Global Financial Markets and New Business Environment

Money and finance in the global economy

• The international monetary system is the body of rules and procedures by which different national currencies are exchanged for each other in world trade.

• The global financial system (GFS) refers to those financial institutions and regulations that act on the international level.

• The main players are private (banks, hedge funds etc) and public (central banks and government departments) and international organizations (the IMF, Bank for International Settlements etc).

Money and finance in the global economy

• The international monetary system is closely tied to the international finance system.

• Flows of international capital and FDI are conducted in money. If there is a change in exchange rates they inevitably impact on the value of investment.

The role of the international monetary system

• It requires a nation, or a group of nations, to maintain and manage it; leading nations might agree to entrust an international organization to achieve this, see IMF and World Bank.

• It has to determine the way to solve imbalances of national economies, by some agreed form of adjustment.

• It has to provide sufficient international liquidity. Countries need to rely on sufficient financial reserves to meet sudden shocks.

The post-Bretton Wood international monetary system

• Fixed exchange rates broke down in 1971. What followed were fluctuating exchange rates with no general rule on exchange rate adjustments.

The dollar remains the key reserve currency, although the system is based on some cooperation among the FED, the European Central Bank (the Bundesbank before 1999) and the Bank of Japan.

The IMF act as regulator of the world international monetary system.

The post-Bretton Wood international monetary system

• Many countries have chosen either to create monetary unions (the euro), or to peg their currencies to the dollar (dollar peg as in many South East Asian countries before 1997).

• Some countries manage their currencies with currency reserve boards, which means relinquishing control to the IMF, which will cover their money supply with dollars (for example Hong Kong in the 1990s, and Argentina in early 2000s).

The International Monetary Fund

• The International Monetary Fund (IMF) oversees exchange rates and balance of payments. It offers financial and technical assistance when requested.

• Its headquarters are located in Washington D.C. and offices around the world. It has currently 185 members.

• It came into existence in December 1945, when the first 29 countries signed its Articles of Agreement.

The International Monetary Fund

• An unwritten rule establishes that the IMF's managing director must be European and that the president of the World Bank must be from the US.

• The IMF is for the most part controlled by the major Western Powers, especially the US, with voting rights on the Executive board based on a quota which reflects its monetary stake in the institution.

The post-Bretton Wood international monetary system

• The desirable objectives of the international monetary system are.

• 1) exchange rate stability.• 2) being able to run an independent monetary (and

more broadly economic) national policy, for example a fiscal deficit when needed to boost economic growth.

• 3) enjoy freedom of capital flows, in order to have a more efficient financial system, international investment etc. As we shall see this third point is now being challenged.

The post-Bretton Wood international monetary system

Desirable objectives of IMS:• 1) exchange rate stability; • 2) independent monetary policy;• 3) free capital flows.

• The three objectives however are incompatible, only two are achievable at the same time.

• Under Bretton Woods there was 1 and 2, but not 3. • Currently most countries, have 2 and 3, but not 1. • The Euro means that each UE member state enjoys

1 and 3, but not 2.

Flexible, fluctuating exchange rates

• Pros• They prevent

currency misalignments

• Allow countries to conduct independent monetary policies

• Cons.• They produce too

much fluctuations on a day-to day basis: volatility.

• They produce long periods of currency under or over-evaluation, distorting trade.

International monetary system: alternative solutions

Possible alternatives:

•Return to gold. Advocated by extreme neo-liberals.•Managed currencies. Imply limitations to the free flow of capital. see Tobin tax.•Regional monetary Unions.•Currency pegs.

Financial markets are central

• Well functioning financial markets are a central feature of a modern market economy. They allow resources to be taken from people who do not need them or can not use them to people who need them and can use them.

• 1) they mobilize savings, 2) they allocate capital, to finance investment; 3) they pool risk and distribute risks to those who can bear them; 4) they monitor managers.

Financial markets are risky and fragile

• Financial markets are fragile and vulnerable. • They suffer from inadequate information.• Banks have short term liabilities in domestic or

foreign currency, which are payable on demand, while most of their assets are long-term, and subject to fluctuations.

• Financial markets are liable to wild swings in prices. They tend towards herd behaviour.

