International financial crises

Transcription

1 International Macroeconomics Master in International Economic Policy International financial crises Lectures Nicolas Coeurdacier

2 Lectures 11 and 12 International financial crises 1. Financial crises and balance sheet effects 2. Sovereign Debt Crises 3. Asset bubbles

3 Lectures 11 and 12 International financial crises 1. Financial crises and balance sheet effects 2. Sovereign Debt Crises 3. Asset bubbles

4 Bubbles and Crashes Asset bubbles are often associated with financial crashes Two important questions: What is a bubble? Can it be identified? Should policies and monetary policies in particular do something about it?

5 Asset bubbles Are assets priced according to fundamentals that are public information? efficient market hypothesis(e.g.: fundamentals for equity: future dividends) Plenty of empirical evidence against it: in particular excess volatility of asset prices(fundamentals are not so volatile) Bubbles exist when prices deviate from their fundamental value. Price Distortion + speculation: hold an overpriced asset in the hopetosellitatanevenhigherpricetosomeonewhowill buyitforthesamereason. (note: on average in US, less than 10 % of real estate purchase is for investment purpose; in 2005 it increased to 28%)

6 Asset bubbles Asset bubbles: Coordination of investors on a class of asset. Investors buy an asset expecting price will go up. Purchases of theassetwillindeedbidupthepricethusvalidating expectations. Investors ride the bubble. Each investor thinks he will be smartenoughtogetoutjustbeforethebubbleburst. Aslongasthemusicisplaying,you'vegottogetupand dance [Chuck Prince]

7 Tulip mania: the first bubble In 17th century Holland (Dutch Golden Age), contract prices for bulbs of the newly-introduced tulips reached extraordinarily high levels At the peak of tulip mania in February 1637, tulip contracts sold for more than 10 times the annual income of a skilled craftsman!

8 Tulipmania, 1637 Oxford University Press, All rights reserved. Source: Garber (1990)

9 The rise and fall of NASDAQ stocks Oxford University Press, All rights reserved.

10 Stock Prices Stocks are shares in firms. Stocks pay dividends (share of profits) at date t: d t The value of a share at date t: q t can increase or decrease over time leading to capital gains or losses R = real interest rate Dividend yield is d t /q t Capital gain is (q t+1 -q t )/q t

11 Asset bubbles: a bit of theory Consider risk neutral investors holding a stock of price q t which pays dividends d t : Arbitrage implies (rate of interest R) R = d t /q t + (q e t+1 -q t)/q t or equivalently q t = (d t + q e t+1 )/(1+R) Stock prices are forward looking. Note: Risk averse investors have to be compensated for risk. They ask for a risk premium µ t : R + µ t = d t /q t + (q e t+1 -q t )/q t

12 Asset bubbles: a bit of theory q t = (d t + q e t+1 )/(1+R) This expression is key for a bubble to emerge since expectations of future prices affect today s prices. Such an expression holds for stocks but any asset can be written in a similar way. Housing prices depend on rents + expected value in the future. One can also show that in most models of exchange rates due to uncovered interest parity, exchange rates can written as follows with a<1 e t = f t + a e e t+1where f t denotes the fundamental value of exchange rate

13 Go one period forward:q t+1 = (d t+1 + q e t+2)/(1+r) q t+1 = (d t+1 + q e t+2 )/(1+R) so q e t+1= (d e t+1+ expectation (q e t+2))/(1+r) = (d e t+1+ q e t+2)/(1+r) Note: application of the law of iterated expectations. You expect to expect what you expect Use : q t = (d t + q e t+1 )/(1+R) so q t = d t /(1+R)+ d e t+1/(1+r) 2 + q e t+2 /(1+R) 2 And q e t+2 = (d e t+2+ q e t+3 )/(1+R) so. q t = d t /(1+R)+ d e t+1/(1+r) 2 + d e t+2 /(1+R) lim q e t+k/(1+r) k k inf. The net present value of future dividends = fundamental price

14 Conditions for a bubble The stock price today is determined by expected fundamentals + the value of the stock very far in the future q t = d t /(1+R)+ d e t+1/(1+r) 2 + d e t+2 /(1+R) lim q e t+k/(1+r) k What determines lim q e t+k/(1+r) k? k inf. k inf. suppose you expect all to expect this to be high lim q e t+k/(1+r) k > 0: a bubble exists(price is above fundamental value) k inf. if q e t+kgrows faster than 1/(1+R) k goes to zero: the path is explosive. Investors have to expect prices will rise at ever faster rates to make sense of ever crazier prices!

