Crisis Talk - The World Bank Group

Barking Under the Wrong Tree?

Andrew Long, group general manager and head of global transaction banking at HSBC, had this to say about trade finance problems: "It's a bit of a chicken and egg situation, is trade finance causing the problem or is the problem resulting in trade finance difficulties? I happen to think it's the second one -– we are in a global recession and therefore demand is falling off a cliff. So suppliers aren't sure they are going to get paid, and the buyers don't want to buy stuff anyway as they aren't sure they are going to be able to sell it.”  The quote is from his article "Credit Gets Tied up Tight," in the November issue of Trade Finance magazine.

Talking about the trade finance squeeze has been the craze in the last month. WTO head Pascal Lamy, OECD head Angel Gurria and just about everyone else have pointed with alarm at disappearing trade credit. Various fixes have been proposed, most in the form of trade finance facilities.

The more I look at the data and read the anecdotes in the newspapers, the more I doubt trade finance is the real issue. Tellingly, all the stories in the popular press come from countries whose exports are concentrated in a few commodities, the prices of which have plummetted in recent months. Whether it is palm oil and timber in Indonesia or copper in Chile and Zambia, Andrew Long's insight rings true: demand has fallen precipitously and creditors would be crazy to finance such exports right now.

More generally, what started as a crisis in the financial sector in several rich countries, seems to increasingly manifest itself as a generic-type economic slowdown in emerging markets. The construction sector goes first, then tourism, then parts of manufacturing, especially those dependent on exports. If you read the press in emerging markets (as I did yesterday), the concern is with the real economy not the financial sector. There will, of course, be a second-wave of financial sector woes as economies dive. Still, the majority of solutions are not financial-sector-related. For example, the European Commission announced a five-point plan yesterday on dealing with the crisis. The plan is going to be discussed at a meeting of heads of state in mid-December. Among the five points, reducing VAT to leave more money in the hands of consumers and businesses and "providing the ability to new businesses to register in less than 3 days in all EU countries, reducing the minimum capital requirement to 1 euro, and eliminating the need for annual statistical reporting for small businesses." Sounds like the Doing Business agenda.

More on the Impact on Africa

World Bank financial specialist Samuel Munzele Maimbo paints a dire picture for Africa's financial sector in a just-published article:

"As the immediate crisis faced in the last couple of months subsides, and policymakers begin to consider the longer term impact of the crisis in Africa, an emerging view is that the impact on the financial sector in Africa may actually be more significant and longer lasting than first assumed, and the impact on the non-financial sector in Africa will be more notable than has been the case in developed countries."

-- read more in "The Impact of the Financial Crisis on African Financial Systems", AccessFinance newsletter (World Bank/IFC)

The Sky Is Falling

October was a bad month for equity brokers in most emerging markets. Irate customers must have been calling constantly, selling stocks and using not nice words. Argentina, Brazil and Peru in Latin America; India, Indonesia, Korea and Thailand in Asia; Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Lithuania, Poland, Romania, Russia, Turkey and Ukraine in Eastern Europe; Egypt in the Middle East all lost about 30% of market value. In one month. Other countries would have fallen similarly -- say Pakistan -- except they introduced price floors.

I spoke to several brokers to understand what is happening. Some countries are easier to figure out -- e.g., Hungary, Romania and Ukraine; it is not that obvious why other countries fell as much. Supposedly one of the reasons to invest in emerging markets is that returns there are less correlated with returns in the United States and other rich countries.

Impact of the Crisis on African Financial Markets

World Bank and industry experts met on November 6 to discuss the impact of the financial crisis on African financial markets. Topics included the outlook for economic growth, the need for countries to focus on their domestic agendas (as trade and capital flows become less reliable) and the need for international action to support Africa. Panelist Michael Fuchs, a financial economist at the World Bank, offered this summary.

Super-Bankruptcy

Old ideas get recycled, including bad ones. One such idea is the adoption of “super-bankruptcy,” a temporary tool to be used when a country faces systemic bankruptcy brought on by large macro-economic disturbances. Read paper on bankruptcy regimes during financial distress.

