THE GLOBAL ECONOMIC CRISIS: SYSTEMIC FAILURES AND MULTILATERAL REMEDIES Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation.

THE GLOBAL ECONOMIC CRISIS: SYSTEMIC FAILURES

AND MULTILATERAL REMEDIES

Report by the UNCTAD Secretariat Task Force on

Systemic Issues and Economic Cooperation

The Myth of Decoupling

Figure 2.4EQUITY MARKET DOLLAR RETURNS, 2008

-80 -70 -60 -50 -40 -30 -20 -10 0

Russian FederationTurkeyChinaIndiaIndonesiaRepublic of KoreaBrazilArgentinaPhilippinesEmerging marketsUnited KingdomHong Kong, ChinaSouth AfricaFranceGermanyMalaysiaMexicoG-5 (average)ColombiaUnited StatesJapan

Dollar return (per cent)

Source: UNCTAD secretariat calculations, based on stocks and markets data from Thomson Datastream.

A Crisis Foretold

Proximate cause:We built too many houses

What really went wrong: Inexistent global monetary system Weak regulatory regime

Global imbalances fed many bubblesFighting the last crisis?

Bad idea if each crisis is different from the previous

But are they different?Avoid regulatory cycles

Learn from “near misses”

The subprime credit collapse highlighted the exposure to risk in many areas and triggered the sudden unwinding of

speculative positions in different markets

Subprime Credit Collapse

Finanacial Market

Commodity Market

Currency Market

Unwinding of speculative flows

• Uncertainty associated with the subprime crisis generated a sudden unwinding of speculative position in many markets

• The Report highlights three specific areas in which global markets experienced systemic failure:

•Financial markets•Commodities markets•Currency markets

Responses:– Firefighting:

•Inflation is not the main risk right now– Expansionary policies are necessary

•More coordination in conducting such expansionary policies

– Countries that have more space to adopt expansionary policies should do more

•Avoid procyclical policies in developing countries by providing the necessary financial resources

Responses:– Long term issues (but to be tackled now):

•Rethink financial regulation– Both domestic and international

•Build a coherent monetary system aimed at avoiding competitive depreciations

– Multilateral code of conduct»Avoid excessive exchange rate volatility»Target PPP

•Build a system for the stabilization of commodity prices

7 Lessonsfor Financial Regulators

1 Focus on the Right Definition of Financial

Efficiency• Five possible definitions (Tobin, 1984)

– Information arbitrage efficiency– Fundamental valuation efficiency– Full insurance efficiency– Transactional efficiency– Functional or social efficiency

• From the point of view of a regulator, social efficiency should be the only relevant definition of efficiency

• Several financial products can yield large private returns but have no social return

• Key objective of regulatory reform:– Do not stunt financial innovation but weed out

financial instruments which increase risk but have no social return

Large Private Returns, But Where Are the Social

Returns?• In 1983, the US financial sector generated 5 per

cent of the nation's GDP and accounted for 7.5 per cent of total corporate profits.

• In 2007, the US financial sector generated 8 percent of GDP and accounted for 40 per cent of total corporate profits.

• In the meantime, the US financial sector had to be bailed out 3 times in three decades– Tobin (1984) “There must be something wrong with an

incentive structure which leads the brightest and most talented graduates to engage in financial activities remote from the production of goods and services”

– Rodrik (2008) “What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?”

Pure Gambling

Figure 2.3OUTSTANDING CREDIT DEFAULT SWAPS, GROSS AND NET NOTIONAL AMOUNT

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

October 2008 November 2008 December 2008 January 2009

$ bi

llion

Net exposure

Gross minusnet exposure

Source: UNCTAD secretariat calculations, based on data from the Depository Trust and Clearing Corporation.

2 Market-Based Regulation Does Not Always Work

• There are flaws with the assumption that markets know best and regulators should not try to second guess them– Regulation is necessary because markets sometimes

do not work. – How can one avoid market failures by using the

same evaluation instruments used by market participants?

– Market-based risk indicators (such as high-yield spreads or implicit volatility) tend to be low at the peak of the credit cycle, exactly when risk is high

33 Guaranteeing the Safety of Guaranteeing the Safety of Individual Banks Is Not EnoughIndividual Banks Is Not Enough

• This is a fallacy of composition because actions that are good and prudent for individual institutions may have negative systemic implications– Problems with mark-to-market accounting– Problem with ratings

• Macroprudential regulation needs to complement microprudential regulation– It can work like a system of automatic stabilizers

which is also good for political economy reasons

4 Avoid Regulatory Arbitrage

5

10

15

20

25

30

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Leve

rage

Banks Financial services Life insurance

Figure 2.1LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR

Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream.Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average.

Asset backed securities issuers

4.1

Brokers and dealers

2.9

Finance companies

1.9

Government sponsored enterprises

7.7

0

2

4

6

8

10

12

14

16

18

Market based Bank based

$ tr

illio

n

Credit unions 0.8

Savings institutions

1.9

Commercial banks10.1

Figure 2.2THE SHADOW BANKING SYSTEM, 2007, Q2

Source: Shin (2009).

Each institution can be a source of systemic riskProviders of financial products should be supervised on the basis of the risk they produce

If an investment banks issues insurance contracts like CDS, it should be supervised like an insurance companyIf an insurance company is involved into maturity transformation, it should be regulated like bank

4 Avoid Regulatory Arbitrage

55 International Cooperation

• Data sharing– No data on cross-border exposure among banks and

derivative products– Need to develop a system for evaluating cross-

border systemic risk• Need to agree on regulatory responsibility for

banks and other financial institutions with an international presence

• Avoid races to the bottom– But no common regulatory system– Increase the participation of developing countries in

standard-setting bodies and agencies in charge of guaranteeing international financial stability

6 Adjust Incentives in The Financial Industry

• Pay structure• Credit rating agencies

7 Lessons for Developing Countries

• Protect yourself– Avoid appreciations– Accumulate reserves

• But they are never enough

– Avoid currency and maturity mismatches– Can open capital account deliver the goods

with a well-regulated financial system?• But who has a well-regulated financial system?

