Why the Sub-Prime Crisis is a Turning Point for the World Economy
Why the Crisis is a Turning Point
“Things that can’t go on forever, don’t.” Herbert Stein.
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Why the Crisis is a Turning Point
• Crisis of credibility for Anglo-Saxon financial capitalism
• Crisis for securitised lending
• Crisis for central banks and regulators • Crisis for belief in free markets
• Crisis for global asset markets
• Crisis for global macroeconomic balances • Crisis for US and global economic activity • Crisis for game of “pass-the-external-deficits”
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1. Crisis of Anglo-Saxon financial capitalism
• First, a mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London:
– From “ninja” (no-income, no-job, no-asset) sub-prime lending, – To the placing (and favourable rating) of assets that turn out to be almost impossible to understand, value or sell, – These activities have been riddled with conflicts of interest and incompetence. – Huge risks have been taken. In the subsequent era of financial “revulsion”, core financial markets have seized up
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1. Crisis of Anglo-Saxon financial capitalism
HIGH REWARD MEANS HIGH RISK
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1. Crisis of Anglo-Saxon financial capitalism
CREDIT SHOCK IN THE US
SPREAD BETWEEN COMMERCIAL PAPER AND TREASURY BILL RATES
3.00
2.50
2.00
1.50
1.00
0.50
0.00
01/01/2007
01/02/2007
01/03/2007
01/04/2007
01/05/2007
01/06/2007
01/07/2007
01/08/2007
01/09/2007
01/10/2007
01/11/2007
01/12/2007
01/01/2008
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01/02/2008
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-0.8 0.2 0.4 0.6 0.8 1.2 1.4 0 1 -0.6 -0.4 -0.2
01/01/2007 15/01/2007 29/01/2007 12/02/2007 26/02/2007 12/03/2007 26/03/2007 09/04/2007 23/04/2007 07/05/2007 21/05/2007 04/06/2007 18/06/2007 02/07/2007 16/07/2007 30/07/2007 13/08/2007
UK US Eurozone
27/08/2007 10/09/2007 24/09/2007 08/10/2007 22/10/2007 05/11/2007 19/11/2007 03/12/2007 17/12/2007 31/12/2007 14/01/2008
1. Crisis of Anglo-Saxon financial capitalism
SPREADS BETWEEN INTERVENTION RATES AND THREE-MONTH LIBOR
2. Crisis for securitised lending
• These events have called into question the workability of securitised lending:
– The argument for this change was that it would shift the risk of term-transformation (borrowing short to lend long) out of the banking system onto those best able to bear it; – What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it; – What also occurred was a multiplication of leverage and termtransformation, not least through the banks’ “special investment vehicles”; and – What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper.
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2. Crisis for securitised lending
EXCESS DEBT LEADS TO CREDIT IMPLOSION
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3. Crisis for central banks and regulators
• Third, the crisis has opened up big questions about the roles of central banks:
– How far, for example, do the responsibilities of central banks as “lender-of-last-resort” during crises stretch? – Should they, as some argue, be market-makers-of-last resort in credit markets? – What, more precisely, should a central bank do when liquidity dries up in important markets?
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3. Crisis for central banks and regulators
• Equally, the crisis suggests that liquidity has been significantly underpriced:
– Does this mean that the regulatory framework for banks is fundamentally flawed? – What is left of the idea that we can rely on financial institutions to manage risk through their own models? – What, moreover, can reasonably be expected of the rating agencies? – A market in US mortgages is hardly terra incognita. If banks and rating agencies got this wrong, what else must be brought into question?
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3. Crisis for central banks and regulators
NOTE HOW THINLY CAPITALISED BANKS ARE
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4. Crisis for belief in free markets
• US officials used to lecture, not least the Japanese, about letting asset prices reach equilibrium and transparency enter markets. That was then:
– Now we see Hank Paulson, US Treasury secretary, a cartel of holders of toxic securitised assets in his “superSIV”; – We see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market. – We see increasing talk of a bail out of over-indebted households – Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face.