15 Can a rational bubble exist in such a context? If a bubble exists, asset price could go very far above its fundamental value But who will buy this asset if price not based on fundamentals? rational investors should realize that at some point the bubble will collapse (the value of the dollar, of houses, equity cannot exceed world income!) Working backwards from the inevitable collapse, investors should realize the chain of expectations driving the bubble is illogical and therefore can never happen! Bubbles are irrational! Why do they exist? Myopic investors Behavioral biases Short-termism if uncertain about when the collapse happens, bubbles can develop higher order knowledge: I know that the price is too high, but I am not sure whether others know

16 The so-called Wile E.Coyote Effect

17 What pricks a bubble? Sudden shift in market sentiment and self-fulfilling expectations : Keynes animal spirits Liquidity shocks/increase in the rate of interest. Some argue that Fed interest rate increases in 2007 did it for the housing bubble. Adverse shock to fundamentals

18 Does financial globalization generate bubbles? Historically not: bubbles can develop with small international capital movements: Dutch Tulipmania (1637), the South Sea bubble in England (1720), the Mississippi bubble in France ( ), emerging markets, internet, housing But financial globalization may facilitate the emergence of bubbles. How? Globalization increases the pool of potential investors/speculators. Emergence of high savings countries in Asia has lowered world interest rates. Facilitates the emergence of bubbles

19 Bubbles and exchange rates Carry trade strategies Borrow in currencies with low interest rates to invest in high interest rate currencies Investors expect the high interest rate to appreciate which happens as long as capital is flowing into the high interest rate currency. Investors pocket the interest rate differential plus the currency appreciation. One of the main source of the failure in UIP. However risky strategy. Many examples: Icelandic Krona, South African rand, New Zealand Dollar

20 Carry trade in Iceland (end ) Glacier bond issuance: the most popular form of króna carry-trade activity ISK Eurobond issuance started in August 2005 Total issues approaching 500 b.kr. and around 370 b.kr. outstanding (32% of GDP) Similar to the New Zealand case European retail investors the main buyers

21 Carry trade in Iceland CB Policy Rates Nominal exchange rates Carry trade fueled by a fairly high interest rate differential between Iceland and the eurozone Carry trade favoured the appreciation of the Icelandic Krona towards the end of 2005 Source: Portes et al. (2007)

22 Carry trade in Iceland Short-term capital inflows in forex markets, billions ISK

23 Carry trade in Iceland Effects of the carry trade in Iceland in the medium-term 1. Access to credit easier extended the life time of the consumption, investment and housing boom (bubble?) delayed the needed adjustment larger imbalances to unwind A case of increased financial integration causing excess borrowing? 2. Altered the transmission mechanism of monetary policy making it more complex for the Central Bank to unwind the imbalances. Raise in interest rates to stabilize the credit boom fuel the carry trade.

24 Carry trade in Iceland Credit expansion in Iceland External imbalances in Iceland ( ) Domestic Credit % of GDP Net Foreign Asset % of GDP (left axis); Net External Debt % of GDP (right axis) Source: Portes et al. (2007)

25 Crash in Iceland Carry trade generated cheap liquidity for Icelandic bank and favored the emergence of a credit boom and an housing bubble. Despite the issuance of Glacier bonds, most of foreign debt was denominated in foreign currency (euro in particular) vulnerable to balance-sheet effects and expectation driven crisis as seen previously Contraction of liquidity due to the sub-prime crisis and then financial crisis made it impossible for Icelandic banks to rollover their short term debt. Financial Crashwhere most Icelandic bank went bankrupt

26 Quick Summary 1. Borrowing in foreign currency and lending in domestic currency makes countries vulnerable to self-fulfilling crashes due to balance sheet effects. 2. Similar balance-sheet effects might arise when borrowing shortterm and lending long-term. This makes high leveraged banks very vulnerable to liquidity shocks. 3. Sovereign risk can lead to sovereign debt crisis when public debt becomes unsustainable. Changes in interest rates and growth rates have large impact on debt sustainability. 4. Asset prices bubbles are common even though hard to justify with rational expectations. Bubbles on exchange rates can lead to carry trade speculation.