Saturday, January 10, 2009
Sunday, November 2, 2008
What caused the current financial sector meltdown?
All the papers nowadays are full of the subprime credit crisis. What caused the present crisis?
One of the responsible factors has been global interest rates that have fallen and are exceptionally low by historical standards – they are about 200 basis points below their long run average. Stephen Jen of Morgan Stanley Research calculates that the market capitalization weighted real interest rates (10-year rate) for the US, Eurozone, UK, Canada, Switzerland, Sweden, Norway, Japan, Australia, and New Zealand was 3.2% from 1991-2000 and this average is down to 2.25% from 2002-2006. With very low interest rates people began to “search for yield” or for higher return and were prepared to take on more risk to achieve that objective.
Second, there was an unjustifiable confidence about the continued rise in US housing prices that went up about 90 percent between 1996 and 2005. People began to feel that at such times if they did not buy a new house they were missing out on a market upswing that would be foolish to not participate in when most others were doing so. Mortgage lenders did not bother about making loans in the face of rising house prices as they figured that if repayments were not made they could put the house on the market and since it was a rising market there was no risk of losing money by reselling the house.
Third, mortgage lending sought high yields by lending towards less creditworthy borrowers – subprime borrowers who do not have a strong credit history or who have characteristics associated with a higher than usual probability of default on their credit repayments. Between 2003 and 2006 the share of subprime mortgages more than tripled.
Fourth, the introduction of capital markets in the financing of mortgages led to incentive problems. It used to be the case that if you got a mortgage you got it from a bank that checked your eligibility to borrow and held the loan till you paid it off and so took on all the credit risk. In the last decade this changed as your mortgage is sold by the bank to a third party that packages it with other mortgages and sells it onwards to others who purchase these assets – a process called securitization. In the process of securitization the bank had an incentive to sell more loans and the risks associated with those as its returns were tied to the volume of loans processed and not the quality of those loans. Incomplete income documentation and weak borrower credit histories began to become part of the mortgages given that was not the case earlier.
Fifth, credit rating agencies that rated the securitized products had incentives to give them higher ratings which indicate more safe products than was the case. Credit rating agencies were heavily into consulting as well and so one part of the firm would provide consulting as to how to design securitized products that could get a high credit rating and then another part of the firm would give a credit rating that the consulting part had suggested they would get if they were designed that way. Rating firms like Moody’s made much money in the recent past in this way.
Sixth financial regulation was weak as the Federal Reserve that regulates banks did not monitor how much of bank portfolios were going into housing related loans.
This all may seem like what should have happened in developing economies and not in mature markets. However, the view about financial markets in the mature economies in the last decade was that financial players know best about the nature of financial products and the risk associated with such products as they trade in them more continuously than do bureaucrats and regulators who would just impede the development of such markets due to their ignorance. We are about to see a new phase of regulation in financial markets that will emerge from the ashes of the credit crisis.
One of the responsible factors has been global interest rates that have fallen and are exceptionally low by historical standards – they are about 200 basis points below their long run average. Stephen Jen of Morgan Stanley Research calculates that the market capitalization weighted real interest rates (10-year rate) for the US, Eurozone, UK, Canada, Switzerland, Sweden, Norway, Japan, Australia, and New Zealand was 3.2% from 1991-2000 and this average is down to 2.25% from 2002-2006. With very low interest rates people began to “search for yield” or for higher return and were prepared to take on more risk to achieve that objective.
Second, there was an unjustifiable confidence about the continued rise in US housing prices that went up about 90 percent between 1996 and 2005. People began to feel that at such times if they did not buy a new house they were missing out on a market upswing that would be foolish to not participate in when most others were doing so. Mortgage lenders did not bother about making loans in the face of rising house prices as they figured that if repayments were not made they could put the house on the market and since it was a rising market there was no risk of losing money by reselling the house.
Third, mortgage lending sought high yields by lending towards less creditworthy borrowers – subprime borrowers who do not have a strong credit history or who have characteristics associated with a higher than usual probability of default on their credit repayments. Between 2003 and 2006 the share of subprime mortgages more than tripled.
