Part 3 finance class summer 2010 forum nexus

Class #3Tuesday in Spain

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes at the university Faculdade Boa Viagem.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

[email protected]

LinkedIn/briandbutler

Skype: briandbutler

Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets.

http://globotrends.pbworks.com/ , http://blog.globotrends.com/

Lecture Schedule*

* Does not include professional visits, *Subject to change, modification without warning

•Tues 22th – boat to Greece

•Mon 26th – Athens

•Tues 27th – Rhodes•Wed 28th – Rhodes•Thurs 29th – Rhodes EXAM

Observations while in Spain…

•For next 2 classes –

•Each student - tell one thing about Spanish economy they noticed so far + class discuss

•Note: observations should come from reading (wall street journal, etc)… any other sources?

Spain & the Crisis:

What risks do you see going forward?

SpainCrisis, recovery, EU, Euro

Economist Intelligence Unit, Country Report, Spain, June 2010

Where are the major regions of Spain? - Industrial? Government? Tourism?

Economist Intelligence Unit, Country Report, Spain, June 2010

Next questions:

1. Which regions richest? Poorest?

2. Where is unemployment highest?

Spain review

•Crisis & recovery in Spain --

•Spain can not control monetary policy (lower interest rates). Who can explain? What is the impact on Spain? How was it different before Spain joined the Euro-zone?

Discussion on Spain…

•Post crisis – ▫How can Spain regain competitive edge?

▫Why doesn’t Spain drop out of Euro?

▫What is the risk or leaving?


▫competitive devaluations. ▫Productivity, pay cuts. ▫Danger of civil unrest.


•Risk is in 1-2 years from now, when inflation picks up, and if the ECB is forced to raise interest rates BEFORE Spain's economy picks up.

•Who can explain this risk?


•If Spain’s economy is still slow, and if rates go up, it could choke off recovery (politically raising anger v ECB, euro)

Recent news…

•“The Spanish stock market is one of Europe’s worst performers, having fallen by around a third, in dollar terms, since the start of 2010.”

•Why? Discuss…

http://www.economist.com/displaystory.cfm?story_id=16216443

Key points to highlight…1. Dual structure – labor market

▫ Who can explain?▫ Why important for crisis?

2. Dual structure – banking market▫ Banks / cajas (caixas)▫ Who can explain?▫ Why important for crisis?

▫ EXAM material!!

Dual Labor Market•Temp:

▫High unemployment▫Young, ▫Immigrants▫University grads

•The rest enjoy a high level of job protection which politicians dare not dismantle.

•Risk = political backlash if crisis is LONG (if recovery takes YEARS not months)

Economist.com, A special report on the euro area, Jun 11th 2009

Temp workers –during the boom

• The spread of fixed-term employment contracts in Spain (from the mid-1980s) helped make hiring and firing more responsive to the business cycle.

• Benefits:▫ Immediate pay-off: it created jobs. ▫Firms were content to take on temporary

workers, often immigrants, because they knew they could easily lay them off again.

• Growth▫Before the crisis hit, temporary jobs accounted

for more than a third of Spain’s total, the largest share in the EU.


Temp workers - crisis•Unfair:

▫“The downturn has highlighted the gross unfairness of the dual labour market.

▫It puts the burden of adjustment on groups with no tenure (women, immigrants and the young).

•Future ▫Firms have little incentive to train tomorrow’s

workforce. Instead they are stuck with older, tenured workers heading for retirement.

• less than 5% are converted into permanent jobs.


Dual Banking system – banks + Cajas

•Prediction: ▫“the banking crisis will hit Spain...

but not with the Big 2 banks of BBVA & Santander, but rather with the many small "cajas", or regional banks that lent heavily to the construction sector”

The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009

Cajas

•Spain’s cajas are mutually owned and controlled by a mix of depositors, employees and local politicians, and they distribute a big chunk of their profits to local causes.

•Since the 1960s they have increased their market share of loans from about 10% to 50% by opening branches in smaller cities and by extending credit to people and businesses ignored by the market leaders.


Cajas & the crisis (housing)• When the big two banks put the brakes on in

2006-07, the cajas continued lending more keenly, tapping wholesale debt markets to fund themselves.