Capital flows in the global economy Capital flows in the global economy

Under Bretton Woods countries controlled their capital market. Free capital flows started to materialize

• with the Eurodollar market in the 1960s. After the end of Bretton Woods the situation gradually evolved with:

A) Liberalisation of financial markets. Scrapping of capital controls.

B) Innovation in financial instruments (Derivates etc.)

Today huge amounts of capital is exchanged every day on the foreign exchange market: in 2007 the daily volume of foreign currency transactions was $ 3.2 trillion.

Liberalization of capital markets in the 1980s and 1990s

• Since the late 1980s the IMF became a strong supporter of free capital markets: it advised countries that came under its influence to dismantle controls over cross-border lending and borrowing.

• The removal of capital controls would increase the demand for services from the City and Wall Street. The US and Britain pushed for capital liberalization.

Liberalization of capital markets in the 1980s and 1990s

• The EU during the 1980s turned towards capital liberalization. During the late 1980s capital controls had been removed in all the major European countries. Free capital movements were enshrined in the Maastricht Treaty.

• The OECD adopted free capital flows as part of it Code of Liberalization of capital controls. New member countries, such as Mexico and S.Korea, adopted the Code.

Global finance: new developments, opportunities

and risks• Today’s global financial movements are different from those

of the past, since they have no relation with international trade.

• Financial globalisation has made all national economies closely interdependent. It has also made available vast financial resources for developing countries.

• A large share of global finance consists of short term capital flows, which by definition are highly volatile and speculative. Speculators can attack currencies whose exchange rate is deemed to be non-credible.

Free capital flows

• Pros • They improve the global

allocation of resources• They provide an

incentive to governments to pursue sound fiscal monetary policy

• Cons• International capital

markets do not allocate resources efficiently. Speculators and investors tend to be irrational and short-term.

• Global finance is unregulated and lacks institutional support (standards, supervision, lenders of last resort.

Tobin tax

• Already in 1978 James Tobin (a Keynesian economist from Yale) criticized “excessive” financial capital mobility. These flows constrained the ability of governments to pursue adequate domestic economic policies.

• He recommended a tax on international currency transactions: consisting in a small levy on each transaction.

• Tobin met with considerable opposition but his suggestion is being reconsidered in the light of the recent massive global financial crises.

Financial crises: general outlineHow do they break out?

•Speculation fuelled by euphoria over the performance of a single sector or of a particular country’s economy (herd psychology)

•Rise in profits and in investment.

•Prices rise and the velocity of exchanges accelerates, generating a boom.

Financial crises: general outline

• At one point the bubble bursts. This can be the result of a single event such as a bank failure or a corporate bankruptcy. The large increase in prices and profits suddenly goes into reverse gear. Overreaction generates a “run on the countries”.Banks stop extending credit, and in fact demand payment for the credits they earlier had granted, i.e. there is a credit squeeze. Foreign capital moves out. Currencies are forced to devalue.

Financial crises 1970s- early 1980s: Crisis in developing

countries, especially Latin America.

Build-up of high debt levels with Western banks, which had used their lines of credit to recycle Petrodollars.

Starting in 1979, Paul Volcker, the Fed Chairman, raised interests drastically to fight US inflation.

International banks followed suit, raised interest rates and the unsustainable debt of many countries position was exposed.

Japan: crisis of the 1990s

• At the end of the 1980s real estate prices rose by three times, producing a real estate bubble. This uncovered one of the unspoken factors of the Japanese economic miracle, i.e. the power of big speculators, with ties to the criminal world as well as top politicians.

• Japan’s Central Bank responded first by raising interest rates and this determined a steep fall of house prices in 1991. This was not, however, accompanied by economic recovery, rather it was followed by a creeping recession.

• In the next stage, In the next stage, interest rates were loweredinterest rates were lowered, down to zero, in , down to zero, in order to jump start the economy. The State launched big public order to jump start the economy. The State launched big public expenditure programs, borrowing large quantities of money.expenditure programs, borrowing large quantities of money.

• The economy did not react as hoped. Japan’s economy was based on a low rate of private consumption. GDP growth rates remained low, below the economy’s growth potential. In other workds Japan had fallen into a deflationary trap.

Japan’s growth rate.

Japan’s economic crisis

• Japan’s economic problems were compounded by the fact that its banking sector became heavily indebted.

