deficit and prospects in the current situation of continuous. growth. Finance professionals

also claims that a deficiency has been known throughout history America. Which will eventually

amount of the deficit, as will cover this huge deficit and that will be the effects on the national

situation in general and living standards of every family in particular are as big question marks.

Obama argued in his election campaign and after that all possibilities exist to reduce this deficit

over 533 billion U.S. dollars over the next five years. Even if this statement was only meant to

encourage the U.S. population, revived the spirit of distrust ever higher, putting in doubt the

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current economic outlook. Estimates of increasing budget deficit by the end of 2009, refers to

several trillion dollars, which will generate a deficit of around 1 trillion dollars annually for the

next decade. Such a situation provides not only current generations but also those to come in a

huge economic risk. Some current needs for excessive expenses are covered by hundreds of

billions of U.S. dollars loan from the various countries including China. Others rely on taxes that

will require population while reducing or liquidating national programs (for the repair of

infrastructure in each state and nationally, repair bridges some risk in using, repairing and

equipping schools with necessary equipment laboratories), eliminating a number of increasingly

large staff of activities for public services (teachers, librarians, policemen, firemen, postman, S.

All these effects are immediate and long term, do not stop at U.S. borders. They have

spread around the world. Europe, Asia, Middle East, Latin America also faced with various

aspects of the current economic crisis. Are now all sorts of efforts to find and address this globaleconomic crisis. Economists are asked experts from different countries opiniilr called to say, and

give some solutions as soon as possible effects.

Currently, we are observing one of the most severe and deep world financial and

economic crises in history caused by globalization processes. The most important economies

(like those of the United States, China, India, Japan, Germany and Britain) are in deep recession

and we also observe a severe financial crisis, e.g., mistrust between the financial institutions.

This caused a reaction in which almost all governments engaged in substantial deficit spending

to inject liquidity into financial markets and to fight the economic downswing. All this happened

within half a year to nine months, and economic researchers are now confronted with explaining

how this could have happened. The public and politicians ask the economics profession, what the

causes of this deep crisis were and what can be done to overcome it.

The financial crisis which had its origins in the United States and the induced worldwide

economic crisis pose two important questions:

(1) What caused the crisis?

(2) What should be done to minimize the risk of repetition if not of identical events than of at

least something similar?

A more parsimonious way of turning around these two questions is the following: If in

retrospect the causes of this crisis are so obvious, why did so many smart researchers (and

especially economists) fail to appreciate the gravity of the situation beforehand? One could

imagine that with sufficient preparation, these problems (financial and economic) would have

been addressed well before the seriousness of the current crises had become apparent. It is

reported1) that former US Treasury Secretary Henry Paulson6 tabled a plan for re-organizing and

6

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consolidating the supervision and the regulation of the US financial system. One might similarly

imagine that, sooner or later, federal agencies would have extended insurance to money market,

mutual funds, and investment banks, but they remain unregulated so far. Early action would have

brought on the regulatory umbrella. But such major changes in regulatory policy take time –

even now (June 2009) it is not clear what type of regulatory framework will be implemented

ultimately.

At the most basic level, the sub prime crisis resulted from the tendency of financial

normalisation and innovation to run ahead of financial regulation, as Eichengreen .

For a long time, deregulation was the order of the day not only outside but also within

financial markets, as illustrated, for example, by eliminating the Glass-Steagall Act’s restrictions

on mixing investment and commercial banking7. However, considering what had happened, the

problem was that other (regulatory) policies were not adapted to the new environment.Conglomerization and globalization takes time. In the short-run, investment banks were

allowed to lever-up their bets, they “stood” completely beyond the purview of the regulators. As

independent entities funded themselves on a short-term basis, they were vulnerable to liquidity

“crunches” and disruptions to their funding. A crisis sufficient to threaten the financial system

ultimately precipitated the inevitable consolidation8.

A second major element of the crisis was a consumer spending boom from 2002 to 2007

and the resulting domestic and international imbalances. The Bush administration cut taxes,

causing a massive deficit for the government9. The Federal Reserve cut interest rates in response

to the 2001 recession. In addition to this action, the new financial innovations made credit even

cheaper and more widely available. This, of course, is just one, but nevertheless a major element

in the “crisis” story, contributing in its own way to the collapse of the market for sub prime

mortgages. Such loans were packaged, “securitized” and pushed by the subsidiaries of Lehman

Brothers and other major financial institutions. The result was increased US consumer spending

and the decline of measured household savings into negative territory.

The third element was financial internationalization. Much as with the separation of

investment from commercial banking, the Great Depression led to the imposition of tight and

persistent restrictions on international capital flows. From the 1970s on, these restrictions have

gradually been relaxed, which was another indication that policy makers had forgotten the Great

Depression. Deregulation continued and accelerated during the 1990s.6) Facilitating US

7 Eichengreen B. (2008), Thirteen Questions About the Subprime Crisis, mimeo, University of

California, Berkeley (January),8 Eichengreen B. (2008a), Origins and Responses to the Crisis, mimeo, University of

California, Berkeley. 9 Ibid.

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dependence on foreign finance and feeding in this way the country’s credit boom helped to set

the stage for what followed from 2007 on. What additionally helped to set the stage for the crisis

were the rise of China and the decline of investment in Asia following the 1997 - 1998 currency

crisis. With China saving on average nearly 50% of its GNP, this “money” more or less had to

go abroad10

. A great part of it went into US Treasury securities and the obligations

of the Federal Home Loan Banks (FHLB), Fannie Mae and Freddy Mac. These capital inflows

“propped” up the dollar 11. It reduced the cost of borrowing for Americans on some estimates by

as much as 100 basis points, encouraging them to live far beyond their financial means. This

behaviour created an opportunistic market for Freddy, Fannie and for other financial institutions,

creating substitutes for those agency’s own securities.

To sum up: In the United States the financial crisis was facilitated by policies of domestic

and international liberalization accompanied by however well-intended financial innovations,such as complex derivative securities, “conduits” and “structured investment vehicles”, which

were not regulated at all. Other innovations in risk management worked in the same direction.

According to Eichengreen (2008a, 2008b)12, commercial banks, investment banks and hedge

funds were encouraged by the dynamic development of the financial market to use more

leverage and their counterparties were inspired to provide it by the development of mathematical

models and methods to quantify and hedge risks. These new models, which were rigorous and

promised to provide “exact” information emboldened market participants to believe that the

additional leverage was safe since participants now used scientific techniques and were

convinced that they could manage it.

A major problem was, however, that these “new” models were estimated using data from

recent periods of low volatility over, typically, relatively short intervals, given that the financial

instruments, whose returns being modelled, had existed only for a few years. Events, which

should have been modelled or simulated, like a sharp drop in housing prices, were outside the

sample period and, hence, were not captured by these models. Institutional investors convinced

themselves on the basis of these models that their financial practices were relatively safe. They

persuaded the public regulatory agencies to allow financial institutions to use these models when

deciding how much capital to hold to provision against risk.11)

This short analysis is by no means a complete or comprehensive explanation for the

financial crisis.Other authors, such as Eichengreen (2008, 2008a), Acemoglu (2009), Adams

(2009), or Congleton (2009), emphasize other factors (not testing the economic models out of-

10 Caballero, R., E. Farhi, and P.-O. Gourinchas (2008), An Equilibrium Model of ‘Global Imbal-ances’ and Low Interest Rates, American Economic Review 98 (3), p.358-393.11 12

15



sample, relying on trust or mistrust, and placing too much confidence in the market's adjustment

capacity, for example).

The specialists consider that the starting of the financial crisis in October 2008, in USA

and other countries represents the most serious commotion of the international finances from the

Great Depression from 1929-1933. Effects of the present crisis are spreading, beyond the

financial sphere, to the level of the world economy, affecting the economical growth and the

labor market and generating a series of other linked up effects with conjuncture implications or

with long and medium terms implications, regarding the structure of the financial world system

and its interface with the real economy. The drivers of the financial and economic crisis are

complex and multifaceted. The main causes of the crisis are linked to systemic fragilities and

imbalances that contributed to the inadequate functioning of the global economy. Major

underlying factors in the current situation included inconsistent and insufficiently coordinatedmacroeconomic policies and inadequate structural reforms, which led to unsustainable global

macroeconomic outcomes. The present financial crisis which crosses the world economy points

out the interlacing of some common causes, traditional of the economical-financial crisis

phenomena, generally, with other untraditional, specific.

Among the main traditional causes of the economical-financial crisis we mention: the

boom period of the credit growing in very big proportions; the strong growth of the prices for the

actives, mainly on the real-estate market; the lending in uncontrolled proportions of the

economical agents less or at all solvable (it is about the sub-prime mortgagers).

Regarding the particular untraditional causes of the financial crisis started in October

2008, we mention, first of all, the proportion and the profundity of the sub-prime crisis. The sub-

prime mortgage crisis, which led to a wider crisis in credit markets, was partly caused by an

“excess” supply of liquidity in global capital markets and the failures of the central banks in the

United States and some other advanced industrial countries to act to restrain liquidity and

dampen the speculative increases in housing and other asset prices. While lax financial

regulation may have contributed to the particular form taken by the crisis, the magnitude of this

excess liquidity, and other associated factors, made further difficulties likely.

These factors were made acute by major failures in financial regulation, supervision and

monitoring of the financial sector, and inadequate surveillance and early warning. These

regulatory failures, compounded by over-reliance on market self-regulation, overall lack of

transparency, financial integrity and irresponsible behavior, have led to excessive risk- taking,

unsustainably high asset prices, irresponsible leveraging and high levels of consumption fuelled

by easy credit and inflated asset prices. Financial regulators, policymakers and institutions failed

to appreciate the full measure of risks in the financial system or address the extent of the growing

16



economic vulnerabilities and their cross-border linkages. Insufficient emphasis on equitable

human development has contributed to significant inequalities among countries and peoples.

Other weaknesses of a systemic nature also contributed to the unfolding crisis, which has

demonstrated the need for more effective government involvement to ensure an appropriate

balance between the market and public interest.

The level of international economic interdependence may also have contributed to an

increase in vulnerability of the global economic system to external shocks that produce larger

negative impacts on global aggregate demand.

Globalization creates opportunities and brings extraordinary progress in some areas.

Such as globalization or not happen overnight, most likely not resolve the current global

economic crisis will not immediately find the solution. Will be needed for months if not years to

find optimal solutions, the unanimous acceptance of their application and manifestation of globalresults. During this time the whole world is seriously concerned and intrigued by what has

happened and continues to take place in the United States and the global effect of this economic

crisis. It is a time when the psychological factor of insecurity and mistrust of each man and

seized it creates a state of total confusion. Nobody knows how and what you have to act to save

modest financial reserves that the agonist in a working life, to survive until the black cloud will

disappear of this global disaster. Great private investors and major banks are extremely wary and

reluctant to act. Placing us on an optimistic position believe that a shorter or more distant, global

economi will find the necessary stability to propel it to new heights in the current century. How

and when this will happen, only time will tell who will be able to confirm. What is particularly

important until then is to provide a general equilibrium, economic, social and especially political

challenge of sparks to prevent disastrous effects of various countries at national or even for all

mankind.