• That alone makes them higher risk. • But the savings banks also supplied about half

of the €318 billion borrowed by Spain’s property developers. These loans now represent about a fifth of the cajas’ assets, according to Santiago López Díaz, an analyst at Credit Suisse.

• They are deteriorating fast.The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009

Cajas & the crisis (housing)

•Mr López Díaz (analyst at Credit Suisse) reckons that 9% of the cajas’ total loans could become non-performing, and within that a fifth of the loans made to property developers.


Recent news…•Spain has been in the spotlight in recent

days. The government has had to rescue CajaSur, a small savings bank, and four other savings banks have chosen to join forces (see article).

•An IMF report on Spain, published on May 24th, gave warning that the risks for banks “remain elevated and unevenly distributed across institutions” and recommended consolidation “to reduce overcapacity and produce more robust institutions.”

http://www.economist.com/displaystory.cfm?story_id=16216443

• cajas, which are unlisted and make up close to half of Spain’s financial system by assets

• Analysts estimate Spanish banks have 30% more branches than are needed.

• it would be a mistake to assume all of the country’s 45 savings banks were as mismanaged as CajaSur

• Following CajaSur’s seizure, four cajas announced their intention to create a joint banking group, known as a system of institutional protection, to pool resources. Several others are also contemplating these “virtual” mergers, racing to meet a June 30th deadline to tap money from the state’s €99bn Fund for Orderly Bank Restructuring (FROB).

The Economist.com, “Spain's cajas, Unholy mess Spain’s troubled savings banks edge towards their day of reckoning, May 27th 2010

Cajas…• The politicians who control the cajas like this

virtual structure because it allows the banks to keep their own brands, governing bodies and local retail operations while combining treasury and risk-management functions. The four savings banks—from Valencia, Asturias, Extremadura and Cantabria—have agreed to shore up each other’s solvency and liquidity, and will have a combined credit rating, which should make it easier to raise funding. The details are still fuzzy but the new entity will become Spain’s third-largest caja and its fifth-largest lender overall.

The Economist.com, “Spain's cajas, Unholy mess Spain’s troubled savings banks edge towards their day of reckoning, May 27th 2010

Why does potential crisis in Spain (or Greece, Italy, etc) matter to the EU?

EU Banks

EU Banks

•Exposed to Greece:

•France’s BNP Paribas, for example, one of the institutions hardest hit by the sell-off, has revealed about €5bn ($6.1bn, £4.2bn) in exposure to Greek sovereign debt.

• Investors, however, are concerned not just about banks’ exposure to individual countries but also about the interlinked nature of that exposure

EU Banks

•Lending by the global banking sector, excluding domestic banks, to the public and private sectors in Greece, Spain, Portugal, Ireland and Italy – the five eurozone economies currently regarded as the most troubled – was $4,000bn at the end of 2009, according to the Basel-based Bank for International Settlements. European banks’ exposure accounted for three-quarters of this total, of which French banks made up nearly one-third and German banks almost a quarter.

Fears- Contagion

•There are many other countries that are running deficits.

•What happens if credits stop funding?•PIIGS of Europe

▫Portugal, Italy, Ireland, Greece, Spain▫Threaten to tear apart Euro

•US, UK are the big ones

Other countries – BIGGER Debts

http://www.economist.com/world/europe/displayStory.cfm?story_id=16003661&source=most_commented









Hedging example

Hedging (to protect against risk)

Hedging foreign currency riskAssume… you are a US based company…

buying machinery from a company in Germany

▫You agree to pay 1mm Euros in 6 months▫Assume the currency exchange rate is

currently 1.25 USD for each 1 Euro

▫Team assignment:1. Assume the exchange rate, doesn’t change…

how many US dollars do you expect to pay in 6 months?

2. Draw it out…

Hedging foreign currency risk

Next question: In 10 words or less, describe “What is your currency risk”? (you could be harmed if WHAT happens?... Be specific!!)

0 6 mo.

US$ 1.25mm


▫Answer: Risk = US dollar will depreciate (Euro will

appreciate)… and you would owe more USD (for same bill in Euros)

You always owe 1mm Euros

•Next question: ▫Assume the exchange rate changes from

1.25 USD$ / Euro… and becomes 1. 5 USD$ / Euro… how many US dollars will you owe in 6 months?


•Example:

▫Answer: Instead of owing $US 1.25mm You would owe $US 1.5 mm

•Next question: ▫What could you do to avoid that risk?

