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 The Economist notes that foreigners have invested $13.8 bn in India’s stockmarkets since April, having withdrawn $8.6 billion over the same period last year.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

Today in Bubbles

The editors of the Financial Times appear to be concerned about bubbles. Three out of today's four op-eds are dedicated to the theme.

First, George Soros argues that the implosion of 2008 was an aggregation of a series of bubbles over the past decades, creating, in his words, a "super-bubble":

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

The Case for Prudency: Latin America Edition

Bloggers at the IMF are looking at why Latin America fared better in this crisis than during previous episodes of financial duress. Their explanation: financial soundness mixed with enhanced credibility.

This improvement can be attributed to the fact that the region faced the crisis equipped with economic policy frameworks that were more solid and credible than in the past, and with smaller financial, external, and fiscal vulnerabilities. This allowed a number of countries of the region to implement countercyclical monetary and fiscal policies.

The estimates here suggest that these countries were able to “save” about 4 percentage points of GDP during the crisis, thanks to their better preparations for confronting external shocks.

A key element of this preparedness was credibility. Those countries which had responsibly managed their monetary and fiscal policies before the crisis were able to quickly lower interest rates, while increasing public expenditure and fiscal deficits. Countries such as Brazil, Chile and Peru managed to store away enough revenues from the commodity booms of the previous years in order to enact the necessary mix of countercyclical policies. Mexico, which is suffering from dwindling oil reserves, had less of a cushion, and has in turn struggled more than most of its neighbors.

Update: Vox has an interesting paper on the policy responses of Latin America Central Banks during the crisis, written by the former governor of the Central Bank of Ecuador.

East Asian Production Networks: Beggar Thy Neighbor?

There is an interesting article in Econbrowser by Willem Thorbecke of the Asian Development Bank, which looks at East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination.

Thorbecke highlights the important relationship between exchange rates and production chains in East Asia, arguing for increased policy coordination between the two. The paper presents both good news and bad news regarding East Asia's crisis recovery. First, the good news:

Signs are emerging that East Asian production networks are reviving. Imports for processing and processed exports both collapsed earlier this year. Since then, however, imports for processing have recovered 85 percent of their losses and processed exports 75 percent. Thus trade within East Asian production networks is recovering.

Crisis Roundup

European exports declined by 5.8 percent last month, the biggest drop since last January.

Understanding the European Central Bank means looking at its individual members.

The economic blogosphere really is a remarkable resource.

Bloggers at the IMF's ask, Did Islamic Banks in the Gulf Do Better Than Conventional Ones in the Crisis?

Did economic theory actually do a good job of predicting the crisis?

Greg Mankiw ♥ VAT.

Thoughts on exit strategies from one of China's prominent market economists.

Does China have a dollar problem?

Still confused about the dollar? Why do many of Asia's currency remain weak? Why are the euro and yen so strong, when their respective economies look weak? Bilal Hafeez, global head of foreign exchange research at Deutsche Bank is fielding questions from readers, which he will answer on Monday October 19.

World Economic Forum Financial Development Report

The World Economic Forum has released its Financial Development Report 2009, which scores and ranks 55 of the world’s leading financial systems and capital markets according to their level of financial development. It analyzes the drivers of financial system development and economic growth in developed and developing countries to serve as a tool for countries to benchmark themselves and establish priorities for reform.

The United Kingdom replaced the US as this year's top performer. America's fall is largely due to lower financial stability scores and a weakened banking sector:

 

The report also highlights the impact of the financial crisis on the Millennium Development Goals. Erik Feyen, Financial Economist in the World Bank’s Financial and Private Sector Development Vice Presidency, has written a chapter in the report that highlights this impact.

Below is an excerpt:

Global Monetary Architecture Matters

Editor's Note: Nadia Piffaretti is an assistant to the Chief Economist at the World Bank Group and a Special Assistant to the Senior Vice President. She is the author of an upcoming paper on Reshaping the International Monetary Architecture.

The crisis has taught us that economists ought to believe their own warnings about systemic vulnerability. If analysis points out that a system can fail, it probably will at some point. Knowing what we know today, having experienced – in a sort of “real-life economic laboratory” – how systemic vulnerabilities can transmit and amplify shocks, we cannot avoid turning a worried eye to the largely imbalanced growth of the global economy.

Before this crisis, many economists had warned about another crisis – a disorderly unwinding of global imbalances. It didn’t happen. It still may.

While most recently global imbalances have been narrowing, due to short term factors (like oil prices), the IMF is forecasting a widening again starting in 2010. At the same time, conditions do not seem to be reunited for a clear shift of growth engines at both sides of the global imbalances, especially at a juncture when governments attempt to calibrate exit-strategies from fiscal stimuli, walking the fine line between possible fiscal unsustainability, and the risk of too early withdrawal of stimulus.

It is against this backdrop, and the realization that the international monetary architecture looks vulnerable indeed, that I reminded myself of the almost forgotten “1941 Keynes’ Plan” which the “Master” had elaborated in view of the Bretton Woods negotiations.