1.3 The role of international institution in managing

international financial crises

International financial institutions have a key role to play in softening the impact of the

crisis in developing countries. They are crucial in providing financing to cash-strapped public

and private sectors in developing countries and supporting growth-oriented fiscal policy. They

have also a key role in providing assistance in strengthening social safety nets and the quality of

public spending.

17



The financial crisis has brought international financial organizations and institutions into

the spotlight. These include the International Monetary Fund, the Financial Stability Board (an

enlarged Financial Stability Forum), the Group of Twenty (G-20), the World Bank, the Group of

8 (G-8), and other organizations that play a role in coordinating policy among nations, provide

early warning of impending crises, or assist countries as a lender of last resort. The precise

architecture of any international financial structure and whether it is to have powers of oversight,

regulatory, or supervisory authority is yet to be determined. However, the interconnectedness of

global financial and economic markets has highlighted the need for stronger institutions to

coordinate regulatory policy across nations, provide early warning of dangers caused by

systemic, cyclical, or macro prudential risks13 and induce corrective actions by national

governments.

In response to the financial crisesPolicy proposals for changes in the international financial architecture have included a

major role for the IMF. As a lender of last resort, coordinator of financial assistance packages for

countries, monitor of macroeconomic conditions worldwide and within countries, and provider

of technical assistance, the IMF has played an important role during financial crises whether

international or confined to one member country.

The financial crisis has shown that the world could use a better early warning system that

can detect and do something about stresses and systemic problems developing in world financial

markets. It also may need some system of what is being called a macro-prudential framework for

assessing risks and promoting sound policies. This would not only include the regulation and

supervision of financial instruments and institutions but also would incorporate cyclical and

other macroeconomic considerations as well as vulnerabilities from increased banking

concentration and inter-linkages between different parts of the financial system14 In short, some

institution could be charged with monitoring synergistic conditions that arise because of

interactions among individual financial institutions or their macroeconomic setting.

However, the IMF’s current system of macroeconomic monitoring tends to focus on the

risks to currency stability, employment, inflation, government budgets, and other

macroeconomic variables. The IMF, jointly with the Financial Stability Board, has recently

13 See CRS Report R40417, Macro prudential Oversight: Monitoring the Financial System, byDarryl E. Getter 14 Lipsky, John. “Global Prospects and Policies,” Speech by John Lipsky, First Deputy ManagingDirector,International Monetary Fund, at the Securities Industries and Financial Markets Association,

New York, October 28,2008. World Bank. “The Unfolding Crisis, Implications for Financial Systems and Their Oversight,” October 28, 2008.

p. 8.

18



stepped up its work on financial markets, macro-financial linkages, and spillovers across

countries with the aim of strengthening early warning systems. The IMF has not, however,

traditionally pressed countries to counter specific risks such as how macroeconomic variables,

potential synergisms and blurring of boundaries among regulated entities, and new investment

vehicles affect prudential risk for insurance, banking, and brokerage houses. The Bank for

International Settlements makes recommendations to countries on measures to be undertaken

(such as Basel II) to ensure banking stability and capital adequacy, but the financial crisis has

shown that the focus on capital adequacy has been insufficient to ensure stability when a

financial crisis becomes systemic and involves brokerage houses and insurance companies as

well as banks.

The financial crisis has created an opportunity for the IMF to reinvigorate itself and

possibly play a constructive role in resolving, or at the least mitigating, the effects of the globaldownturn. It has been operating on two fronts: (1) through immediate crisis management,

primarily balance of payments support to emerging-market and less-developed countries, and (2)

contributing to longterm systemic reform of the international financial system15 The IMF also

has a wealth of

information and expertise available to help in resolving financial crises and has been providing

policy advice to member countries around the world.

IMF rules stipulate that countries are allowed to borrow up to three times their quota250

over a three-year period, although this requirement has been breached on several occasions in

which the IMF has lent at much higher multiples of quota. In response to the current financial

crisis, the IMF has activated its Emergency Financing Mechanism to speed the normal process

for loans to crisis-afflicted countries. The emergency mechanism enables rapid approval (usually

within 48- 72 hours) of IMF lending once an agreement has been reached between the IMF and

the national government.

As of April 2009, the IMF, under its Stand-By Arrangement facility, has provided or is in

the process of providing financial support packages for Iceland ($2.1 billion), Ukraine ($16.4

billion), Hungary ($25.1 billion), Pakistan ($7.6 billion), Belarus ($2.46 billion), Serbia ($530.3

million), Armenia ($540 million), El Salvador ($800 million), Latvia ($2.4 billion), and

Seychelles ($26.6 million). The IMF also created a Flexible Credit Line for countries with strong

fundamentals, policies, and track records of policy implementation. Once approved, these loans

can be disbursed when the need arises rather than being conditioned on compliance with policy

15 See CRS Report RS22976, The Global Financial Crisis: The Role of the International Monetary Fund (IMF), byMartin A. Weiss.

19



targets as in traditional IMF-supported programs. The IMF board has approved Mexico for $47

billion under this facility. Poland has requested a credit line of $20.5 billion.

The IMF also may use its Exogenous Shocks Facility (ESF) to provide assistance to

certain member countries. The ESF provides policy support and financial assistance to low-

income countries facing exogenous shocks, events that are completely out of the national

government’s control. These could include commodity price changes (including oil and food),

natural disasters, and conflicts and crises in neighboring countries that disrupt trade. The ESF

was modified in 2008 to further increase the speed and flexibility of the IMF’s response.

Through the ESF, a country can immediately access up to 25% of its quota for each exogenous

shock and an additional 75% of quota in phased disbursements over one to two years.

The increasing severity of the crisis has led world leaders to conclude that the IMF needs

additional resources. At the 2009 February G-7 finance ministers summit, the government of Japan lent the IMF $100 billion dollars. At the April 2009 London G-20 summit leaders of the

world’s major economies agreed to increase resources of the IMF and international development

banks by $1.1 trillion including $750 billion more for the International Monetary Fund, $250

billion to boost global trade, and $100 billion for multilateral development banks. For the

additional IMF resources, $250 billion was to be made available immediately through bilateral

arrangements between the IMF and individual countries, while an additional $250 billion would

become available as additional countries pledged their participation. The increased resources

include the $100 billion loan from Japan, and the members of the European Union had agreed to

provide an additional $100 billion. Subsequently, Canada ($10 billion), South Korea ($10

billion), Norway ($4.5 billion), and Switzerland ($10 billion) agreed to subscribe additional

funds. The Obama Administration has asked Congress to approve a U.S. subscription of $100

billion to the IMF’s New Arrangements to Borrow. China reportedly has said it is willing to

provide $40 billion through possible purchases of IMF bonds. The sources for the remaining

$145.5 billion of the planned increase in the NAB have not been announced.

The IMF reportedly is considering issuing bonds, something it has never done in its 60-

yearhistory16 These would be sold to central banks and government agencies and not to the

general public. According to economist and former IMF chief economist Michael Mussa, the

United States and Europe previously blocked attempts by the IMF to issue bonds since it could

potentially make the IMF less dependent on them for financial resources and thus less willing to

take policy direction from them.254 However, several other multilateral institutions such as the

16

Timothy R. Homan, “IMF Plans to Issue Bonds to Raise Funds for Lending Programs ,” Bloomberg.com, April 25,2009.

20



World Bank and the regional development banks routinely issue bonds to help finance their

lending.

The IMF is not alone in making available financial assistance to crisis-afflicted countries.

The International Finance Corporation (IFC), the private-sector lending arm of the World Bank,

has announced that it will launch a $3 billion fund to capitalize small banks in poor countries that

are battered by the financial crisis.

The World Bank Group has an important role to play in helping developing countries

assess and respond to the challenges presented by the global economic crisis. The Bank is well

positioned to play a role in helping its clients stabilize their economies, preserve and enhance the

foundations for longer-term economic growth, and protect the most vulnerable against fallout

from the crisis. Because of the magnitude of the crisis and the heterogeneity of its impact on

individual developing countries, the Bank is mobilizing a wide range of support, which will betailored to country and community needs, including through technical assistance and policy

advice, direct financing, and by helping to leverage financial support from a variety of public and

private sources. The Bank is actively working with other IFIs and MDBs to design, develop and

implement many of the new approaches and instruments it is proposing.

The World Bank Group is stepping up its financial assistance to its clients on a number of

fronts. There is scope to almost triple lending to around $35 billion in FY2009, and lending

volumes could potentially reach $100 billion over the next three years. Following its record 15th

replenishment, IDA is positioned to assist LICs in dealing with the impact of the global financial

crisis, with commitments amounting to nearly $42 billion over the next 3 years, and scope for

front-loading this support over the next year. The Bank is at the forefront of global efforts to

mobilize resources for developing countries, particularly those without the means to cushion the

impact of a crisis not of their making.

In addition to direct financial support, the Bank continues to provide

developing countries with access to diagnostic and capacity-building

instruments like Public Expenditure Reviews (PERs) and Debt Management and

Performance Assessments (DEMPA)—the former to help improve budget management and

identify priority expenditures to be protected should financing shortfalls persist, the latter as a

critical tool for assuring essential fiscal sustainability. The value to developing countries of these

instruments has increased in a resource constrained environment, as will the usefulness of

technical assistance to improve revenue and customs administration. A number of client

countries are also looking for assistance in building bank supervisory capacity to enable them to

more effectively monitor developments and respond to weaknesses in domestic financial sectors

as they emerge.

21



The role of the G-20 in dealing with the global financial crisis began on November 15,

2008, with the G-20 Summit on Financial Markets and the World Economy that was held in

Washington, DC. This was billed as the first in a series of meetings to deal with the financial

crisis, discuss efforts to strengthen economic growth, and to lay the foundation to prevent future

crises from occurring. This summit included emerging market economies rather than the usual

G-7 or G-8nations that periodically meet to discuss economic issues. It was not apparent that the

agenda of the emerging market economies differed greatly from that of Europe, the United

States, or Japan.

The G-20 Washington Declaration to address the current financial crisis was both a

laundry list of objectives and steps to be taken and a convergence of attitudes by national leaders

that concrete measures had to be implemented both to stabilize national economies and to reform

financial markets. The declaration established an Action Plan that included high priority actionsto be completed prior to March 31, 2009. Details are to be worked out by the G-20 finance

ministers.