• Stagnation also meant a rise in unemployment, which reached 5% of the work force. Investment and consumption both were flat or negative.

• Reflationary policies proved too weak.• Reforming the economy proved difficult, because of

over regulation and structural rigidities.• Japanese society resisted steps towards

liberalization. The Japanese social model was called into question, but reforming it was slow and painful.

Japan’s economic crisis in the 1990s

• Two mistakes in economic policy (Krugman):• A) Government did not act consistently. In 1997 after a

few years of slow recovery, fears were raised about the rise in public debt due to government deficits and projected pension costs. As a result taxes were raised, growth was throttled and the country plunged again in recession.

• B) Politicians failed to address the real weakness which lay in the banking system. Banks had suffered from the fall in real estate stock and, following that, they had exposed themselves by lending to the State. Protracted recession compounded the problem.

• Recapitalization of the banks was carried out in 1998, with a State injection of $ 500 bn.

Japan recovers?

• First signs of recovery of the Japanes economy had to wait until 2003. In that year GDP grew by more than 2% and the deflationary spiral began to loosen.

• Japanese exports benefited from the rise in US trade deficit and from the strong performance of China. Big flows of Japanese FDI to China.Interest rates remained very low, leaving Japanese monetary policy almost defenceless against the new economic crisis of 2008.

Financial crises – 1990s

• 1992-3 Crisis in the European Exchange Rate Mechanism. (ERM). The Italian Lira and the pound sterling devalue.

• 1994-5, a boom in Mexico attracts short term capital flows from the US.In December 1994 the Mexican peso devalues, following an abrupt crisis of confidence in the Mexican economy. President Clinton leads a recovery effort, sustained by US Treasury funds as well as by the IMF. In 1995 Mexico’s GDP fell by 6%.

Financial crises –East Asia

• 1997-2000 – Crisis in South and South-east Asia. Possible background causes: growing Chinese competition with the exports of the Asian Tigers casts doubts on the durability of the boom. Overvaluation of Asian currencies.

The origins of the Asian crisis

• Asian economies had liberalized their capital markets since the early 1990s. This factor is seen by some as the origins of the subsequent financial crisis.

• Rapid capital liberalization was deeply unsettling to the paradigms of the Asian model, which was based on government “soft control” of the economy.

• Liberalization was not accompanied by regulation, i.e. by new rules and standards to govern capital markets (for example transparency, reserve requirements for banks etc).

• The combination of semi-fixed exchange rates (dollar peg) and capital liberalization was also potentially deeply unsettling.

The origins of the crisis • The Asian capitalist model is different from the

American or European models. Although each country had its own specific features, there were some common trends. The Asian model can be described as a developmental State, based on close links between the government, banks and other businesses in the industrial and service sectors. Often loans were granted on a personal basis, on the basis of close connections hence the term “crony capitalism”. A more benign interpretation speaks of “alliance capitalism”.

• Bad loans of Asian banks had reached astronomic proportions.

The origins of the crisis

• There was a strong resistance to liberalization of inward flows of FDI, which possibly aggravated the crisis. South Korea for example, even after the crisis has broken out, ruled out allowing its banks to borrow long-term, rather than short term. Although short term debts were one of the keys to the current crisis, long term borrowing meant leaving the door open for FDI to penetrate the S. Korean economy.

• Many bad or dubious debts were concealed to everybody until the end.

Asia’s financial crisis: 1997-8

• Japan had already incurred into financial and economic difficulties since the early 1990s. Japan’s crisis had originated from bad loans of its banking system and had developed into a full scale recession, with a protracted fall in the economy’s demand.

• Speculation on shares is hit by a crisis of confidence. In the preceding decade, high growth rates had been customary for South East Asian countries. This record of success prevents a stronger reaction to the crisis.

Asia’s financial crisis: 1997-8

• Throughout the 1990s East Asia was booming. Large inflows of foreign capital, about $90 bn. a year of short term capital fuel the boom, plus FDI inflows as well.

• By 1997 prosperity brought its own problems, there was rising prices and exports from East Asia faltered.

• Banks were becoming highly indebted. There was a real estate bubble. At this point investors got nervous and started moving out their capital from these countries.

• This generated a sell-off. Currencies devalued. Stock markets collapse and the real estate market crumbled.

