Description
implications of the Crisis on Emerging Economies, Impact on Financial Systems, Transfer of Crisis to Emerging Economies and Lessons to learn from the Crisis
Macro Economics Assignment Global Financial Crisis and its Implications for Emerging Economies
CONTENTS 1. 2. 3. 4. 5. 6. Overview: Global Financial Crisis Implications of the Crisis on Emerging Economies Impact on Financial Systems Transfer of Crisis to Emerging Economies Lessons to learn from the Crisis References
Macro Economics Assignment Group 3
1. Overview: Global Financial Crisis ? INTRODUCTION The global financial crisis was triggered by the sub-prime mortgage crisis in the US. It This has destabilized the financial markets of the developed world leading to collapse of notable names in the banking business. Production in these economies has also been also got adversely affected leading to a decline in output. THE CAUSES ? Globally, companies and individuals have an ever increasing demand for capital for both personal and corporate investments. Traditionally, banks have been very conservative and stringent in their requirements. This makes access to finance difficult for the majority of the people. ? Banks and other financial institutions in the United States of America have gone through a long period of inappropriate lending. Relaxation of lending terms for mortgages was as a result of the boom in the housing sector. Millions of Americans with poor credit history who might not have bought their homes were granted subprime mortgages. ? Traditionally banks finance lending using deposits from customers. With increasing demand for mortgage loans, banks moved to a new model where mortgages were being issued on the bond market. This led to the growing of the mortgage bond market as mortgage brokers focused on less than ideal clients. This proved to be very profitable as banks earned a fee for each mortgage sold and urged brokers to sell more and more. ? The sub-prime mortgages, referred to as Adjustable Rate Mortgages (ARM) had a fixed payment for two years. Then reset to higher (double the interest rate) rates and became more expensive for the people to repay. Millions of Americans had are having their homes repossessed due to failure to repay the mortgages. House prices which have been were falling at an annual rate of 4.5 percent in the past 3 years since 2005 and are expected to fall by at least 10 percent in 2008. fall by 10 percent in 2008.
?
OTHER SHOCKS TO THE GLOBAL ECONOMY The effect of the global financial crisis was worsened by rising global energy and commodity prices which pushed up inflation. Emerging and developing countries have particularly in particular experienced strong rise in prices reflecting the high weight of food in their consumption baskets IMPACT ON THE US ECONOMY
Macro Economics Assignment Group 3
1. The banking industry has been was badly hit as many of the mortgage bonds backed by sub-prime mortgages have had fallen in value. As a result of the bad debts, banks became reluctant to lend and this that led to a credit crunch. A slowdown in the building industry which contributes contributed 15 percent to US output has had a ripple effect on other industries especially makers of durable goods. 2. Bailouts of financial entities before the financial crisis reached its peak in the US, the federal government bailed out investment bank Bear Stearns with nearly $30 billion to avert a major financial default. It invested as much as $200 billion in preferred stock of the loss-plagued finance giants Fannie Mae and Freddie Mac and at least $5 billion in their mortgage securities; It further provided an emergency loan of $85 billion to American International Group (AIG) Inc. in return for an ownership stake of as much as 80% in the stricken insurance giant. 3. The Collapse of Lehman Brothers Ranked among the world's top investment banks, the Lehman Brothers expanded aggressively into property related investments including the sub-prime mortgages. The sub-prime crisis with the decline in value of housing forced the company to take huge write downs on the value of those assets and led to the loss of about US$14 billion. This further led to Lehman’s prime customers pulling out their monies money into much safer investment avenues e.g. investing in government bonds. This contributed to the company’s filing for bankruptcy protection and hence its fall. The collapse of the company putted tens of thousands of jobs around the world at risk. The impact was also huge in other major economies considering the integration of the financial markets and the global nature of business today.
