Crisis Talk - The World Bank Group

Friday Crisis Roundup

Here are some of this week's highlights, from inside and outside the World Bank:

Does easy money and capricious legislation fuel commodity speculation? (Baseline Scenario)

Or is it a curse in general? (The Big Picture)

The World Bank's East Asia blog gives a roundup of the region, arguing that Asia will lead the world out of the crisis.

Meanwhile, our Africa blog ponders success in South Africa.

The European Central Bank has released a report on the international role of the euro...

...with Alea giving us the highlights. Bottom line:

The international role of currencies tends to be relatively stable over time.

Diaspora, Remittances, and the Crisis

The World Bank will be hosting a conference next Monday and Tuesday on diaspora and development. Myriad experts will be attending, addressing a diverse set of topics ranging from "Moroccan Scientific Diaspora between Transfers of Knowledge and Development" to "Diaspora Bonds". There is a session Monday morning from 9:15-10:45 that will discuss the impact of the crisis on migration and remittance flows. For those who would like to watch remotely, the Bank is providing a live webcast.

Note to Central Banks: Get More Dollars

That is what Terrence Keeley, head of sovereign client services at UBS, prescribes in today's FT: 

In an extreme crisis, there is no alternative to the US dollar. Indeed, far from needing a new “super-sovereign currency” most central banks need more US dollars. Moreover, those dollars need to be invested in the safest instruments possible, namely US Treasury bills, notes and bonds. All other assets in a crisis are ineffective.

Over the past eight years, central banks have over-invested in illiquid assets, such as credit and equity instruments, which created the need emergency currency swap lines with the Federal Reserve once the crisis hit:

Europe: The Biggest Loser?

The IMF just released a revised survey of its global economic outlook, which is generally less pessimistic than the one it originally released in April, particularly for GDP growth in 2010. There is one obvious exception amidst this "optimism": Europe.

Of all advanced economies, only Japan is expected to perform worse in 2009 (though the German economy, Europe's largest, should contract more). The Eurozone is the only entity forecasted to experience negative growth in 2010. The recovery in Central and Eastern Europe, when it arrives in 2010, is forecasted to be slower than in any other emerging market.

Deficits and the Dollar, Mutually Exclusive?

There has been a lot of chatter among policymakers about the future of the dollar. In particular, the BRIC countries have opined on the need for a new, global reserve currency to replace the greenback's predominance. (Last week, India chimed in).

At the same time, many emerging market countries, including the BRICs, continue to increase their dollar holdings. I recently posted on how foreign exchange reserves have been very useful in cushioning the adverse effects of the crisis. (Imagine how confidence in the Russian economy would differ if the central bank didn't hold over $400bn in reserves).

What do we make of all of this? How is it that the dollar's reserve status is being questioned, but simultaneously reinforced by the same countries who are doing the questioning? This paradoxical sentiment can probably be viewed as an expression of concern about the United States' deteriorating fiscal health.

A Return to Risk

There is a false sense among some regulators that more capital is the 'solution' to banking problems. Takafumi Sato, commissioner of Japan’s Financial Services Agency, takes issue with this supposed axiom. Writing last week in the Financial Times, Sato argues that bank management needs to change its (excessive) risk-taking behavior, with capital acting as the ultimate backstop:

Just asking for more capital will not cure the disease of capitalism. To avoid a recurrence of crises, we need a paradigm change. A global community adopting a uniform platform is vulnerable to a virus, as we have witnessed during the current financial pandemic. Capital adequacy regulations should be designed to foster diversity in business models, demanding the right level of capital for the business type of the bank in question.

More capital and no change in behavior leads to nothing - hence the importance of governance, where the reforms announced to-date, focusing primarily on executive compensation, are (at least in my mind) very timid in nature.

Zoellick Cautions Against Optimism

World Bank President Robert Zoellick has written to the leaders of the upcoming G-8 conference, warning them against complacency in fighting the crisis. The letter acknowledges the work done by central banks in preventing the global economy from descending into free-fall, but urges leaders to remain vigilant:

2009 remains a dangerous year. Recent gains could be reversed easily, and the pace of recovery in 2010 is far from certain.

The poor continue to be the most vulnerable to further economic volatility: a 1 percentage point drop in developing-country GDP is capable of pushing 20 million people into extreme poverty.

Crisis Roundup

Here's a look at what's being discussed during this short week in finance:

Should China's policy response to the crisis be geared toward short or long-term objectives? (East Asia and Pacific on the Rise)

Is total US unemployment higher than 9.5 percent? Some are arguing it is closer to 16.5 percent. (WSJ Real Time Economics)

Demand for US reserves dramatically increased during the buildup to the Crisis. Now it is falling.  (Excellent graph from Brad Setser at the Council on Foreign Relations) 

Some at the Fed are worried about not enough inflation... (Via Naked Capitalism)

...but that doesn't seem to stop interest rates from going up (Via Credit Writedowns)

Skidelsky, Wolf on Global Imbalances

The most recent issue of the New York Review of Books features an essay by Robert Skidelsky, biographer of Keynes, which discusses Martin Wolf's 2008 book, Fixing Global Finance (itself an excellent summary of global imbalances and the seeds of the crisis). Skidelsky elaborates on the role of the dollar as the world's premier reserve currency, arguing that the dollar's preeminence created a capital glut via the creation of the unofficial "Bretton Woods II" system of fixed exchange rates.