The declaration also called for a second G-20 summit that was held in London on April 2,

2009. Since the attendees now include the Association for Southeast Asian Nations, the G-20 no

longer refers to just 20 nations.

At the April 2009 G-20 London Summit, leaders agreed on establishing a new Financial

Stability Board (incorporating the Financial Stability Forum) to work with the IMF to ensure

cooperation across borders; closer regulation of banks, hedge funds, and credit rating agencies;

and a crackdown on tax havens. The leaders could not agree on the need for additional stimulus

packages by nations, but they considered the additional funding for the IMF and multilateral

development banks as key stimulus directed at developing and emerging market economies. The

leaders reiterated their commitment to resist protectionism and promote global trade and

investment17.

At the November G-20 summit, the leaders agreed on common principles to guide

financial market reform:

• Strengthening transparency and accountability by enhancing required disclosure on complex

financial products; ensuring complete and accurate disclosure by firms of their financial

condition; and aligning incentives to avoid excessive risk taking.

• Enhancing sound regulation by ensuring strong oversight of credit rating agencies; prudent risk

management; and oversight or regulation of all financial markets, products, and participants as

appropriate to their circumstances.

17 G-20, Meeting of Finance Ministers and Central Bank Governors, United Kingdom, 14 March2009, Communique, March 14, 2009.

22



The leaders agreed that needed reforms will be successful only if they are grounded in a

commitment to free market principles, including the rule of law, respect for private property,

open trade and investment, competitive markets, and efficient, effectively-regulated financial

systems.

The Inter-American Development Bank (IDB) announced on October 10, 2008 that it will

offer a new $6 billion credit line to member governments as an increase to its traditional lending

activities. In addition to the IDB, the Andean Development Corporation (CAF) announced a

liquidity facility of $1.5 billion and the Latin American Fund of Reserves (FLAR) has offered to

make available $4.5 billion in contingency lines. While these amounts may be insufficient should

Brazil, Argentina, or any other large Latin American country need a rescue package, they could

be very helpful for smaller countries such as those in the Caribbean and Central America that are

heavily dependent on tourism and property investments.

23



The starting point for the current crisis on the financial markets was a decade of extraordinarily

favourable macroeconomic conditions in western industrialised nations characterised by low,

stable inflation and ongoing economic growth. The extremely positive economic environment

generated a mood of euphoria among market participants, causing them to be increasingly blind

to the risks being assumed. The volatility of key economic variables such as growth, inflation

and unemployment had been falling steadily in industrialised nations since the mid-eighties, with

emerging nations also seeing the same trends a decade later. This “great moderation” was

attributed to improved central bank policy, greater deregulation and competition, and last but not

least the increasing level of globalisation. Even the USA’s highly expansive monetary policy had

no direct negative effects and was therefore not regarded as problematic. There was an

increasingly strong belief that the fall in volatilities was a long-term trend. Trends in the

emerging economies appeared to be increasingly decoupling themselves from those of theindustrialised world, paving the way for genuine diversification and a more stable global

economy. In this positive environment, public debate on financial market regulation was largely

driven by fears of over-regulation and the promotion of the international competitiveness of

financial centres. Few thought it possible that the positive economic environment that had

shaped the preceding years could be brought to an end by the securitisation of subprime

mortgages in the USA. However, as whould become evident later, people did not take into

account the disastrous interplay of various different aspects. In light of this, the stress tests

carried out by the big global banks and the International Monetary Fund (IMF) were based on

assumptions that were far too mild. The volatilities of certain economic variables and the

illiquidity of various securities observed during the crisis were not predicted by even the most

conservative extreme scenarios.

During this period of growth, various Asian and oil-producing countries recorded very

high saving levels. These exceeded domestic investment and, in combination with the fixed or

heavily controlled exchange rate policy pursued in order to support the export sector, led to a

huge accumulation of foreign currency reserves. The majority of these funds were invested in US

Treasury securities and in bonds issued by the government-backed mortgage finance providers in

the USA. The resulting increase in demand for government bonds had a negative impact on the

risk-free yield. Coupled with the favourable economic environment and a period of falling risk

premiums, this boosted the attractiveness of alternative investments. Financial innovations made

possible by advances in information technology generated correspondingly high demand and led

to an increase in credit securitisation. The raw material for these securitisations came first and

foremost from the USA, but also from the UK, the Republic of Ireland, Spain and other countries

that had built up large trade deficits in the preceding decade. The new possibilities made debt an

24



even more attractive proposition for private households. However, the low interest rates and risk

premiums also led to a rise in debt financing in many other areas, not least among financial

institutions.

This rising and very widespread level of debt (leverage) was only recognized as a

problem in isolated instances. International standard setters and central banks viewed the

securitization of risks as a stabilizing factor, and it therefore appeared reasonable to relax capital

adequacy requirements for securitized risks. This approach also influenced the formulation of

Basel II1, not least as a result of lobbying by financial institutions. The anticipated stabilizing

effect was based on the assumption that the capital markets were bottomless and always liquid.

The associated risk allocation was deemed to be more efficient than that of the traditional

business model, in which banks grant loans themselves and keep them on their own balance

sheet until they are repaid by the borrower (buy-and-hold strategy). The new originate-to-distribute business model of many international investment banks was designed to convert loans

they originally granted themselves or purchased from other banks and financial institutions into

marketable securities via the securitisation process and sell them to other investors. The

prevailing opinion was that securitisation and credit derivatives offered banks and the entire

financial system more protection against shocks thanks to the broader distribution of risks across

a large number of investors.2In reality, however, the new business model did not result in the

hoped-for risk diversification, as a substantial proportion of the securities were held off-balance-

sheet in vehicles closely related to the banks. Thus, although the risks were no longer subject to

capital adequacy requirements, bank balance sheets were still exposed to the risks, particularly

liquidity risks, due to formal and informal guarantees in favour of these vehicles. The one-off or

repeated re-securitisation of individual subordinated debt tranches of initial securitisations also

increased the leverage effect, without this being visible under the relevant balance sheet item

(covered leverage). Financial institutions also sold their products to each other (acquire-to-

arbitrage), thereby giving the impression that the market was very deep, without the risks

ultimately being borne by parties outside the banking system. When this illusion finally

collapsed, the huge complexity that had made the bubble possible resulted in a complete absence

of demand and an illiquid market. Prior to this point, liquidity had only been seen as a potential

problem at the level of individual institutions. However, the idea that entire markets could be

illiquid over a long period was never considered.

The crisis was finally triggered by the US mortgage market. The influx of foreign capital

and the rise in the US balance of trade deficit also led to private households taking on

significantly higher levels of debt. The constant rise in real estate prices led borrowers and

25



lenders to assess the risks as low, while low interest rates (partly in the form of loss-leader

products with interest rates that only rise at a later date) made mortgages affordable, and in their

securitised form they were an attractive alternative investment for investors. The granting of

mortgage loans to borrowers with poor credit ratings (subprime borrowers) was actively

encouraged by politicians as a means of extending home ownership to disadvantaged sections of

the population and was not seen as critical due to the constant rise in real estate prices. If a

borrower got into difficulties, in general the mortgage was simply restructured and the loan-to-

value ratio increased. A growing proportion of subprime mortgages were granted by financial

institutions that were not subject to banking regulation and arranged by brokers remunerated on

the basis of sales, which encouraged the relaxing of due diligence standards for the granting of

loans. Real estate prices peaked in 2006. As a result it became impossible to prevent impending

loan defaults through restructuring and more and more subprime borrowers defaulted on their mortgages. Borrowers also had little incentive to continue servicing mortgages that exceeded the

value of their property, as local US laws enabled them to withdraw from their obligation by

transferring ownership of the property to the bank. Securities based on subprime residential

mortgages recorded increasing losses. At the start of 2007 the focus was on the tranches with

poor risk evaluations; by the summer even those with confirmed good credit quality had been

affected. In hindsight, however, the collapse of the subprime market is just one of several events

that had the potential to trigger a financial market crisis.

In June 2007, when the insolvency of subprime hedge funds caused such severe liquidity

problems at Bear Stearns that the bank had to be taken over by JP Morgan Chase in the

following year, it was considered unlikely that the difficulties would extend to areas beyond the

US subprime market. In early summer of that year, international organisations such as the IMF,

the Bank for International Settlements (BIS) and the Financial Stability Forum (FSF) were

following the initial turbulence on the financial markets with a degree of concern, but as yet they

had no comprehension of the extent of the subsequent financial market crisis. The forecasts

issued by these institutions mainly predicted a slowdown in economic growth in the USA, but

there was no suggestion whatsoever that the problem would spread to most of the world’s

economies. Their assessments were based primarily on a still strong macroeconomic

environment, with low inflation and positive growth rates. Even before the crisis broke, a

number of central banks, the European Central Bank (ECB) and the Swiss National Bank (SNB)

among them, had already highlighted the very low risk premiums, the associated rise in risk

tolerance and the high levels of debt at certain financial institutions. The initial turbulence in

2007 was therefore also seen as a necessary correction, but for a long time it was considered

26



unlikely that the situation would spill over into other sectors or develop into a crisis affecting the

entire financial market, let alone a slide into a global recession.

When market participants became aware of the negative performance of securities backed

by subprime mortgages, there was a rapid rise in the previously extraordinarily low risk

premiums, even for securities backed in other ways. The valuations of the complex paper were

primarily based on the assessments of rating agencies. When the agencies downgraded a host of

these securities by three rating classes in one go, suspicion grew that the risks associated with the

paper had not been fully understood. There had never been a mass downgrade on this scale for

other types of fixed-income security. Many of the mortgage-backed securities were held by

special purpose vehicles that did not appear on bank balance sheets. Refinancing for these

vehicles, which previously came from the short-term money market, subsequently dried up.

Forced sales and a loss of confidence in products with little transparency caused key securitiesmarkets to dry up, triggering further price falls. In line with the principle of fair value

measurement, securities held in the trading book have to be booked at market value. The major

decline in the value of these securities led to high losses, reducing the equity capital of financial

institutions. As the crisis developed it became increasingly difficult and ultimately impossible to

raise new funds on the capital market, with the result that many banks no longer possessed the

minimum regulatory capital reserves required, so their only option was to massively reduce their

balance sheet positions. This in turn led to a further price crash across the board, triggering major

criticism of the pro-cyclical effect of fair value accounting. The rules on consolidation, which

favoured outsourcing arrangements and did not adequately reflect the existing legal or

reputational obligations towards off-balance-sheet vehicles, also came in for criticism.