2. Implications for Emerging Economies The beginning of 2008 augured a period of robust growth for emerging economies. Even though a deceleration was expected in growth for most emerging economies for 2008, the expectations by end 2007 were that GDP would grow by some 7½ %, and 9% for Developing Asia and 4½% for Latin America. Inflation was expected not to exceed 5½%. After the onset of the international crisis, circumstances changed compared with the previous projections and perceptions that emerging markets economies had become delinked from events in the Developed World. Although output growth was helped by the favourable conditions at the beginning of the year, growth was estimated to have been below 6 1/2 %, one percentage point under the average for the previous six years. Growth in Asia was 7.8%, also one percent below the previous six years, while growth in Latin America, was 3.8%, in line with period 2003-07 but well below the previous five years.
Macro Economics Assignment Group 3
After reaching significant lows, inflation rose in 2007 in line with commodity prices and almost reached 10 percent, with higher levels of inflation in Asia than in Latin America. Eventually, inflation decelerated in 2008 as price pressures receded towards the end of the year, but still remained high at 9 percent-reaching over 7 percent in Asia and more than 8 percent in Latin America. During the first part of 2008, high inflation reflected the increase in world demand. In the second half, many countries experienced major currency devaluations, thus precluding a decline in local prices, on account of lower commodity prices in international markets. The fall of activity in the advanced economies was aggravated by the expected volatility in financial markets, with a direct effect on the demand for goods and services. The fall in commodity prices resulted in a sharp decline in export receipts for Latin America and parts of Asia, as these regions continue to be highly dependent on exports of raw materials, even as some Asian countries were expected to benefit from lower prices. However, the decline in international demand had hit them hard. To some extent, the adverse effect on the balance of payments and the public accounts was mitigated by the strong devaluation that has been was observed since mid 2008, particularly in Latin America. After an appreciation of many currencies of approximately 20% in real effective terms, there was a subsequent devaluation. In relation to the US dollar, the devaluation in the six months to end-2008 was of the order of 45% in Brazil, 35% in Mexico, and 14% in Argentina (See Table). In Asia, where the real exchange rate had appreciated less during the period of the boom (15 percent for Developing Asia, and about 10 percent for the NICs), the depreciation has been was much smaller, ranging from virtually no change in China, 13% in India, and 20% in Korea. The devaluations were in part the consequence of the strengthening of the US currency with respect to the most important currencies of the world, but also of a decline in the worldwide demand for Asian and Latin American exports, and strong negative pressures in the financial markets of the region.
Macro Economics Assignment Group 3
3. Impact on Financial Systems The stock markets have experienced a sharp fall that has exceeded that of the stock markets in the advanced countries. The fall was particularly strong from midyear, in contrast with what happened in the US and Europe, where the reduction began in the middle of 2007. For example, the SP 500 index of the United States fell by 36% from June to end-2008 and the Japan Nikkei index fell by 37%. Among Asian countries, the stock market valuation declined by 36% in Korea, 41% in India, and 48% in China (See Table above), reflecting the wide-ranging effect of the world financial crisis. The stock market index in Brazil fell by 49%, and in Mexico, the other key Latin stock market, the valuation fell by 29%. Initially, it was thought that because of the characteristics of the developing financial markets, there would be no significant presence of “toxic” financial assets. However, in many of the Asian markets, including in Korea, India, China, Brazil and Mexico in Latin America, companies
Macro Economics Assignment Group 3
had invested in derivatives, particularly regarding foreign exchange risk, and, to a lesser extent, commodities. The fall in international prices and the devaluation of local currencies had an important adverse impact on the finances of these companies and therefore, their share values suffered, generating strong pressures on the exchange market. Commercial banks in Latin America did not invest to any significant degree in “toxic” financial instruments, but they were being hit by the sharp contraction in external credit. These institutions, not being strongly exposed to external risks, and focusing mainly on domestic markets, are not incurring incurred no risks similar to financial institutions in the advanced countries and in Asia, where the banking system is was much larger and banks have tended to be more invested in the troubled assets, with the possible exception of India, among the larger countries. Latin America has been was helped by the relatively small size of the national financial systems and the strong supervision and prudential regulations, an inheritance of the crisis of last ten to fifteen years. Thus, the risks have tended to be concentrated in possible disruptions in the traditional flows related to international trade and foreign investment; and the contraction in international economic activity. As is was observed in Asia, problems in the financial system were due to the combination of lower exports and share values, if this were combined with the maintenance of poor policies, or if some countries experienced a further deterioration in the next months. 