"Global financial crisis:mechanisms of transmission".

Contents

Introduction
Chapter 1.Global financial crisis: overview
1.1.The financial crisis in US (2007-2008)
1.2.The impact of the financial crisis on different countries (2007-2010)
Chapter 2.Global financial crisis: mechanisms of transmission
2.1.Various mechanisms of the crisis transmission
2.2.The World Bank: response to the financial crisis
2.3.The policy response to the financial crisis
2.4.Public-private partnership: the mechanisms of the crisis transmission
2.5.Financial sector regulation: crisis lessons
Conclusion
Literature

"Global financial crisis:mechanisms of transmission".

The largest industrial economies are also among the least affected. Although the three largest industrial economies – the United States, Japan, and Germany – have suffered large stock market declines, each has clearly benefited from a safe haven effect, resulting in declines in their less risky ten-year bond yields. The yen and U.S. dollar have appreciated vis-à-vis almost all other countries, and the euro has appreciated vis-à-vis most developing countries. All members of the euro-zone have seen their spreads widen vis-à-vis Germany. Dollar spreads of all countries have widened vis-à-vis the United States.  
However, Japan and Germany have also faced the sharpest declines in industrial production – 30 percent and 19 percent, respectively, between September and March – driven by slumpingglobal demand for advanced manufacturing products. Consistent with that picture, GDP in Japan dropped 15.4 percent at an annualized rate (saar) in the first quarter of 2009, while Germany’s GDP fell by 15.2 percent annual rate in the same quarter. (4, p. 170)
Ironically, despite reduced global demand for its exports, the net effect of international financial channels was to support U.S. activities, as money flowed into the dollar and U.S. assets. GDP in the first quarter of 2009 fell by 5.7 percent in the United States, and is expected to shrink by 4 percent overall for the year.
Developing countries must use great caution in opening up their capital accounts and exposing their financial systems to shocks emanating from abroad. And as they integrate into global financial markets they can only do so sustainably if their macroeconomic policies are sound, they eschew large external deficits, and practice prudential regulation of banks.
Even when the crisis originates in industrialized countries, developing countries are, in fact, highly vulnerable to capital fleeing toward the source of the crisis. For that reason, developing countries have a crucial interest in the financial soundness of the United States and other large financial centers.
No wonder, then, that there has been a push to have the G20, rather than the G8, design the regime to govern international finance. Or that Brazil, Russia, India, and China (the BRICs) organized their first summit to discuss, among other things, the role of the dollar as the reserve currency.  A country’s domestic financial health is now a global concern.
The serious nature of this still-unfolding crisis is evident in the increasingly pessimistic picture painted by forecasts for economic growth. Since the beginning of the crisis in 2007, forecasts for growth rates in 2008 and beyond have been repeatedly revised downward. As of this writing, this monotonic pattern of downward revisions has yet to be reversed. The latest projections from the IMF World Economic Outlook are shown in Table 2.
Table 2. GDP Growth Projections (in percent)
The global economy is now expected to contract this year by 1.3 percent – the first such contraction since the Second World War. However, this figure hides significant differences among countries and regions. The worst affected regions include emerging Europe, the CIS countries and the newly industrialized Asian economies, each of which is expected to see contractions in GDP in 2009 near or even above five percent. Some other regions are expected to do much better, including the emerging market countries of South Asia, Africa and the Middle East, most of which are expected to avoid recession. But there is a wide range of projections even within regions. Most notably, while emerging Asia as a whole is projected to grow by 2.5 percent this year, the developing countries within the region are set to grow at near five percent, while the newly industrialized countries are projected to contract by 5.6 percent. The worst hit counties are expected to include Singapore (-10 percent), Taiwan-China (-7.5 percent), Hong Kong-China (-4.5 percent) and Korea (-4 percent). China and India, the largest emerging economies in the region and in the world, are projected to grow by 6.5 percent and 4.5 percent, respectively. While surprisingly good in the current environment, these growth rates are, of course, below those registered by these countries in recent years. Some of the reasons for this diverse performance will be touched upon in subsequent sections of this paper. The global contraction is forecast to give way to renewed growth next year, with world GDP increasing by almost two percent. Again, however, the performance in the advanced economies is expected to be markedly different from that in the emerging market economies; and growth rates within regions are also expected to vary substantially. The major industrial economies are expected to see little or no growth year-on-year in 2010, and, at best, to return to potential only at the end of the year. The emerging economies, however, are projected to grow by over three percent, with Asia leading the way at about five percent. Once again, the developing countries in Asia are expected to register the best performance. As always, there are significant caveats about these projections. However, there are recent signs that the bottom may have been reached in a number of countries, including in Asia, so that the next revision of these projections may see at least a halt to the repeated worsening of the picture seen over the last two years. For example, the most recent data from China indicate that investment spending, bolstered by the stimulus package introduced late last year, has risen to record highs, bank lending is already ahead of the government’s target for all of 2009, industrial production is expanding significantly, and retail sales have recovered. That said, there are well known lags in the recovery process – including in the recovery of employment. This is particularly the case in the advanced economies where employers commit to new hiring only after clear signs of a rebound in activity. Thus, in most of the industrial world, unemployment is expected to continue to increase throughout most of 2010, causing continued pain. Moreover, there will be a critical question about the sustainability of any recovery. A return to the global imbalances of the past decade will threaten that sustainability. Renewed global growth will be secure only if the macroeconomic structures of a number of economies – especially the savings balances in the United States and China – emerge as significantly different from what they were in the lead up to the current crisis.