The plan stemmed from the idea that monetary architecture matters.

Weekend Reading

Real Time Economics interviews: Hernando de Soto talks about the effects of the crisis on the world's poorest, while our Chief Economist Justin Lin discusses China, the IMF, and stimulus packages.

Paul Kedrosky praises venture capitalists.

One quarter of US jobs are offshorable. It might not matter.

Unemployment is high on Europe's frontiers.

In other unemployment news, Ryan Avent thinks that the stimulus is needed to fight joblessness. Tyler Cowen doesn't.

The US trade gap narrowed last month. It is down almost 50 percent from a year ago. Could it have anything to do with the dollar?

Larry Summers dismisses the idea of a low-growth America.

Our East Asia blog looks at 60 years of China's development, and asks, "Are China's banks having a good crisis?"

The Cost of Remittances

A few months ago I attended a World Bank conference on Diaspora for Development, which featured several discussions about the relationship between economic crisis and migration. An important component of this relationship is, of course, remittances.

The World Bank estimates that remittance flows will drop by 7-10 percent in 2009.  Yet, because of the fall in foreign direct investment caused by the crisis, remittances have become a more important source of external financing than ever.

If remittances have become an essential source of external finance for developing countries, then lowering the cost of sending remittances would serve as a de facto foreign currency stimulus.

Which brings me to today's announcement that the World Bank has launched its latest remittance prices data series. The new website has a handy menu where you can insert different corridors and calculate the costs of sending money. It even lets you compare the prices of various banks. 

The database has been expanded to include 33 new corridors, and the following new sending countries: Australia, New Zealand, Brazil, Chile, Costa Rica, Dominican Republic, Ghana and Tanzania corridors.

The least expensive corridors are Singapore-Bangladesh and Singapore-Philippines. On the other side of the table are Netherlands-Indonesia and UK-Sierra Leone. 

IFC Distressed Debt Update: China's On Board

Last week I discussed IFC's new plan to launch a vehicle to purchase toxic assets in emerging markets. The initial report indicated that much of the financing was expected to come from private sector banks. Reuters is now reporting that China's Sovereign Wealth Fund, China Investment Corp, is interested in participating in the project:

China has shown interest in investing in a new International Finance Corp program to acquire and restructure distressed debt in developing countries, World Bank President Robert Zoellick said on Monday.

Zoellick, speaking at a ceremony to launch the program that that aims to mobilize more than $6 billion to help banks and companies sell or restructure troubled assets, said he recently discussed the program with China Investment Corp, Beijing's sovereign wealth fund.

"They're interested in investing in distressed debt. They told us 'we can do it in the United States, but we're a little wary of doing it in the developing world because we don't want to be accused of anything'," Zoellick said. "To come in with us in a real restructuring program, they have some significant interest."

Washington Update

Although much of the Washington-based development community is headed to Istanbul, there is quite a bit of news coming from headquarters.

First, IFC is teaming up with several private sector banks to launch a vehicle to purchase distressed assets in emerging markets. IFC will commit $1.5bn to the fund and is hoping to raise an additional $4bn from the private sector. A particular emphasis will be on Eastern Europe, which was home to 40 percent of pre-crisis foreign capital flows. Further details of the project will be announced in Istanbul. In the meantime, the FT reports:

The idea is to mimic the functions of a "bad bank" at an international level through a number of platforms rather than a single global investment vehicle.

As part of the initiative...the IFC is teaming up with HSBC to purchase and restructure distressed assets, in what it hopes will eventually be  $900m scheme.

IFC's chief executive, Lars Thunnel, is known for having managed Sweden's "bad bank" during its banking crisis in the early 1990s.

Crisis Talk Readers: Participate in Next Week's Annual Meetings

The World Bank Group and IMF are descending upon Istanbul for their annual meetings. One of this year's highlights will be a panel on the post-crisis world, led by World Bank Group President Robert Zoellick.

In addition to Mr Zoellick, the panel will feature Sri Mulyani Indrawati, Minister of Finance, Indonesia; Mahmoud Mohieldin, Minister of Investment, Egypt; Eleni Gabre-Madhin, CEO, Ethiopian Commodity Exchange; and Professor Paul Collier, Department of Economics, University of Oxford.

As part of the program, the panelists will be answering questions from the audience, including those sent by the online audience. The debate will be recorded on Friday, October 2, and will be broadcast over the next two days on France 24.

Crisis Talk readers can submit their questions here.

China Can't Do It Alone

As rich countries, led by the Untied States, prepare themselves for a tepid recovery, can the BRICs, led by China, pick up the slack?

In a new paper for Vox, Deutsche Bank's Markus Jäger discusses China's prospects for becoming the de-facto engine for global growth. His concussion: China already is the decisive engine for global growth. 

By 2014, assuming things are back to normal, China and the US will account for around 30% and a little over 10% of global growth, respectively – and this assumes relatively optimistically US growth of more than 3% per annum. In this sense, China will be the global growth “engine”. But this is nothing new. China’s contribution to global growth amounted to 20% during the better part of this decade, almost twice size of the US contribution.

