Crisis Talk - The World Bank Group

The Double-Edged Sword of Emerging Market Growth

The Economist has two interesting articles this week about capital flows in India. The Indian government is currently confronted with the a challenge of nurturing the growth of India's financial markets and multinationals, while mitigating the risks of excessive "hot money" flowing into the economy.

Proponents of capital controls point to India's success in avoiding the worst of the Asian financial crisis in the late 1990s and the current crisis, which was in part achieved by limiting the amount of money flowing in and out of the economy (for example, foreigners are limited in the amount of local bonds they can purchase).

Yet, India remains a sponge for foreign capital. The Economist notes that foreigners have invested $13.8 bn in India’s stockmarkets since April, having withdrawn $8.6 billion over the same period last year. The Sensex, India’s most widely watched stockmarket index, has surged by almost 100% since its March lows.

Advocates of a stricter capital controls are facing a strong resistance from the market...

Credit Rating Agencies: No Easy Regulatory Solutions

Editor's Note:  This is the eighth in a series of policy briefs on the crisis—assessing the policy responses, shedding light on financial reforms currently under debate, and providing insights for emerging-market policy makers.

About the authors: Jonathan Katz is a consultant and former secretary of the U.S. Securities and Exchange Commission. Emanuel Salinas is a senior investment officer at the Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group. Constantinos Stephanou is a senior financial economist in the Financial and Private Sector Development Vice Presidency of the World Bank Group.

In the United States and Europe faulty credit ratings and flawed rating processes are widely perceived as being among the key contributors to the global financial crisis. That has brought them under intense scrutiny and led to proposals for radical reforms. The ongoing debate, while centered in major developed markets, will also influence policy choices in emerging economies: whether to focus on strengthening the reliability of ratings or on creating alternative mechanisms and institutions that can perform more effectively the role that in developed markets has traditionally been conferred on credit rating agencies.

Click here to view the policy brief in its entirety.

Better Credit for Brazil

Yesterday, I analyzed the prospects for decoupling during the recovery. Will a robust emerging market rebound boost OECD growth? Or, are we due to see a multi-speed global recovery? The rise of emerging market IPOs, and its positive influence on IPO markets in developed economies, provides one data point in favor of the first theory. Today's news from Brazil may support the second. 

Moody's announced that it has elevated Brazil's credit rating to investment grade. The ratings agency described Brazil as a "winner", primarily because of its quick rebound from the recession, and strong growth potential for the future. This in an important step for Brazil, as it allows many institutional investors, who are forbidden from investing in "junk" debt, the opportunity to invest in Brazilian bonds.

Which country is next?

Pity the Pound

A few weeks ago I wondered if Britain was back. According to the Bank of England, it's not.

The Times reports:

In its Quarterly Bulletin, the Bank tried to explain the reasons for the collapse in value of sterling since the final quarter of last year. It said: "It is possible that sterling's depreciation may be part of a more prolonged process of rebalancing of the UK economy, generating a fall in the long-run sustainable real exchange rate."

Weekend Reading

The European Central Bank's crisis efforts are laudable. The current account surplus is back in the black, and the euro is hitting one-year highs against the dollar.

Meanwhile, sterling continues to suffer.

An explanation of the new dollar carry trade.

The American manufacturing sector is rebounding.

The jobless recovery has been kind to those with jobs. Wages are up.

California is investigating the ratings agencies.

Speaking of California and the ratings agencies, Moody's forecasts that California's real estate sector won't return to normal until 2030.

Finally, where is Paul Volcker?

Plus: In case you get lost in the thicket of financial jargon, the Devil's Dictionary is here to help. A taste:

STRESS TEST, n. 1. A measure of arterial blood flow to the head. 2. Alchemic process by which struggling, undercapitalized banks are transformed into paragons of modern finance. (See BANKS, GOOD.) Also known as the "Timothy F. Geithner Seal of Approval," which some bankers insist is good until it isn't anymore. (See BANKS, BAD.)

Wall Street's Premature Exuberance

I've been wondering lately if investment banks are experiencing a bout of irrational exuberance with respect to a recovery. Bullish advice on China comes to mind in particular.

There is growing momentum behind the idea that many banks are getting the recovery wrong. From Bloomberg: 

Paul Tudor Jones, the billionaire hedge-fund manager who outperformed peers last year, is wagering that Goldman Sachs Group Inc. and Morgan Stanley got it wrong in declaring the start of an economic recovery.

Europe's Recovery: Half full or half empty?