The impact of the crisis in the US and Europe on the emerging market economies has surprised some analysts. A proposition had been put forward that the emerging economies had «decoupled» from the industrial world to a degree that would permit them to more easily absorb the impact of a slowdown in economic activity in those countries. The serious global impact of this crisis would seem to put the lie to that proposition. The evidence is growing that decoupling has not occurred to anything like the extent that would be needed to isolate the emerging economies from a weakening of activity in the industrial world.8 Indeed, it could be argued that the explosion of global trade – the major force in the rapid growth of many of the emerging economies over the last few decades, together with the design of the world’s supply chains, as well as the ever-increasing integration of financial markets has, in fact, increased the coupling of the emerging market economies – and many of the poorer developing countries – with the industrial world. (13, p. 102)
Perhaps even more important, beyond trade, other inter-linkages have developed that increase the dependency among various groups of countries and, in some ways, reverse the direction of influence. For example, for years it was the developing world and the emerging market countries, in particular, that were dependent for their financing on the global financial markets centered in the industrial countries. Large current account deficits in the emerging market countries were financed through capital flows from the industrial world. Much of that financing took the form of bank loans until the mid 1980’s; and then increasingly took the form of flows through the bond markets. That story ended in the financial crises in Latin America in the 1980’s and in Asia and elsewhere in the 1990’s and the first few years of this millennium. Important lessons were learned in those crises and many of the emerging market countries fundamentally changed the management of their economies. Macroeconomic policies became more orthodox; policy-making institutions were strengthened; and the flow of capital shifted dramatically. Together with the rise in crude oil and other commodity prices, the rapid growth of emerging market countries with high savings rates, and the shift in the United States to negative savings by both the government and consumers, fundamentally changed the nature and the flow of capital – and dependency – among the world’s economies.
The increase in commodity prices was further evidence of the shift in influence that was taking place. It was the rapid growth of many of the emerging market countries themselves that led to the sharp rise in commodity and raw material prices. That development, in turn, became the dominant influence on inflationary pressures in the industrial world, limiting the power of traditional central bank policy instruments to control domestic inflation. Thus, the interlinkages between the industrial and emerging world have become far more complex and multi-dimensional – and the very concept of decoupling seems almost quaint! The framework of analysis can no longer be limited to the impact of the level of activity in the industrial world – or the impact of a single market, such as that for equities – on the emerging market economies. As important are the influence of high savings rates and capital flows from the emerging economies to the industrial world – and especially to the United States.Thus, rather than a decoupling, an increased inter-dependence has emerged. Policy in the industrial countries needs to anticipate the impact of growth in the emerging world (through the effects on commodity prices, for example), and the impact of changing savings rates and portfolio investment preferences on interest rates and exchange rates. In turn, policy in the emerging market countries needs to anticipate the impact of changing levels of activity in the industrial world on exports and on foreign direct investment, and changing savings rates, especially in the U.S. (11, p. 92)
Chapter 2.Global financial crisis: mechanisms of transmission
2.1.Various mechanisms of the crisis transmission
The transmission of the crisis from the U.S. and Europe to the rest of the world came through a number of channels. The financial institutions in most emerging market economies had not engaged in the kind of practices seen in the institutions that populate the financial centers in the major industrial countries. Balance sheets were typically not exposed to the toxic assets that increasingly dominated positions in the major institutions. Derivatives were employed much less frequently and were generally limited to the more traditional instruments employed to hedge against currency and other risks associated with trade. Financial institutions in the emerging economies either shied away from the more exotic instruments, including such things as credit default swaps and collateralized debt obligations, or were prevented by regulation from holding or trading such instruments. Banking was generally of the more «boring», old fashioned kind!