The banks were forced to take large write-downs on the positions they held in their

trading books. Certain illiquid trading position were transferred to banking books. To protect

their reputations, many banks moved their off-balance-sheet special purpose vehicles (SPV) with

heavy investments in asset-backed securities (ABS) back onto their own books, thereby

increasing the need for capital and liquidity in the banking sector. At the same time, uncertainty

over the economic prospects of counterparties led to a loss of liquidity on the interbank market,

which collapsed completely following the failure of Lehman Brothers. Central banks throughout

the world were obliged to pump liquidity into the interbank market and reduce key interest rates

to record low levels. As monetary policy measures alone were not enough to stabilise the

interbank market, other big banks and major insurance conglomerates such as AIG, which had

also built up a considerable capital market business in addition to its insurance activities, reached

the verge of collapse. This would have further exacerbated the crisis of confidence among

27



lenders and depositors. As a result, many governments decided to bail out their banks and

insurance companies with state rescue packages and take over some of their risk positions.

Supervisory authorities were accused of missing the signs, of relying too heavily on the

evaluation of the institutions under their supervision and of not building up enough analytical

expertise of their own. There was also a feeling that capital requirements had been set too low, as

certain risks had been underestimated. Liquidity, too, was felt not to have received the attention

it deserved. Corporate governance practices at numerous institutions had also failed, but the

supervisory authorities had not intervened. Furthermore, there was a belief that regulation was

totally lacking or at best inadequate in certain key areas, and that supervisory tools and

processes, particularly for groups operating internationally, had proved to be inadequate. The

same complaints were also levelled at international standard setters such as the Basel Committeeon Banking Supervision, the International Association of Insurance Supervisors (IAIS), the

International Organization of Securities Commissions (IOSCO) and their common body the Joint

Forum. It is a fact that the development of the Basel II capital adequacy requirements, which

began in 1998, and their eventual implementation from 2006 onwards placed huge demands on

the Basel Committee, the various national supervisors and of course the banking industry itself.

The burden of Basel II meant that the issuing of quantitative international minimum standards to

regulate and monitor liquidity risk was put back and not treated as a priority even at national

level until shortly before the crisis. Competition pressures also eroded the quality of the big

global banks’ eligible equity capital, notably through the issue of tax-efficient hybrid core

capital. Although the Basel Committee did issue a number of guidelines in 1998 to counter this

negative trend, which were applied relatively strictly by the Swiss Federal Banking Commission

(SFBC), further international harmonisation of equity definitions was deferred until Basel II had

been approved. Both supervisors and the banks were also focused too heavily on the risks of

individual institutions and did not recognise the risks accumulating throughout the entire system

until it was too late. This in turn would primarily have been the task of the central banks, which

are charged with ensuring the stability of the system, but they lacked company-specific

information on the risk situation. However even institutions such as the US Federal Reserve

System (Fed) that perform both macro and micro prudential functions fared no better with regard

to recognition of the crisis. It is therefore clear that the failure to adequately recognise the causes

of this crisis did not stem from the way an authority is structured, its size or the style of

supervision.3

28



Numerous studies of the causes of the crisis clearly demonstrate that it was brought about

by a disastrous combination of various aspects. In particular, the value-at-risk models used by

the banks to measure and provide capital cover for market risks proved to be completely

inadequate. In stress situations, trading book positions are markedly less liquid than previously

assumed. The capital adequacy requirements for these risks were therefore insufficient and set

false incentives for shifting from credit to market risks. Through securitisation, fundamentally

illiquid loans were converted into marketable securities. Some were subsequently securitised a

second and third time and broken down into tranches with differing rankings in the event of

bankruptcy, which external rating agencies gave top ratings depending on their ranking. As a

result, the trading portfolios of global investment banks were massively inflated with credit

derivatives and credit default swaps (CDS). In line with the market risk regime introduced in

1996 as an amendment to Basel I, only a fraction of the capital cover in the traditional bank book was required for securitised loans in the trading book in periods of low volatility. Prior to the

crisis, therefore, the large banks’ capital adequacy requirements for market risks accounted for

less than 10% of the overall requirement. These models were adopted almost unchanged in the

Basel II regulations. The Basel Committee will now rectify this deficiency based on the

knowledge acquired during the crisis. In general, both the financial sector and the supervisory

authorities relied far too heavily on financial mathematics models. As a result of this, and also

the low default probabilities estimated by the rating agencies, people wrongly believed they were

in a secure situation. Not enough consideration was given to the fact that these models were

based on a host of assumptions and parameters tailored to observations taken during periods of

positive economic performance. As the regulatory authorities also used the same models to

determine capital requirements, a strong pro-cyclical effect emerged during the crisis. The rapid

increase in the volatility of the now illiquid trading portfolios also triggered a rise in the value-at-

risk in the market risk models and hence in the capital required, while at the same time the

amount of capital available was decimated by losses and write-downs on these positions. At a

time of major difficulties, many institutions therefore had to make additional capital available to

cover the increased risks. International accounting standards, with their pronounced emphasis on

the short-term investor’s viewpoint, market valuation and the extension of fair value

measurement to include traditional bank assets and liabilities, made it more difficult to create

forward-looking value adjustments from a prudential perspective. They heightened the pro-

cyclical effect and encouraged the distribution of short-term gains prior to the crisis. These

effects were mitigated to a certain extent, however, thanks to the existing filters for the

prudential calculation of regulatory capital. For example, goodwill or fair value gains arising

from the devaluation of a bank’s own liabilities (own credit) due to a decline in its

29



creditworthiness must be excluded from regulatory capital. However the full impact of these

cyclical fluctuations is felt in the income statement, for instance because it is precisely in periods

of stress that goodwill on participations has to be written down, while conversely a fall in a

bank’s own creditworthiness creates paper gains that subsequently revert to losses again in the

event of a later recovery.

One of the key functions performed by banks is maturity transformation, whereby

relatively short-term liabilities are loaned for a longer term. This function has an indisputable

economic value, but also entails liquidity risks for companies, which is why financial

intermediaries are also subject to regulation and enjoy access to central bank facilities. In recent

years, however, there has been a pronounced shift of this maturity transformation into vehicles

that do not appear on bank balance sheets. As a result, this key financial market function has

partially shifted into unregulated territory. The forced sales that had to be made during the crisisto meet the obligations falling due in the short term further exacerbated the liquidity crisis.

Clearly, therefore, it is time to consider the extent to which previously unregulated areas of the

financial market must in future be covered by the supervisory authorities and if necessary made

subject to regulation. Debate is focussed in particular on money market funds, hedge funds and

private equity firms. According to the experts, hedge funds did not cause this crisis but as key

market participants however, they did amplify the downward trend in the face of deleveraging

pressures and demands from investors wishing to withdraw their capital.

Remuneration systems were also partly to blame for the crisis. Those of the investment

banks, with their lack of any long-term focus, created false incentives that favoured the

acceptance of unreasonable risks. Supervisors recognised the problem, but felt that intervention

was futile due to competitive pressures or trusted in the smooth functioning of the banks’ own

governance and risk control processes.

Both the causes of this crisis and the failure to recognise the growing systemic risks were

global in nature. The long-lasting positive economic trend and the perceived increase in the

stability of the financial system led financial institutions, supervisory authorities and academics

to misjudge the situation in the run-up to the crisis. In this respect, it is impossible to identify any

specific mistakes on the part of the Swiss supervisory authorities. In terms of recognising the

crisis at an early stage or preventing it from happening, they performed no better and no worse

than their partner authorities, some of whom have significantly more staff and are much closer to

the markets in question.

30



§ 2.2 The impaс of recent tinternational financial crisis on economic and social

issues in the world economy

The world is confronted with the worst financial and economic crisis since the Great

Depression. The evolving crisis, which began within the world’s major financial centers, has

spread throughout the global economy, causing severe social, political and economic impacts.

The global economic and financial crisis is having a significant impact on all countries.

However, central, Eastern, and south-Eastern Europe (CESEE) has been particularly hard hit.

The crisis poses a significant challenge to budget policies worldwide, and many countries,

especially major economies, are relying not just on automatic stabilisers, but are responding to

the crisis with discretionary fiscal stimuli and support for the financial sector. Indeed, the current

economic environment would seem to call for Keynesian policies to counterbalance both

domestic and foreign demand shortages.

CESEE countries face significant budgetary challenges. Most have very limited fiscal

policy options. Many of them face significant financing constraints, are small and open, have

generally lower-quality fiscal institutions than major economies, and should respect investors’

confidence. Although public debt relative to GDP is considerably lower in most CESEE

countries than in major economies, markets’ tolerance for public debt in emerging and

developing countries is much lower.

CESEE countries have been hit severely by the crisis, though there are significant

differences within the region. Before the crisis, i.e. up to 2007, CESEE countries seemed to be

catching-up with theEU-15 quickly and reasonably smoothly; this was reflected in forecasts

made at that time (Figure 1). For example, in October 2007, cumulative GDP growth from

2008 to 2010 was forecast to be 11.4 percent on average in the region, while, by comparison, the

EU-15 was predicted to grow by 4.3 percent during these two years. Some CESEE countries had

built up various vulnerabilities, such as huge credit, housing and consumption booms and thus

high current account deficits and external debt. It was widely expected that these vulnerabilitieswould have to be corrected at some point in time. However, the magnitude of the correction, as

also reflected by the fall in GDP, was amplified by the global financial and economic crisis.

Figure 1 indicates that there were substantial downward revisions in economic growth

forecasts from October 2007 to October 2009 in all countries. The 2010 GDP level of the

CESEE country group was in October 2009 forecast to be 14.8 percent lower than was expected

in October 2007. Downward revision in other emerging and developing country groups has been

smaller, ranging from 3.3 percent (average of 48 African countries) to 6.9 percent (average of 25

Asian countries excluding China3). CESEE countries not only had to assume the largest

downward revision of their forecast GDP level, but the actual fall in GDP is also expected to be

31



the greatest among emerging and developing country groups. The average GDP change in the 26

CESEE countries from 2008 to 2010 was forecast in October 2009 to be minus 4.3 percent.

Meanwhile the 25 Latin American countries were expected to maintain their GDP level, and the

25 Asian countries, and the 48 African countries and the 13 Middle East countries were expected

to grow by between 5.2 percent and 6.0 percent during the same period.

The three Baltic countries were hit the most seriously with GDP projected to fall between

16 and 22 percent from 2008 to 2010, according to October 2009 forecasts18. Forecasts made in

2007 foresaw growth of about 15 percent during the same period. Furthermore, growth in 2008

was -4.6 percent in Latvia and -3.6 percent in Estonia and hence the total output fall experienced

by these countries will be even larger than the forecasts for 2009 and 2010 would imply. The

downward revision of the 2010 GDP level is between 34 and 39 percent for the three countries.

18 Darvas, Zsolt (2009) ‘The Baltic Challenge and Euro Area Entry’, Bruegel PolicyContribution. -p8

32



2010 GDP level is between 34 and 39 percent for the three countries19.

The sensitivity of CESEE countries to the crisis is mainly due to three factors:

- Capital flows and financial integration;

- Dependence on foreign trade;

- Migration and remittances.

