“Financial Market Cycles, Globalization, and the Recent Sub-Prime Crisis”
Graeme Wheeler, Managing Director, The World Bank
Eighth Annual International Seminar on
Policy Challenges for the Financial Sector
June 4-6, 2008, Washington, D.C.
The World Bank, the International Monetary Fund, and the Federal Reserve Board
I am conscious of George Bernard Shaw’s comment that, “If all the economists were laid end to end, they would never reach a conclusion.”
So I will try to be more of a one-handed economist in offering personal thoughts on financial cycles, globalization, and the sub-prime crisis.
Economic cycles have been recorded since the days of variable wheat harvests in ancient Egypt. Those who date business cycles suggest that there have been over 30 such cycles in the US over the past 150 years. Several originated in the financial sector.
Amsterdam, in the 1630s, provides an early example of how speculative behavior led to financial market panic and recession. During the tulipmania frenzy, the market for rare tulip bulbs boomed for twelve years before collapsing in 1636. At the height of its activity, prices for the rarest bulbs ranged from 6 to 20 times the annual income of artisans, and twice the amount that Rembrandt received for painting “The Night Watch” in 1639.
Even in those days, globalization played an important role. Foreign buyers were active in the tulip market and the wave of the bubonic plague which swept across Northern Europe killed 15 per cent of Amsterdam’s population in 1636.
The cycles of exuberance and extreme risk aversion which characterize financial markets remind me of the little black cat that Victor Hugo described in an intriguing passage in “Les Miserables.”
“We all know the habit of cats of hesitating in an open doorway – hovering uncertainly at the risk of being crushed by the closing of the door.”
Herding behavior, and the black holes in liquidity which follow the collapse of asset bubbles, are common features of financial cycles. We know the pattern. Reductions in the cost of financing encourage credit creation, carry trades and leverage, and fuel asset prices. Investors take on greater risk in the search for higher yield and in doing so, significantly lower risk premia. We see dominant institutional investors placing similar bets, sharing similar benchmarks, and having similar pricing and risk management platforms. All face the pressure of generating alpha, meeting short-term profit goals, and outperforming peers.
We saw this pattern in the lead-up to the Argentinean crisis in the late 1990s. Investors continued to provide bond financing to Argentina – often at declining spreads – fearful of missing out on returns captured by those who preceded them. Argentina came to represent nearly one quarter of the emerging market bond index. Rather than requiring higher risk premiums from an increasingly leveraged borrower, investment managers benchmarked to the emerging market bond index felt obliged to buy at the going price.
Eventually, the party loses its sparkle when the onset of increased investor caution elevates risk premiums, lowers asset values and promotes the liquidation of the debt that supports higher asset prices.
Some things do not change. During the 1630s tulipmania, ordinary tulip bulbs contaminated the rare tulip bulb market. There were fraudulent credit practices, shady derivative trades involving tulip bulb offshoots, widespread default, and, in the aftermath, a vigorous debate over regulation.
Note the similarities with the March 2008 policy statement of the President’s Working Group on Financial Markets. This suggested that the principal causes of the recent turmoil in financial markets were a breakdown in underwriting standards, a significant erosion of market discipline, risk management weaknesses, and the failure of regulatory policy to offset them. And we are hearing financial intermediaries stress how self regulation and sound ethical practices can overcome the need for far reaching regulatory changes that might help to limit public risk but would constrain private returns.
When Benjamin Franklin said, “There are only two certainties in life – death and taxes,” he might have added financial cycles.
One might hope that the frequency and amplitude of financial cycles would diminish as governments improve their economic management through initiatives such as medium term financial strategies, fiscal responsibility rules, more independent central banks, flexible exchange rates, and prudent balance sheet management.
One might hope, but one should not be confident. In recent years, we have seen major corrections in equity markets – first in 2000 and again more recently, a private equity contraction in the high-tech sector, a boom and correction in emerging market fixed income, the same in securitized lending products linked to real estate, and currently, a commodity price boom. Risk capital moves rapidly from one asset class to another as each cycle plays out.
International capital flows increasingly dominate our cycles of industrial production. These flows, and the complex financial engineering which accompanies them, are overpowering the traditional instruments of monetary policy and the regulatory architecture. Cross border capital flows will increase rapidly as the growing middle class and large institutional savers in developing countries (and especially in Asia) diversify their portfolios and become important equity investors in OECD countries.
Developing countries are closely following the policy responses to the sub-prime crisis. They have not been substantially exposed to its fallout – at least so far - but the crisis has demonstrated how all of the elements that will form the Basle II pillars can fail in a G7 economy, including market discipline. The nationalization of Northern Rock and the handling of Bear Stearns and other institutions have changed the face of central banking and assumptions about the assignment of public risk. Developing countries will be more cautious in liberalizing their financial sectors as a result.
These countries are also watching to see where the next wave of internationally mobile capital will flow. With highly structured and customized financial engineering out of favor – at least for the time being – investors are looking for new avenues. Developing countries are an obvious target – especially given their rapid economic growth resulting from the global transfer of skill enhancing technologies, and the enormous transfer of wealth to commodity producers. It is important to remember that developing countries now supply 60 per cent of global crude oil production, and more than two-thirds of lead, zinc, and copper production.
Investment conditions are improving dramatically in developing countries. Government balance sheets are being bolstered as foreign exchange reserves swell, refinancing risk in debt portfolios diminishes, and risks around contingent liabilities and government ownership are better managed. The poorest countries have already qualified for debt relief worth over $110 billion under the HIPC and Multilateral Debt Relief Initiative.
Capital flows – and particularly those embodying new technology – can be critical in creating opportunities to escape poverty. This is particularly true for sub-Saharan Africa – where 54 per cent of its population is aged under 20. At the same time, we should not sow the seeds of a crippling debt burden for future generations. Capricious borrowing by governments that are courted by bankers whose compensation arrangements make them eager and anxious to compete for new mandates, has been all too familiar in the past.
We saw large flows of capital into Latin America in the 1990s and the added difficulties this created for macroeconomic management. Some of the developing economies are very small – particularly several of the commodity producing countries in Africa. The combined Gross National Income in US dollars for the 47 countries of sub-Saharan Africa – including South Africa – is below that of the Netherlands.
How is the World Bank Group trying to help?
Our goal is to help increase access to finance for the poor and to develop more effective financial markets. We are working closely with institutions to upgrade corporate governance, and payment, trading, and settlement functions. We are also working to enhance practices on the ground with respect to accounting and auditing, and legal and judicial matters. Another key area is helping to assess the risks in developing countries’ debt strategies – particularly in respect of non-concessional borrowing.
We partner with the IMF on many of these issues, but particularly on assessments of financial needs and vulnerabilities and on crisis preparedness. And of course, we are assessing and helping to build supervisory and regulatory practices.
Where does all this leave us?
Important changes are underway in the financial sector. Bank investors have seen major declines in market capitalization and will continue pressing the largest international banks to shrink their balance sheets, and focus on core activities as the financial supermarket model falls out of favor.
Most of the recommendations of the Financial Stability Forum submitted to the G7 in April are likely to be implemented. Financial reporting will be enhanced and rating agencies will provide analysis of more aspects of risk more explicitly, while regulatory authorities will have more bite and build up their knowledge of financial product innovation.
But, the days of boom and bust in financial markets will continue. The desire for reward and the fear of danger are too hard wired into the human condition for these to disappear. The thought I would like to leave with you tonight is that these cycles will be much more damaging than they need to be as long as the balance between private rewards and taxpayer risk remains heavily tilted in favor of those investing risk capital.
As Winston Churchill said, “The farther backward you can look the farther forward you can see.”