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 The Economist notes that foreigners have invested $13.8 bn in India’s stockmarkets since April, having withdrawn $8.6 billion over the same period last year.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...

What's New in Decoupling?

I recently wondered what the relationship between developed and emerging economies would look like during the recovery phase of the crisis:

Will a robust emerging market rebound boost OECD growth? Or, are we due to see a multi-speed global recovery?

John Authers points out that, thus far, the recovery has been quite heterogeneous:

The grand theory was that decoupling by emerging markets would be good for everyone- they would grow even if consumers in the developed world caught a cold, and help everyone through. The latest data suggest a decoupled world, but that does not seem so positive.

Authers highlights the Reserve Bank of India's recent decision to raise rates and the "stunning" recovery in South Korea. Meanwhile, consumer confidence in the US is awful. He concludes:

Asian economies are already at the point where overheating is the main danger, while US consumers, for all the money thrown at them, are still not feeling any better. This is not encouraging.

Meanwhile, equity indices are down and the dollar is up. Perhaps investors were a bit too sanguine, and are now sobering up?

More on bubbles

A few days ago I offered a series of bubble warnings from a German financial pundit, two academics, the man who broke the Bank of England, and the man who built Singapore. Today, we have a warning from the world's largest bond fund.

Free Exchange links to a discussion (via Buttonwood) about asset inflation, led by Pimco's Bill Gross.

Bottom line:

Cumulatively, asset values have risen twice as fast as GDP over the 50 year period. As Gross writes "you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce."

Nuff said.

Emerging Market IPOs: Leading the way

Two years ago, as financial markets in the United States and Europe began to break down, there was much speculation over whether emerging markets would continue to grow in spite of the woes in the West. A year ago, this idea of decoupling was quickly dispelled.

As emerging markets rebound from the crisis, will there be a new decoupling, where they grow, and OECD economies struggle? It is probably too early to tell, but in one area, IPOs, developed economies are profiting from emerging market successes.

Sovereign Wealth Funds: A Stabilizing Force?

I attended a discussion at the IMF today on the effects of sovereign wealth funds (SWFs) on financial market stability, particularly during the crisis*. It was hosted by two resident economists, Tao Sun and Heiko Hesse, who presented the results from their paper on Sovereign Wealth Funds and Financial Stability. The study analyzes whether or not the introduction of the massive financial resources behind sovereign wealth funds destabilizes capital and equity markets. 

The answer, for now, appears to be no. 

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.

Today in China: Panda Put or Cliff Dive?

In light of yesterday's 6 percent drop in the Shanghai composite, there is increasing speculation about the sustainability of the buildup in Chinese equity markets (see recent post).

China’s stimulus efforts, led by increased bank lending, have caused the economy to look more and more frothy:

Is there a China bubble brewing?  If so, will the Chinese government intervene to avoid a crash (the panda put option)? Or are we in for a sharp correction?  Let's see where the market pundits stand:

Making Goods vs Making Money: China, finance and rent-seeking

Simon Johnson has written an excellent essay contrasting the growth of traditional industry in China with America's fastest growing sector in the past 40 years: finance. 

Johnson argues that America's current bloated financial system absorbs more money than it produces, transforming it into a rent-seeking industry:

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Investor Protections and Economic Growth

A close look at equity prices around the world reveals how much they have been affected by the current financial crunch as well as by credit and market risks. Fluctuations in growth and exchange rate expectations have only enhanced their influence. Financial integration has scaled up the correlation between advanced, emerging, and (to a measurable extent) developing economies’ equity markets over the last dozen weeks, so that equity prices have been moving more closely together. However, financial integration has not been accompanied by a harmonization of investor protections and corporate governance principles.