Darvas and Veugelers (2009) demonstrate that foreign trade played a crucial role in the

pre-crisis economic growth of CESEE countries, and that their dependence on foreign trade is

greater than many other emerging and developing countries. Remittances are also very important

for some countries: Moldova (34 percent of GDP in 2007), Bosnia/Herzegovina (17 percent),

19 Zsolt Darvas, The Impact of the Crisis on Budget Policy in Central and Eastern Europe,Institute of Economics Hungarian Academy of Science, Budapest, 2009, p.7.

33



Armenia (14 percent), Albania (13 percent), Georgia (seven percent), Bulgaria &

Romania (five percent), and between two and four percent for eight further CESEE countries20.

In general, CESEE countries entered the crisis more vulnerable than other emerging

regions, although there are considerable differences within the region. A key feature of these

countries is that their pre-crisis growth was associated with rising current account deficits (with

the exception of commodity exporters), that is, the correlation between GDP growth and the

current account was negative, as the left-hand panel of Figure 2 indicates. In contrast, correlation

was positive in other emerging and developing countries as suggested by the right-hand panel of

Figure 2.

Figure 2

In terms of Russia's need mention that it tends to be in a category by itself. Although by

some measures, it is an emerging market, it also is highly industrialized. As the case with most

of the world’s economies, the Russian economy has been hit hard by the global economic crisis

and resulting recession, the effects of which have been apparent since the last quarter of 2008.

Even before the financial crisis, Russia was showing signs of economic problems when world oil

20 Zsolt Darvas, The Impact of the Crisis on Budget Policy in Central and Eastern Europe,Institute of Economics Hungarian Academy of Science, Budapest, 2009,

34



prices plummeted sharply around the middle of 2008, diminishing a critical source of Russian

export revenues and government funding.

The crisis and other factors brought an abrupt end to a decade of impressive Russian

economic growth. In 2008, it faced a triple threat with the financial crisis coinciding with a rapid

decline in the price of oil and the aftermath of the country’s military confrontation in August

2008 with Georgia over the break-away areas of South Ossetia and Abkhazia 21. These events

exposed three fundamental weaknesses in the Russian economy: substantial dependence on oil

and gas sales for export revenues and government revenues; a decline in investor confidence in

the Russian economy; and a weak banking system.

The rapid decline in world oil prices has been a major factor in the overall decline in

Russia’s economy. Russian government revenues have diminished because of the drop in oil

revenues, but also because of the decline in income tax revenues, which will cause the Russiangovernment to incur a budget deficit in 2009 for the first time in ten years, a deficit of perhaps

8% of GDP22. Russia has also been adversely affected by the world-wide credit crunch that

ostensibly began with the proliferation of subprime mortgages in the United States and the

subsequent burst of the real estate bubble. Because low interest credit was not available

domestically, many Russian firms and banks depended on foreign loans to finance investments.

As credit tightened, foreign loans became harder to obtain.

The economic downturn has been showing up in Russia’s performance indicators.

Although Russia real GDP increased 5.6% in 2008 as a whole, it increased more slowly than it

did in 2007 (8.1%) and grew only 1.2% in the fourth quarter of 2008.152 The economic

slowdown has been reflected in the Russian ruble exchange rate as well. The ruble has been

declining in nominal terms because foreign investors have been pulling capital out of the market

to shore up domestic reserves, putting downward pressure on the ruble. Russian official reserves

have declined substantially in part because of the Russian Central Bank has intervened to defend

the ruble and current account surpluses have shrunk. Russian official reserves declined from

$597 billion at the end of July 2008 to $384 billion at the end of February 2009, although they

increased to $402 billion by the end of July 2009 23.

Russia remains highly dependent on oil and natural gas exports as a source of income. If

world oil prices continue to be depressed, the Russian economy would likely experience slow

growth, if any. Many economists have argued that, in the long run, for Russia to achieve

21 See CRS Report RL34618, Russia-Georgia Conflict in August 2008: Context and Implications for U.S. Interests, by Jim Nichol.22 Economist Intelligence Unit. Country Report—Russia. June 2009. p. 3.2323 Central Bank of Russia

35



sustainable growth, it must reduce its dependence on exports of oil, natural gas, and other

commodities and diversify into more stable production.

How is the Crisis Unfolding in Asia?

The crisis manifested in emerging Asia in early 2008, and is likely to worsen in

response to slackening demand from advanced economies and growing tensions in

regional financial markets. A selective review of the evidence is given below. Growth in China

eased to 101/2 per cent in the first half of 2008, from 12 per cent in 2007, partly

because of slowing exports. Investment and consumption, however, maintained their momentum.

In India, growth in the second quarter slowed to 8 per cent, on the back of weakening

investment, while private consumption and exports have held up better than feared, with signs of

the latter registering a sharp drop in October, 2008 . In fact, exports have fallen sharply in other

Asian country too, including South Korea, China, Japan and Taiwan.In the so-called NIEs and ASEAN economies, activity has decelerated. Domestic

demand has softened as a result of surge in food and fuel prices, and investment plans have been

scaled down. Vietnam, for example, is undergoing a sharp correction as the demand boom

caused by large capital inflows unwinds24.

Financial markets have weakened due to a pessimistic global outlook and investor risk

appetite has declined following the September turbulence. Equity markets that had a bull run

during 2005-07-prices more than quadrupled in China and tripled in India-plummeted. In some

countries borrowing spreads shot up for banks relying on wholesale funding25. Current accounts

are beginning to show strains as well, largely due to rising import bills for commodities and

slowing export growth, while capital account and exchange rate developments have varied.

Capital inflows to China have remained strong, as reflected in the continuing surge of foreign

reserves; capital flows to other countries in the region have become more volatile, particularly to

those running large external deficits. Consequently, their currencies have come under pressure,

prompting central banks to intervene (India, Pakistan and Vietnam). Differing nominal exchange

rate developments underlie differing real exchange rates, with the Chinese renmimbi and the

ASEAN currencies continuing to appreciate, and the South Asian and NIE’s currencies

weakening.

Headline CPI inflation soared in many countries in the first half of 2008, with slight

reductions in a few. In China, headline CPI inflation has declined from its peak of 81/2 per cent

in April, 2008, as food supply has improved. In India, CPI inflation jumped to 9 per cent in

August. Underlying inflationary pressures have increased, as robust credit growth could cause

second round effects. It is therefore likely that inflation will remain at elevated rates oven the

24 (Business Standard, November 11, 2008).25 Financial Times (11 November, 2008)

36



near term. For the region as a whole, headline inflation is project to rise 7 1/4 per cent in 2008,

up from 5 per cent in 2007. In 2009, it is projected to be about 6 per cent 26.

The sharp global contraction is affecting both advanced and developing countries. Global

industrial production declined by 20 percent in the fourth quarter of 2008, as highin come and

developing country activity plunged by 23 and 15 percent, respectively. Particularly hard hit

have been countries in Eastern Europe and Central Asia and producers of capital goods. Global

GDP will decline this year for the first time since World War II, with growth at least 5

percentage points below potential. World trade is on track to register its largest decline in 80

years, with the sharpest losses in East Asia, reflecting a combination of falling volumes, price

declines, and currency depreciation. Financial conditions facing developing countries have

deteriorated sharply.

In Latin America financial crises has two unusual dimensions. First it originated in theUnited States, with Latin America suffering shocks created by collapses in the U.S. housing and

credit markets, despite minimal direct exposure to the “toxic” assets in question. Second, it

spread to Latin America in spite of recent strong economic growth and policy improvements that

have generally increased economic sector.

The economies of Latin America and the Caribbean27 grew at an average annual rate of

nearly 5.5% for the five years 2004-2008, lending credence to the once prominent idea that they

were “decoupling” from slower growing developed economies, particularly the United States.

Latin America has experienced two levels of economic problems related to the crisis. First order

effects from financial contagion were initially evident in the high volatility of financial market

indicators. All major indicators fell sharply in the fourth quarter of 2008, as capital inflows

reversed direction, seeking safe haven in less risky assets, many of them, ironically, dollar

denominated. Regional stock indexes fell by over half from June to October 2008. Currencies

followed suit in many Latin American countries. They depreciated suddenly from investor flight

to the U.S. dollar reflecting a lack of confidence in local currencies, the rush to portfolio

rebalancing, and the fall in commodity import revenue related to sharply declining prices and

diminished global demand. In Mexico and Brazil, where firms took large speculative off-balance

sheet derivative positions in the currency markets, currency losses were compounded to a degree

requiring central bank intervention to ensure dollar availability28.

26 Katsushi Imai, Raghav Gaiha, Ganesh Thapa , Financial crisis in Asia and the Pacific Region: Its genesis, severityand impact on poverty and hunger, Economics School of Social Science, The University of Manchester, November 2008.27 United Nations. Economic Commission on Latin America and the Caribbean. Latin America

and the Caribbean in the World Economies, 2007. Trends 2008. Santiago: October 2008. p. 28.

28 International Monetary Fund. Global Markets Monitor , June 15, 2009, and Fidler, Stephen.Going South. Financial Times. January 9, 2009. p. 7.

37



The more serious effects of the global crisis for Latin America appear in second order

effects, which point to a deterioration of broader economic fundamentals. These will take much

longer to recover than financial indicators. GDP growth for the region is expected to be a

negative 2% in 2009, with an estimated growth of 3.4% in 2010.124 The fall in global demand,

particularly for Latin America’s commodity exports, has been a big factor, as seen in contracting

export revenue.

Latin American exports are expected to fall by 11% in 2009, the largest decline since

1937. Similarly, imports may fall by 14%, reflecting the decline in world demand in general. The

trade account, along with rising unemployment, point to the most severe aspects of the crisis for

Latin America29. Remittances have also fallen, ranging between 10% and 20% by country.

Although still important financial inflows, the decline in remittances is expected to diminish

family incomes and fiscal balances, contributing to the regional slowdown30

. Public sector borrowing is expected to rise and budget constraints may threaten spending on social programs

in some cases, with a predictably disproportional effect on the poor. Social effects are also seen

in the rising unemployment throughout the region.

Part of the fallout from the financial crisis has been a precipitous decline in the prices of a

large number of basic commodities and the weakness in global demand, is expected to keep

commodity prices low for a prolonged period. During the second half of 2008, non-energy

commodity prices plunged 38 percent, with most indices ending the year well below where they

started. In December, non-energy prices fell 6.8 percent, down for the fifth consecutive month on

weak global demand. Primary commodity prices continue to display extraordinary volatility,

falling swiftly as the downturn in global activity has intensified. Oil prices fell 69 percent

between July and December 2008, reversing the oil price increases of the previous 31/2 years.