4. Transfer of Crisis to Emerging Economies 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 are namely withdrawal of funds, seizing of international credit markets, crisis on economic activity, prospects of remittances and psychological factor. 1. 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
Macro Economics Assignment Group 3
(e.g., hedge funds) and in the emerging world that rely relied on dollar (or even Euro) funding. This has been was the case notwithstanding the massive support injected into banking systems in the financial centers that are were home to most of the major international banks. 2. 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 subjective evidence suggests that this withdrawal has continued in most regions. Data on capital flows showed 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 2009 and are were 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 were expected to be very large: 62 percent for international bond issues; 61 percent for commercial bank loans; and 54 percent for inward direct investment. (See table below) 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. In total, emerging market economies – especially those that are were heavily indebted and faced large financing requirements both from current deficits as well as from the need to refinance maturing debt - have seen saw 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 recorded significant declines; emerging countries in Europe were the most seriously affected.
Macro Economics Assignment Group 3
3. 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 caused 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.
4. 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 were estimated to have reached reach more than $230 billion in 2008 (See Table below). Like
Macro Economics Assignment Group 3
unemployment figures, remittances tend to lag the decline in economic activity – and will also likely lag in the recovery. Given this scenario, While recent data are sketchy, remittances to emerging market countries appear to be falling fell significantly and are estimated to total only to about $170 billion this year in 2009 before being estimated to recovering recover 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 Not only this, 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 caused 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.
5. Fifth, and final, is was the psychological factor. The world has become all too familiar with financial crisis. 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
Macro Economics Assignment Group 3
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. 5. Lessons to learn from the Crisis Against this background, a number of critical policy questions now confront the emerging market countries. Much work will be needed to sort through the lessons of this crisis. Here only four important questions that need to be addressed – both individually by these countries, and collectively by both the emerging and the more developed countries. These questions are: a) What has been learned about financial sector regulation and supervision in the current crisis? More generally, what is the appropriate model for emerging market countries to look to in designing their financial regulatory systems? b) Did the accumulation of large stocks of international reserves by many of the emerging market countries put them in a better position to confront the current crisis? Was it beneficial from a longer term cost/benefit perspective, or was it overdone? Related to the question of the appropriate level of reserves, are there lessons to be learned about the dominant role of the U.S. dollar as the primary reserve asset in the global system? c) What preliminary lessons have been learned about the capacity of the emerging market economies to engage in stimulating domestic monetary and fiscal policies in the face of a softening or a contraction of global demand? What conditions are necessary for such measures to be both feasible and effective and how powerful can the impact of such measures be on the global economy? And d) A number of countries, in Eastern Europe and elsewhere, have been severely damaged by the reversal of capital flows in the past years. In many cases, the fault has been seen to lie, at least in part, in the policies pursued in opening their capital markets. What are the lessons that have been learned? What should be done to avoid a repeat of this experience in these and, as importantly, in frontier emerging economies? Is there a greater role for the IMF here? These are all difficult questions. However these can be taken as an element for the discussions over the reform of the IMF and of the global economic and financial architecture.
