The Current Financial Crisis and its Impact on Emerging Markets LILIANA ROJAS-SUÁREZ Interamerican Development Bank Washington DC, May 2008

The Current Financial Crisis and its Impact on Emerging

Markets

LILIANA ROJAS-SUÁREZ

Interamerican Development Bank

Washington DC, May 2008

Hypotheses about the Origin of the Current Financial Turmoil

• Highly expansive monetary policy in industrial countries.

• The persistence of global macroeconomic imbalances.

• Technological developments in financial markets, which led to the creation of complex instruments.

• Insufficient transparency of non-bank entities’ operations and off-balance sheet bank operations.

• Inadequate regulation for the current sophisticated financial and equity markets.

Hypotheses about the Origin of the Current Financial Turmoil

ALL the advanced hypotheses are part of the problem. But there is one more:• A not-yet learned lesson: capital markets

complement, not substitute the banking system.

All financial crisis are characterized by the presence of incentives for excessive risk taking.

The Crisis: Policies and Incentives

Excepting the period 2005-2006, monetary policy has remained expansive in industrial countries (with periods of negative real interest rates).

US Fed Funds Rate (%)

-4

-2

0

2

4

6

8

2000

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-IMF and FED.

Japan Overnight Call Rate (%)

-0.2

0

0.2

0.4

0.6

0.8

1

2000

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-IMF and Central Bank of Japan.

c

Euro Area Main Refinancing Rate (%)

-1

0

1

2

3

4

5

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-FMI andEuropean Central Bank.


The main reasons that prevented a restrictive monetary policy in the US:

• The vulnerability of the economic recovery after the 2001 recession, especially in the context of geopolitical risks.

• Low inflation expectations.

The Crisis: Policies and IncentivesDespite the stock markets crash in 2001, monetary policy stabilized real

consumption growth in the period 2000-2006, through its effects on the consumers’ wealth. This was possible because of the large increase in housing prices associated with low interest rates.

Over the last decade, consumption has offset declines in investments. This responds to the consumers’ perception of greater wealth, through the value of stocks at first and then through the value of real state.

GDP, Consumption and Investment Growth (%)

-4

-2

0

2

4

6

8

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Consumption Investment GDPSource: Bureau of Economic Analysis


The large global liquidity (low interest rates) created incentives for:

• The aggressive expansion of financial non-bank intermediaries (mortgage lenders, hedge funds) with increasing demand for high-yield assets.

• The use of financial products that “saved” capital for banks through “securitization”. (Under Basel I, mortgages held on banks’ balance sheets are subject to a 50% capital charge. There is no capital charge when mortgages are sold to a SIV.)

• The use of housing equity to get individual funding (home equity loans).

In contrast to the 2001 crisis, in 2008 the American consumer is highly indebted.


The Mortgage Loans Expansion in the Industrial World

Before:

Traditional Relationship between Borrower and Creditor

Bank

Borrower

- Pays interest and

principal

- Lends money

- Manages delinquencies


The Mortgage Loans Expansion in the Industrial World

Now: Mortgage Broker

Creditors:

Banks and others BorrowerLoan

Servicer Monthly payments

Issuer of Structured

Products -securities- (SIV)

Monthly payments

Loan Cash

Investors (investment banks,

hedge funds, pension funds,

mutual funds, etc.)

Cash Securities Monthly payments

Fuente: Shéila Bair, FDIC

Trustee

Underwriter

Rating Agencies

Insurers (monolines)

The Crisis: Policies and Incentives• The system, though complex, can work if risks are correctly

assessed.• The problem is that under conditions of large liquidity, the

quest for “returns” encourages excessive risk taking and exposes the system’s vulnerabilities:– Market participants that work for fees (mortgage brokers, payments

receivers) don’t have incentives to monitor the quality of loans, only to increase the quantity of loans.

– The same thing happens with the credit rating agencies which supply “ratings” for the structured products and do not face any financial responsibility to cover losses from their mistakes.

– Regulatory Arbitrage: different financial institutions undertaking similar activities face different regulations (especially capital requirements).

– Principal-Agent Problem: huge disparity in traders’ maximum loss (zero bonus) vs. investors’ losses (the full capital invested).


• But the largest problem is that, if an adverse shock to the system occurs (in this case, the generalized fall of housing prices), all the involved financial institutions lose capital.

• Because banks provide liquidity to capital markets and hold structured products as assets, a complex system in crisis might collapse to the simple system: bank-borrower.

• This trend is already happening:– Banks have absorbed many SIVs into their books.– Banks faced pressures from authorities to finance insurers

(monolines).– Many mortgage brokers have declared bankruptcy.

