Global Financial Crisis ASSIGNMENT 2
Session 2016/17 TITLE HOW TO AVOID THE NEXT EUROPEAN FINANCIAL CRISIS AUTHOR
GABRIELE CALABRO’
Table of Contents 1 Introduction ......................................................................................................................................... 3 2 Financial Crises ................................................................................................................................... 3 2.1 Type of Financial Crises ................................................................................................................ 4 2.2 The illiquidity Risk ........................................................................................................................ 4 2.3 The Italian liquidity issue .............................................................................................................. 5 2.4 The impact of globalization on crises (Depth & Frequency) ......................................................... 6 3 Prevention Methods............................................................................................................................ 7 3.1 Prevention Method 1 .................................................................................................................... 7 3.2 Prevention Method 2 .................................................................................................................... 8 4 Conclusion ......................................................................................................................................... 12 5 Key learning points ............................................................................................................................ 12 References ............................................................................................................................................ 14
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“The situation is uncomfortably painful, even unbearable for Italy. There is no magic bullet,� (Codogno, 2016)
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1 INTRODUCTION In this paper, will be analyzed the danger regarding the possibility of a next Financial crises. One of the main factors of the 2007-08 crises consisted of the global synchronized contractions all over the real and financial aggregates. In this regard, the hypothesis of multiple self-fulfilling equilibria in credit market will be considered and analyzed. The first section discusses the different type of Financial Crises, including the Debt crises and the liquidity risk behind it. The second section will present and analyze the Italian market through indicators to show the actual situation and highlight the major risk. Moreover, in this section will be considered the impact of globalization on crises its depth and frequency. The following chapter will contain two prevention methods to avoid the next financial crises of either national and global market. At the end, the last section will summarize the main ideas of this paper and the key learning points of this module.
2 FINANCIAL CRISES There are a considerable number of definition for Financial Crises (FC). For instance, according to Frederic S. Mishkin (1991) a Financial Crises consist of a breakage to financial markets in which moral hazard and adverse selection issues lead to bad equilibria, consequently financial markets cannot canalize funds to those who offer the most efficient investment possibilities. (Frederic S. Mishkin, 1991) Kindleberg (1978) give a broader definition saying that financial crises include plunge in assets prices and defeat of non-financial and financial firms. (Kindleberg, 1978) The difference between the two definition above is clear, in fact the second one highlight the monetarist view that financial crises are related to a banking issue (Mishkin, 1994)
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2.1 TYPE OF FINANCIAL CRISES There are diverse types of financial crises, (Reinhart and Rogoff, 2009): Currency such as 90-92 ERM Crisis and 97-98 Russian Crisis Banks crisis such as 2008-09 sub-prime crises Twins crisis when both currency and bank happen Debt crisis (Balance of Payments (BoP), Sovereign debt crisis or household debt crisis) The BoP crisis occur when a country cannot attract or generate the capital needed to finance a current account deficit. (Geoff Riley, 2016)
2.2 THE ILLIQUIDITY RISK Firstly, is useful to clarify the difference between insolvency and illiquidity. Insolvency means that the DEBT VALUE is bigger than the ASSETS VALUE, while illiquidity means that, although the DEBT VALUE is smaller than the ASSETS VALUE, the latter is illiquid. Consequently, it will be difficult to sell it, for its original price. However, there are distinct types of liquidity. Funding liquidity defined as “ability of banks to meet their liabilities, unwind or settle their positions as they come due� (M. Drehmann and K. Nikolaou, 2013) Market liquidity defined as the capability to sell a collateral in a brief period, without influence on its price. (Fernandez, 1999) Central Bank liquidity defined as the capacity of the central bank to provide the required level of liquidity into the Financial system (European Central bank, 2009) To sum up the illiquidity can come from different sectors. But the fundamental issue it is always the credit. Indeed, having credit in the economy is not possible to eliminate the risk.
2.3 THE ITALIAN MARKET OVERVIEW 4
Having defined the illiquidity risk is going to be easier to understand the Italian situation. Funding liquidity: The graph witness the number of nonperforming loans or as we call them in Italy (SOFFERENZE) across the whole Italian Banking system.
Market liquidity:
Italian impairment rate, defined as a reduction in the value of a company’s assets, went down of 0.6%. (EBA, 2016 stress test results)
Central Bank liquidity: The graph clearly show an increase which means that the Government often require help from the Central Bank but this increment cannot carry on forever.