The super-bankruptcy approach was advocated by Joe Stiglitz during the early stages of the East Asian crisis.  The basic presumptions of the super-bankruptcy are that management stays in place and that there is a forced debt-to-equity conversion. The existence of such a bankruptcy option will likely result in higher interest rates in normal times. However, in a systemic crisis it can preserve the going concern value of firms by preventing too many liquidations and keeping in place existing managers, who sometimes know best how to run the firms. Sounds very much like today's announced rescue of Citigroup, albeit what Stiglitz had in mind was a procedure for the whole economy.

An important issue is when to call for super-bankruptcy. When is the crisis of a systemic nature, and who has the authority to call for such a suspension of payments? Also, as wealth is often concentrated in emerging markets and some debtors stand to gain disproportionately from a suspension of payments, this could lead to social upheaval.

The evidence from East Asia suggests that adopting a temporary super-bankruptcy is unnecessary. While corporations and banks moved slowly to restructure outstanding debt, in the hope that economic recovery will obviate the need for write-offs (for banks) or surrendering of equity control (for large shareholders), few firms appeared to be prematurely liquidated. If anything, too many firms continued to operate for too long, as was the case with several chaebol-related firms in Korea, and that equity holders bore too little of the costs of restructuring.

More Weekend Reading

If you've got the time after reading Michael Klein's speech, check out a new working paper from the Commission on Growth and Development called International Finance and Growth in Developing Countries: What Have We Learned? (Hat tip: Dani Rodrik) From the abstract:

...This survey discusses the policy framework in which financial globalization is most likely to prove beneficial for developing countries. The reforms developing countries need to carry out to make their economies safe for international asset trade are the same reforms they need to carry out to curtail the power of entrenched economic interests and liberate the economy’s productive potential.

What's Next for Emerging Markets?

Download Michael Klein's recent speech on the international financial crisis. He discusses the various dimensions of the financial crisis, its effect on developing countries, and how the world's financial architecture may change. Michael is the World Bank Group's vice president for financial and private sector development.

No Exit

A question not yet asked in the unfolding global crisis is whether the existing bankruptcy regimes can adequately deal with the likely deluge of corporate and perhaps financial failures. Bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options are needed.

To judge how efficient bankruptcy regimes may be in times of systemic distress, it is useful to know how well they perform in normal times. Not well. A recent study finds that bankruptcy procedures are time consuming, costly, and inefficient. In a sample of 88 high- and middle-income countries, only 36% of the countries achieve the efficient outcome of keeping the business as a going concern. Between the transaction costs of debt enforcement, the delay cost of the proceedings, and the loss from reaching the wrong outcome, a worldwide average of 48% of the business’s value is lost in debt enforcement. On average, the bankruptcy cases take 2.64 years to resolve. And this on a simple case (a downtown hotel), with only one secured creditor. The usual case probably takes longer, costs more and has smaller chance of successful outcome.

Less Polyester

BASF, the world's largest chemicals producer, will cut output by 25 percent and reduce the working hours of 20,000 of its staff for the next two months, as the effects of the global crisis start to affect demand.

In the immediate future, this suggests that the crisis is going down the production chain of consumer goods. With less demand for cars, there is less need for plastics; less demand for new homes, fewer building materials; fewer trips to the clothing store, less polyester.

In the mid-term, this may be a delayed opportunity for producers like BASF to shift production from expensive west European locations to cheaper locations in emerging markets. And not just for BASF, for many of the European producers that have not made the move yet. In other words, the unfolding crisis will have permanent effects on the location of production.

G20 Summit: Unprecedented Focus on Financial Reporting

Financial accounting and reporting were a central issue at the November 15 meeting of G-20 leaders plus the leaders of Netherlands and Spain. The Summit’s Declaration sets the stage for several important reforms, some of which are already in progress.

First, the summit leaders agreed on “enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions….” This widely-heard complaint in the immediate aftermath of the crisis is something that securities regulators and accounting standard-setters have already begun addressing. For instance, in September 2008, the SEC sent a letter to certain public companies regarding disclosure and the application of FAS 157. Also, last month, the IASB has issued a proposal for improvements to financial instruments disclosures. Much work remains to be done on this front but a strong consensus exists.