Fourth, the introduction of capital markets in the financing of mortgages led to incentive problems. It used to be the case that if you got a mortgage you got it from a bank that checked your eligibility to borrow and held the loan till you paid it off and so took on all the credit risk. In the last decade this changed as your mortgage is sold by the bank to a third party that packages it with other mortgages and sells it onwards to others who purchase these assets – a process called securitization. In the process of securitization the bank had an incentive to sell more loans and the risks associated with those as its returns were tied to the volume of loans processed and not the quality of those loans. Incomplete income documentation and weak borrower credit histories began to become part of the mortgages given that was not the case earlier.
Fifth, credit rating agencies that rated the securitized products had incentives to give them higher ratings which indicate more safe products than was the case. Credit rating agencies were heavily into consulting as well and so one part of the firm would provide consulting as to how to design securitized products that could get a high credit rating and then another part of the firm would give a credit rating that the consulting part had suggested they would get if they were designed that way. Rating firms like Moody’s made much money in the recent past in this way.
Sixth financial regulation was weak as the Federal Reserve that regulates banks did not monitor how much of bank portfolios were going into housing related loans.
This all may seem like what should have happened in developing economies and not in mature markets. However, the view about financial markets in the mature economies in the last decade was that financial players know best about the nature of financial products and the risk associated with such products as they trade in them more continuously than do bureaucrats and regulators who would just impede the development of such markets due to their ignorance. We are about to see a new phase of regulation in financial markets that will emerge from the ashes of the credit crisis.
Wednesday, August 27, 2008
Patterns of Capital Flows in India and Abroad
It is appropriate to begin this blog with a comment on a salient macroeconomic event that is dominating policy making in the Indian and other economies. In this post I comment on the patterns of capital flows to India and compare this with other emerging and developing economies. The world economy is undergoing increased integration of goods and financial markets. Global trade in goods and services has outpaced the growth in world output since the 1990s. Even though world output growth decelerated from 3.3 per cent during the 1980s to 3.1 per cent during the 1990s, growth in the volume of world trade in goods and services accelerated from 4.5 per cent to 6.4 per cent over the same period. Between 1980 and 2003 while world output doubled, world trade has trebled. Trade liberalization, the falling cost of trade, productivity growth in the tradable goods sector, and increasing income per head are factors supporting the growth in trade.
Accompanying the increased trade flows is a fundamental change in recent years in the movement of capital flows. In fact, capital flows significantly influence exchange rates and the economy today much as trade deficits did earlier. The nature of these flows has changed since the 1980s when capital flows were mainly aid flows. In the 1990s capital flows to developing economies increased rapidly and these flows were mainly private capital flows that were in part associated with a strengthening of macroeconomic policy frameworks and structural reforms in these economies.
In the past two decades there have been two great waves of capital flows to emerging economies. The first began in the early 1990s and ended with the 1997-98 Asian crisis. The second wave has been in the making since 2002 and in fact has accelerated since 2006. The capital flows have been predominantly private capital flows since the 1990s. Official flows (mainly aid flows) that were marginal have in fact declined substantially since 2002.
Within private capital flows net foreign direct investment flows have dominated relative to net financial flows (portfolio and other flows). In fact, direct investment inflows have been relatively stable while portfolio and debt flows have been more volatile.
In contrast to global capital flows private capital flows to India began increasing from 2000 with net foreign direct investment flows dominating as in other emerging markets. A marked change since 2002, however, when the second wave of global capital flows began is the predominance of portfolio flows in India unlike in other emerging and developing countries.
What differentiates this recent wave of capital flows from the previous early 1990s one is that they have been associated with stronger current account positions for many emerging market countries and a significant accretion of foreign exchange reserves in these economies.
In contrast the increased capital flows to India were accompanied by an accumulation of reserves, but the current account turned into a deficit after 2003 unlike most emerging market economies.
The regional patterns of capital flows demonstrate that most flows have gone to emerging Europe (Central and Eastern Europe) and the Commonwealth of Independent States . This is part of a trend begun in the early 1990s due to the opportunities created by entry into the European Union. Unlike other regions, though these capital inflows have been accompanied by a deteriorating external position with the current account deficit at about 6 per cent of regional GDP in 2006.