Overview: Moreover, the populist candidate Beppe Grillo is leading polls. Grillo wants from euro. Consequently, it is hard to know the way forward for Italy, where per capita income has fallen during the euro era. With flat population growth and swelling debt (over 130% of GDP), Italy’s Source: tradingeconomics.com, 2017 economic prospects appear bleak. FORECAST: • Slow recover • Weak Productivity Growth • Increasing debt • Sick bank sector Considering these condition, the economy will not recover before 2025 and Italy faces two lost decades. To sum up, by having: -The lowest productivity among the main European Countries (France, Germany and Spain) -The highest government debt to GDP (133%) -The highest impairment rate (0.6%) The Italian liquidity problem is obvious and the EBA 2017 Stress test results demonstrated it.
2.4 THE IMPACT OF GLOBALIZATION ON CRISES 5
Figure 1:Rolling Correlations of quarterly GDP growth amogn G7 Cuontries
Source: Working Paper 17201, 2011
Financial globalization is defined as the integration of a nation’s local and international financial systems markets and institutions. (Sergio L. Schmukler, 2004). Globalization can be also described as the mechanism by which the globe is becoming more and more interconnected because of huge increased trade and cultural exchange. (BBC, 2016) Another definition is that globalization is the reason why is not needed to be in a country to do business in that country. (A. Craneand and D. Matten, 2016) Obviously, Globalization carry there a considerable number of benefits and drawbacks. The main benefit is that with a more financially integrated world, the economy will be more stable and better regulated, consequently a more rapid growth is expected. (Levine, 2001) On the other hand, the most dangerous issue is that with the integration Capital inflow may occur which might lead to a deterioration of market fundamental and consequent speculative attacks and contagion of International market imperfections. Being aware of that to what extend Italian illiquidity issue (market imperfection) may infect Europe? When other nations like the UK, Spain and Ireland went forecasted the problem, they sort everything out by cleaning up their banking systems. Italy did not. Unlikely the main issue in Italy is that household are also investors in Bank Bonds, and it would be unsustainable if they must deal with those losses. Consequently, no one react and bank could carry on its activity regardless for the Sofferenze. (Bad Loans) 6
Since the few bad periods were not enough the crises did not occur yet, but the financial problem is still there. Now Italy has infected the macroeconomy and there are consequences for the whole EU, indeed if not agreement among Rome (bondholders’ protection) and EU (increased regulation) the Italian recession can make the EU collapse. Moreover, considering 2008-09 crisis, 2016 Brexit and the Greeks desperation to be carried by Europe, it is not the best period for this to happen. (The Telegraph, 2016)
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3 PREVENTION METHODS 3.1 PREVENTION METHOD 1 The first prevention method consists of a separation of Euro in to currency. Hard Euro ďƒ Northern countries such as Germany Soft Euro ďƒ Southern Countries such as Spain, Italy, Greece etc. The hard one is referred to the strongest countries, which is expected to be less volatile, consequently, they will have a stable purchasing power. Policy of central Bank, political stability and fiscal outlook have a crucial position on the performance and pegs among currencies The free convertibility and high liquidity of these currency attract a lot of investors since they provide durable and less volatile returns. Instead, the Soft currency is related to countries which face political instability or in extreme case its economy is not open. Consequently, investments in these currencies are riskier and usually just traders willing to earn a lot in brief period invest on them. However, From the European point of view this option could be very useful since the shock and externalities between European countries could be absorbed through devaluation and/or appreciation process. The main difficult could be to decide the range within both hard and soft Euro should deviate and the exchange rate between them. Moreover, the countries to include in each currency must be chosen extremely carefully since a wrong placement would not lead to an optimal solution.
3.2 PREVENTION METHOD 2, Nash Equilibrium in Macroeconomic Market. 8
One of the main factors of the 2007-08 crises consisted of the global synchronized contractions all over the real and financial aggregates. According to V. Quadrini (2011) multiple self-fulfilling equilibria1 in credit market can explain dimension and depth of the crisis, and consequently avoid the next financial crises. Empirical evidence:
Figure 2: The dynamics of GDP during the six most recent recessions in the G7 countries
Source: Working Paper 17201, 2011
Figure 3: GDP, Consumption, Investment and Employment in US and G6: 2005-2010
1 Self-fulfilling equilibria: refers to a situation in which investors’ fear of the crisis makes the crisis inevitable, which justified their initial expectations.