Second, they agreed to “strengthen regulatory regimes, prudential oversight, and risk management….” This is a potentially more difficult issue insofar as financial regulators and accounting standard-setters do not necessarily see eye to eye on all accounting issues. Many in the accounting world are wary of possible interference from prudential rules with transparent financial reporting. One traditional sticking point has been fair value accounting, a major attribute of modern financial reporting, which has been blamed by some for its pro-cyclical effects.

The fact that the leaders of the world’s 22 largest economies devoted so much attention to accounting issues in their discussions is unprecedented and should be applauded. Indeed, strengthening prudential supervision and market discipline, two building blocks of the international financial architecture, will require bold action backed by strong political commitment at the highest level, and much closer cooperation between all key decision makers on the world stage. The Declaration sets forth an ambitious, fairly detailed and prescriptive Action Plan to Implement Principles for Reform, which is likely to keep policymakers, financial sector regulators and accounting standard-setters around the world very busy over the coming months.

Early Trade Woes

Total U.S. merchandise imports fell significantly in both August and September of this year. Imports fell by about 5 percent in each month (figure 1). While trade values are volatile month-to-month, declines were not nearly so large in 2007, suggesting troubles to come. These findings come from a new report by Caroline Freund, a trade economist at the World Bank.

Imports from the Middle East and North Africa and Sub Saharan Africa saw the largest declines, falling by more than a quarter in September relative to the preceding month (table 1). Despite the sizeable drops, the trade values in September 2008 remained above trade values in September of the previous year in all regions.

Imports of minerals, vegetables, wood, and transportation products recorded the largest drop, which probably reflects falling commodity prices. This also explains the large drop in imports in the Middle East and Africa, which mainly export raw materials. Moreover, wood and transportation products were imported in values below their September 2007 levels. Imports by air fell significantly in August but picked up in September, with the exception of Africa.

The real trouble in international trade started in October, and these figures are only going to be available on December 11. It will be interesting to see whether the much-talked-about problems with trade credit are apparent in the October data, or whether the real issue was elsewhere: falling commodity prices.

Microfinance and the financial crisis

Editor's Note: Elizabeth Littlefield is Director and CEO of CGAP. From November 18-20, CGAP is running a virtual conference on microfinance and the financial crisis.

Throughout past financial crises—especially those of the 1990s (Mexico, Asia, Russia)—financial services for poor people have shown remarkable resilience to shock. In fact, the loan portfolios of microfinance institutions (MFIs) in Asia during the Asian crisis and in Latin America during various banking crises in that region barely blinked while corporate portfolios collapsed.

This is because these banking and currency crises had little relevance to subsistence-based economies in closed ecosystem markets. Our present financial crisis is like no other, and microfinance is far more connected now. Although microfinance still has deep shock-resistant roots, there will be impact—both on the institutions and the clients they serve. The medium and longer term effects of a global recession are likely to be punishing to poor people.

"Solvency II" -- An EU Proposal for the Insurance Industry

Europe's ambitious plans to modernize its regulatory and capital adequacy regime for the insurance industry were discussed at a World Bank-sponsored event last week. More than 50 policy makers and financial and accounting practitioners from Latin America and Caribbean attended. The attached note  summarizes the proposal -- dubbed "Solvency II" -- and discusses the potential impact of the financial crisis on its future.

It's worth noting that the project emphasizes market discipline -- which many seem to have doubts about due to the current crisis -- as an important pillar of regulation. Similarly, it endorses a "market consistent" approach to valuing assets and liabilities, which is advocated by international accounting standards (IFRS). This is an encouraging sign for those who believe that prudential regulation and transparent financial reporting not only can coexist peacefully, but hopefully support one another.

World Bank Research on Past Crises

The World Bank's Development Research Group has just published a working paper on lessons from past crises. It warns of the difficult tradeoffs between rapid crisis response and longer-term development goals.