• The outflow of foreign capital from Indonesia, Maleysia, the Philippines, S. Korea and Thailand in 1997 was $12 bn. From net creditors they turned net debtors (-$100bn ,io.e 10% of their combined GDP).

Chronology of the Asian financial crisis

Thailand had benefited from dollar and yen loans, converted into baht to speculate in local real estate and other assets. International banks and hedge funds poured money into Thailand. By 1996 doubt began to creep in: were these loans secure? Selling of baht assets into dollars commenced. To counter the impending crisis and maintain the value of the baht, the Thai central bank raised interest rates. However higher interest rates reduced the demand for real estate and brought prices down. Selling of the baht increased and the Bank ran out of dollars to support the baht.

July 1997- Thailand dropped the baht-dollar peg, leaving the bath free to float

August 1997- The IMF grants a 17 billion dollar loan to Thailand. Indonesia prime minister blames foreign speculators for the crisis

October 1997. The Hong Kong stock market falls by 25% over just 4 days and a few days later falls by another 5%. Shares fall all over the world, including on Wall Street. The IMF approves a rescue package of 42 billion dollars for Indonesia.

November 1997: The crisis spreads to Brazil. The South Korean currency, the won, crashes. In Japan Yamaichi Securities collapse, revealing how the acute problems of the Japanese economy have not been solved.

December 1997 . Fears for the South Korean economy dramatize the crisis. The IMF grants a huge bailout loan of 58 billion $ to South Korea.

January 1998. The IMF and the Indonesian government agree on a package of economic reforms while Indonesia sinks deeper.

April 1998. Signs of crisis in Japan. New agreement between the IMF and Indonesia. The US Congress criticizes the IMF’s role in the Asian crisis.

May 1998. Student revolts in Indonesia. Amidst further economic trouble, the Indonesian president, Suharto, resigns.

January 1998. One of the most important investment banks in Hong Kong, Peregrine Investments Holding folds. However despite renewed heavy losses on the stock markets in the entire region, the Hong Kong dollar resists.

Monetary policy in H.K is managed through a Currency Board, which backs the money supply with of US dollars. Also China is prepared to support the Hong Kong dollar with its own vast monetary reserves. Speculators retreat. 

May 1998: devaluation of the ruble. Bad news from Russia sparks a wave of panic on world markets, with a sharp fall in Wall Street. Brazil’s currency, the real, comes under attack

October 1998. The IMF, strongly backed by the US Treasury, grants Brazil a huge, 40 bn. $ loan, demanding a change in Brazil’s economic policy and further market reform.

January 1999: failure by Brazil to carry out economic reform leads to a 35% devaluation of the real and the flight of investors.

China and India escaped the crisis. Their capital markets had remained closed

Asian financial crisis: 1997-8

•Exchange rates in Asia were semi-fixed and pegged to the dollar.Countries did not have the credibility however to maintain their dollar peg, and this encouraged speculators.

• Governments acted to defend their overvalued exchange rates by raising interest rates. This hurt domestic businesses, while international investors were facilitated.

•There was a flight of capital away from local currencies to the dollar, pushing them to devalue.

•Domestic banks were exposed, having taken out large dollar loans; a weaker domestic currency meant paying a higher dollar rate.

• Moreover they had borrowed short and loaned long-term to domestic businesses.

Asian crisis: the IMF steps in.

• The IMF followed a bailout strategy. It granted substantial loans to the countries hit by the crisis and at the same time it imposed upon them a strict medicine of structural reforms. Ailing banks and firms were shut down.

• The economies were supposed to eliminate any remaining barrier to foreign capital. Budget discipline meant drastic cuts in expenditure. Cuts in subsidies hurt the poor and caused social unrest.

Asian crisis: the IMF steps in

• The IMF prescription included the following elements:• Cuts in public expenditure• Higher interest rates• Currency revaluation and stabilization• Structural reform, especially bank mergers.• Improvement in accounting standards• Opening the market to foreign acquisitions.• Cuts in subsidies. • The IMF package caused deep resentment in many

South Asian countries. Many countries resisted to what they saw as US-inspired measures to destroy the Asian model.

Debates and recriminations

Was the IMF prescription correct?