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Source: Working Paper 17201, 2011
Figure 4: Domestic co-movement of credit, employment and GDP: 2005-2010
Source: Working Paper 17201, 2011
Figure 5: GDP, Stock markets and credit conditions in US and G6: 2005-2010 10
Source: Working Paper 17201, 2011
It is possible to highlight a strong correlation between US and G6 countries. However, the most interesting data is the domestic co-movement of credit, employment and GDP. Based on this data the idea is that low credit level influence productivity and particularly employment. (F. Perri, 2011) In the model analyzed there are two different actors, workers and investors. The main difference among them consist of the different investment possibilities they have. In fact, because of the market segmentation just investors can own firms whereas workers cannot. Since investors Discounted Future Earnings2 is higher than the workers’ one.
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Discounted Future Earnings: forecasts for the earnings of a firm and its terminal value at some point in future
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Indeed, at the beginning a firm must face with a liquidity mismatch due to wages, current debt and dividends, consequently to balance the mismatch the firm open the intra-period loan which is supposed to be repaid at the end of the period. But in case of default the firm will face difficulties to pay back the loan, therefore, once liquidated assets and revenue, the only collateral left is the physical capital. Fluctuation on the size and quality (Ξ) of the physical capital influence the ability to borrow. Indeed, if Ξ decrease (recession) the firm must reduce dividends or workers. In case of the firm would not change them, consequently the only solution would be to reduce the intraperiod loan. But this will lead to a proportionate reduction of workers which will lead to tradeoff and less dividends. On the other hand, if Ξ increase (expansion) the firm have a boom in borrowing capacity and therefore in the general equilibrium with increased productivity and employment. In period of crises they affect the borrowing capacity and consequently, real activity and financial prices. If the countries are financially integrated fluctuation in credit capacity cause huge spillovers in real activity and there are two possibility of transmission: -
Cost of capital which is equal since the countries are integrated Endogenous nature of credit market conditions, which change depending on the selffulfilling equilibrium. (positive or negative expectations)
Figure 7
Source: Working Paper 17201, 2011
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But in an integrated market the change in one nation can happen just if happen in another nation as well, consequently movements in financial market condition are strongly correlated when financial markets are integrated. Lastly although, a lot of cycle changes influence the international co-movement the importance of the changing in credit market conditions resides on their ability to develop huge international co-movements in either the real sector and in financing and asset prices.
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4 CONCLUSION To sum up, by having a perfectly financial integrated world, managers can use endogenous constraints to manage the level of credit which cannot be changed if not supported by fundamentals. In case of managers do not respect a credit constraint the equilibrium employment is influenced by the shadow cost of credit which is influenced by the tightness of credit limits. Consequently, as in Nash Equilibrium firms do not have stimulus to change their choice depending on their competitors’ choices. Otherwise, an ‘exogenous’ shrink of credit limitations influence economic employment and activity in all Nations, regardless of where the original shrink came from. (F. Perri, 2011)
BOTH RESPECT CONSTRAINT
A RESPECT
A DOSE NOT RESPECT
NEITHER A and B RESPECT CONSTRAINT
B RESPECT
B DOES NOT RESPECT
MINIMAL RISK HIGH RET
ELEVATED RISK HIGH RET
MINIMAL RISK LOW RET
ELEVATED RISK LOW RET
5 KEY LEARNING POINTS This module involves a lot of learning points such as: •
AWARENESS OF TYPE OF FINANCIAL CRISES (Bank, Currency, Twins etc.)
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PRACTICAL MARKET ANALISYS (Understanding of drawbacks and benefits related to the globalization and the importance of correlation to find out variables through which transfer positive or negative externalities in macroeconomy)
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DEEPER UNDERSTANDING OF THE MARKET FUNDAMENTALS (Understanding of market fundamental indicators and the consequences related to their movements)
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UNDERSTANDING OF GROUP WORK BENEFITS AND DRAWBACKS (Time managing, ideas sharing and pre-presentation to persuade the partner to accept them, integration of ideas and different studying methods.)