6. References:
1. Global financial turmoil and Emerging Market Economies: Major contagion and a shocking loss of wealth? -- by the Asian Development Bank (ADB)
Macro Economics Assignment Group 3
2. The Impact of the Financial Crisis on Emerging Market Economies: The Transmission Mechanism, Policy Response and Lessons – by Jack Boorman
doc_669002176.docx
implications of the Crisis on Emerging Economies, Impact on Financial Systems, Transfer of Crisis to Emerging Economies and Lessons to learn from the Crisis
Macro Economics Assignment Global Financial Crisis and its Implications for Emerging Economies
CONTENTS 1. 2. 3. 4. 5. 6. Overview: Global Financial Crisis Implications of the Crisis on Emerging Economies Impact on Financial Systems Transfer of Crisis to Emerging Economies Lessons to learn from the Crisis References
Macro Economics Assignment Group 3
1. Overview: Global Financial Crisis ? INTRODUCTION The global financial crisis was triggered by the sub-prime mortgage crisis in the US. It This has destabilized the financial markets of the developed world leading to collapse of notable names in the banking business. Production in these economies has also been also got adversely affected leading to a decline in output. THE CAUSES ? Globally, companies and individuals have an ever increasing demand for capital for both personal and corporate investments. Traditionally, banks have been very conservative and stringent in their requirements. This makes access to finance difficult for the majority of the people. ? Banks and other financial institutions in the United States of America have gone through a long period of inappropriate lending. Relaxation of lending terms for mortgages was as a result of the boom in the housing sector. Millions of Americans with poor credit history who might not have bought their homes were granted subprime mortgages. ? Traditionally banks finance lending using deposits from customers. With increasing demand for mortgage loans, banks moved to a new model where mortgages were being issued on the bond market. This led to the growing of the mortgage bond market as mortgage brokers focused on less than ideal clients. This proved to be very profitable as banks earned a fee for each mortgage sold and urged brokers to sell more and more. ? The sub-prime mortgages, referred to as Adjustable Rate Mortgages (ARM) had a fixed payment for two years. Then reset to higher (double the interest rate) rates and became more expensive for the people to repay. Millions of Americans had are having their homes repossessed due to failure to repay the mortgages. House prices which have been were falling at an annual rate of 4.5 percent in the past 3 years since 2005 and are expected to fall by at least 10 percent in 2008. fall by 10 percent in 2008.
?
OTHER SHOCKS TO THE GLOBAL ECONOMY The effect of the global financial crisis was worsened by rising global energy and commodity prices which pushed up inflation. Emerging and developing countries have particularly in particular experienced strong rise in prices reflecting the high weight of food in their consumption baskets IMPACT ON THE US ECONOMY
Macro Economics Assignment Group 3
1. The banking industry has been was badly hit as many of the mortgage bonds backed by sub-prime mortgages have had fallen in value. As a result of the bad debts, banks became reluctant to lend and this that led to a credit crunch. A slowdown in the building industry which contributes contributed 15 percent to US output has had a ripple effect on other industries especially makers of durable goods. 2. Bailouts of financial entities before the financial crisis reached its peak in the US, the federal government bailed out investment bank Bear Stearns with nearly $30 billion to avert a major financial default. It invested as much as $200 billion in preferred stock of the loss-plagued finance giants Fannie Mae and Freddie Mac and at least $5 billion in their mortgage securities; It further provided an emergency loan of $85 billion to American International Group (AIG) Inc. in return for an ownership stake of as much as 80% in the stricken insurance giant. 3. The Collapse of Lehman Brothers Ranked among the world's top investment banks, the Lehman Brothers expanded aggressively into property related investments including the sub-prime mortgages. The sub-prime crisis with the decline in value of housing forced the company to take huge write downs on the value of those assets and led to the loss of about US$14 billion. This further led to Lehman’s prime customers pulling out their monies money into much safer investment avenues e.g. investing in government bonds. This contributed to the company’s filing for bankruptcy protection and hence its fall. The collapse of the company putted tens of thousands of jobs around the world at risk. The impact was also huge in other major economies considering the integration of the financial markets and the global nature of business today.