Would Basel II Helped Prevent the Crisis?

Most likely not!• Under the “Standardized Approach” Basel II emphasizes the

reliance on external credit ratings. The current crisis has seriously questioned the credibility of these agencies for the adequate assessment of risks.

• For large and sophisticated banks, Basel II relies on the banks’ internal risk models for assessing credit risk. During the current crisis, large banks were heavily affected using their own internal models!

• Because of the large demand from investors for mortgage-backed structured products, a reduction in capital charges (from 50 to 35 percent in Basel II for mortgage held on banks’ balance sheets) would not have prevented excessive securitization.

• Basel II does not properly take into account liquidity risk. Funding for SIVs collapsed when doubts about the quality of their assets emerged. Under huge liquidity constraints, many SIVs were forced to sell their assets at very low prices.

And Moving Forward?

Under current circumstances, when the value of the fundamentals is adjusting (the decrease in housing prices)…

Housing Prices (% annual change in S&P - Case Shiller Index)

-10

-5

0

5

10

15

20

2003 2004 2005 2006 2007

Source: Thomson Datastream

CME Housing Prices Futures (contract mid price)

140

150

160

170

180

190

2008 2009 2010 2011 2012

Source: Chicago Merchantile Exchange; Bloomberg

And Moving Forward?

… The system’s equilibrium involves a lower size of the banking system (according to the available capital)…

… And that’s already happening.

Market Capitalization ($bn)

0 50 100 150 200

HSBC

Santander

UniCredit

Intesa Sanpaolo

BNP Paribas

BBVA

Sberbank

RBS

UBS

Société Générale

Deutsche Bank

Barclays

Mar 5 2008 Jan 1 2007Source: Thomson Datastream

And Moving Forward?With a lower lending capacity to corporations (affecting

investment) and with a poorer consumer (decrease in wealth), the chances of a prolonged US slowdown or recession are very high.

Consumer confidence is at levels of past recessions.

University of Michigan Consumer Confidence Index

40

50

60

70

80

90

100

110

120

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Source: University of Michigan

Effects of the Current Financial Turmoil on Emerging Markets

Up to now, the effects of the financial turmoil in industrial countries on emerging markets have been:

– Mild and mostly limited to financial variables

– Different between regions and between countries

– HAVE NOT BEEN AN OBSTACLE TO THE CONDUCT OF FISCAL AND MONETARY POLICY

Effects of the Current Financial Turmoil on Emerging MarketsA most important current feature of many emerging markets is their

ability to tighten monetary policy -increase interest rates- in the presence of inflationary pressures.

Source: Central Banks and IFS-IMF

Czech Republic

1%

2%

3%

4%

5%

6%

7%

8%

J an-06 May-06 Oct-06 Mar-07 Aug-07 J an-08

Inflation P olicy rate

Chile

1%

2%

3%

4%

5%

6%

7%

8%

9%



China

%

1%

2%

3%

4%

5%

6%

7%

8%

9%



Colombia

3%

4%

5%

6%

7%

8%

9%

10%



South Africa

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%



South Korea

1%

2%

3%

4%

5%

6%



This contrasts with monetary policy in industrialized countries where fears of a significant slowdown in economic growth are keeping interest rates low and decreasing…

… in spite of expectations of higher inflation.

Effects of the Current Financial Turmoil on Emerging Markets

Inflation

%

1%

2%

3%

4%

US Euro Area Japan

2007 2008FSource: Market Forecasts

Interest Rates Forecasts

%

1%

2%

3%

4%

5%

6%

2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4

US Fed Funds Rate ECB Refinance Rate Bank of Japan Call Rate

Source: Market Forecasts

What Factors might weaken the Performance of Emerging Markets?

• Severe and protracted recession in the US / Banking crisis (a mild recession is already priced in).

• High inflation leading to increases in industrial countries interest rates (more relevant in 2009).

• The China factor and the sustainability of high commodity prices.

The External Risks affecting Emerging Markets

1. US Recession / Banking Crisis– Without doubt the worst case scenario for global growth and

emerging markets performance is a systemic banking crisis in the US.

– This worst case scenario can only materialize if the US enters in a vicious circle where:

severe decline in the value of banks’ assets loss of bank capital

credit crunch financing problems in corporations and non-bank

financial institutions recession increase in severity of bad

banks’ assets banking crisis prolonged recession

– This is still a relatively low probability scenario, however, because the Fed and the Treasury are currently aligned to prevent its occurrence.