According to Stiglitz the Asian crisis was different from the financial crises in Latin America during the 1980s. Whereas in Latin America the problem had been inflation and debts in the public sector, in Asia public finances were in good shape, whereas the corporate sector was badly in debt.

The solution therefore should have been different, and should not have included budget cuts and austerity measures. It should have, instead, concentrated on macro-economic stability, and in corporate restructuring.

Rather than imposing austerity, the IMF should have let corporations pay the price of their profligacy, by allowing exchange rate devaluation. Interest rates should not have been raised.

Financial crisis in Asia: debate

Left wing critics: They blame the IMF for its arrogance and insensitivity and for its neo-liberal ideological approach. The IMF proved to be the tool of international finance, and its prescriptions followed the wishes of the US government and Wall Street.

Right wing, free market critics, the IMF should not have spent so much money bailing out speculators.

Financial crisis in Asia: debate

The IMF defence. Only a strong IMF package stopped the crisis from damaging the entire world economy.

According to Martin Wolf the IMF was made the scapegoat, while responsibility for bad economic management rests with governments.

It is reasonable and consistent that the IMF should follow to a certain degree the will of its paymasters, i.e. the lending nations. If it were to act otherwise creditors would stop funding it and would seek to manage their relations with debtor countries bilaterally.

Proposals and remedies.

Gilpin believes that short term capital flows should be regulated. A tax could be levied to discourage speculation. Other observers think this solution – called the Tobin tax -both impractical and unreasonable.

The Asian crisis highlighted the need for better international rules. Prescription on bank reserves were introduced through the Basel convention. Proposals were floated for an international bankruptcy procedure.

It remains true that the international financial system is the weakest link in the global economy and that its governance is very weak and contested.

Outcome of the crisis

• Of the five most affected countries, Malaysia, the Philippines, S. Korea, Thailand, Indonesia, in 2001 only Indonesia had failed to recover previous GDP levels.

• South Korea, on the other hand, had experienced GDP growth of over 20% on its pre-crisis level. The aggregate GDP level of the five was 13% higher than in 1996.

• The quick recovery suggests that the crisis was mainly financial. Economic fundamentals were not to blame. Global finance is a factor of instability (Roderick)

Argentina 2001

• Argentina had pegged its currency to the dollar, but the peso weakened and to sustain the peg it was necessary to raise interest rates, causing an economic recession.

• An aggravating factor was the fact that the Brazilian currency depreciated against the dollar, as did the euro, causing all kinds of problems for Argentinean exports.

• The peg could not be sustained, and the currency was devalued and following from that there the country defaulted on its debts.

The 2007-2010 crisis. The origins.

• Long term. Structural imbalances in the world economy, with USA and China.

• Greenspan’s two bubbles:• A) The new economy bubble (dot.com) burst in 2000

determining a sharp fall in the stock market and a domestic and international recession. The Fed reacts with aggressive cuts interest rate cuts.

• B) The real estate bubble was a consequence of very low real interest rates after 2001. There was a boom in risky mortgage lending. Dubious loans were securitized as widely traded instruments. Speculative activity was fuelled by the rise in prices.

The 2007-2010 crisis. The origins.

• The financial crisis in the US was centered, at least initially, not on the big commercial banks, but on the informal or shadow unregulated financial sector, (hedge funds, futures, money markets and corporate bond markets), where a huge amount of transactions was carried out. The size of the informal market in 2007 amounted to various trillion dollars, much larger than the formal banking sector. Also the big investment banks Goldman Sachs, JP Morgan, Lehman) were heavily involved in it.

• After the Great Depression, up until the 1980s, the majority of financial transactions were carried out by institutions supervised by the FED.

• After the 1980s, a parallel market without formal rules and no supervision, highly leveraged, had grown in size and importance.

The financial crisis spreads.

• The growth in short term capital movements has encouraged the spread of the crisis in many countries, with serious effects in some emerging economies. Iceland, the Ukraine, the Baltic States all requested IMF help. Other countries followed

The crisis and the lessons of the past.

• The current crisis includes a number of features of the previous financial crises.

• A) the real estate bubble (Japan, end of the 1980s)

• B) collapse of the financial system (Great Depression 1929-31)

• C) deflationary trap in the USA and in Western Europe (Japan 1990s)

• D) waves of international speculative hot money and competitive devaluations. (South East Asia, 1997-1999)