As the policy response to the economic crisis moves from short-term solutions – corporate bailouts and economic stimulus – to longer-terms fixes like financial market regulatory reform, it becomes increasingly important that policy-makers move beyond finger-pointing. Countries with stronger investor protections tend to grow faster than those with poor protections. A recent paper, using objective measures of investor protections in 170 countries, establishes that the level of investor protection matters for cross-country differences in GDP growth. An improvement in investor protection leads to better risk sharing, which implies a larger demand for capital. This “demand” effect indicates a positive association between investor protection and growth.

When Will Stocks Rebound in Eastern Europe?

Editor's Note: The following is a joint contribution from Simeon Djankov and Facundo Martin. You can also download a PDF of When Will Stocks Rebound in Eastern Europe?

Eastern European stock markets had a traumatic 2008. In several countries, including Bulgaria, Lithuania, Romania and Ukraine, the market indices dropped 75%. In all other countries but Slovakia, stocks lost about half their value.

Will 2009 be different? Do investors have something to look forward to?

Stock market returns depend primarily on the underlying company profits. In emerging markets, these depend on the global economic outlook, as a large share of production goes to foreign buyers. So to know when stocks will rebound, you need to know two things: when the economic downturn will end (both at home and in major export markets), and whether stock prices turn up before or after economic activity picks up.

We study the latest economic forecast by the World Bank to answer the first question. We look at historical data in emerging markets and two developed economies (the United States and the United Kingdom) to answer the second question. In particular, we investigate the relationship between changes in industrial production and changes in stock market indices during previous downturns in six emerging markets (Indonesia, 1997-98; Korea, 1997-98, Thailand, 1997-99; Malaysia, 1997-98; Russia, 1998-99, and Argentina, 2001-02); and the United States (1980-81, 1982-83, 1990-91, and 2001-02) and the United Kingdom (1990-92 and 2001-03).

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.

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.

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."

Examples of Good Financial Innovation

These days "financial innovation" has a negative connotation. OTC credit-default swaps come to mind. Yet as economists we naturally think most innovation is good. Could the last decade have been in aberration in terms of financial innovation? Or are there some good financial innovations that are now being over-looked?

Steve Waldman, of Interfluidity fame, has the following examples to offer:

• Exchange-traded funds
• The growth of venture capital and angel investing
• The democratization of access to financial information (e.g., Yahoo! finance)
• The democratization of participation in financial markets (e.g., the growth of Internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

Know any others?

Zimbabwe: The Star Stock Market

While not a focal point of the financial crisis, share price gains of 20,000% per month in Zimbabwe are creating a stir -- at least for people who read the latest S&P Emerging Stock Markets Review without looking carefully at the underlying numbers. Standard & Poor's calculates a set of stock indices for 51 emerging markets and expresses monthly returns in US dollars. With hyperinflation running at 10 quadrillion percent, there's simply no meaningful way to convert Zimbabwean dollar returns into US dollar returns. Yet this is what S&P analysts apparently did. The result: the September issue of the Emerging Stock Markets Review lists five Zimbabwean companies with US dollar market capitalizations exceeding $1 trillion. The country's total market capitalization apparently dwarfs that of the United States. Fortunately, foreign investors are not that welcomed in Zimbabwe so few have probably rushed in.

Collapse of Equity Markets - Beyond the Asian Crisis?

During the 1997-98 Asian crisis, the equity markets of the 5 Asian countries at the epicenter fell between 58% (Korea) and 78% (Malaysia). These declines took place in the 12-15 months from mid 1997. Today, 9 countries have already shown such declines in their stock markets -- but in less than 4 months.

Some examples: Iceland, down 85% since August; Russia down 76% since July; Kazakhstan and Ukraine, down 70% since July; and Brazil, Hungary and Peru have fallen over 65% since July. In four months, 9 countries have already fallen more than Korea fell in one year after the Asian crisis (58%). The stock markets in 17 countries (from a subset of 36 countries) have fallen more than 50% since mid 2008. Slovakia has been the best performer in the sample, losing "only" 15% since July. This tells about the magnitude, speed, and extension of the current crisis, reaching countries in all regions. Unfortunately, there are no signs to assume that the worst is over.