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HOUSE PRICES IN REAL TERMS
200 180 160 140 120 100 80 60 40 20 0
THIS TIME, IT’S PERSONAL
4. Crisis for belief in free markets
Composite-10 annual per cent change -15 0 5 -5 -10
REAL HOUSE PRICES (Case-Shiller 10-City)
Ja Jan-8 7 Jan-8 8 Jan-8 9 Jan-9 0 Jan-9 1 Jan-9 2 Jan-9 3 Jan-9 4 Jan-9 5 Jan-9 6 Jan-9 7 Jan-9 8 Jan-9 9 Jan-0 0 Jan-0 1 Jan-0 2 Jan-0 3 Jan-0 4 Jan-0 5 Jan-0 n- 6 07
10 15 20
RATE OF CHANGE OF HOUSE PRICES
5. Crisis for global asset markets
• Fifth, the crisis signals a re-rating of risk.
• It also represents a move towards holding more transparent and liquid assets.
• This correction has been selective, however.
• It is a striking feature of what has happened that emerging markets have emerged as a safe haven.
• For emerging economies, this must be sweet revenge.
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16
1000 1200 1400 1600 1800 200 400 600 800 0
06/01/1997 06/07/1997 06/01/1998 06/07/1998 06/01/1999 06/07/1999 06/01/2000 06/07/2000 06/01/2001 06/07/2001 06/01/2002 06/07/2002 06/01/2003 06/07/2003 06/01/2004 06/07/2004 06/01/2005
5. Crisis for global asset markets
REDUCTION IN EMERGING MARKET RISK SPREADS (percentage points over US Treasuries)
DISAPPEARING EMERGING ECONOMY RISK
COMPOSITE MEXICO TURKEY CHINA
06/07/2005 06/01/2006 06/07/2006 06/01/2007 06/07/2007 06/01/2008
4. Crisis for global asset markets
DISAPPEARING EMERGING ECONOMY RISK
EXPLOSIVE GROWTH OF FOREIGN CURRENCY RESERVES ($m)
7,000,000
Other developing Mexico Brazil Russia Oil exporters
6,000,000
5,000,000
Other industrial Australia UK
Source: IMF
4,000,000
Eurozone US Other Asia Thailand Malaysia Hong Kong Singapore
3,000,000
2,000,000
1,000,000
Korea India Taiwan Japan China
0
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Ja nM 99 ay -9 Se 9 p9 Ja 9 nM 00 ay -0 Se 0 p0 Ja 0 nM 01 ay -0 Se 1 p0 Ja 1 n02 M ay -0 Se 2 p0 Ja 2 nM 03 ay -0 Se 3 p0 Ja 3 nM 04 ay -0 Se 4 p0 Ja 4 nM 05 ay Se 05 p0 Ja 5 nM 06 ay -0 Se 6 p0 Ja 6 nM 07 ay Se 07 p07
6. Crisis for global macroeconomic balances
• Sixth, this event marks the limits to the US role as consumer of last resort in the world economy. • The US is re-importing the stimulus it exported to the rest of the world in previous years. • The credit crunch is accelerating this process. • For this reason, US policymakers are relaxed about the dollar’s fall, provided it does not awaken fears of rapidly rising inflation.
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6. Crisis for global macroeconomic balances
UNBALANCED WORLD ECONOMY
CURRENT ACCOUNT BALANCES (as per cent of GDP)
Source: IMF, World Economic Outlook , October 2007 1.5 1 0.5 0 -0.5 -1 -1.5 -2 1997 1998 1999 2000 2001 2002 Euro area 2003 2004 2005 2006 2007 2008 2009 2010
United States
Japan
Emerging Asia
Oil exporters
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6. Crisis for global macroeconomic balances
US AS BORROWER OF LAST RESORT
GLOBAL CURRENT ACCOUNT 2006 ($bn)
-$1,000 US UK Western Europe, excluding UK Japan China Rest of Asia Total Asia Fuel exporters Rest of World Discrepancy -$131 $19 $396 $102 $511
Source: IMF, World Economic Outlook, April 2004, April 2007 and April 2007 Database.
-$800
-$600
-$400
-$200
$0
$200
$400
$600
-$857 -$68 $131 $170 $239
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6. Crisis for global macroeconomic balances
SHRINKING CURRENT ACCOUNT DEFICIT
CURRENT ACCOUNT BALANCE (per cent of GDP)
2 1 0 -1 -2 -3 -4 Source: BEA -5 -6 -7 -8
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Q 1 8 Q 0 2 8 Q 1 3 8 Q 2 4 8 Q 3 1 8 Q 5 2 8 Q 6 3 8 Q 7 4 8 Q 8 1 9 Q 0 2 9 Q 1 3 9 Q 2 4 9 Q 3 1 9 Q 5 2 9 Q 6 3 9 Q 7 4 9 Q 8 1 0 Q 0 2 0 Q 1 3 0 Q 2 4 0 Q 3 1 0 Q 5 2 0 Q 6 3 07
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100 110 120 130 60 70 80 90
Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06
FALLING DOLLAR
US REAL EXCHANGE RATE (JP Morgan)
6. Crisis for global macroeconomic balances
7. Crisis for US and global economic activity
• Seventh, a deep US recession is possible. Whether it happens depends overwhelmingly on consumers:
– The principal counterpart of the external deficits has been the excess of spending over income by households. – That has meant negligible savings and a big jump in household debt: mortgage debt jumped from 63 per cent of disposable incomes in 1995 to 98 per cent in 2005. – This rising trend will not continue in a falling housing market. – Unwillingness (or inability) to borrow on such a scale willhamper the effectiveness of US monetary policy.
– That, in turn, makes a weak dollar and strong export growth yet more important.
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7. Crisis for US and global economic activity
US DOMESTIC IMBALANCES
FINANCIAL BALANCES IN THE US ECONOMY, SINCE 1990 (per cent of GDP)
8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0%
1990-III
1991-III
1992-III
1993-III
1994-III
1995-III
1996-III
1997-III
1998-III
1999-III
2000-III
2001-III
2002-III
2003-III
2004-III
2005-III
2006-III
Private Financial Balance
Government Financial Balance
Foreign Financial Balance
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2007-III
1990-I
1991-I
1992-I
1993-I
1994-I
1995-I
1996-I
1997-I
1998-I
1999-I
2000-I
2001-I
2002-I
2003-I
2004-I
2005-I
2006-I
2007-I
7. Crisis for US and global economic activity
HOUSEHOLDS SPENT; COMPANIES DID NOT
US HOUSEHOLD AND BUSINESS FINANCIAL BALANCES (as per cent of GDP)
5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0%
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19 90 19 -I 90 -I 19 V 91 -I 19 II 92 -I 19 I 93 19 -I 93 -I 19 V 94 -I 19 II 95 -I 19 I 96 19 -I 96 -I 19 V 97 -I 19 II 98 -I 19 I 99 19 -I 99 -I 20 V 00 -I 20 II 01 -I 20 I 02 20 -I 02 -I 20 V 03 -I 20 II 04 -I 20 I 05 20 -I 05 -I 20 V 06 -I 20 II 07 -II
Business Financial Balance Household Financial Balance
7. Crisis for US and global economic activity
US LEADS THE ECONOMIC SLOWDOWN
CONSENSUS FORECASTS OF GROWTH FOR 2008
3.5
3.0
2.5
2.0 1.5
1.0 Source: Consensus Forecasts 0.5
0.0 Jan07 Feb07 Mar07 Apr07 May07 Jun- Jul-07 Aug07 07 UK 2008 Sep07 Oct07 Nov07 Dec07 Jan08 Feb08
USA 2008
Japan 2008
Eurozone 2008
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27
0
01/01/2007 15/01/2007 29/01/2007 12/02/2007 26/02/2007 12/03/2007 26/03/2007 09/04/2007 23/04/2007 07/05/2007 21/05/2007 04/06/2007 18/06/2007 02/07/2007 16/07/2007 30/07/2007 13/08/2007 27/08/2007 10/09/2007 24/09/2007 08/10/2007 22/10/2007 05/11/2007 19/11/2007 03/12/2007 17/12/2007 31/12/2007 14/01/2008 28/01/2008 11/02/2008 25/02/2008
1
2
3
4
5
6
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7. Crisis for US and global economic activity
THE FED DULY PANICS AS NEWS GETS BAD
US FEDERAL FUNDS EURO SHORT TERM REPO UK BASE RATE
CENTRAL BANK INTERVENTION RATES
7. Crisis for US and global economic activity
• A very long and deep US recession is possible
• This depends on how far house prices fall
• If they fall a further 30-40 per cent, losses in the financial system could be anywhere between $1,000bn and $3,000bn. The latter would decapitalise the US banking system • Similar points of weakness can be seen in housing markets and financial systems elsewhere
• Particularly the UK
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29
100 120 140 160 180 200 20 40 60 80 0
Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07
7. Crisis for US and global economic activity
REAL UK HOUSE PRICES (FT price index)
8. Crisis for game of “pass-the-external-deficits”
• This event also has big significance for the game of “pass-the-external-deficits” that has characterised the world economy for several decades.
– It has proved virtually impossible for emerging market economies to run large deficits, without running into crises; – Over the past decade, the US filled the (growing) gap – But surpluses being run by China and Japan, by oil exporters and, within the European Union, by Germany continue to grow. – If we are to enjoy global macro-economic stability, a creditworthy set of countervailing borrowers must emerge.
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8. Crisis for game of “pass-the-external-deficits”
EMERGING ECONOMIES SHIFT INTO SURPLUS
SAVINGS, INVESTMENT AND CURRENT ACCOUNTS OF EMERGING MARKET AND OIL-PRODUCING COUNTRIES (per cent of GDP) 9 8 7 6 5 4 3 2 1 0 -1 -2
Source: IMF, World Economic Outlook, April 2007
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19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06
Current Account Saving Investment
8. Crisis for game of “pass-the-external-deficits”
CHINA’S EXPLOSIVE CURRENT ACCOUNT
400 300 200 100 0 -100 -200 -300 -400 -500 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
CA Balance
Net FDI
Other Capital Inflows
Reserves Accumulation
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8. Crisis for game of “pass-the-external-deficits”
WHO DOES THE SAVING IN CHINA
COMPOSITION OF SAVINGS (per cent of GDP)
60.0 Source: World Bank 50.0
7.0 7.6
40.0
4.5 4.8 8.6 6.8 7.9 6.9
7.8
30.0
15.6 15.8 15.3 14.4 14.2 16.2 25.0 19.8
28.3
20.0
10.0
18.7
16.7
14.8
14.2
16.3
15.8
15.4
14.6
15.3
0.0 1998 1999 2000 2001 Enterprises 2002 2003 2004 2005 2006
Households
Government
Gross capital formation
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34
$0.000
02/01/1990 02/01/1991 02/01/1992 02/01/1993 02/01/1994 02/01/1995 02/01/1996 02/01/1997 02/01/1998 02/01/1999 02/01/2000 02/01/2001 02/01/2002 02/01/2003 02/01/2004 02/01/2005 02/01/2006 02/01/2007 02/01/2008
8. Crisis for game of “pass-the-external-deficits”
THE PEGGED EXCHANGE RATE
$0.050
$0.100
$0.150
$0.200
$0.250
8. Crisis for game of “pass-the-external-deficits”
THE FIXED CHINESE REAL EXCHANGE RATE
TRADE-WEIGHTED REAL EXCHANGE RATE
130 120 110 100 90 Source: JP Morgan 80 70 60
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
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Jan-08
9. Conclusion
• So we have some huge tasks ahead:
– Managing the present crisis;
– Rethinking financial regulation; – Rethinking central banking; – Rethinking the management of global imbalances; and – Rethinking exchange-rate and macroeconomic policies in developing countries
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