A few weeks ago I pondered if Europe was the biggest loser in the crisis. In light of today's upbeat economic news coming out of France and Germany, was I being too harsh? 

Alas, Europe is not a homogeneous body, and this certainly holds true for its economies. The eurozone's northern members are doing better than those on the Med. Growth within the Europe is uneven and often unrelated. For example, Germany seems to be growing in spite of Europe, tying its export-led fortunes to the winds of Asia.

Furthermore, while good news tends to stay within national borders, bad news can spill over. Stronger exports in Germany cannot fix Spain's unemployment woes, and effective consumer stimulus efforts in France will not cure Ireland's Celtic Tiger hangover. Yet, a currency peg collapse in the Baltics, or a Hungarian debt crisis, can spread damage to Scandinavian and Austrian banks, and beyond. 

What to Do with Rating Agencies

Willem Buiter, a former chief economist at the EBRD, suggests the following ideas for reform of the credit rating agencies:

• Rating agencies should be turned into single-activity or single-product line firms. They should provide just ratings, not any other products or services, including advice. The conflict of interest in combining rating activities with advisory services or the sale of other lucrative services or products to customers looking for the best possible rating is obvious and inescapable. Chinese walls don't work and are aptly named. The Great Wall of China did not keep the barbarians out or the Han Chinese in.
• The quasi-regulatory role of the rating agencies in Basel II should be eliminated.
• The customer wishing to have his company, country, or instrument rated should not pay the rating agency, ex ante or ex post. Instead, the customer should pay the regulator, who would then allocate/auction the individual rating activity among the population of competing rating agencies.
• Rating agencies should be paid in part in the securities they are rating. Such securities should be held to maturity and cannot be hedged by the rating agency.

The first two are straightforward, and I tend to agree. The latter two are strange and won't work. Keep thinking.

30 Wise Men

The Group of 30 (a club of top-flight financial thinkers and doers) just released a report called A Framework for Financial Stability that details recommendations on what regulatory and "industrial organization" reforms may be needed. It is a dry read, but has many good ideas. As it is still early days, many ideas are still not detailed enough.

I have been thinking about one issue in particular - why the credit ratings agencies failed so miserably. The Group of 30 says that a new "payment model" should be constructed. In other words, the credit agencies should not depend fully on being paid by the people they evaluate. That sounds right, but an alternative model is not that obvious.

There has been considerable noise about introducing more competition in the sector. The merits of this argument are not that clear, as many of the first victims of the crisis in the US were companies or products which were rated by all 3 agencies. Presumably, these agencies did not collude in producing their ratings, so there was some competition.

The real issue is that this market has not been high-margin, so competition from entry is not present. This is what Andrei Shleifer (Harvard) suggested during a recent visit. In fact, the big 3 credit rating agencies have more or less the whole market and have had it for years. For this to change, other players may need bigger incentives. The crisis may provide just that.

Reforming the Credit Rating Agency Industry

A lot has been said and written about the role of credit agencies in the current crisis. Almost everyone agrees that their role has been negative, understating the risk of many financial products and papers and misleading many investors. But how can the incentive structure of this industry be reformed? Is tougher regulation the response? Or perhaps more competition in a three company industry?

A recent theoretical paper by Patrick Bolton, Xavier Freixas and Joel Shapiro (The Credit Ratings Game) offers some suggestions towards reform of the industry, but also clearly shows that there are no silver bullets. As any theoretical model, it relies on simplifying assumptions, but it presents very clearly the incentives faced by different stakeholders, including credit rating agencies and issuers of securities, and how different policy measures will affect them. At the core of the incentive problem is the fact that it is the issuers who buy ratings rather than the "users", i.e. investors, and that issuers can shop around for good ratings.

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.

Time to rethink market discipline

What, really, is market discipline, and how much can we rely upon it for prudential purposes? Market discipline is usually defined as the mechanism or process by which market participants monitor and punish excessive risk-taking behavior by financial institutions. It has gained appeal in recent years--given global financial market trends that have limited the ability of supervisors to adequately monitor such institutions--and it has now become part of the supervisory architecture (pillar 3 of Basel II and Solvency II).

Market purists hold market discipline as an article of faith and as a means to criticize "excessive" government regulation. Some commentators have even argued that market discipline should progressively replace, rather than complement, official supervision. In reality, of course, market discipline has less to do with the market per se than with the institutional and legal framework used to address moral hazard and asymmetric information problems that are endemic in the financial system.