THE GLOBAL FINANCIAL CRISIS LESSONS FOR FINANCIAL SECTOR REFORM Ulrich Volz, German Development Institute (DIE) ICRIER-InWEnt Workshop on Current Developments in the Indian Financial System New Delhi, 20 March 2009
Overview Recap: the story so far Outlook: how bad will it get? Causes of the crisis Lessons for financial sector reform
Global financial crisis & dev. countries Recap: the story so far
Recap: the story so far Unlike previous developing and emerging markets crises, the ongoing financial crisis originated in mature economies When the sub-prime crisis erupted in the US in 2007, not only Europe but also developing and emerging countries were thought to be immune (decoupling hypothesis) on account of: - limited exposure to sub-prime market/impaired assets - improved fundamentals and policy framework
Recap: the story so far Decoupling hypothesis proved to be a myth Even countries whose financial sector was not or hardly exposed to toxic assets are hit Dependencies on developed markets exist, both in trade and finance, and they are felt now Countries with large current account deficits and financing needs, exposure to foreign exchange risk, and high leverage were hit the hardest
Recap: the story so far Contagion has been making its way through: Financial market links Deleveraging and heightened risk aversion on the back of existing vulnerabilities financing in int l capital markets more difficult and costly Real economy links Global slowdown/contraction lower trade, falling commodity prices, decline in remittances - Indirect impact on bank credit risk/quality of loan portfolio - Indirect impact on government revenue and fiscal balance
02/09/08 02/11/08 02/07/08 Recap: the story so far Heightened risk aversion 900 800 EMBI + spread 700 600 500 400 300 200 100 02/01/07 02/03/07 02/05/07 02/07/07 02/09/07 02/11/07 02/01/08 02/03/08 02/05/08
Recap: the story so far Plunging stock markets 500 400 300 200 100 0 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 MERVAL Argentina RTSI Russia SSE Composite Index China BOVESPA Brazil BSE SENSEX India IPC Mexico IHSG Indonesia
Recap: the story so far Depreciating currencies 130 120 110 depre c iatio n 100 90 80 70 60 Jan- 06 Mar- 06 May- 06 Jul- 06 Sep- 06 Nov- 06 Jan- 07 Mar- 07 May- 07 Jul- 07 Sep- 07 Nov- 07 Jan- 08 Mar- 08 May- 08 Jul- 08 Sep- 08 Nov- 08 Argentinean peso Brazil real Chinese RMB Indian rupee Russian rubel Indonesian rupee Mexican peso Source: IMF/IFS
Recap: the story so far Tumbling commodity prices 240 200 160 120 80 40 04/01/07 04/05/07 04/09/07 04/01/08 04/05/08 04/09/08 Oil Gold Metals Agriculture Source: Bloomberg and Global Insight
Recap: the story so far Other effects Decline in foreign direct investment (FDI) by an estimated 10% in 2008 (UN Jan 2009) Sharp decline in remittances, which in 2007 amounted to $282 billion worldwide (about 3 times as much as ODA, and about 6% of GDP of LIC; according to the World Bank) Global shortfall in trade finance has soared to about $100bn (WTO March 2009)
Global financial crisis & dev. countries Outlook: how bad will it get?
How bad will it get? GDP growth (% change) 10 8 6 4 2 0-2 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Emerging and developing economies World Advanved economies Source: IMF World Economic Outlook Update, January 2009
How bad will it get? Growth estimates for developing countries for 2009 2007 2008 2009 Pessimistic scenario Middle scenario Optimistic scenario Transition economies 8.3 6.9 2.7 4.8 6.1 Developing countries 7.2 5.9 2.7 4.6 5.1 Africa 6.0 5.1 0.1 4.1 4.7 East Asia 9.0 6.9 4.6 5.9 6.4 South Asia 7.4 7.0 4.0 6.4 6.6 West Asia 4.7 4.9 1.6 2.7 3.3 Latin America & Caribbean 5.5 4.3-0.2 2.3 2.7 Source: UN World Economic Situation and Prospects 2009
How bad will it get? Growth in global industrial production and merchandise trade (annualised 3-months %change) 15 50 10 Industrial Production (left scale) 40 30 5 20 10 0 0-10 -5 Merchandise export value (right scale) -20-10 -30-40 -15-50 1997M1 1997M5 1997M9 1998M1 1998M5 1998M9 1999M1 1999M5 1999M9 2000M1 2000M5 2000M9 2001M1 2001M5 2001M9 2002M1 2002M5 2002M9 2003M1 2003M5 2003M9 2004M1 2004M5 2004M9 2005M1 2005M5 2005M9 2006M1 2006M5 2006M9 2007M1 2007M5 2007M9 2008M1 2008M5 2008M9 Source: IMF World Economic Outlook Update, January 2009
How bad will it get? External financing flows to emerging market economies (millions of dollars) 2003 2004 2005 2006 2007 2008e 2009f Private flows, net 236,746 333,311 523,486 564,909 928,553 465,792 165,328 Equity investment, net 138,539 195,006 250,082 222,309 296,131 174,065 194,823 Direct equity investment, net 103,168 154,659 197,322 170,911 304,146 263,358 197,476 Portfolio equity investment, net 35,371 40,347 52,760 51,478-8,015-89,293-2,653 Commercial banks, net 34,994 62,215 163,946 211,915 410,259 166,643-60,642 Credit flows, net 37,650 64,403 164,223 210,915 408,353 167,620-60,604 Interest arrears 678 53-20 0 0 0 410 Discounted debt transactions -1,350 122 0 0 0 0 0 Other private creditors, net 63,214 76,091 109,459 130,684 222,163 125,083 31,147 Official flows, net -19,942-15,397-65,460-57,499 11,374 40,971 29,374 International financial institutions, net -6,133-14,336-40,305-30,436 2,651 16,642 31,013 Official bilateral creditors, net -13,809-1,061-25,155-27,063 8,723 24,329-1,639 Resident lending abroad, net -49,788-111,301-247,014-315,216-384,407-421,937-271,726 Errors and omissions, net -23,769 27,959-59,796-21,222-41,157-28,013 0 Monetary gold (- = increase) 709 646 1,069-81 283 129 139 Reserves excluding gold (- = increase) -272,503-400,113-429,204-554,838-948,656-444,289-245,860 f = IIF forecast, e = estimate Source: Institute of International Finance, Capital Flows to Emerging Market Economies, 27 January 2009