Where to Look for Early Signs?

While Hungary, Iceland, Pakistan and Ukraine are now officially "in crisis," a number of other governments have done their best to show the crisis will not influence their economies much. One such country is Bulgaria. In an earlier blog, I predicted a significant slowdown in the economy next year: to 2.5-3 percent growth. This is about 1.5 percent below the current government forecast.

There are reasons for some optimism, as detailed in another recent blog. Most of all, the government finances are in great shape. Still, where to look for the coming troubles? Here are four leading indicators to watch:

The Global Credit Crunch and Economic Stimulus Packages - Does Microfinance Belong?

Editor's Note: The following item is cross-posted on the CGAP Microfinance Blog.

Hopes that the developing world would sidestep the worst effects of the global credit crunch are fading, as it becomes apparent that the transmission of problems from the sub-prime niche to broader credit markets to whole financial systems is now leading to the real economy. The IMF adjusted its month-old economic growth forecasts for developing countries downward.

Governments around the world over have serious stimulus measures on the drawing board to cushion their economies and citizens from the worst effects of recession in the North. Keeping domestic credit flowing is typically a central component. Will these policy prescriptions include support for microfinance? And if they do, is this something to be applauded or criticized?

Study finds campaign contributions influenced bailout vote

Yesterday, Treasury Secretary Henry Paulson announced that equity injections are now the most “effective” way to bolster balance sheets of financial institutions and get credit flowing again while minimizing taxpayer losses.

How different were things roughly 40 days ago. On October 3rd, after the second roll call, the dust had finally settled over the Emergency Economic Stabilization Act (EESA) and its centerpiece the Troubled Asset Relief Program (TARP), everybody thought Paulson would mainly use $700 billion tax dollars to buy up toxic mortgages and other troubled assets of banks.

Given that nobody in the private sector even wanted to come near this toxic material, it was no wonder that TARP was perceived as a huge wealth transfer from “Main Street to Wall Street”, at least in the short run.

These perceptions shaped the voting behavior of members of the House of Representatives, according to a recent study.

Mexico adopts IFRS: a timely decision

November 11, 2008 will be a landmark in Mexico's accounting history. On Tuesday, the Securities and Banking Commission (CNBV) announced that it was requiring listed companies to apply International Financial Reporting Standards (IFRS) starting in 2012.

Some may question the timing of the decision considering that IFRS strongly emphasizes the use of fair value accounting, and the latter has been heavily criticized since the current financial crisis erupted. One should note however that the most vocal critics of fair value accounting have been the bankers, and the CNBVs' decision will not affect Mexican financial institutions.

Depression, visualized

David Hendrickson, a professor at Colorado College, maintains the less than optimistically named Cause for Depression blog. There are a ton of charts, ranging from world stock market capitalization - which now looks like a rollercoaster with a precipitous dropoff - to 'credit default swamps.' I rather liked the chart (pictured below) on the debt to GDP ratio in the 1920s.

 

Downgrades

Fitch Ratings published on Monday its latest rating review of emerging markets. The main news: Fitch expects advanced economies to contract by 0.8% in 2009, the largest decline since World War 2. The movers: downgrades for Bulgaria, Hungary, Kazakhstan and Romania; and downward outlook revisions for Chile, Korea, Malaysia, Mexico, Russia and South Africa.

After some weeks of lumping together the East Europeans, finally some unbundling. Romania falls the most (in relative terms), from "BBB/BBB+/Negative Outlook" to "BB+/BBB-/Negative Outlook." The reason: the current account deficit is expected to exceed 14% of GDP this year, with large foreign-currency mismatches in private sector and households' balance sheets. Bulgaria is also downgraded, but only one notch -- to "BBB-/BBB/Stable Outlook." The rationale on Bulgaria is an increased likelihood of a decline in foreign investment. On the positive side, the government's net financial liabilities are virtually zero.

The outlook revisions are more varied. Chile and Russia may suffer from lower commodity prices; Korea -- as a result of the global fall in trade and reduced international credit; Mexico -- as a consequence of the slowing US economy.