Non-oil commodities also fell 38 percent on average over the same period, with substantial

declines in the dollar prices of food commodities, beverages, agricultural raw materials and

metals and minerals.

29 Ibid. p8,9.30

Orozco, Manual. Understanding the Continuing Effect of the Economic Crisis on Remittancesto Latin America and the Caribbean. Inter-American Development Bank. Washington, DC.August 10, 2009.p.8

38



Fig

The dramatic fall in commodity prices is affecting different developing countries

differently. Just as the increase in food and fuel prices between early 2007 and mid 2008 created

both winners and losers among developing countries,5 the sharp decline in commodity prices has

done the same. Of the 68 developing countries with available data which experienced

deteriorating terms of trade during the first three quarters of 2008, all but eight saw a partial

reversal of the deterioration in the final quarter of the year. Of the 39 countries for which the

terms of trade improved in the first three quarters, all but two saw a partial reversal in the final

quarter. Oil-importing emerging market countries—including many Asian countries—were the

top gainers from the oil price decline, receiving an income boost of some 2 percent of GDP, on

average.6 Many oil exporters, faced with a sharp drop in prices, have been able to draw on

savings and reserves accumulated when prices were at historically high levels and indeed many

of the countries that gained from recently high prices have been prudent in saving more of their

gains than in previous commodity price booms (e.g., Nigeria). Such expenditure smoothing may

help mute the impact of extremely volatile commodity prices on the real economy. Nevertheless,

for some low-income commodity producers, the cumulative windfall was not large, particularly

relative to their development needs. And for some commodity producers, the high prices from

2007 and into 2008 followed on the heels of a prolonged period during which their terms of trade

declined.In many countries, commodities generate a large share of government revenue. This is

particularly the case for major oil exporters and many LICs. In Africa, for example, oil is

39



responsible for generating more than half of all revenues for Congo, Equatorial Guinea, Gabon

and Nigeria; cocoa generates almost one-fifth of Cote d’Ivoire’s revenue as do minerals in

Guinea31. On average between 1999 and 2004, cotton and aluminum accounted for almost one

fifth of tax revenues in Tajikistan32.For at least nine Latin American countries, commodity

revenue was, on average, at least 2 percent of GDP between 2002 and 200733

. For Trinidad and

Tobago and Bolivia, respectively, this share has recently been as high as 22 and 12 percent of

GDP. Respondents to a survey of Bank country teams in LICs have indicated that commodity

based revenues have already started to decline in many LICs. Careful monitoring of this trend is

needed, while at the same time, it is essential that donors increase budget and other financial

support to vulnerable LICs to avoid long-lasting setbacks to poverty reduction efforts.

The economic crisis is projected to increase poverty by around 46 million people in 2009.

The principal transmission channels will be via employment and wage effects as well asdeclining remittance flows. While labor markets in the developing world will take a while to

experience the full effects of the on-going global contraction, there is already clear evidence of

the fall-out. The latest estimates from the Ministry of Labor in China show 20 million people out

of work. So far, the most affected sectors appear to be those that had been the most dynamic,

typically urban-based exporters, construction, mining and manufacturing. The garment industry

has laid off 30,000 workers in Cambodia (10% of workforce) where it represents the only

significant export industry. In India, over 500,000 jobs have been lost over the last 3 months of

2008 in export-oriented sectors—i.e., gems and jewelry, autos, and textiles. ILO forecasts

suggest that global job losses could hit 51 million, and up to 30 million workers could become

unemployed.

Workers are increasingly shifting out of dynamic export-oriented sectors into lower

productivity activities (and moving from urban back into rural areas). These trends are likely to

jeopardize recent progress in growth and poverty reduction resulting from labor shifting to

higher return activities. For instance, nearly half of the increase in GDP per capita experienced in

Rwanda between 2000 and 2008 is explained by movement of labor away from agriculture into

the secondary and tertiary sectors34.

31 Marinkov and Burger, “The Various Dimensions of Commodity Dependence in Africa”, SouthAfrican Journal of Economics, Volume 73:2, June 2005

32 Kumah, F. and J. Matovu, “Commodity Price Shocks and the Odds on FiscalPerformance: a Structural VAR Approach”, IMF Working Paper WP/05/171, August 2005:33

Vladkova-Hollar, I. and Jeronim Zettelmeyer, “Fiscal Positions in Latin America:Have TheyReally Improved?” IMF Working Paper 08/173; May 1, 200811 In Africa, as a result of a drying up in trade finance, there has been

40



Declining remittances and migration opportunities are also undermining poverty gains

and depressing wages. Remittances are a powerful poverty reduction mechanism, so that the

current forecasts for a significant decline in remittances in 2009, will have strong welfare

impacts in some countries. Estimates for Tajikistan suggest that halving of the remittance flows

would raise the poverty headcount from 53% to 60% and would deepen poverty and inequality35

.

According to recent projections in Bulgaria and Armenia, two countries heavily dependent on

migration, a decline of 25% in remittances would increase poverty rates among recipients from

7% and 18% respectively to nearly 23% and over 21% respectively 36.The international return

flows of migrants as well as reduced new departures will reinforce the shortage of employment

opportunities and further strain tight labor markets in the developing world.

Falling real wages and employment impede households’ ability to provide adequate food

and necessities to their members, particularly given their already stretched coping mechanismsfrom the 2008 food and fuel crises. Compounding this is the very real risk that, in many

countries, fiscal pressures will result in reduced services to the poor, which is particularly

problematic at a time when people are switching from private to public education and health

services. Absent assistance, households may be forced into the additional sales of assets on

which their livelihoods depend, withdrawal of their children from school, reduced reliance on

health care, inadequate diets and resulting malnutrition. The long-run consequences of the crisis

may be more severe than those observed in the short run. When poor households withdraw their

children from school, there is a significant risk that they will not return once the crisis is over, or

that they will not be able to recover the learning gaps resulting from lack of attendance. And the

decline in nutritional and health status among children who suffer from reduced (or lower

quality) food consumption can be irreversible. Estimates suggest that the food crisis has already

caused the number of people suffering from malnutrition to rise by 44 million.

§ 2.3 The scenarios of international financial crisis management

34 World Bank (2009) “The Role of Employment and Earnings for Shared Growth: The Case of Rwanda.”.35 World Bank (2009) Simulation of the impact of reduced migrant remittanceson poverty in Tajikistan,2009.

36 World Bank (2009) Bulgaria, The impact of the Financial Crisis on Poverty ,World Bank (2009)

Armenia, Implications of Global Financial Crisis for Poverty.

41



In responding the global economic crisis, developing and emerging market countries will

face three main challenges:

• Stabilization: The crisis threatens growth, employment, and balance of payments stability even

in those countries that have made significant improvements in macroeconomic management in

recent years. Give the unprecedented severity of the crisis, few countries will be able to avoid

heavy pressures on their fiscal and external positions. The challenge for policymakers in this

environment is to assess their ability to undertake countercyclical policies given the resources

available to them as well as their institutional and administrative capacity to rapidly expand and

adapt existing programs.

• Protecting Longer-Term Growth and Development : An important lesson learned during the

Asian crisis is that neglecting core development spending during a major crisis can have large

long run costs. Responding to immediate fiscal pressures by putting off maintenance of existinginfrastructure essential for economic development, for example, can lead to costly rehabilitation

over the longer term and also hold back economic recovery. The same can be said of reduced

public spending on human capital development, such as basic education

• Protecting the Vulnerable. Inevitably, the crisis will impact social and human development

objectives. Declining growth rates combined with high levels of initial poverty leave many

households in developing countries highly exposed to the crisis. The Bank estimates that of 116

developing countries, 94 have experienced decelerating growth, of which 43 experience high

levels of poverty. This implies new spending needs and may warrant a re-prioritization of

existing public spending. While impacts are country specific, the crisis entails real risks for

future poverty reduction and exposes poor and vulnerable households to potentially severe

welfare losses. Households in the poorest countries are the most in danger of falling back into

poverty and have less access to safety nets to cushion the impact. To some extent, countries that

established or improved the efficiency of social safety nets during the food and fuel crisis can

utilize these channels to protect the poorest and most vulnerable. Critical to protecting

households in exposed countries will be the ability of governments to cope with the fallout and

finance programs that create jobs, ensure the delivery of core services, and provide safety nets.

However, given the scarcity of resources, the challenge remains to continue to improve the

targeting and effectiveness of social support.

Pursuin these objectives can require significant resources. But in an environment

characterized by rising needs and scarce resources, policymakers face difficult challenges of

setting spending priorities and maximizing the development impact of their spending. These

challenges are particularly daunting for debt-distressed countries for which the resources

42



constraints are often greatest. Even if a country’s public debt is low, it may find it difficult to

finance a large fiscal stimulus package.

There is also considerable uncertainty with respect to both the severity and length of the

economic downturn, further complicating the task of policy makers. A less protracted slowdown

would suggest a focus on shorter term measures that are easily reversible, emphasizing (where

possible) the acceleration of pre-existing spending plans rather than new initiatives. A more

protracted slowdown would lengthen the horizon over which it would be desirable to implement

countercyclical polices. With no clear sense of the length and depth of the crisis, contingency

planning and enhanced monitoring of evolving economic and fiscal conditions will be critical.

To date, all advanced economies and a majority of developing countries in the G-20 have

announced plans for coping to crises. In Pittsburgh, at the summit, the G-20 members agreed to

support six broad policy goals:1. The new G-20 “Framework for Strong, Sustainable and Balanced Growth” will launch

by November 2009. This framework promotes shifting from public to private sources of demand,

establishing a pattern of growth that is sustainable and balanced, avoiding destabilizing booms

and busts in asset and credit prices, and adopting macroeconomic policies that are consistent

with stable prices. In order to achieve this framework, the G-20 members agreed to implement a

“cooperative process of mutual assessment.” This cooperative process is comprised of: shared

policy objectives; a medium-term policy framework and an assessment of the impact national

policies have on global economic growth and financial stability; and actions to meet common

objectives. Within this framework, the G-20 members agreed to:

• implement responsible fiscal policies, attentive to short-term flexibility

considerations and longer-run sustainability requirements;

• strengthen financial supervision to prevent the re-emergence in the financial

system of excess credit growth and excess leverage and undertake macro prudential and

regulatory policies to help prevent credit and asset price cycles from becoming forces of

destabilization;

• promote more balanced current accounts and support open trade and

investment to advance global prosperity and growth sustainability, while actively rejecting

protectionist measures;

• undertake monetary policies consistent with price stability in the context of

market oriented exchange rates that reflect underlying economic fundamentals;

• undertake structural reforms to increase potential growth rates and, where

needed, to improve social safety nets; and

43



• promote balanced and sustainable economic development in order to narrow

development imbalances and reduce poverty.