Crisis Roundup: Trade and Finance Edition

Chinese car sales are up 35 percent this year.

A look at tariffs over the past eight years. In 2008, they were significantly below the eight-year average.

The Baltic Dry Index is down, i.e. shipping costs have plummeted. Does this mean less trade, and lower growth? Or just increased capacity?

Global capital markets are entering a new era, with a greater role for emerging markets. The McKinsey Global Institute explains why.

Should the ratings agencies be downgraded?

Tensions are high at the G20 over how to reform the IMF. Simon Johnson's solution? Move it to Europe.

The World Bank is boosting its support to Eastern Europe and Central Asia. This past week Hungary, Ukraine and Latvia received a combined $2bn in assistance.

In other World Bank news, Robert Zoellick will be leading a discussion on the financial crisis next Monday (the 28th) from 1100-1230 EST. Crisis Talk will be Tweeting the event live.

The IMF's Medium-term Outook: Anything is Possible

The IMF released the latest chapters of its World Economic Outlook, which focuses on building a sustainable recovery. The first chapter addresses lessons for monetary policy from asset price fluctuations, while the second deals with the impact of the crisis on medium-term output.

The IMF believes that the crisis has not yet struck a dagger into the heart of medium-term growth prospects, but it does pose serious risks. Historically, the seven-year impact of banking crises reduces output levels by 10 percent of their pre-crisis trend. Things tend to improve afterwards, and a permanent decrease in medium-term output growth is rare.

Yet this has been an a-typical banking crisis, and as such, governments face a complex juggling act in shielding the global economy from acquiring a few scars:

China's Crisis Response Goes Global

China has been an essential player in fostering a global economic recovery. As one of the first countries to announce a massive stimulus package last November, China brought increased stability to markets when it was dearly needed. Today's conventional wisdom holds that in order to ensure a stable global recovery, Chinese consumers must increase their consumption patterns to fill the economic void left by their battered American counterparts (see previous post).

Can the Chinese government succeed in boosting domestic consumption? Are there other initiatives that China can take to put the global economy in motion?

The answer to both of these questions is a tentative 'yes'.

Zoellick's Pittsburgh Prescription

World Bank President Robert Zoellick has given his policy suggestions for this week's G20 summit in Pittsburgh. In an interview with the Financial Times, Zoellick urged world leaders to focus on adopting a responsible approach to global economic growth:

I would like the G20 to talk about responsible globalisation. That would capture balanced global growth, financial stability, climate change, help for the poorest including our proposal for a new facility to help countries cope with economic shocks not of their own making.

Zoellick also called for prudence, warning that a sustained economic recovery is far from certain, even in the brightest patch of the global economy, Asia:

China has expanded credit rapidly. As credit growth is moderated there is a risk that China could turn down again. Conversely, the strong rebound so far in east Asia could lead to increased interest rates that draw in a lot of capital – then what will the governments do in terms of currency policies, inflation policies, interest rate policies?

Sage, rather than sanguine, needs to be the running theme this week.

Doing Business 2010: Reforming through Difficult Times

The World Bank Group has released its annual Doing Business Report, which provides quantitative measures of regulations of the life cycle of a small or medium-size enterprise. Regulations related to registering property, employing workers, dealing with construction permits, and paying taxes are measured. Getting electricity and worker protection were added to this year's metrics.

In spite (or because) of the crisis, governments worked hard at improving the business climates within their borders:

In 2008/09 more governments implemented regulatory reforms aimed at making it easier to do business than in any year since 2004, when Doing Business started to track reforms through its indicators. Doing Business recorded 287 such reforms in 131 economies between June 2008 and May 2009, 20% more than in the year before.

Reformers focused on making it easier to start and operate a business, strengthening property rights and improving the efficiency of commercial dispute resolution and bankruptcy procedures.

The US Dollar: The worst choice (except for every other option)

Barry Eichengreen has written a piece in this month's Foreign Affairs outlining the difficulties of replacing the dollar with an alternative reserve currency (subscription required).

Professor Eichengreen sets the stage with the usual talking points over the dollar's weaknesses:

• Confidence in the US-championed global financial system is waning
• The US government will continue to issue staggering amounts of debt
• In order for central banks to acquire dollars, the US must run a current-account deficit, which aggravates global imbalances and puts further downward pressure on the dollar
• The political logic for supporting the dollar has weakened, as the US is no longer seen as the military protector of Europe and Asia

In spite of this cocktail of structural weaknesses, there is an "inconvenient truth" to the dollar: its global importance hasn't changed as a result of the crisis. Based on the Federal Reserve's holdings of US Treasuries on behalf of its foreign counterparts, "foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of the 2009."

What gives? Why stick to a currency that is so clearly flawed? Why buy into a system that many respected economists warn is destined to fail?

Bernanke's Challenges: Look North

Now that we are due for at least four more years of a Bernanke Fed, what will Act Two look like? The New York Times invited several economists to forecast the challenges lying ahead for Mr Bernanke.