1. US Recession / Banking Crisis– While a mild US recession would find emerging markets in

good standing, a severe and prolonged recession would increase risk aversion, hurting investment inflows to emerging markets.

Foreign direct investment tend to decline sharply in the face of global slowdowns.

Global Foreign Direct Investment (as % of GDP)

-2%

0%

2%

4%

6%

8%

10%

12%

1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: IFS - IMF.

The External Risks affecting Emerging Markets1. US Recession / Banking Crisis

– Trade flows would also be affected, especially if the US financial troubles expand to other industrial countries, particularly Europe (some markets estimations calculate that UK residential properties are 30% overvalued).

Export growth has suffered the most in periods of global slowdowns.

– Re-emerging calls for trade protectionism in the US exports are also a potential threat for emerging markets exports.

Global Real GDP and Merchandise Export Volume (Annual % change)

-5

0

5

10

15

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Real GDP Merchandise Export VolumeSource: WEO - IMF.


2. The Costs of Preventing a US Financial Meltdown: Inflation– Concerns about inflation are keeping long-term interest rates high.

– A medium-term risk (2009 onwards) is a sudden increase in interest rates in industrial countries to contain inflation.

– This risk, which will affect emerging markets financing costs, has a low probability under current circumstances, when fears of a prolonged recession in the US is the main driver of monetary policy.

Fed Funds Target Rate and Corporate BAA Rated

1%

2%

3%

4%

5%

6%

7%

8%

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08

Federal Funds Target Rate Corporate BAA RatedSource: FED


3. A Decline in Commodity Prices?

Although, as stated before, global exports are at risk in the face of a US-led global slowdown, the sustainability of high commodity prices is less risky in the short and medium-term due to two factors:

A. Cyclical

– There is an inverse correlation between the value of the dollar and the price of commodities.

– This is because commodities (especially oil and gold and food, more recently) are perceived as a hedge against dollar weakness and the risk of inflation.

Nominal Dollar Broad Index (traded weighted) and CRB Commodities Index

80

90

100

110

120

130

140

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

150

200

250

300

350

400

450

500

550

Dollar Index CRB CommoditiesSource: FED and CRB.

The External Risks affecting Emerging Markets3. A Decline in Commodity Prices?

A. Cyclical

– … and the dollar is expected to depreciate further, especially with respect to Asian currencies. Recent policy signals by the Chinese authorities to control inflation point towards further increases in interest rates in China and further appreciation of the RMB against the US dollar.

JPY per USD: Spots and Forwards

80

90

100

110

120

130

140

2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: JP Morgan

Forw ards


3. A Decline in Commodity Prices?B. Structural Factors

– China, a major importer of many commodities -second importer of oil-, will continue a strong path of growth in the coming years.

– Supply problems in the precious and industrial metals are a long-term issue, especially given South Africa’s power crisis (SA produces 69% of platinum, 30% of palladium and 18% of world’s supply of gold). Supply problems of aluminum are also large.

– Land and water constraints supporting high prices for agricultural commodities.


B. Structural Factors

– And the markets are forecasting a continuation in the upward trend of major commodities prices.

Aluminum prices: Spots and Futures

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

2002 2003 2004 2005 2006 2007 2008 2009 2010U

SD

per

met

ric

ton

Source: IFS-IMF and LME

Futures

Gold prices: Spots and Futures

200

400

600

800

1000

1200

2002 2003 2004 2005 2006 2007 2008 2009 2010

US

D p

er t

roy

ou

nce

Source: IFS-IMF and NYMEX

Futures


Also oil prices will remain high, supported by: (a) China’s strong demand, (b) ageing infrastructure leading to unplanned outages and (c) climate change leading to extreme weather conditions.

Future prices anticipate a modest decline, but these prices have not been effective predictors of oil returns in the past.

Oil Prices: Spots and Futures

0

20

40

60

80

100

120

140

2002 2003 2004 2005 2006 2007 2008 2009 2010

US

D p

er b

arre

l

Spot Future Sep-04 Future Apr-05 Future Oct-07 Future May-08

Source: IFS-IMF and NYMEX

In Conclusion

• Prospects in the industrial economies (especially in the US) aren’t encouraging in the short-term.

• The good news is that, at least in the short-term, investors are increasing their investments in commodities and emerging markets.

• The bad news is that if the financial problems remain severe and prolonged, there will be adverse effects on the sustainability of growth in emerging markets.

Documents

The Current Financial Crisis and its Impact on Emerging Markets LILIANA ROJAS-SUÁREZ Interamerican Development Bank Washington DC, May 2008