2. To strengthen the regulatory system for banks and other financial firms by raising

capital standards, implementing strong international compensation standards, improving the

over-the-counter derivatives market, and holding large global firms accountable for their risks.

As components of this process, the G-20 agree to: building high quality bank capital and

mitigating procyclical actions; reforming compensation practices to strengthen financial stability;

improving over-the-counter derivatives markets; and addressing cross-border resolutions and

systemically important financial institutions. In addition, the G-20 leaders indicated their support

for efforts to improve the financial system by taking actions against non-cooperative

jurisdictions, including using “countermeasures against tax havens,” and by tasking the Financial

Action Task Force (FATF) to issue a list of high risk jurisdictions by February 2010.3. To modernize the global architecture by designating the G-20 as the premier forum for

international economic cooperation, by establishing the Financial Stability Board (FSB), by

having the FSB include major emerging economies, and by having the FSB coordinate and

monitor progress in strengthening financial regulation. Also, the G-20 agreed to shift the IMF

quota share to dynamic emerging markets and developing countries of at least 5%, using the

current IMF quota formula. The change in quotas is keyed to the IMF’s quota review that is

scheduled to be completed by January 2010. In addition to reviewing the quotas, the G-20

indicated its support for reviewing the size of any increase in IMF quotas, the size and

composition of the Executive Board, ways of enhancing the Board’s effectiveness, the Fund

Governors’ involvement in the strategic oversight of the IMF, and the diversity of IMF staff, and

the appointment of department heads and senior leadership through an open, transparent and

merit-based process. The G-20 countries also agreed to contribute over $500 billion to a renewed

and expanded New Arrangements to Borrow facility in the IMF. Additional IMF funding will

also be available through gold sales and through additional Special Drawing Rights (SDRs). The

G-20 also called for reforming the mission, mandate, and governance of the development banks,

including the IMF, which the G-20 indicated must play a “critical role in promoting global

financial stability and rebalancing growth.” They also called on the World Bank to play a leading

role in responding to problems whose nature requires globally coordinated action, such as

climate change and green technology, food security, human development, and private-sector led

growth.

4. To take new steps to increase access to food, fuel, and finance among the world’s

poorest economies, while clamping down on illicit outflows. The G-20 also agreed to improve

energy market transparency and stability, and to improve regulatory oversight of energy markets.

44



5. To phase out and rationalize over the medium term inefficient fossil fuel subsidies

while providing targeted support for the poorest. Agreed to stimulate investment in clean and in

renewable energy and in energy efficiency, and to take steps to diffuse and transfer clean energy

technology.

6. To maintain openness and move toward greener, more sustainable growth.

In addition, the G-20 countries are addressing a number of issues related to correcting

abuses in the financial markets, particularly those involving non-bank financial institutions and

complex financial instruments. Analysts and policymakers generally agree that the lack of

regulation of new non-bank financial institutions, such as hedge funds and private equity firms,

and the lack of transparency of new complex financial instruments, such as derivatives, were key

factors in the current financial crisis.

The G-20 leaders also called for common principles for reforming financial markets.These principles include: strengthening the transparency and accountability of firms and

financial products, extending regulation to all financial market institutions, promoting the

integrity of financial markets (such as bolstering consumer protection) and consistent regulations

across national borders, and reforming international financial institutions to better monitor the

health of the financial system. The G-20 London Summit reiterated the need for financial

supervision, regulation, and transparency of financial products37.

The role of the G-20 in dealing with the global financial crisis began on November 15,

2008, with the G-20 Summit on Financial Markets and the World Economy that was held in

Washington, DC. This was billed as the first in a series of meetings to deal with the financial

crisis, discuss efforts to strengthen economic growth, and to lay the foundation to prevent future

crises from occurring. This summit included emerging market economies rather than the usual

G-7 or G-8 nations that periodically meet to discuss economic issues. It was not apparent that the

agenda of the emerging market economies differed greatly from that of Europe, the United

States, or Japan.

At the November G-20 summit, the leaders agreed on common principles to guide

financial market reform:

• Strengthening transparency and accountability by enhancing required disclosure on

complex financial products; ensuring complete and accurate disclosure by firms of their financial

condition; and aligning incentives to avoid excessive risk taking.

• Enhancing sound regulation by ensuring strong oversight of credit rating agencies;

prudent risk management; and oversight or regulation of all financial markets, products, and

participants as appropriate to their circumstances.

37 Pittsburg summit

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• Promoting integrity in financial markets by preventing market manipulation and fraud,

helping avoid conflicts of interest, and protecting against use of the financial system to support

terrorism, drug trafficking, or other illegal activities.

• Reinforcing international cooperation by making national laws and regulations more

consistent and encouraging regulators to enhance their coordination and cooperation across all

segments of financial markets.

• Reforming international financial institutions (IFIs) by modernizing their governance

and membership so that emerging market economies and developing countries have greater

voice and representation, by working together to better identify vulnerabilities and anticipate

stresses, and by acting swiftly to play a key role in crisis response.

At the London Summit, the leaders reviewed progress on the November G-20 Action

Plan that set forth a comprehensive work plan to implement the above principles. The Planincluded immediate actions to:

• Address weaknesses in accounting and disclosure standards for off balance sheet

vehicles;

• Ensure that credit rating agencies meet the highest standards and avoid conflicts

of interest, provide greater disclosure to investors, and differentiate ratings for

complex products;

• Ensure that firms maintain adequate capital, and set out strengthened capital

requirements for banks’ structured credit and securitization activities;

• Develop enhanced guidance to strengthen banks’ risk management practices, and

ensure that firms develop processes that look at whether they are accumulating

too much risk;

• Establish processes whereby national supervisors who oversee globally active

financial institutions meet together and share information; and

• Expand the Financial Stability Forum to include a broader membership of

emerging economies.

The leaders instructed finance ministers to make specific recommendations in the

following areas:

• Avoiding regulatory policies that exacerbate the ups and downs of the business cycle;

• Reviewing and aligning global accounting standards, particularly for complex securities in

times of stress;

• Strengthening transparency of credit derivatives markets and reducing their systemic risks;

• Reviewing incentives for risk-taking and innovation reflected in compensation practices; and

46



• Reviewing the mandates, governance, and resource requirements of the International Financial

Institutions.

The leaders agreed that needed reforms will be successful only if they are grounded in a

commitment to free market principles, including the rule of law, respect for private property,

open trade and investment, competitive markets, and efficient, effectively-regulated financial

systems.

The leaders further agreed to:

• Reject protectionism, which exacerbates rather than mitigates financial and economic

challenges;

• Strive to reach an agreement this year on modalities that leads to an ambitious outcome to the

Doha Round of World Trade Organization negotiations;

• Refrain from imposing any new trade or investment barriers for the next 12months; and• Reaffirm development assistance commitments and urge both developed and emerging

economies to undertake commitments consistent with their capacities and roles in the global

economy.

To respond to the global crisis, the ILO wished to put in place a global jobs pact; a

political agreement that would focus on social protection, employment rights, and social

dialogue. An analysis of 40 stimulus packages in place had found that they did not respond to

those issues. A jobs pact implied a change in approach and a move away from the easy notion

that economic recovery would automatically lead to job creation; a jobs crisis had existed even

before the economic downturn and that was why there was an informal economy. Within a social

market economy, targeted policies that invested in job creation would help to move markets in a

productive direction. As Professor Sachs had suggested, investment in green energy and a

sustainable environment would be important. At the same time, there needed to be investment in

small businesses as they provided most job creation with relatively few resources.

Social protection was needed to ensure safe and viable jobs, shorter hours and skills

development, limit wasteful layoffs, support job seekers through unemployment benefits and

employment services, and reinforce labour market programmes. Governments should use

measures that had been proven to work, but which had been marginalized as economic bubbles

developed. At the request of the United Nations, the components of a global jobs pact would be

discussed at the International Labour Conference and the G20 had requested that ILO measure

job creation initiatives that were already in place. There would be no improvement in the

economy until the financial system had recovered. There would probably be a little growth in

2009 but the risk was that, as economies recovered, continuing unemployment would be ignored.

47



The jobs crisis, which had preceded the economic crisis, had arisen due to imbalances in

a global economy which overvalued the role of markets and their capacity to regulate themselves

and undervalued the role of the state and of governance and regulation. Worse still, the dignity of

work had been devalued as salaries in terms of GDP had fallen: both developed and developing

countries had reduced the participation of workers in the wealth they were creating. New

economies would have to espouse respect for the environment, for public goods and for social

welfare; aspects that had been cut in International Monetary Fund programmes. It was not

acceptable for Governments to cut social expenditure in order to pay creditors. Parliamentarians

should consider what type of globalization would be reasonable and sustainable. Before the

present downturn had begun, the World Commission on the Social Aspects of Globalization,

established by the ILO in 2002, had found the imbalances in the global economy to be morally

unacceptable and politically unsustainable.In order to confront the crisis, it was essential that parliamentarians should set aside

internal rivalries and unite to produce a strong, national position. Parliamentarians should listen

to the people they represented and respond to their need for jobs, social protection and social

safety nets, themes which were set out in the ILO’s Decent Work Agenda.

To the OECD level was elaborated a Guide for Multinational Enterprises which covers a

wide series of the problem for the behavior and ethic in business. This guide was agreed by the

state members of the OECD and signed by 11 member states of the OECD and includes the

general principles and recommendations which promotes the compatibility with the laws, with

the protection of the consumer interests, respecting the man rights, the care against the

occupation, work relations, environment protection. The guide was utilized by the Agencies of

Rating and Grants when they elaborated recommendations for the corporate responsibility.

Another multilateral instrument refers to the Principles of Corporate Governance (PCG)

elaborated by OECD as part of the Forum of Stability regarding the key standards of the healthy

financial markets. The principles of the corporate governance solve the structure and the quality

of the systems of settlements, distinguishing the importance of some high ethical standards when

we develop a business or in relations with the stakeholders. The principles underline the role of

the Board of Directors in establishing the ethical standards of some company which doesn’t

refers only to the compatibility with the law systems but to an ethical code “of behavior” which

can be an effective method to know “the high tone”. If the standards of the high ethic are desired

within their nature, the PCG make a direct bound with the performance of the corporations,

therefore is underlined the idea that the ethic generate performance (profit)38.

38Carmen Năstase1 and Miika Kajanus University Stefan cel Mare, Suceava, Romania Savonia

University of Applied Sciences, Finland THE IMPACT OF THE GLOBAL CRISIS ONSME AND ENTREPRENEURSHIP BEHAVIOR – ROMANIA AND FINLAND CASES

48



OECD works intense to improve the multilateral agreements mentioned as in 2009 to

offer increased chances to consolidate the ethical environment in business on different canals.