In reading all this, let's keep perspective: the ratings agencies are to blame for missing a lot of calls in the past year. One hopes they have done their homework this time around.

The Crisis: Round Two

So far the crisis has largely come from banking sector problems. Prepare for round two: collapsing international trade, and the resulting hit on small export-oriented economies.

A leading indicator on how many trade shipments are in transit is the Baltic Dry Index. Every working day, the Baltic Dry Index surveys shipping brokers around the world and asks how much it would cost to book various cargoes of raw materials on various routes (e.g., 100,000 tons of iron ore from San Francisco to Hong Kong, or 1,000,000 metric tons of rice from Bangkok to Tokyo). A Slate magazine article from 2003 explains why the index is a leading indicator on trade volumes.

In the last two months, the index has fallen to an all-time low (closing at 842 on Friday, November 7). This from a high of 15,000 about a year ago.

Once trade slows down, some countries' economic growth will be reduced substantially: some East Europeans, some countries in East Asia, and Latin America. Experts forecast these slowdowns in early 2009. It will be a bleak winter.

Over 7,100 Stocks Worldwide are Banned for Short Selling

The short-sell bans in the US and Canada have ended, but many countries still have bans for as many as 7,157 stocks today, mostly for non-financial stocks (excluding bans on naked short sells, a form where the short seller sells stocks without having them in their possession).

Will they help more than they hurt?

Should you buy bans on short selling?

Popular belief has it that only villains try to profit from the demise of others. This idea is nicely illustrated by banker-to-terrorists Mr. Le Chiffre in the Bond movie Casino Royale when he shorted the stock of aircraft manufacturer Skyfleet, hoping to profit from the destruction he had ordered of its new prototype airliner.

Yes, short sellers try to make a living by exploiting overvalued stocks. They do so by borrowing shares and selling them at their overvalued price. When the price drops, they buy back shares and return them to the original lender for the lower price, pocketing the difference. Obviously, this strategy works nicely when markets go down (and backfires in case they go up). The practice of short selling can even accelerate the fall in prices, which is how short sellers got a reputation of “looters after a hurricane”, as President Hoover put it after the 1929 stock market crash.

Hungary Offered Package Similar to Mexico in 1995

The IMF, the World Bank, and the EU have offered Hungary a financing package totalling $25.1 bn -- around 18% of 2007 GDP. This is in line with the package offered to Mexico by the IMF and the US during the Tequila Crisis ($51.8 bn or 18% of GDP) and significantly more than the package made available to Brazil in the 1998 crisis ($41.8 bn or just 5% of GDP). The table below shows additional details:

A Lead Role for the World Bank in a New Global Financial Architecture?

Regulators need a place to meet to "exchange information on what's going on in each country" and come up with a "realistic concept of global risk," Blackstone Group CEO Steve Schwartzman told Fortune in this video interview.

"You can imagine a World Bank concession, or some group where you have permanent representatives from each country, and every quarter they’re looking at the risk in their system,” he said. Findings could be published immediately on the Internet so that market participants can instantly see "which countries are creating high-risk systems, where the bubbles are."

Book: Resolution of Financial Distress

Time to dust off the East Asia crisis writings. In 2001, I edited a book (with Stijn Claessens and Ashoka Mody, both IMF) on what we learned in the 1998-2000 dealings with financial distress. I had nearly forgotten about this work -- it was rarely cited after it got published. Now you may want to take a look.

The overview is a good start -- it summarizes the findings on insolvency regimes; dealing with systemic distress (asset-managements companies and the like); corporate restructuring; and injecting government equity into troubled financial institutions.

Other good reads are Bankruptcy Laws: Some Basic Principles, by Joseph Stiglitz; Asset Management Companies, by Daniela Klingebiel; and Bankruptcy Procedures in Countries Undergoing Financial Distress, by Michelle White.

A parting thought found on page one of the book: "Broadly in a systemic crisis, the government's role lies, first, in defining rules that would lead to efficient private restructuring efforts and, second, in providing direct assistance where the private initiatives prove insufficient to resolve distress at acceptable output losses."