2. Implications for Emerging Economies The beginning of 2008 augured a period of robust growth for emerging economies. Even though a deceleration was expected in growth for most emerging economies for 2008, the expectations by end 2007 were that GDP would grow by some 7½ %, and 9% for Developing Asia and 4½% for Latin America. Inflation was expected not to exceed 5½%. After the onset of the international crisis, circumstances changed compared with the previous projections and perceptions that emerging markets economies had become delinked from events in the Developed World. Although output growth was helped by the favourable conditions at the beginning of the year, growth was estimated to have been below 6 1/2 %, one percentage point under the average for the previous six years. Growth in Asia was 7.8%, also one percent below the previous six years, while growth in Latin America, was 3.8%, in line with period 2003-07 but well below the previous five years.
Macro Economics Assignment Group 3
After reaching significant lows, inflation rose in 2007 in line with commodity prices and almost reached 10 percent, with higher levels of inflation in Asia than in Latin America. Eventually, inflation decelerated in 2008 as price pressures receded towards the end of the year, but still remained high at 9 percent-reaching over 7 percent in Asia and more than 8 percent in Latin America. During the first part of 2008, high inflation reflected the increase in world demand. In the second half, many countries experienced major currency devaluations, thus precluding a decline in local prices, on account of lower commodity prices in international markets. The fall of activity in the advanced economies was aggravated by the expected volatility in financial markets, with a direct effect on the demand for goods and services. The fall in commodity prices resulted in a sharp decline in export receipts for Latin America and parts of Asia, as these regions continue to be highly dependent on exports of raw materials, even as some Asian countries were expected to benefit from lower prices. However, the decline in international demand had hit them hard. To some extent, the adverse effect on the balance of payments and the public accounts was mitigated by the strong devaluation that has been was observed since mid 2008, particularly in Latin America. After an appreciation of many currencies of approximately 20% in real effective terms, there was a subsequent devaluation. In relation to the US dollar, the devaluation in the six months to end-2008 was of the order of 45% in Brazil, 35% in Mexico, and 14% in Argentina (See Table). In Asia, where the real exchange rate had appreciated less during the period of the boom (15 percent for Developing Asia, and about 10 percent for the NICs), the depreciation has been was much smaller, ranging from virtually no change in China, 13% in India, and 20% in Korea. The devaluations were in part the consequence of the strengthening of the US currency with respect to the most important currencies of the world, but also of a decline in the worldwide demand for Asian and Latin American exports, and strong negative pressures in the financial markets of the region.
Macro Economics Assignment Group 3
3. Impact on Financial Systems The stock markets have experienced a sharp fall that has exceeded that of the stock markets in the advanced countries. The fall was particularly strong from midyear, in contrast with what happened in the US and Europe, where the reduction began in the middle of 2007. For example, the SP 500 index of the United States fell by 36% from June to end-2008 and the Japan Nikkei index fell by 37%. Among Asian countries, the stock market valuation declined by 36% in Korea, 41% in India, and 48% in China (See Table above), reflecting the wide-ranging effect of the world financial crisis. The stock market index in Brazil fell by 49%, and in Mexico, the other key Latin stock market, the valuation fell by 29%. Initially, it was thought that because of the characteristics of the developing financial markets, there would be no significant presence of “toxic” financial assets. However, in many of the Asian markets, including in Korea, India, China, Brazil and Mexico in Latin America, companies
Macro Economics Assignment Group 3
had invested in derivatives, particularly regarding foreign exchange risk, and, to a lesser extent, commodities. The fall in international prices and the devaluation of local currencies had an important adverse impact on the finances of these companies and therefore, their share values suffered, generating strong pressures on the exchange market. Commercial banks in Latin America did not invest to any significant degree in “toxic” financial instruments, but they were being hit by the sharp contraction in external credit. These institutions, not being strongly exposed to external risks, and focusing mainly on domestic markets, are not incurring incurred no risks similar to financial institutions in the advanced countries and in Asia, where the banking system is was much larger and banks have tended to be more invested in the troubled assets, with the possible exception of India, among the larger countries. Latin America has been was helped by the relatively small size of the national financial systems and the strong supervision and prudential regulations, an inheritance of the crisis of last ten to fifteen years. Thus, the risks have tended to be concentrated in possible disruptions in the traditional flows related to international trade and foreign investment; and the contraction in international economic activity. As is was observed in Asia, problems in the financial system were due to the combination of lower exports and share values, if this were combined with the maintenance of poor policies, or if some countries experienced a further deterioration in the next months. 4. Transfer of Crisis to Emerging Economies 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 are namely withdrawal of funds, seizing of international credit markets, crisis on economic activity, prospects of remittances and psychological factor. 1. 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