How bad will it get? Current account balance of emerging market economies (millions of dollars / % of GDP) 2003 2004 2005 2006 2007 2008e 2009f Trade balance 204,022 244287.0836 347916.1497 463576.97 491524.4471 510731.3498 477593.8613 Merchandise exports 1,791,942 2327685.424 2822517.832 3418961.577 4076993.526 4857258.109 4488754.343 Merchandise imports -1,587,920-2083398.34-2474601.682-2955338.826-3585488.178-4346527.648-4011110.571 Balance on services, income & transfers -75,475-79392.90324-70997.72876-79628.32689-57515.70383-123353.7661-154796.9402 Interest payments -101,072-104456.6767-112834.8724-131980.925-155138.0514-165009.6516-144929.6947 Private transfers, net 65,838 72701.73124 93435.44981 108486.407 129475.3112 156771.1259 143182.7733 Official transfers, net 6,546 6311.56126 6726.649104 8809.424383 11404.53565 8175.5 10356.73013 Current account balance 128,547 164894.1804 276918.4209 383948.6431 434008.7433 387377.5837 322777.0609 (% GDP) 1.9 2.079248562 2.949246221 3.493216037 3.248071436 2.473000826 2.17308282 f = IIF forecast, e = estimate Source: Institute of International Finance, Capital Flows to Emerging Market Economies, 27 January 2009
How bad will it get? The World Bank estimates that the slowdown in economic growth will push 53 million people into poverty, in addition to the 155 million already suffering the effects of the food and energy crisis
How bad will it get? How bad will it get for India? India is safe from the global turmoil. [ ] The only fear is fear itself. (Palaniappan Chidambaram, Finance Minister, 6 October 2008) The Indian financial sector has shown resilience and there are no signs of a currency crisis or a banking crisis. (Usha Thorat, Deputy Governor, Reserve Bank of India, 6 March 2009)
How bad will it get? Real GDP growth forecasts for India 2009-10 2007 2008 2009 2010 IMF 9.3 7.3 5.1 6.5 World Bank 9.0 6.3 5.8 7.7 Sources: IMF (WEO Update January 2009) and World Bank (Global Economic Prospects 2009, December 2009)
Global financial crisis & dev. countries Causes of the crisis
Causes of the crisis Regulation failure!
Causes of the crisis Excessive liquidity as a result of Lax monetary policy in the US and elsewhere Global imbalances & global savings glut
Causes of the crisis Current account balance 600 400 200 0-200 -400-600 -800-1000 (in billion USD) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 China Japan Germany S audi Arabia India United States United Kingdom Euro Area Source: IMF/IFS
Causes of the crisis Accumulation of foreign exchange reserves (in billion USD) 1,500 1,000 500 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Brazil China Ho ng Ko ng Ind ia Japan Ko rea Russia Singapore United States Source: IMF/IFS
Causes of the crisis 400 200 Trade balance (in billion USD) 0-200 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007-400 -600-800 -1000 Brazil China Hong Kong India Singapore Kore a United States Russia Source: IMF/IFS
Lessons for financial sector reform Lessons for financial sector reform
Lessons for financial sector reform Lessons relearned that should guide policy responses aiming at a reform of the int l financial system: Financial stability is a public good on the national, regional, and global level International co-operation is needed to ensure financial stability
Lessons for financial sector reform Two sides of financial co-operation: Crisis prevention - Surveillance - Exchange of information - Cross-border arrangements between financial entities Crisis management
Lessons for financial sector reform Better financial regulation and supervision of national AND international financial markets WB & IMF FSAPs should be made mandatory for all (systemically) important countries and published No tolerance of shadow financial sectors and tax havens BUT: desirable forms of financial regulation will inevitably differ across countries, depending on their preferences and level of development
Lessons for financial sector reform Strengthened role of IMF and other IFIs, which requires a more equitable governance structure of these institutions Regional financial cooperation and reserve pooling arrangements could complement IFIs
Lessons for financial sector reform Further development of financial markets in developing countries and emerging economies is key More banking and securities markets needed not less!!! Strong rationale for strengthening of national and regional financial markets to better channel developing countries savings to investments