The recovery of the economical growth and the edification of some new international financial

system entered into the sphere of preoccupation of the decision factors to the national and

international levels. Therefore, OECD elaborated the Strategically Answer to the Economical

and Financial Crisis destined to strength the ethic in business in different ways. In this sense, it is

to mention the assistance which can give OECD to the countries to strength the transparency in

domains like transparency, competition, corporate governance, taxes and pensions, concomitant

with promoting of a better financial education and the identification of the domains in which is

followed serious difficulties of the settlement instruments.

OECD will intensify the efforts and in other domains like:

- The Implementation of the Principles of the Corporate Governance into the financial sector in

which the re-establishment of the thrust had become a major imperative. To the G-20 Summit

from Washington from 2008, the member countries of OECD promised to formulate an action

plane to solution the weaknesses of the corporate government connected to the financial crisis,

mainly regarding: the management of the risk; the remuneration; the rights of the shareholders;

the practices of the administrations councils.

- The improvement and the actualization of the OECD guides for Multinational Enterprises

elaborated 9 years ago, considering the new elements and changes which brought the present

crisis. This guides offer to the enterprises behavior reference adequate to the systems of

conformity and management and interpret concrete situations for the financial system.

- It will offer mechanisms perfected by peer review in key domains like opened and responsible

investments, anticorruption, competition or other aspects of the responsible behavior in business.

- The cooperation to build a new frame of settlement for a global economy more secure and

global. In this sense, OECD with G-20 sketch an action plan in the domain of “Strengthening the

International Cooperation and of the Promoting the Integrity on Financial Markets”.

In response to the liquidity pressures on emerging markets, the IMF has created a new

facility, the Short-Term Liquidity Facility (SLF), to provide major, up-front, quick-disbursing

Economic Policy in the Wake of the Crisis P756. Vol XII • No. 27 • February 2010

49



and short-term financing to eligible emerging countries with a good track record of sound

economic policies39.

The World Bank Group is stepping up its financial assistance to its clients on a number of

fronts. There is scope to almost triple lending to around $35 billion in FY2009, and lending

volumes could potentially reach $100 billion over the next three years. Following its record 15th

replenishment, IDA is positioned to assist LICs in dealing with the impact of the global financial

crisis, with commitments amounting to nearly $42 billion over the next 3 years, and scope for

front-loading this support over the next year. The Bank is at the forefront of global efforts to

mobilize resources for developing countries, particularly those without the means to cushion the

impact of a crisis not of their making.

Central to this effort is a World Bank proposal for an umbrella Vulnerability Fund to

which developed countries could dedicate 0.7 percent of their planned economic stimulus. TheVulnerability Fund, which could channel resources not only through the Bank but also through

the UN or other MDBs, would help countries without the resources to respond to the crisis by

funding investments in three key areas:

• Infrastructure projects that would help put people in developing countries back to work

while building a foundation for future growth and productivity.

• Safety net programs, such as conditional cash transfers that make it possible for people

to keep their children in school, get adequate nutrition and seek health care.

• Financing for small and medium-sized businesses and microfinance institutions to help

the private sector create jobs.

The Bank continues to adapt its financial instruments to the specific needs of its

clients.The World Bank Group is also establishing a comprehensive IBRD/IDA Vulnerability

Financing Facility (VFF) to streamline its support to protect the poor and vulnerable during

global and systemic shocks. The VFF could be one option for countries wishing to contribute to

the Vulnerability Fund. Along with its support to the private sector and to sustain infrastructure

investment, the VFF is part of an emerging framework for addressing developing country

vulnerability to crises. The VFF currently incorporates three initiatives: the Global Food Crisis

Response Program (GFRP); the IDA Fast-Track Facility, which will fast-track up to $2 billion of

financial assistance, with potential to increase this amount in future; and the Rapid Social

39 Commission STAFF WORKING DOCUMENT “COMMUNICATION FROM THE

COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE

EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF

THE REGIONS” Supporting developing countries in coping with the crisis Millennium Development Goals — Impact of the Financial Crisis onDeveloping countriesSEC(2009) 445 Brussels, 8.4.2009, p33.

50



Response Fund to help protect the poor and vulnerable in middle and low-income countries

affected by different dimensions of the global crisis. These initiatives focus respectively on three

key areas of vulnerability response: agriculture, which is the main livelihood for the majority of

the world’s poor, programs to protect investments in longer term development in the

poorest countries, and employment, safety nets and protection of basic

social services to help the poor and vulnerable groups cope with crisis.

To respond to the challenges the current crisis presents for the infrastructure sector, the

WBG is also launching an Infrastructure Recovery and Assets (INFRA) Platform. The objectives

of the three-year INFRA Platform are to: stabilize existing infrastructure assets by restructuring

current portfolios, covering maintenance costs, and advising clients on currency and interest rate

risk management; (ensure delivery of priority projects through Public Expenditure Reviews and

government capacity building, by accelerating disbursements and/or identifying additionalfinancing, and by seizing the opportunity for “green infrastructure” through access to leveraging

facilities, (e.g. Carbon Partnership Facility, Clean Technology Fund); support Public Private

Partnerships (PPPs) in infrastructure through advisory and restructuring support, use of Bank

Group guarantees, innovative instruments, and in coordination with the IFC Infrastructure Crisis

Facility; and (iv) support new infrastructure project development and implementation by

providing financing and advice to governments launching growth and job enhancement

programs, as well as new infrastructure projects.

IBRD/IDA aims to support the achievement of the INFRA Platform objective through.

• Direct IBRD and/or IDA funding of infrastructure projects of up to $15 billion per year,

• Diagnostic and advisory support to identify countries most at risk and projects most appropriate

for INFRA support,

• Technical assistance to governments in the development of fiscal stimulus packages,

• Providing parallel financing to ensure collaboration and complementarity among bilateral and

IFI financing for priority projects,

• Providing concessional financing for project preparation and financing for priority projects to

mobilize additional funds for infrastructure development.

In addition to direct financial support, the Bank continues to provide developing countries

with access to diagnostic and capacity-building instruments like Public Expenditure Reviews

(PERs) and Debt Management and Performance Assessments (DEMPA)—the former to help

improve budget management and identify priority expenditures to be protected should financing

shortfalls persist, the latter as a critical tool for assuring essential fiscal sustainability. The value

to developing countries of these instruments has increased in a resource constrained

environment, as will the usefulness of technical assistance to improve revenue and customs

51



administration. A number of client countries are also looking for assistance in building bank

supervisory capacity to enable them to more effectively monitor developments and respond to

weaknesses in domestic financial sectors as they emerge.

The IFC Private Sector Platform will provide support to the private sector in LICs and

vulnerable MICs for crisis-related activities. The International Finance Corporation (IFC) has

launched or expanded five facilities to address problems experienced by the private sector.

Financing for the new facilities is expected to total about US$30 billion over three years,

combining IFC funds and externally mobilized resources, including from governments, export

credit agencies, and international financial institutions. Among the efforts underway are:

- Expansion of the Global Trade Finance Program (GTFP). The existing program, which offers

banks partial or full guarantees on the payment risk in trade transactions, was doubled in size and

can now support up to US$18 billion in short-term trade finance over the next three years. Sinceits inception in September 2005, US$3.2 billion in trade guarantees have been issued in support

of 2,600 transactions. Of these, 48 percent were for banks in Africa, 70 percent involved small

and medium enterprises, half supported trade with the world's poorest countries, and 35 percent

facilitated trade between emerging markets. The expanded facility is expected to benefit

participating banks in more than 65 developing countries.

- Creation of a Global Trade Liquidity Pool (GTLP). While expansion of the GTFP greatly

increases the potential to support trade finance through the use of guarantees, the severe shortage

of liquidity has made it difficult for many companies to line up the basic financing to be

guaranteed. IFC is therefore working with a number of partners to create a funded Global Trade

Liquidity Pool and will seek Board approval for its adoption at the end of March. With the

involvement of a number of global or regional banks active in trade finance, the GTLP will fund

trade transactions for up to 270 days and will be self liquidating once conditions for trade finance

improve.

- Bank Recapitalization Fund. IFC recently approved a US$3 billion Bank Recapitalization

Fund to provide Tier I and Tier II capital to distressed banks in emerging markets which lack

alternative sources of financing. It will also provide advisory services to strengthen private sector

development and improve economic and financial performance. IFC expects to invest US$1

billion of its own money. Japan has announced its intention to become a key founding partner

and provide the remaining US$2 billion in financing.

- Infrastructure Crisis Facility. This IFC facility, which is part of the WBG’s broader

Infrastructure Recovery and Assets (INFRA) Platform, will help ensure that viable, privately

funded infrastructure projects in emerging markets have access to the funding they need to

weather the financial crisis by providing temporary financing to private or public-private

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partnership infrastructure projects in emerging markets. Among other things, it will roll-over

financing and temporarily substitute for commercial financing for new infrastructure projects, if

funding is unavailable. IFC expects to invest a minimum of US$300 million and mobilize

between US$1.5 billion and US$10 billion from other sources.

- Microfinance Liquidity Facility. As one of the top three international investors in microfinance,

IFC has designed a liquidity facility to help ensure availability of adequate refinancing for

Microfinance Institutions amidst the market turmoil. The US$500 million facility is a joint effort

with Germany’s KfW. Using three of the industry’s largest fund managers, the facility will

provide refinancing options of up to 70 percent of the microfinance market. IFC expects to invest

up to $150 million40.

In addition, IFC will contribute up to €2 billion in a coordinated effort (with the EBRD

and the EIB) to finance assistance to businesses hit by the crisis in Central and Eastern Europe. Itwill be disbursed through IFC’s various crisis response initiatives in sectors including banking,

infrastructure, and trade as well as through its traditional investment and advisory services. This

is part of a broader €24.5 billion joint effort to support the banking sectors in the region and to

fund lending to businesses hit by the global economic crisis, of which the World Bank Group

will provide support of about €7.5 billion.

The Multilateral Investment Guarantee Agency (MIGA) continues to focus its guarantee

activity in higher risk/low income countries and on difficult structured finance transactions.

During December of 2008 and January 2009, MIGA approved US$675 million in guarantees in

support of loans to three foreign-owned financial institutions operating in Ukraine.

A US$95 million guarantee was provided to a subsidiary of foreign-owned financial

institution operating in Russia. Similar guarantees are being explored for banks operating in

other Eastern Europe countries and in Africa, in collaboration with IFC. MIGA is in the process

of proposing changes to its operational regulations to allow it to respond more rapidly to

emerging needs.

40 “Swimming against the tide: how developing countries are coping with the global crisis”

Background Paper prepared by World Bank Staff for the G20 FinanceMinisters and CentralBank Governors Meeting, Horsham, United Kingdom on March 13-14, 2009.p14-15.

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Ana Costiuc

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