Chief among these challenges is unwinding the massive stimuli and support mechanisms that the Fed introduced in order to "prevent another Great Depression" (in the words of Barack Obama). This will involve a deceleration of monetary easing as the Fed balances growth and recovery with inflation and the credibility of the dollar.

Iceland may be an interesting case study of what's ahead. Just as Iceland was a precursor to the severity of the credit crunch, it may be the first to feel the withdrawal symptoms of diminishing government stimulus policies. Robert Wade argues:

IMF Weighs in on Recovery; World Bank Discusses Finance in Africa

The IMF and World Bank have both released reports discussing their latest thoughts on the global and regional effects of the financial crisis. 

Olivier Blanchard, the IMF's chief economist, has published his views on Sustaining a Global Recovery, arguing that the path out of the crisis for emerging markets is much simpler than in developed economies:

If past is prologue, the world economy likely will return to its past growth rate. But, especially in advanced countries, the period of above-average growth, characteristic of normal recoveries, may be short-lived or nonexistent.

Blanchard exposes two caveats to recent good news about growth:

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.

Global Regulation Now Important Enough to Merit a Newsletter

It's a sign of the times: the Institute of International Finance has started issuing a monthly global regulatory update. Here's one excerpt from the June edition (subscription required) on the transformation of the Financial Stability Forum into an expanded Financial Stability Board (FSB):

Importantly, the FSB has been expanded to include Argentina, Brazil, China, India, Indonesia, Korea, Mexico, the, Russia, Saudi Arabia, South Africa, Spain, and Turkey, as well as the European Commission. Also, for the first time, the members of the G20 have made a clear mutual commitment, as a condition of membership, to achieve the regulatory goals the G20 and FSB have set out.

There is thus a new degree of political intervention in regulation – which may be concerning as well as positive in some respects – and a new political commitment to achieve the goals that the standard-setters have pursued without a clear political mandate and on the basis of informal good will up to now.

Time for the Tax Experts

A new report from Citigroup Global Markets (subscription required) titled Out of the Frying Pan? Fiscal Vulnerability Takes Centre Stage argues that the global financial crisis has moved into its third stage. First there was a financial vulnerability phase, in which countries with high loan/deposit ratios suffered, and this was followed by (and overlapped with) an external vulnerability phase. In this second phase, countries with high external financing needs suffered the most. Fortunately, they have been buoyed by a combination of an increased supply of finance - in large part through a ramped up IMF - and a decline in demand for external finance through improved current account balances.

Czech Exceptionalism

The Czechs have long sought to identify themselves more with the West than the East. It looks like the financial crisis has given a boost to their claims to be exceptional. A new note from J.P. Morgan (subscription required) on the EBRD meetings reports:

The CNB [Czech National Bank] is pleased that foreign investors and the media have started to differentiate between the specifics of the Czech economy and the rest of Central and Eastern Europe. The CNB emphasized that, unlike the rest of the region, the local banking sector is a creditor to foreign banks due to the surplus of deposits over loans. Household FX borrowing is non-existent.

It's interesting to note one of the reasons behind this Czech exceptionalism - they avoided the eastern European equivalent of subprime loans in the United States. No foreign-currency denominated mortgages for the Czechs, unlike their neighbours a little further east. Smart move.

Quantitative Easing: Do Actions Speak Louder than Words?

The IMF provides some cautionary advice on quantitative easing to emerging market policy makers in a recent position note, Coping with the Crisis: Policy Options for Emerging Market Countries:

Quantitative easing (QE): The central bank expands its balance sheet by purchasing assets such as longer maturity government bonds. QE seems less appropriate for EMEs [Emerging Market Economies], where deflationary expectations are unlikely to be present (and even in advanced countries, evidence on its effectiveness is limited). If anything, there is a risk that markets misinterpret QE as a return to inflationary policies—particularly if there is little commercial paper and QE takes the form of purchases of government securities. Therefore, except in extreme situations (e.g., the policy rate is already set to zero), QE should only be attempted by countries with a history of low inflation and macroeconomic stability, with central bank independence and credibility.

I suspect the IMF will have to be a little more vocal on this one if it wants to be heard, though. Actions speak louder than words, and the actions of the U.S. Federal Reserve in buying up $1.2 trillion of government debt and mortgage-related securities could very well be deafening.

Europe Divided

It looks like the IMF will have its work cut out for it in eastern Europe:

The European Central Bank has rejected pleas from central and eastern European states for it to use its firepower to boost euro liquidity in the region’s beleaguered banking system, Emerging Markets can reveal.

Non-eurozone central banks in eastern Europe had aggressively lobbied the ECB in recent months, to accept their local currency-denominated sovereign bonds as eligible securities in ECB refinancing operations with parent banks operating in the region.

But central banks in Poland, Hungary and the Czech Republic – the most vocal of lobbyists on this issue – yesterday received letters from ECB president Jean-Claude Trichet informing them he had rejected their calls, people familiar with the matter said.

Perhaps we should go back to capitalizing "eastern" in "Eastern Europe"? 