Under Bretton Woods II, many East Asian economies pegged their exchange rates to the dollar in order to build an arsenal of central bank reserves and retain export competitiveness. This buildup allowed the United States government to borrow cheaply and led American consumers to invest in asset-bubbles such as real estate and equities.

More on Russia's Recovery

Vladimir Putin has ordered Russia's top bankers to forgo any upcoming holidays and dedicate their summer time to making more loans. The Prime Minister has demanded an additional $16bn in fresh loans, arguing that increased lending is the only way to break the cycle of fear that has paralyzed the nation's banking system. According to Mr Putin:

The less lending goes on, the greater the risk is that loans won't be returned, because by ceasing to credit, you are strangling the real sector.

Russia's Economic Prognosis

Last week the World Bank released its Russian Economic Report, forecasting an annual GDP contraction of 7.9 percent and a 10 percent reduction in the ranks of the middle class. The report highlights a 59 percent drop in year-on-year capital flows for the first five months of 2009, contributing to a decline in all major sectors of the economy.

What will be the leading factors of a Russian turnaround? Goldman Sachs argues that the restoration of capital flows is more important to Russia's economic recovery than the return of higher oil prices. From Bloomberg:

Russia's deep output decline, in our view, is less the direct impact of lower commodity prices and more the effect of the sudden stop in capital inflows that the country suffered beginning in the third quarter of 2008.

Crisis Roundup

Here's a roundup of some of the more interesting crisis-related discussions in the blogosphere:

1.  Simon Johnson, former Chief Economist of the IMF, summarizes his main points from last week's World Bank conference in Seoul, "Lessons from East Asia and the Global Financial Crisis":  

If the size, nature, and clout of finance is the problem, then the official view is nothing close to a solution. At best, pumping resources into the financial sector delays the day of reckoning and likely increases its costs. More likely, the Mother of All Bailouts is storing up serious problems for the near-term future

2.  Should we be promoting access to finance in the developing world, even in the midst of a financial crisis? CGAP Microfinance

3.  Is the next bubble in emerging markets? FT Alphaville

4.  Nouriel Roubini discusses China's waning dollar appetite...

Our creditors' nervousness about the eventual debasement of the US dollar has some increasing validity.

5.  ...while others are less convinced.

Stress Testing: An extraordinary balancing act

The IMF held an unofficial discussion yesterday morning on what the financial crisis has taught us about stress tests. (The discussants were very clear—none of the views expressed at the meeting represent the official views of the IMF. The same is true of the summary here.) 

The conversations highlighted the delicate balance that such tests need to achieve. When creating the parameters for these tests, how do we "think the unthinkable", while still adopting reasonable parameters that provide credibility? How do we decide if a 25 percent exchange rate depreciation is enough, or if 50 percent is too much? How do we design a scenario that is exceptional, but plausible?

Charting a Path out of the Crisis

The World Bank Group (WBG) has just released the first batch of a series of policy briefs on the financial crisis, whose aim is to assess government responses to the crisis, shed light on the financial reforms currently under debate, and provide insights for emerging-market policy makers. The first three papers cover a lot of ground in a short amount of space—sizing up the global policy response, forecasting what future financial systems will look like as a result of these policy responses, and determining how financial regulation will evolve. They will be followed by papers, written by different authors inside and outside the WBG, that will take ‘deep dives’ in specific crisis-related financial sector topics.

• Dealing with the Crisis: Taking Stock of the Global Policy Response provides an overview of the immediate financial sector policy responses to the financial crisis—including emergency liquidity support, expansion of financial safety nets, and interventions in financial institutions—that have succeeded in stemming widespread panic. But the effort has generally been ad hoc and insufficient. Issues that remain include the resolution of problem assets, the restructuring of troubled, systemically important financial institutions, and the development of credible exit strategies. Only a handful of countries have attempted to tackle these issues head-on. As past experience has shown, that may well have negative repercussions for the duration and strength of a subsequent recovery.

• The Reform Agenda: Charting the Future of Financial Regulation reviews the crisis-induced shift toward a tighter and more macro-prudential approach to financial regulation. But the reform agenda still needs to address the role of supervisory (rather than regulatory) failures, while the institutional arrangements needed to implement the new framework remain to be worked out. For most emerging economies, the existing reform agenda—developing institutional and legal underpinnings for the financial system and promoting financial access—remains valid. But for those characterized by weak financial oversight structures and more volatile economic cycles, adopting capital “buffers” as part of a macro-prudential regime may be a useful complement.