But, in the end, this did not protect these countries. Five major channels brought the crisis home to these economies:
First was the withdrawal of funds by some of the major financial institutions from their subsidiaries located in the emerging economies. The general contraction of the balance sheets of the major institutions and the need to rebuild their capital base has constrained the funding available to other institutions in both the industrial countries (e.g., hedge funds) and in the emerging world that rely on dollar (or even Euro) funding. This has been the case notwithstanding the massive support injected into banking systems in the financial centers that are home to most of the major international banks. (8, p. 102)
Second was the seizing-up of the international credit markets. Credit flows through theinternational banks and global bond markets to emerging market countries all but dried up. This has created significant financial stress in some of those countries – especially those in central and Eastern Europe – that ran up dangerously large current account deficits and took on substantial international debt. For example, BIS data show that consolidated claims of BIS-reporting banks on all emerging market economies decreased from a peak of $5.4 trillion in June, 2008 to $4.6 trillion by December – a decline of over 14 percent. No emerging market regions were spared, and all of them saw similar declines. Recent anecdotal evidence suggests that this withdrawal has continued in most regions. Data on capital flows show an even more dramatic picture. Net private flows to emerging market countries peaked at about 5 percent of GDP in 2007. However, all categories of inward flows to emerging market countries have registered significant declines from 2007 to 2008 and are projected to decline further in 2009. The cumulative decline in the major categories of flows to emerging market countries between 2007 and 2009 are currently expected to be very large: 62 percent for international bond issues; 61 percent for commercial bank loans; and 54 percent for inward direct investment. (Table 3) The flow of export credits to the emerging market countries as well as inward portfolio investment all but collapsed in 2008. The withdrawal of portfolio investment was a key factor behind a decline in emerging stock markets that exceeded the sharp declines in advanced economy markets. (9, p. 98)
Table 3. Capital Flows, Export Financing and International Reserves (US$ billions)
In total, emerging market economies – especially those that are heavily indebted and face large financing requirements both from current deficits as well as from the need to refinance maturing debt – have seen a substantial decline in all major categories of capital inflows. Some of the worst affected countries have also recorded significant capital flight and sharp depreciations of their currencies. All of this has been reflected in a substantial fall in international reserves, with emerging market countries in all regions of the world other than East Asia recording significant declines; emerging countries in Europe were the most seriously affected.
Third, was the impact of the crisis on economic activity – in the first instance, in the United States and Europe, and subsequently in Japan. Initially, this manifested itself in a sharp contraction in exports from those emerging market countries that had become the largest exporters to the industrial world. Quite rapidly, however, exports declined from the other emerging economies, i.e., those whose exports consisted of raw and intermediate goods shipped to those larger emerging market countries, particularly China, that had become key providers of final manufactured goods in the increasingly complex supply chains that came to populate world trade. This fall in exports – at a virtually unprecedented rate of collapse – created an internal feedback loop wherein the initial reduction in trade weakened the domestic economies of the emerging market countries, with further negative feedback on the financial sectors in those countries as the quality of domestic credit deteriorated.
Fourth, are the still uncertain prospects for remittances – an important source of income and foreign exchange in many emerging market economies. Total remittances to emerging market countries were over US$ 206 billion in 2007 and are estimated to have reached more than $230 billion in 2008 (Table 4). Like unemployment figures, remittances tend to lag the decline in economic activity – and will likely lag in the recovery. While recent data are sketchy, remittances to emerging market countries appear to be falling significantly and are estimated to total only about $170 billion this year before recovering somewhat to about $195 billion in 2010. Such projections are subject to a wide margin of error and are dependent on an assumed recovery in the global economy. Interestingly, the transfer of domestic remittances, i.e., those remittances that go from individuals who have moved to urban areas in search of employment and higher income to those left behind in the rural or less developed regions of a country, have also declined. This is helping to transfer the weakness in the export and service sectors in emerging economies to parts of those countries that otherwise would have been less affected. The return of workers from abroad could put additional pressure on these regions as those workers seek employment in already depressed economies.
Table 4. Workers Remittances (US$ billions)
Fifth, and finally, is the psychological factor. The world has become all too familiar with financial cries. But a financial crisis originating in the United States and spreading quickly to other industrial countries took most of the world by surprise. So did the severe worsening of the crisis in September and October, 2008 which saw the collapse of some of the world’s most prized private financial institutions and extraordinary – and untested – policy actions by industrial country governments. This was quickly followed by a seizing-up of financial markets around the world, a massive loss in asset values, and a virtually unprecedented collapse of exports. It is fair to say that no one was prepared for this, and that it undermined the business plans and expectations of almost everyone. The decline in asset values, especially of equities and houses, and the rapid rise in unemployment brought that insecurity and its accompanying fear to consumers. Financial systems and economies are driven by confidence. These events thoroughly shook consumers’ confidence, causing a self-aggravating feedback to the rest of the economy. This experience may well affect the nature of any recovery in ways as yet not fully understood. (18, p. 95)
2.2.The World Bank: response to the financial crisis
Though the most acute phase of the global financial crisis has passed, recovery remains fragile and uneven. Developing countries, in part due to sound policies in the run-up to the crisis, are expected to account for almost one-half of global growth in the next few years. Still, they face enormous challenges. Continuing high food prices are of particular concern, as is limited international financing. For developed countries, low growth and high unemployment persist.
The poorest countries continue to need assistance to move beyond the crisis. These countries can play a key role in helping to boost demand to support global recovery, but they will need access to financing for years to come.
Demand for Bank assistance continues to be high. In FY09, Bank Group loans, grants, equity investments, and guarantees saw an unprecedented 54% increase over FY08. Assistance has focused on maintaining long-term infrastructure investments and sustaining potential for private sector-led growth and job creation. Throughout the crisis, the Bank has helped keep children in school, health clinics open, and microfinance loans flowing to women.
Since the crisis began, the World Bank Group has committed $138 billion to its members and disbursed a record $81 billion, including $21 billion to the world’s 79 poorest countries. (7, p. 55)
As of June 2010, assistance included: