A970079 Module 2


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This is a presentation on the causes and the transmission mechanisms of the current financial and economic crisis

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A970079 Module 2

  1. 1. Module 2 The causes and the transmission mechanisms of the crisis
  2. 2. Learning objectives <ul><li>Understand immediate and root causes of the financial and economic crisis </li></ul><ul><li>Comprehend the transmission mechanisms of the crisis and what makes economies vulnerable/resilient to it </li></ul>
  3. 3. Module outline <ul><li>The current crisis </li></ul><ul><li>The pre-crisis situation </li></ul><ul><li>What went wrong? </li></ul><ul><li>Spread of crisis: transmission channels </li></ul><ul><li>Vulnerability analysis </li></ul><ul><li>To remember </li></ul><ul><li>Reflection points </li></ul>
  4. 4. The current crisis <ul><li>The worst crisis since the Great Depression of the 1920s. </li></ul><ul><li>Shrinking global economy and recession; all countries and sectors affected </li></ul><ul><li>The ILO projects a job loss ranging from 29 to 59 million and dramatic deterioration in quality of employment, i.e. vulnerable employment and working poverty. </li></ul>
  5. 5. The pre-crisis situation <ul><li>Unprecedented growth, high level optimism leading to excessive economic deregulation. </li></ul><ul><ul><li>Growth in industrial countries especially in the U.S. was largely due to debt-driven consumption </li></ul></ul><ul><ul><li>In the case of some emerging economies, growth was export-led hence highly dependent on external demand. </li></ul></ul><ul><ul><li>Growth in most developing countries especially in the middle-east and Sub-Saharan Africa was propelled by high commodity prices especially oil and minerals. In addition, large flows of remittances had important roles. </li></ul></ul><ul><li>Global saving-investment imbalances </li></ul><ul><ul><li>massive accumulation of global reserves by oil reach countries and high reserve countries such as China </li></ul></ul><ul><ul><li>National de-saving in countries such as the US </li></ul></ul>
  6. 6. Pre-crisis situation …cont’d <ul><li>Weak regulatory and supervisory framework (due to excessive deregulation) of financial markets in major industrial countries, especially the U.S. </li></ul><ul><ul><li>Led to excessive investment in high interest but risky financial and economic ventures </li></ul></ul><ul><ul><li>Low interest rates encouraged excessive borrowing especially for investment in housing </li></ul></ul><ul><li>Weak labour market performance </li></ul><ul><ul><li>High economic growth failed to generate adequate employment opportunities </li></ul></ul><ul><li>Growing income inequalities between and within countries </li></ul><ul><ul><li>As income disparities rose, richer households – which typically save more – fuelled aggregate savings disproportionately. In contrast, poor and medium income household who faced relative stagnated median wages and incomes reverted to credit to sustain consumption and housing investment decisions; this was made possible by lax financial regulation. </li></ul></ul>
  7. 7. Weak financial regulation and sub-prime mortgages <ul><li>The financial regulatory framework, in particular, in the U.S. was weak in terms of: </li></ul><ul><ul><li>Excessive deregulation allowed the introduction of complex and risky financial instruments (e.g. sub-prime credit – see next slides) without comprehensive understanding of the risk associated. </li></ul></ul><ul><ul><li>Lax regulation towards risk assessment practices </li></ul></ul><ul><ul><li>Sustained low interest rates due to high capital inflows encouraging higher private borrowing especially for mortgage loans on the belief that house prices will always increase </li></ul></ul><ul><li>As a result, house prices overshot through speculation thereby setting the stage for the immediate trigger for the crisis. </li></ul>
  8. 8. <ul><li>A type of mortgage given to borrowers who normally would not have qualified to get credit under conventional mortgages (so called prime mortgage) due to either their poor credit rating or incapability to make sufficient down-payment. </li></ul><ul><li>Sub-prime lenders view sub-prime borrowers as having a higher risk of defaulting on the loan than conventional borrowers.  </li></ul><ul><li>To compensate for the high risk, interest rates on sub-prime mortgages are much higher than conventional mortgages. </li></ul>But is what a sub-prime mortgage?
  9. 9. Then something dramatic happened!!!! <ul><li>Housing bubble (i.e. the high prices) in the U.S. which reached its peak in 2006 suddenly busted and house prices started to tumble sending panics at the heart of financial institutions. </li></ul>
  10. 10. <ul><li>Then What? </li></ul>
  11. 11. <ul><li>Housing prices collapsed </li></ul><ul><li>Mortgage-backed securities collapsed </li></ul><ul><li>Wide spread collapse in stock markets/Bank crisis </li></ul><ul><li>Loss of assets by lending institutions and house owners </li></ul><ul><li>Liquidity problems and difficulty of finding credit by enterprises and house owners (credit crunch) </li></ul><ul><li>Collapse of investors’ and consumers’ confidence </li></ul>Enterprises unable to finance their operations Cut in household expenditure/demand Rise of private precautionary saving Further collapse in purchasing power Job losses Business closure/lower capacity utilization Inventories rising The domino effect of the crisis
  12. 12. <ul><li>How did the crisis then transmitted to developing countries? </li></ul>
  13. 13. Crisis transmission channels <ul><li>There were three important channels by which the crisis transmitted to developing countries: </li></ul><ul><ul><li>Remittances </li></ul></ul><ul><ul><li>Capital flows (portfolio investment and FDI) </li></ul></ul><ul><ul><li>Trade </li></ul></ul><ul><li>For some countries, reduced aid has been an issue. </li></ul>
  14. 14. <ul><ul><li>For some countries a notable decline in remittances has been noted due to loss of jobs of migrant workers. As an example, the survey result by Inter-American Dialogues (2009) in the United States shows: </li></ul></ul><ul><ul><ul><li>45% of all remitters will send less during 2009 than 2008. </li></ul></ul></ul><ul><ul><ul><li>Average remittance per transaction has decreased by about 5%, from $241 in 2008 to $230 in 2009. </li></ul></ul></ul><ul><ul><ul><li>Moreover, the frequency of remitting has dropped significantly from 15.3 transactions per year in 2008 to a projected 12 transactions per year in 2009. </li></ul></ul></ul>Remittances
  15. 15. Capital flows UNCTAD, 2008 <ul><li>It was estimated that global FDI flows declined by 21 per cent in 2008 </li></ul><ul><li>Developed countries were mostly affected. </li></ul><ul><li>Export-oriented FDI projects in developing and emerging economies could be increasingly affected due to the low dynamism of advanced countries markets </li></ul><ul><li>Growing share of FDI outflows from emerging and developing countries </li></ul>
  16. 16. The trade channel UNCTAD, 2008 <ul><li>Developing countries dependence on export markets has increased sharply from 25% of their GDP in 1995 to over 50% in 2007. </li></ul><ul><li>Sharp fall of global demand is the major channel by which the crisis was transmitted to developing countries. </li></ul><ul><li>World merchandise trade fell between 6 and 8 per cent in volume this year and the fall in value is expected to be larger. </li></ul><ul><ul><li>Most countries in East Asia and some countries in Latin America have been affected by sharp fall of demand and prices for manufacturing goods causing decline industrial production, hence growth and employment. </li></ul></ul><ul><ul><li>Most countries in Africa, West Asia and the Middle East were affected by slumps in demand and prices for primary commodities including oil and minerals. </li></ul></ul>
  17. 17. <ul><li>Not all developing countries are equally affected depending on the degree of resilience in coping with external shocks </li></ul><ul><li>Initial conditions; external linkages ( see next slide ) </li></ul>Vulnerability analysis
  18. 18. Vulnerability analysis
  19. 19. To remember <ul><li>Unfair globalization and weak labour markets as systemic problems </li></ul><ul><li>Danger of excessive market deregulation </li></ul><ul><li>Flows of crisis from the financial sector to real economy to people </li></ul><ul><li>An imported crisis to developing countries </li></ul><ul><li>Vulnerability to external shocks associated with dependence on exports, remittances and investment </li></ul>
  20. 20. Reflection point <ul><li>Imbalances in financial markets are related to wider disequilibrium in society and in the process of globalization. Ensuring recovery to a sustainable global development path requires coherent policy action within and between countries across several policy fields, including finance and investment, trade, employment and social affairs and environment. </li></ul><ul><li>But, what can be done to make the recovery inclusive, comprehensive and effective? </li></ul>