The IMF Blows One

Apparently, in the zeal to show just how bad the situation in eastern Europe is, the IMF exaggerated the external financing needs of a few countries "due to typographical errors." See a polite Reuters report on this story. Also see a less-polite Financial Times story.

After the numbers for some countries were challenged by central bankers, analysts and journalists, the IMF revised the data and began publishing new figures for the external debt/reserve ratios of some eastern European countries. The ratio for the Czech Republic was cut from 236 per cent to 89 per cent and Estonia’s was reduced to 132 per cent from 210 per cent. It is understood that the figure for Ukraine is also being cut to 116 per cent from 208 per cent, that Lithuania’s ratio of 425 per cent may also be recalculated and that others may follow.

The IMF said on Wednesday it would verify its numbers and publish correct figures on its website as soon as they were available. “We regret any confusion that may have arisen as a result of our publication of erroneous figures.”

Bosnia: The Latest IMF Client

Bosnia just announced a $1.6 billion package from the Fund. Who is next?

Hedging the Fund II: The IMF as Policeman or Social Worker?

This is the second post on views presented at an April conference on “New Ideas in Development After the Financial Crisis,” sponsored by the Center for Global Development and the School of Advanced International Studies. The first post summarized a speech by Dominique Strauss-Kahn, Managing Director of the IMF. Here I deal with other ideas put forward on how the IMF should change and function.

Sebastian Mallaby, Director of the impressively named Center for Geoeconomic Studies at the Council on Foreign Relations, strongly supported the resurgence of the IMF. But what he envisions is IMF 2.0, or perhaps 3.0, considerably altered from its previous state. His take: In reaction to the crises of the late 1990s, and ensuing IMF conditionality, developing countries have accumulated massive U.S. dollar balances to self-insure against the next crisis. The present situation exacerbates the trend. But these reserves failed to provide security either to the holders, or to the United States (or the world economy), not despite but precisely because many of these dollars were parked in U.S. debt instruments. (I assume he means that this promoted the “there is too a free lunch” mentality.) While acknowledging the significance of unfettered greed and regulatory failure, Mr. Mallaby views the existence of the reserves, and the way they were managed (or mis-managed), as contributing greatly to the present meltdown.

Hedging the Fund

On 04.23.09 I attended the second day of a conference here in Washington on “New Ideas in Development After the Financial Crisis,” jointly presented by the Center for Global Development and the School of Advanced International Studies.  A number of the economic illuminati spoke:  e.g., Dominique Strauss-Kahn, Kemal Dervis, Sebastian Mallaby, Santiago Levy, Jose-Antonio Ocampo, Benno Ndulu, Justin Lin and others. 

In this first of two blog posts, I report on the presentation of the Fund’s Managing Director, dealing both with his views on the crisis and how the IMF has changed - and should further evolve - to deal with it.  The second will recount the views of other presenters on what the crisis means for the international financial institutions in general, and the Fund in particular.

What a difference a crisis makes!  Eighteen months ago the IMF was on the ropes.  A highly critical clientele had repaid the bulk of outstanding loans, resources were dwindling, staff were demoralized and diminishing, and there was not much of a purpose in sight.  Today, said Mr. Strauss-Kahn, the need for and relevance of the IMF was “manifest.”  Why?  Because the crisis has shown that “the links between the financial sector and the real economy are deeper” than had been thought, and that “global financial interactions” were both more prevalent and important than foreseen.  The IMF, with its capacity to quickly help poor countries deal with a sudden loss of crucial capital inflows, and middle and high income countries (e.g., Poland, Iceland, Ukraine) cope with crisis and financial collapse, is very much back in business.  Mr. Strauss-Kahn did his commendable best to deplore the dreadful circumstances leading to the Fund’s revival, but I thought I detected the tiniest hint of satisfaction - the IMF is definitely not going under on his watch.

The U.S. as an Emerging Market?

Simon Johnson, a prolific academic writer and former Chief Economist of the IMF, has come out with a relatively negative view on the U.S. financial system, both current and past. According to Simon, the personal interlinkages between the political and financial systems in the U.S. are very similar to those in many, if not most, emerging markets. And the policy approach towards solving the financial crisis has been dominated by attempts to minimize the pain for bankers, rather than for the overall economy. The bank-by-bank approach with generous bail-outs, while avoiding more drastic actions that might risk shareholders’ equity stakes and senior manager bonuses, has not really helped so far. In order to really get out of the slump, Simon recommends more decisive action in the banking sector, including temporary nationalization and clean up of banks, but also the breaking-up of the financial oligarchy with its links to the political system.

The Great Mark-to-Market Debate

The leaders of the Group of 20 (G20) recently called on the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to improve financial reporting standards for calculating the market value of assets in illiquid markets. The debate over mark-to-market accounting, which is a subset of fair-value accounting, and its role in the financial crisis, made its way to Congress during the first half of March 2009. The concern is that banks will not incur the losses booked per mark-to-market accounting as asset values recover over time from today’s clearance sale prices.