0 6 mo.

US$ 1.25mm

0 6 mo.

US$ 1.5mm

Hedging foreign currency risk▫Answer:

1. Purchase from local US suppliers only (risk avoidance)

2. Change money to Euros today, deposit in Euro bank account, pay liability in 6 mo. (deposit hedge)

3. Contract with your bank forward contract to sell dollars (buy Euros) forward in 6 months at specified rate (example , 1.25:1) + fees

4. Similar choices: futures, options, etc…

Last question ; what is the difference between Forward, futures, and options?

Terms you need to know….

•Appreciation:▫Currency gets STRONGER vs other

▫Team answer (on paper)

▫What is appreciation (numerically)? If current FX rate is 2 US dollars to the 1 Euro… what is one rate that would reflect US dollar Appreciation (give sample rate).


•Appreciation:▫Currency gets STRONGER vs other▫Example:

US Dollar Appreciates Goes from 2.0 USD per Euro to 1.0 USD per

Euro So, it takes LESS US dollars to buy one Euro

Goes from 1 usd buys 0.5 Euro…. Now; 1 usd buys 1 Euro So, it 1 USD buys MORE Euros


•Depreciation:▫Currency gets WEAKER vs other▫Example:

US dollar Depreciates Goes from 1.0 USD per Euro to 2.0 USD per

Euro So, it takes MORE US dollars to buy one Euro

Dr. Kishore Dash, January 20, 2007

Exchange Rate Practices

•Pegging

•Floating

Exchange Rate Options

OfficialDollarization

CurrencyBoard

Free Float

Peg

More Flexible Less Flexible

Crawling Peg

BandDirtyFloat

Source: Rafael Barraza

Dr. Kishore Dash, January 20, 2007

Review

Concepts from last class

review

•Anglo Saxon vs Continental model of banking

•What is the difference?

Review -- Series of Crises

This is NOT the first one!!

quotes

•“the age of financial liberalization became the age of crisis”

•What does this mean?

Martin Wolf

History of Crises (series)

What happened around1945?

What happened around1973?

http://mohammedfikri.files.wordpress.com/2010/02/bretton_woods_sign.jpg

Note timing•1945 – end WW2

▫Stability, fixed rates▫Bretton Woods▫only 38 financial crisies between 1945 and

1971

•Early 1970 – end Bretton Woods▫Crises, flexible rates▫Enter age of Liberalization of finance▫139 financial crises between 1973 and 1997

Martin Wolf book, “Fixing Global Finance”

Series of Crises – 1990’s• Japanese recession - 1990 to 2003, collapse of a real estate bubble

and more fundamental problems halts Japan's once astronomical growth, “lost decade”

• United Kingdom - 1992 - devaluation of currency, "broke the bank of England“, currency speculating against the European currency unit peg

• Mexico crisis 1994 ”tequila crisis” - currency devaluation, debt crisis

• Asian Crisis 1997: SE Asia Crisis - 1997 & 1998 - currency devaluation, debt crisis

• South Korea - 1998 • Russia - 1998 • USA - Long term capital management - hedge fund meltdown - 1998

- causes were SE Asia Crisis of 1997, and Russia crisis of 1998• Brazil - 1999 - currency Real was pegged to US dollar, then forced

to float – currency crisis

http://globotrends.pbworks.com/history-of-economic-crisis-and-currency-devaluations

Fixed, Floating

FX discussion…

Fixed vs. Flexible exchange rates

• Fixed exchange rates▫Any examples?

• Floating exchange rates▫Any examples?

• What system is active today? (globally)

• Important to INTERNATIONAL business managers to pay attention to changes▫why?

Fixed vs. Flexible exchange rates

•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Brief History – Key points

•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Inter-war periodGreat Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

Painful ADJUSTMENT mechanism:

Example: Under the GOLD Standard:

If exports > imports… build up gold reservesIf imports > exports… run out of gold reserves

KEY QUESTION:

▫ Under a fixed system, how do you increase exports? (to stop burning through gold reserves)?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

Hedging example

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to borrow

money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

• Which would you choose?• What is the risk of borrowing abroad (in the US)?

– general comment 20 words or less

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

Education

Part 3 finance class summer 2010 forum nexus