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 2.4
EQUITY MARKET DOLLAR RETURNS, 2008
Japan
United States
Colombia
G-5 (average)
Mexico
Malaysia
Germany
France
South Africa
Hong Kong, China
United Kingdom
Emerging markets
Philippines
Argentina
Brazil
Republic of Korea
Indonesia
India
China
Turkey
Russian Federation
-80
-70
Source:
-60
-50
-40
-30
Dollar return (per cent)
-20
-10
0
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 bubbles
Fighting the last crisis?
 Bad idea if each crisis is different from the
previous
 But are they different?
 Avoid regulatory cycles
 Learn from “near misses”
Commodity Market
Finanacial
Market
Currency Market
Unwinding of speculative flows
Subprime Credit
Collapse
The subprime credit collapse highlighted the exposure to risk
in many areas and triggered the sudden unwinding of
speculative positions in different markets
• 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 Lessons
for 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 2.3
OUTSTANDING CREDIT DEFAULT SWAPS, GROSS AND NET NOTIONAL AMOUNT
16,000
14,000
12,000
$ billion
10,000
8,000
6,000
4,000
Net exposure
2,000
Gross minus
net exposure
0
October 2008
November 2008
December 2008
January 2009
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
3
Guaranteeing the Safety of Individual
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
Figure 2.1
LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR
30
Leverage
25
20
15
10
Banks
5
1981
1983
1985
1987
1989
1991
1993
1995
Financial services
1997
1999
2001
Life insurance
2003
2005
2007
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.
4
Avoid Regulatory Arbitrage
Figure 2.2
THE SHADOW BANKING SYSTEM, 2007, Q2
18
16
14
$ trillion
12
Government
sponsored
enterprises
7.7
10
8
6
Finance
companies
1.9
Brokers and
dealers
2.9
Commercial banks
10.1
4
2
Asset backed
securities
issuers
4.1
0
Market based
Source: Shin (2009).
Savings
institutions
1.9
Credit unions 0.8
Bank based
Each institution can be a source
of systemic risk
Providers 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 company
If an insurance company is
involved into maturity transformation,
it should be regulated like bank
5
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)
Figure 3.2
FUTURES AND OPTIONS CONTRACTS
OUTSTANDING ON COMMODITY EXCHANGES,
DECEMBER 1993–DECEMBER 2008
(Number of contracts, millions)
Figure 3.3
NOTIONAL AMOUNT OF OUTSTANDING OVERTHE-COUNTER COMMODITY DERIVATIVES,
DECEMBER 1998 – JUNE 2008
(Trillions of dollars)
50
14
45
12
40
10
35
30
8
25
6
20
15
Other commodities
Other precious metals
Gold
4
10
2
5
0
Dec. Dec. Dec. Dec. Dec. Dec.
1993 1995 1997 1999 2001 2003
0
Dec. Dec.
2005 2007
Source: BIS, Quarterly Review , March 2009, table 23B.
Dec.
1998
Dec.
2000
Dec.
2002
Dec.
2004
Dec.
2006
June
2008
Source: BIS, Quarterly Review , December 2008, table 19.
Correlations between the Exchange Rate of Selected
Countries and Equity and Commodity Price Index
BRAZILIAN REAL TO JAPANESE YEN
June 2008–December 2008
• Strong correlation
between the
unwinding of
speculation in
different markets
that should be
uncorrelated
• All participants
react to the same
kind of information
NEW ZEALAND DOLLAR TO JAPANESE YEN
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 Bubbles
The uncertainty associated with the subprime crisis generated an
unwinding of speculative currency positions
- causing large depreciation of former high-hielding currencies
130
120
100
90
80
70
02
.0
1.
08
02
.0
2.
08
02
.0
3.
08
02
.0
4.
08
02
.0
5.
08
02
.0
6.
08
02
.0
7.
08
02
.0
8.
08
02
.0
9.
08
02
.1
0.
08
02
.1
1.
08
02
.1
2.
08
Index Number
110
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
Real
12
10
12
8
6
8
4
2
4
10
6
Per cent
Per cent
Krona
0
-2
2
0
-2
-4
-4
-6
-6
-8
-8
-10
-10
12345678910
11 212345678910
11 212345678910
11 2123456789
2005
2006
2007
Uncovered interest return
Nominal exchange-rate change
Interest rate differential
2008
12345678910
11 212345678910
11 212345678910
11 2123456789
2005
2006
2007
Uncovered interest return
Nominal exchange-rate change
Interest rate differential
2008
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
1) Crisis management
2) Reform of the financial architecture
•
•
•
•
•
•
•
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
“The Global Economic Crisis:
Systemic Failures and
Multilateral Remedies”
Report by the UNCTAD Secretariat Task
Force on Systemic Issues and Economic
Cooperation