In emerging Asia (China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Pakistan, the Philippines, Singapore, Thailand, and Vietnam) net private capital inflows have rebounded from the reversals associated with the 1997-98 Asian crisis. However, private capital outflows – mainly portfolio flows – have strongly accelerated since the early 2000s, leaving net inflows well below their pre crisis levels. In India the net inflows have actually increased since the early 2000s and this is because the outflows did not accelerate more than the inflows. As a result net private capital flows to India increased at a trend growth rate of 23.5 per cent from 2000 onwards compared to the 12.4 per cent trend growth rate of the 1990s. All components of capital flows in India have shown volatility. The most volatile component have been external commercial borrowings with a coefficient of variation of 203.1, followed by portfolio investment (112.8), NRI deposits (85), and foreign direct investment (83.8) during the period 1990-91 to 2007-08.
The recent capital flows to India are thus different from that in comparator countries on three counts –
(1) they are predominantly portfolio flows and not direct investment flows
(2) they are associated with a deteriorating current account position rather than an improving one, and
(3) the extent of financial outflows has only partially offset the inflows of capital and net inflows have grown at twice the rate of the earlier decade.
What causes these capital flows and what have been the macroeconomic policy responses to these flows? These important issues will be taken up in future posts.
Accompanying the increased trade flows is a fundamental change in recent years in the movement of capital flows. In fact, capital flows significantly influence exchange rates and the economy today much as trade deficits did earlier. The nature of these flows has changed since the 1980s when capital flows were mainly aid flows. In the 1990s capital flows to developing economies increased rapidly and these flows were mainly private capital flows that were in part associated with a strengthening of macroeconomic policy frameworks and structural reforms in these economies.
In the past two decades there have been two great waves of capital flows to emerging economies. The first began in the early 1990s and ended with the 1997-98 Asian crisis. The second wave has been in the making since 2002 and in fact has accelerated since 2006. The capital flows have been predominantly private capital flows since the 1990s. Official flows (mainly aid flows) that were marginal have in fact declined substantially since 2002.
Within private capital flows net foreign direct investment flows have dominated relative to net financial flows (portfolio and other flows). In fact, direct investment inflows have been relatively stable while portfolio and debt flows have been more volatile.
In contrast to global capital flows private capital flows to India began increasing from 2000 with net foreign direct investment flows dominating as in other emerging markets. A marked change since 2002, however, when the second wave of global capital flows began is the predominance of portfolio flows in India unlike in other emerging and developing countries.
What differentiates this recent wave of capital flows from the previous early 1990s one is that they have been associated with stronger current account positions for many emerging market countries and a significant accretion of foreign exchange reserves in these economies.
In contrast the increased capital flows to India were accompanied by an accumulation of reserves, but the current account turned into a deficit after 2003 unlike most emerging market economies.
The regional patterns of capital flows demonstrate that most flows have gone to emerging Europe (Central and Eastern Europe) and the Commonwealth of Independent States . This is part of a trend begun in the early 1990s due to the opportunities created by entry into the European Union. Unlike other regions, though these capital inflows have been accompanied by a deteriorating external position with the current account deficit at about 6 per cent of regional GDP in 2006.
In emerging Asia (China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Pakistan, the Philippines, Singapore, Thailand, and Vietnam) net private capital inflows have rebounded from the reversals associated with the 1997-98 Asian crisis. However, private capital outflows – mainly portfolio flows – have strongly accelerated since the early 2000s, leaving net inflows well below their pre crisis levels. In India the net inflows have actually increased since the early 2000s and this is because the outflows did not accelerate more than the inflows. As a result net private capital flows to India increased at a trend growth rate of 23.5 per cent from 2000 onwards compared to the 12.4 per cent trend growth rate of the 1990s. All components of capital flows in India have shown volatility. The most volatile component have been external commercial borrowings with a coefficient of variation of 203.1, followed by portfolio investment (112.8), NRI deposits (85), and foreign direct investment (83.8) during the period 1990-91 to 2007-08.
The recent capital flows to India are thus different from that in comparator countries on three counts –
(1) they are predominantly portfolio flows and not direct investment flows
(2) they are associated with a deteriorating current account position rather than an improving one, and
(3) the extent of financial outflows has only partially offset the inflows of capital and net inflows have grown at twice the rate of the earlier decade.
What causes these capital flows and what have been the macroeconomic policy responses to these flows? These important issues will be taken up in future posts.
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