7 Lessons for Developing Countries

• Developing countries are often characterized by a non-competitive financial system in which banks make good profits by paying low interest on deposits and charging high interest rates on loans, which they only extend to super-safe borrowers

• Financial development is good – But it can also increase vulnerabilities because it

alters the incentives structure of the various players within the financial system

– Developing country regulators should develop their financial sectors gradually to avoid boom and bust cycles

7 Lessons for Developing Countries

• There is no one-size fits all financial regulatory system– We now realize that good financial

regulation is very difficult to implement. – Thus, there may be a trade off between

financial sophistication and stability• Countries with more ability to regulate and that

are better prepared to absorb shocks may allow a faster process of sophistication of the financial system

• Other countries may want to be more cautious

THE GLOBAL ECONOMIC CRISIS: SYSTEMIC FAILURES

AND MULTILATERAL REMEDIES

Report by the UNCTAD Secretariat Task Force on

Systemic Issues and Economic Cooperation

Commodities

Financialization of Commodity Futures Trading

• The build-up and eruption of crisis in the financial system was paralleled by an unusually sharp increase and subsequent strong reversal of the prices of internationally traded primary commodities

• The strong and sustained increase in primary commodity prices between 2002 and mid-2008 was accompanied by a growing presence of financial investors on commodity futures exchanges (“financialization” of commodity markets)

0

5

10

15

20

25

30

35

40

45

50

Dec.1993

Dec.1995

Dec.1997

Dec.1999

Dec.2001

Dec.2003

Dec.2005

Dec.2007

Source: BIS, Quarterly Review , March 2009, table 23B.

Figure 3.2FUTURES AND OPTIONS CONTRACTS

OUTSTANDING ON COMMODITY EXCHANGES, DECEMBER 1993–DECEMBER 2008

(Number of contracts, millions)

0

2

4

6

8

10

12

14

Dec.1998

Dec.2000

Dec.2002

Dec.2004

Dec.2006

June2008

Other commodities

Other precious metals

Gold

Source: BIS, Quarterly Review , December 2008, table 19.

Figure 3.3NOTIONAL AMOUNT OF OUTSTANDING OVER-

THE-COUNTER COMMODITY DERIVATIVES, DECEMBER 1998 – JUNE 2008

(Trillions of dollars)

• Strong correlation between the unwinding of speculation in different markets that should be uncorrelated

• All participants react to the same kind of information

Correlations between the Exchange Rate of Selected Correlations between the Exchange Rate of Selected Countries and Equity and Commodity Price IndexCountries and Equity and Commodity Price Index

y = -1E-05x + 0.0463

R2 = 0.9561

0.014

0.016

0.018

0.020

0.022

0.024

0.026

0.028

1723 2223 2723 3223

Reuters Commodities Price Index

y = -2E-05x + 0.0443

R2 = 0.9222

0.014

0.016

0.018

0.020

0.022

0.024

0.026

0.028

752 952 1152 1352

S&P 500 Composite Equity Price Index

NEW ZEALAND DOLLAR TO JAPANESE YEN

BRAZILIAN REAL TO JAPANESE YENJune 2008–December 2008

y = -7E-06x + 0.0325

R2 = 0.9576

0.012

0.013

0.014

0.015

0.016

0.017

0.018

0.019

0.020

1723 2223 2723 3223

Reuters Commodities Price Index

y = -1E-05x + 0.031

R2 = 0.9057

0.012

0.013

0.014

0.015

0.016

0.017

0.018

0.019

0.020

752 952 1152 1352

S&P 500 Composite Equity Price Index

Financialization of Commodity Futures Trading

• Regulators need access to more comprehensive trading data in order to be able to understand what drives prices and, if necessary, intervene

• Key loopholes in regulation need to be closed to ensure that swap dealer positions do not lead to ‘excessive speculation’

Exchange Rates

Currency Speculation and Financial BubblesCurrency Speculation and Financial Bubbles

The uncertainty associated with the subprime crisis generated an unwinding of speculativespeculative currency positions

- causing large depreciation of former high-hielding currencies

70

80

90

100

110

120

130

Ind

ex

Nu

mb

er

Hungarian Forint Brazilean Real Mexican Peso Czech Koruna

Currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate

Yen Carry trade on the Icelandic Krona and the Brazilian Real

Krona

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

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2005 2006 2007 2008

Per

cen

t

Uncovered interest return

Nominal exchange-rate change

Interest rate differential

Real

-10

-8

-6

-4

-2

0

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2005 2006 2007 2008

Per

cen

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Uncovered interest return

Nominal exchange-rate changeInterest rate differential

Exchange Rate Regimes and Monetary Cooperation

• Speculation through carry trade pushes exchange rates in the “wrong” direction– The case for reform of the current global non-system draws

from the distorting influence that the present monetary chaos exerts on the effectiveness of international trade

– The new system should be based on just one exchange rate/price adjustment rule: nominal exchange rate changes should follow the difference in the price levels of the trading partners

– This can ensure a level playing field through stable real exchange rate

• Standards and transparency• Financial regulation and supervision • Management of the capital account• Exchange rate regimes• Surveillance of national policies• Provision of international liquidity• Orderly debt workouts

2) Reform of the financial architecture

1) Crisis management

“The Global Economic Crisis: Systemic Failures and Multilateral Remedies”

Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic

Cooperation