The mark-to-market concept may sound trivial, especially when compared to a $787 billion rescue plan, but getting it right would be a significant step toward addressing the causes of the credit crisis. The main aim is to simplify the complexity of financial reporting and off-balance sheet financing and to make progress towards a single set of high quality global accounting standards. 

In a forthcoming paper in the Journal of Economic Policy Reform, I discuss the costs of mark-to-market valuation within the US 2009 (Bailout) Emergency Economic Stabilization Act (EESA). The paper highlights how mark-to-market valuation standards influenced financial institutions, explains why mark-to-market policy suspension proponents can support EESA, and explains how the FASB and the SEC can count on EESA while assessing the need for mark-to-market valuation policy.

A Brave IMF

In a supposedly-leaked report, the IMF has said the best strategy for Eastern Europe in fighting the current crisis is to adopt the euro fast (see the FT article). This is an obvious point and one that some Baltic countries and Bulgaria have made for months. To the consternation of the European Central Bank (ECB), which takes the view that proper procedure should be followed and conversion to the euro shouldn't be rushed. It could in fact be delayed.
 
This is a case of bravery on the side of the IMF - and a second big hit for the institution in a week (also see this). And a case of constipated thinking on the part of ECB. The cost of early euro entry is surely a lot smaller for Europe than the eventual cost of bailouts and macro instability that is otherwise likely in Eastern Europe. So why does the ECB push this line (for now)?

IMF Gets a Deserved Boost

A big outcome of the ongoing G20 meeting is a commitment to triple the amount of money the IMF has for lending (see the BBC story), to $750 billion. This is welcome news. Of all the possible things the G20 leaders could have done, this one would ease the crisis the most.

The G20 has also committed about $250 billion to boost global trade. This one I don't get. Exactly how will this money be used? Perhaps for trade finance. If so, there is no evidence this is a real bottleneck to trade. Or, alternatively, the money could be used to buy products and thus spur demand. But what to buy? This reminds me of one of my first visits to Ukraine. I went to a heavy machinery factory and was shown a huge tank. So huge, in fact, that it couldn't leave the factory - the doors were not large enough. The manager was very proud of it nevertheless.

Banking and the Leverage Ratio

The World Bank has just put out a helpful background note on Banking and the Leverage Ratio. The leverage ratio is a prudential tool that helps limit excessive leverage in a banking system. The note is quite a propos, as the Financial Stability Forum is expected to propose that a leverage ratio be added to bank-capital requirements at the G20 summit in April. So how exactly could a leverage ratio help?

• Limits balance sheet size: The current risk based capital measures (both Basel I and Basel II), encourage banks to assume exposures that attract a low risk weight, as the capital required to be set aside for these exposures is relatively small. As a result, in absolute terms bank balance sheets can become highly leveraged and can include assets that would be difficult to liquidate in times of need without incurring large haircuts. Hence, the prudential leverage ratio can serve as an additional measure to ensure that banks do not become excessively leveraged, as seems to have happened in recent years (see Figure 1).

• Reduces regulatory arbitrage: As described above, the more risk sensitive nature of Basel II can result in the perverse incentive to structure products to obtain a high credit rating, so that they qualify for lower prudential capital requirement. When this incentive is collectively exploited, the system is likely to end up with high concentrations of structured exposures attracting low prudential capital requirements. The prescription of a minimum leverage ratio, among other measures, can dampen this perverse incentive.
• Simplicity: The simplicity of the application and monitoring of the leverage ratio enables quick adoption without imposing high costs or expertise requirements on banks or their supervisors. Moreover, this can be applied irrespective of the capital adequacy regime implemented in a particular jurisdiction.
• Backstop against regulatory concessions: Reliance on banks’ own internal models for capital adequacy purposes, as mandated in Basel II, entails a significant element of judgment and may expose regulators to industry pressures for lenient treatment. A leverage ratio would thus act as a backstop against any creeping regulatory concessions.

In other words, a leverage ratio could be a very useful complement to the Basel capital adequacy ratio. However, the note points out that a leverage ratio is not without limitations - read the whole thing here.

New Blogroll

Our blog page has been updated to list other blogs that have interesting things to say about the crisis (see the Crisis Blogroll in the righthand column). One of the interesting things being said is a comment from Dani Rodrik's blog:

There are two things that can make a real difference to the world economy in the short run: (a) coordinated fiscal stimulus, and (b) massive increase in credit or liquidity facilities for the developing nations.  European obstinacy has taken off the table the first of these. And it is not at all clear that the second is being pushed hard enough by any of the rich countries (although the US proposal on the enlargement of the IMF is considerably more generous than what the Europeans have offered so far).

You can read the whole posting here.

Assessing the Trade Finance Situation

It is difficult to find reliable information on how severe the trade finance problem really is. There are a lot of numbers circulating, all of questionable quality. Take, for example, the figure on the importance of trade credit. Recent news reports state that 90 percent of the US$14 trillion in world trade is financed by trade credit (see, for example, the International Herald Tribune, Forbes, and the WTO). But, where does this “90 percent” come from? I traced the number from various WTO documents, and it appears to come from a 1998 paper by Malcolm Stephens at the IMF. However, the statement in the paper is quite different: “90 percent of world trade is conducted on the basis of cash or short-term credit” [p.5, emphasis is mine]. 