• Safe but Smaller? The Shape of Financial Systems to Come describes how global trends taken for granted in recent decades—the big expansion in global financial assets compared with underlying economic activity, growing global financial integration, shrinking role of the state in financial systems, and rising share of cross-border ownership of financial institutions—may reverse over the foreseeable future. In addition, the structure of financial systems, particularly in developed countries, will likely become oriented less toward capital markets and more toward traditional (and simpler) banking activities. The impact on economic growth and overall welfare is likely to be negative—perhaps the price we have to pay for living in a brave new (and presumably safer) financial world.

Public Finances in the EU

A new report by the European Commission has painted a bleak picture of what is to come. Deficits in nearly all EU countries. And that is coupled with GDP growth forecasts that are oddly lagging by 3-4 months. In other words, the picture will be bleaker.

France reported last week that the deficit is expected to be 7% of GDP. This report says 6.6%. Not too far off.

Reading the report, one thought comes to mind: European citizens may expect higher taxes soon.

More on Emerging Market Corporate Debt

Yesterday, I discussed a new World Bank report that highlights the effects of the financial crisis on the corporate debt market: "The impact of the current crisis in developing countries has been transmitted primarily through the corporate sector." 

There are three core concerns about the strength of the corporate debt market:

1. Short-term FX liabilities, which are difficult to meet as the value of local currencies dwindle;
2. Huge corporate losses in derivatives; and,
3. Mercurial attitudes of foreign investors in local bond markets, which leave corporations vulnerable to investor whims.

World Bank Report Bearish on Recovery

The annual Global Development Finance report was released today by the World Bank, and it forecasts a 2.9% drop in global GDP in 2009. One of the core concerns expressed in the report is the impact of the financial crisis on capital flows to developing countries. Corporations in particular will face serious difficulties in raising capital and meeting their debt obligations:

The implications of these unfolding events for investment flows to developing countries have already been dramatic: total private capital flows in 2008 dropped to $707 billion (4.4 percent of total developing-country GDP), reversing the strong upward surge that began in 2003 and reached a pinnacle of $1.2 trillion in 2007 (8.6 percent of GDP). For 2009 the most likely scenario is that as global equity markets regain momentum and credit markets heal, net private flows to developing countries will remain positive—barely. But they will drop to $363 billion, approximately the level of 2004 and a decline of 5 percentage points of GDP from 2007. The magnitude of the decline is troubling for its macroeconomic consequences and for vulnerability to further shocks, particularly in countries in which banks and firms have high levels of external debt. Much of the $1.2 trillion external debt raised by emerging market banks and firms between 2003 and 2007 is now maturing, putting pressure on the borrowers’ finances at the time when the average cost of external borrowing has increased to 11.7 percent, compared with 6.4 percent in the pre-crisis years when the debt was contracted.

GDP growth in developing countries is expected to drop from 5.9 to 1.2 percent. Excluding China and India, growth will retract by 1.6 percent. The FT, WSJ, and Bloomberg discuss the immediate impact of the report, including a drop in commodities and a bounce for the dollar.

FX Reserves as Insurance Policy

Editor's Note: Brian Hoyt is a consultant in the Financial and Private Sector Development Vice Presidency of the World Bank Group.

A new report from Deutsche Bank on emerging market economies' anti-crisis measures highlights the benefits of FX accumulation. The top performers as identified by the report share one obvious commonality: massive dollar reserves. Nearly every country that has successfully weathered the crisis is either a petrostate and/or has a significant sovereign wealth fund. Not only have FX reserves been key in facilitating an economic stimulus, they have also have provided significant currency stability:

The amount of FX reserves in relation to external financing requirements is still crucial to the assessment of countries’ resilience to external shocks. From a policy perspective, accumulating FX reserves still seems to be pretty good insurance.

This observation seems to contradict concerns that central banks will be hesitant to accumulate further dollar reserves. The question remains as to how central banks' desire to purchase this kind of insurance can be squared with the need to resolve global macroeconomic imbalances.

The Jobs Agenda

As Simeon has pointed out, it may still be premature to predict the end of the crisis. Even if the worst of it is past, the negative impact of the crisis on a number of economic variables could be persistent. A prime example of this is employment, and, potentially, overall labor productivity. 

Public works programs have figured prominently among some stimulus packages (see here and here, for example). While these programs have the clear benefit of supporting employment, they are not without their potential downside. Neil Gregory, a senior adviser on Financial and Private Sector Development at the World Bank, explains the trade-offs:

Samuelson on the Recovery

Paul Samuelson has a nice article on the dangers of sounding too optimistic about a possible recovery late this year in the United States. His main point: the recovery is predicated on printing dollars and selling them to China. The moment China changes its mind on buying dollars, both the US and the world economies are in trouble. For a few years.

Over time, Americans will learn to save more and the Chinese will learn to spend more. Until then, cautious optimism at best.