However, the most important one consist of the awareness of the past mistakes and of the carefulness to not repeat them to avoid recession periods and sufferings to people. 14
REFERENCES: Allen, F., 2011. Cross-border banking in Europe: implications for financial stability and macroeconomic policies. CEPR. Allen, F., Carletti, E. and Gale, D., 2009. Interbank market liquidity and central bank intervention. Journal of Monetary Economics, 56(5), pp.639-652. Azzimonti, M., De Francisco, E. and Quadrini, V., 2014. Financial globalization, inequality, and the rising public debt. The American Economic Review, 104(8), pp.2267-2302. Beck, T., Demirgßç-Kunt, A. and Levine, R., 2009. Financial institutions and markets across countries and over time-data and analysis. Codogno, L., 2009. Two Italian Puzzles: are productivity growth and competitiveness really so depressed? Cooley, T. and Quadrini, V., 1998. Monetary policy and the financial decisions of firms. University of Rochester, mimeo. Crane, A. and Matten, D., 2016. Business ethics: Managing corporate citizenship and sustainability in the age of globalization. Oxford University Press. Drehmann, M. and Nikolaou, K., 2013. Funding liquidity risk: definition and measurement. Journal of Banking & Finance, 37(7), pp.2173-2182. Fernandez-Arias, E. and Hausmann, R., 1999. International initiatives to bring stability to financial integration. Fernandez, F.A., 1999. Liquidity risk. SIA Working Paper. Jermann, U. and Quadrini, V., 2012. Macroeconomic effects of financial shocks. The American Economic Review, 102(1), pp.238-271. Kindleberger, C.P., 1978. Economic response: comparative studies in trade, finance, and growth. Harvard University Press. Kalemli-Ozcan, S., Papaioannou, E. and Perri, F., 2013. Global banks and crisis transmission. Journal of international Economics, 89(2), pp.495-510. Mishkin, F.S., 1999. Global financial instability: framework, events, issues. The Journal of Economic Perspectives, 13(4), pp.3-20. Mishkin, F.S., 1999. International experiences with different monetary policy regimes). Any views expressed in this paper are those of the author only and not those of Columbia University or the National Bureau of Economic Research. Journal of monetary economics, 43(3), pp.579-605. Mishkin, F.S., 1996. Understanding financial crises: a developing country perspective (No. w5600). National Bureau of Economic Research. Monacelli, T., Quadrini, V. and Trigari, A., 2011. Financial markets and unemployment (No. w17389). National Bureau of Economic Research. Obstfeld, M. and Rogoff, K., 2009. Global imbalances and the financial crisis: products of common causes. Perri, F. and Quadrini, V., 2011. International recessions (No. w17201). National Bureau of Economic Research. Quadrini, V., 2011. Financial frictions in macroeconomic fluctuations.
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Reinhart, C.M. and Rogoff, K.S., 2009. The aftermath of financial crises (No. w14656). National Bureau of Economic Research. Reinhart, C.M. and Rogoff, K.S., 2011. From financial crash to debt crisis. The American Economic Review, 101(5), pp.1676-1706. Reinhart, C.M. and Rogoff, K.S., 2013. Banking crises: an equal opportunity menace. Journal of Banking & Finance, 37(11), pp.4557-4573. Reinhart, C. and Rogoff, K., 2013. Financial and sovereign debt crises: Some lessons learned and those forgotten. Riley, S.F. and Quercia, R.G., 2011. Navigating the housing downturn and financial crisis: Home appreciation and equity accumulation among community reinvestment homeowners. The American mortgage system: Crisis and reform, pp.187-208.Kindleberger, C.P., 1986. The world in depression, 1929-1939 (Vol. 4). Univ of California Press. Schmukler, S.L., 2004. Financial globalization: gain and pain for developing countries. Economic Review-Federal Reserve Bank of Atlanta, 89(2), p.39. Schmukler, S.L., 2004. Benefits and risks of financial globalization: challenges for developing countries. Globalization, Growth, and Poverty, World Bank Policy Research Report.
ON LINE REFERENCES: Andy Haldane: Preparing for the next financial crises, 2014 https://youtu.be/TDubCwqdRZg Over－borrowing risks in emerging markets could weigh down global economy IMF, 2015 https://youtu.be/wrgB2uqeoGI Unintended Consequences of the New Financial Regulations, 2013 https://youtu.be/0seeBXABbSQ http://www.telegraph.co.uk/business/2016/02/21/europes-banks-fear-the-coco-market-is-dead/ Accessed at: 21th April 2017 http://news.bbc.co.uk/onthisday/hi/dates/stories/september/16/newsid_2519000/2519013.stm Accessed at: 20th April 2017 http://www.eba.europa.eu/risk-analysis-and-data/eu-wide-stress-testing/2016 Accessed at: 22th April 2017
“THINK LONG, NOT SHORT TERM” (Matt Kinh, 2013)
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