Macro Economics Assignment Group 3
(e.g., hedge funds) and in the emerging world that rely relied on dollar (or even Euro) funding. This has been was the case notwithstanding the massive support injected into banking systems in the financial centers that are were home to most of the major international banks. 2. 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 subjective evidence suggests that this withdrawal has continued in most regions. Data on capital flows showed 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 2009 and are were 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 were expected to be very large: 62 percent for international bond issues; 61 percent for commercial bank loans; and 54 percent for inward direct investment. (See table below) 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. In total, emerging market economies – especially those that are were heavily indebted and faced large financing requirements both from current deficits as well as from the need to refinance maturing debt - have seen saw 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 recorded significant declines; emerging countries in Europe were the most seriously affected.
Macro Economics Assignment Group 3
3. 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 caused 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.
4. 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 were estimated to have reached reach more than $230 billion in 2008 (See Table below). Like
Macro Economics Assignment Group 3
unemployment figures, remittances tend to lag the decline in economic activity – and will also likely lag in the recovery. Given this scenario, While recent data are sketchy, remittances to emerging market countries appear to be falling fell significantly and are estimated to total only to about $170 billion this year in 2009 before being estimated to recovering recover 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 Not only this, 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 caused 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.
5. Fifth, and final, is was the psychological factor. The world has become all too familiar with financial crisis. 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
Macro Economics Assignment Group 3
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. 5. Lessons to learn from the Crisis Against this background, a number of critical policy questions now confront the emerging market countries. Much work will be needed to sort through the lessons of this crisis. Here only four important questions that need to be addressed – both individually by these countries, and collectively by both the emerging and the more developed countries. These questions are: a) What has been learned about financial sector regulation and supervision in the current crisis? More generally, what is the appropriate model for emerging market countries to look to in designing their financial regulatory systems? b) Did the accumulation of large stocks of international reserves by many of the emerging market countries put them in a better position to confront the current crisis? Was it beneficial from a longer term cost/benefit perspective, or was it overdone? Related to the question of the appropriate level of reserves, are there lessons to be learned about the dominant role of the U.S. dollar as the primary reserve asset in the global system? c) What preliminary lessons have been learned about the capacity of the emerging market economies to engage in stimulating domestic monetary and fiscal policies in the face of a softening or a contraction of global demand? What conditions are necessary for such measures to be both feasible and effective and how powerful can the impact of such measures be on the global economy? And d) A number of countries, in Eastern Europe and elsewhere, have been severely damaged by the reversal of capital flows in the past years. In many cases, the fault has been seen to lie, at least in part, in the policies pursued in opening their capital markets. What are the lessons that have been learned? What should be done to avoid a repeat of this experience in these and, as importantly, in frontier emerging economies? Is there a greater role for the IMF here? These are all difficult questions. However these can be taken as an element for the discussions over the reform of the IMF and of the global economic and financial architecture.
6. References:
1. Global financial turmoil and Emerging Market Economies: Major contagion and a shocking loss of wealth? -- by the Asian Development Bank (ADB)
Macro Economics Assignment Group 3
2. The Impact of the Financial Crisis on Emerging Market Economies: The Transmission Mechanism, Policy Response and Lessons – by Jack Boorman
doc_669002176.docx