Global recession and new business environment

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.

• 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 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.

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 overevaluation, 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
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
• Cons
• International capital
• Pros
markets do not allocate
• They improve the global
resources efficiently.
allocation of resources
Speculators and investors
• They provide an
tend to be irrational and
incentive to
short-term.
governments to pursue • Global finance is
sound fiscal monetary
unregulated and lacks
policy
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 outline
How 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, interest rates were lowered, down to zero, in
order to jump start the economy. The State launched big public
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 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 Southeast 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)

Global recession and new business environment

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