An additional reason the number is suspect is because of the growing share of trade between a parent firm and its affiliate. This so-called intrafirm trade is unlikely to use external financing. The OECD reports that approximately one-third of trade for the US and Japan (countries for which data are available) is intrafirm. More than two-thirds of Austria’s imports from Eastern Europe are intrafirm. This makes the 90 percent even harder to swallow.

Another number that has been circulating in these articles is a $25 billion “liquidity gap” in financing by the private sector. This is the "market's estimate" - $25 billion is less than two-tenths of one percent of the value of trade, so it is quite small in the grand scheme of things. How can trade finance be a major issue in the stunning decline in trade (trade was down about 15 percent from the previous year in November and December, and available data for January looks worse) if the liquidity gap is just 0.16 percent?

In order to diagnose and improve the trade finance situation (if necessary), we must first measure it.  Given the market's failure at quantifying assets, liabilities, and risk, we cannot rely on its estimate of the trade finance gap without any supporting data. It is unfortunate that reliable data from banks working in trade finance have not been made available.

Enforcing Transparency

The financial crisis gave new impetus to demands for more transparency and more accountability. “The global financial crisis [is caused] in part by greed and corruption,” was the announcement last December by the United Nations Secretary General Ban Ki-moon. How to enforce transparency? 
 
There might be a few good ideas to learn from the American experience of setting up a transparency watchdog. These ideas were presented by Walter M. Shaub of the US Office of Government Ethics (OGE), the main speaker at a brown bag lunch at the World Bank last week.
 
The work of the OGE is focused on prevention. Assets and interests disclosure is the main tool to identify conflicts of interest among government officials. If a conflict of interest is apparent from the declaration, the agency works with the official on resolving such conflict before it creates prejudice. Increasingly complex conflict-of-interest legislation increases the probability of inadvertent violations. The right advice is important - independent from law enforcement bodies and tax authorities, the ethics agency is conscientious of the trust that its clients place in it.
 
Promoting transparency comes before fighting corruption. It is generally true that a psychological stance of promotion creates acceptance while struggle against something incites resistance. Transparency might be just like healthy food and a healthy lifestyle – it requires steady effort to build up the right habits.

The Man with the Two Trillion Dollar Plan

On Monday, World Bank Chief Economist Justin Lin proposed the establishment of a $2 trillion Global Recovery Plan. A new Marshall Plan, of sorts. You can listen to his presentation and read about it here.
 
The issue is that the United States of today is in a different position than the United States after the Second World War. It is hard to imagine Congress giving much money for causes abroad when the domestic economy is hurting. The same applies to the other rich economies. If anything, one may expect some lean years in development aid.

Guerilla Trade Tactics

In 1930, the Smoot Hawley tariff was implemented in the United States, raising tariffs on nearly 900 goods. The Europeans retaliated with similar tariff hikes. World trade fell by two-thirds from 1929 to 1934 largely as a result of declining demand during the world depression, but also because of the increased tariffs. Such conventional trade warfare finally came to an end with the advent of the GATT in 1947.

Thanks to the rules provided in the WTO, the successor to the GATT, a conventional trade war is now unthinkable. But as demand is plummeting, countries are seeking ways to shift it to domestic goods. This is where guerilla trade tactics come in. The WTO Secretariat reported that in the first half of 2008 (the most recent data available) there was a 39 per cent increase in antidumping investigations among members as compared with the same period in 2007. Subsidies around the world are being directed at specific domestic industries. Now, the U.S. stimulus package appears likely to include a “buy American” clause. 

Such guerilla trade tactics may be just as dangerous as a conventional trade war. A key issue is the non-transparency of these antidumping duties, countervailing duties, and targeted domestic subsidies. If these modes of discrimination explode it will take a long time to disentangle them and reopen the trade system. Not to mention the resources wasted and uncertainty they generate for importers (for example, in the United States, it takes the ITC and ITA between 235 to 390 days to reach a final conclusion in an antidumping investigation!). 

The WTO has been among the most successful of the international institutions. The ongoing Doha Round—with all its promises—may be able to claim victory after all if it can simply prevent protectionism from surging during the global recession.

Relaxing Holiday Reading: The IMF on Fiscal Policy

Hot off the press, the IMF yesterday released a staff position note on Fiscal Policy for the Crisis. Although Dominique Strauss-Kahn, the IMF's Managing Director, has been calling for fiscal stimulus for some time, this note attempts to lay out some principles on how best to go about it. In short, the note argues for the following:

[W]e argue that a fiscal stimulus should be timely (as there is an urgent need for action), large (because the drop in demand is large), lasting (as the recession will likely last for some time), diversified (as there is uncertainty regarding which measures will be most effective), contingent (to indicate that further action will be taken, if needed), collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and sustainable (to avoid debt explosion in the long run and adverse effects in the short run). The challenge is to provide the right balance between these sometimes competing goals—particularly, large and lasting actions versus fiscal sustainability.

These recommendations fall largely within the mainstream, but a few new proposals will likely raise some eyebrows. The authors suggest that the public sector could play a bigger role in financial intermediation through various forms of quantitative easing. They add a proviso that "the public sector does not have a comparative advantage in evaluating credit risk." I'll nominate that one for understatement of the year - if the cartel of credit rating agencies managed to fail so miserably at rating securities, I can only imagine how well a monopoly will perform.

The second proposal concerns the provision of public insurance against large recessions. Banks or firms (or even individuals) could buy this insurance from the government and would receive a payout if GDP growth fell below some defined threshold. Such insurance would serve as an additional automatic stabilizer during a recession or depression. The theory sounds interesting. However, I think that economists tend to forget how often statistics are subject to political pressure. What would happen then if millions or even billions of dollars of publicly provided insurance were tied to output statistics?

Big Brother

As the financial crisis has turned into an economic recession in nearly all OECD countries, governments are pumping money into the banking and real sectors in ways never seen before. The United States alone has committed to various stimulus packages amounting to about 9% of GDP in 2009 (figure 1). This is the largest amount in peacetime since the year 1900!

In addition, the US Fed has opened lending facilities worth $30 billion each to emerging markets such as Brazil, Mexico, Korea and Singapore. And, as a new Barclays Capital report ("Uncharted Territory") comments, the IMF has provided "fast credit without conditionality" to Iceland, Hungary, Ukraine and Pakistan. Several others countries are waiting in line.

The crisis response has evolved in four steps:

1. Aggressive expansion of monetary policy
2. Protecting "too big to fail" financial institutions
3. Fiscal packages for the real economy (with more likely to come)
4. Unconventional monetary policies (central banks purchasing risky assets such as asset-backed commercial paper from corporate issuers and mortgage-backed securities)

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.

"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.

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."

How Large are IMF Packages Compared to Past Crises?

The IMF has already announced tentative loan agreements with Iceland, Hungary, and Ukraine, and it is working with other countries on a similar direction. The Fund is ready to lend $2.1 billion to Iceland, $15.7 billion to Hungary, and $16.5 billion to Ukraine. These numbers are significant: they represent around 11% of GDP for Iceland and Hungary, and 8% of GDP in the case of Ukraine.

How do these numbers compare with those of similar packages in past crises? As the table below shows, Uruguay received a line of credit of 21% of GDP in the 2002 crisis, and Argentina was offered two packages totalling 8% of GDP in 2000 and 10% of GDP in 2003. Turkey was offered two packages of around 7-8% of GDP each in 1999 and 2002. Most other packages were smaller.

The recent numbers do not include financing given by the World Bank, regional development banks, and other multilaterals. For example, the total package just offered to Hungary totals $25.1 billion from the IMF, the World Bank, and the EU -- or 18% of GDP. In the Asian crisis of 1997-98, if other sources of financing are added (including World Bank and Asian Development Bank money), Indonesia was offered $36.1 billion (17% of GDP), Korea, $58.4 billion (13% of GDP), and Thailand $17.2 billion (12% of GDP).

Views of the World Bank Chief Economist

World Bank Chief Economist Justin Yifu Lin today discussed the origins of the financial crisis and its impact on developing countries, and proposed several ways to respond.

Speaking to the Korea Development Institute in Seoul, Lin called for a discussion on several ideas for economic policy management. Among them:

• Governments should consider carefully whether controlling asset price inflation should be added to the mandate of monetary policy authorities. ("If the Fed is not able to keep these bubbles from inflating, it will not be able to achieve its other objectives.")
• Financial supervision needs to try its best to keep up with financial innovation. ("The techniques and art of supervision must be able to follow financial-sector innovators into new territory where, by definition, innovation will always have a head start.")
• Responses to global crises must be systematic, comprehensive, decisive, and coordinated. ("Given how globalized financial sectors now are, piecemeal and unilateral responses to financial crisis will run the risk of worsening the ripples of negative reactions across borders without addressing fundamental problems.")
• Global problems may require global multilateral solutions. (" If indeed the world does find itself in a global recession next year, as we fear is possible, further and more creative multilateral action may be necessary.... [W]e cannot be constrained by the limits of institutional structures and approaches designed for a world before financial globalization."

Crisis response: What can the World Bank do?

If you are a development institution, crises are opportunities to display leadership. Troubled countries look for help and advice, and they naturally come to you (unless they are East Asian and you are the IMF).

What can the World Bank offer in these times of unrest? First, a little money. In previous crises, the World Bank increased lending by up to $20 billion. This time around, it could even be $30 billion. This is still peanuts relative to the $200 billion the IMF is talking about; and certainly relative to the size of the crisis. To make a simple comparison, rich countries so far have announced various packages for their troubled institutions worth about $9 trillion. In the money game, the World Bank will be a team player in packages someone else typically finances.