Financial Turbulence and the Global Debt/Financial Crisis

Financial Turbulence and the Global Debt/Financial Crisis
Carlos M Pelaez

This post provides an analysis of financial turbulence and its consequences for recovery and employment in terms of four vulnerabilities: China’s growth and commodities, sovereign risk issues, US budget deficits and debt and financial regulation. Section I documents financial turbulence; the factors of financial turbulence are analyzed in section II; economic indicators are analyzed in section III and interest rates in section IV; section V concludes.
I Financial Turbulence. There is financial turbulence in the trend of stocks from recent highs and in sharp intraday fluctuations. Similar turbulence is manifested in foreign exchange rates, prices of commodities futures, fixed income markets and indicators of financial risk. These financial variables are discussed in turn. 1. Stocks. The Dow Jones Industrial Average (DJIA) fell to 6547.05 on Mar 9, 2009 after reaching 14,164.53 on Oct 9, 2007, for a decline of 53.8 percent. The DJIA has recovered to 10,211.07 at the close of market on Jun 11, for an increase of 56 percent (http://online.wsj.com/mdc/public/page/marketsdata.html?refresh=on ). However, the DJIA fell from a recent high of 11,205.03 on Apr 26 to the close of market on Jun 11 or by 8.9 percent. On Monday Jun 7, the DJIA dropped 115.48 points to a seven-month low of 9816.49, for a decline of 1.2 percent, mostly at the end of trading, and of 12.4 percent relative to the recent high on Apr 26 (http://professional.wsj.com/article/SB20001424052748703303904575292171374533404.html ). On Jun 10, the DJIA jumped 273.28 point for an increase of 2.8 percent. This financial turbulence in stock markets is explained by the conjecture of apparent indecision of market players in finding direction or trends of major financial variables. It is also evident in other major stock markets in the form of declines from recent highs to the close of market on Jun 11: -12.3 in the DJ Asia-Pacific TSM from Apr 15, -18.8 percent in the Shanghai Composite from Apr 15,
-10.7 percent in the STOXX Europe 50 from Apr 15 and -15.7 in the NYSE Financial from Apr 15. 2. FX Rates. The dollar has appreciated relative to the euro by 25 percent from the high on Nov 11, 2009 to Jun 11 and by 26.9 percent relative to the turmoil of Jun 7 (http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3051 ). Currencies also fluctuate sharply during individual market days. 3 Commodities. Prices of industrial commodities such as crude oil and copper have fluctuated sharply. The flight out of risk was accompanied on Jun 7 by an increase of 1.9 percent in gold prices for Jun delivery. There was sharp rise of gold prices by 2 percent in less than an hour. The DJ UBS Commodity Futures Index fell by 13.8 percent from Jan 6 to Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_cmd_dtabnk&symb=DJUBS ). 4. Bonds. The 10-year Treasury has declined from a recent high of 3.986 percent on Apr 5 to a low of 3.145 on Jun 7, closing at 3.239 percent on Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond ). The decline in yields is explained by market analysts as the flight into Treasuries for temporary safe haven from risk exposures. 5. Financial Risk. European banks had record deposits of EUR364.6 billion or $440 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). US banks increased their reserves deposited at the Fed during the credit crisis and global recession because of the difficulty of assessing lending risk and higher perceptions of risk in transactions with financial counterparties (Pelaez and Pelaez, Financial Regulation after the Global Recession, 158-60, Regulation of Banks and Finance, 225-6). Bloomberg analyzes the indicators of financial risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3JnMp3QMK_8 ). The 3-month LIBOR rate remained around 0.54 percent in the week of Jun 7 after more than doubling this year because of the sovereign risk issues. Markets calmed toward the last days of the week. The dollar-LIBOR OIS spread, which measures risk in transactions with financial counterparties stabilized at 32.5 basis points (bps), much higher than around 9 bps in the first quarter of 2010 but still significantly lower than 364 bps in Sep 2008.
II Factors of Financial Turbulence. The analytical explanation of financial turbulence requires a general equilibrium model of the world economy with specifications for financial markets. A more available option is an analytical narrative in terms of four vulnerabilities that recur in the financial media and in commentary by market participants. These four factors, (1) China’s growth, (2) sovereign risk issues, (3) US government deficits and debt and (4) financial regulation, are discussed in turn. 1. China’s Growth and Commodities. China has been growing at very high relative rates of growth of GDP and GDP per capita since 1991 after a slowdown in 1989-1990 (National Bureau of Statistics of China cited in Pelaez and Pelaez, The Global Recession Risk, 80). Recent data and analysis find that the economy continues to grow but with some concerns about property values and inflation (http://professional.wsj.com/article/SB10001424052748704575304575297462164585550.html?mod=wsjproe_hps_LEFTWhatsNews ). Accelerating world trade is shown by growth of merchandise exports of China by 48.5 percent in May relative to a year earlier. Manufacturing output grew by 16.5 percent in May relative to a year earlier. However, consumer price inflation is rising above 3 percent per year. The major source of concern is in the growth of construction starts by 72.4 per year in May relative to last year together with 44.1 percent in acquisition of land by developers. The decline of Chinese stocks and of industrial commodities such as crude oil and copper from recent highs is attributed to concerns that more restrictive monetary policy may be used by the authorities to prevent adverse events in property markets. Interregional trade in Asia is extremely important for growth. There are concerns that a slowing Chinese economy could impact Asian growth and the rest of the world economy. Investors’ perspectives and risk decisions change with new releases of data and information on the Chinese economy and related markets.
(2) Sovereign Risks. Government revenues decline during recessions because income contraction causes declines of tax receipts and expenditures rise in efforts to maintain economic activity. The euro zone is composed of countries with diverse performance in exports and in fiscal balances. Export economies are moving forward with high growth of manufacturing and lower fiscal imbalances. Economies with fiscal imbalances are experiencing difficulties with credit ratings and refinancing because of high debt/GDP ratios. The European Union is implementing a major bailout program for countries experiencing debt stress. Moreover, banks in the countries with lower debt/GDP ratios and fiscal imbalances have significant exposures to entities in countries with debt stress. As with all similar programs, evaluations of the potential success in resolving the sovereign risk issues fluctuate. The euro and financial markets worldwide are affected by the perceptions of resolution of the sovereign risk issues.
(3) United States Budget Imbalance. The fiscal imbalance and movement of the US debt in an unsustainable path may prove the most important factor of vulnerability of the world’s financial markets and global economy because of the size of the US economy and financial markets. McKinsey and Company and the Committee on Capital Markets Regulation analyze the dimensions of the US financial services industry in 2005 (cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 169-72, Government Intervention in Globalization, 160-3). The financial services industry represented 8.1 percent of US GDP, providing 6 million jobs or about 5 percent of total private sector employment in 2005. The financial stock of the US, consisting of equities, bonds, loans and deposits, was $51 trillion followed by $35 trillion in the euro zone and $20 trillion in Japan. The US global share in investment banking was 42 percent. The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt. In testimony on Jun 9 to the Committee on the Budget of the US House of Representatives, Chairman Bernanke reiterated his perceptive analysis and advice of the US fiscal situation: “Achieving long-term fiscal sustainability will be difficult. But unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100609a.htm ). If the US continues on an unsustainable debt path, financial asset prices and rates will begin to reflect the combination of a forced solution of fiscal imbalances by higher taxes and interest rates, sharp government expenditure reduction and disguised default in the form of dollar depreciation.
(4) Financial Regulation. Regulatory legislation and the general economy continue crossing each other in opposite railroad tracks without noticing each other as trains in London fog. The acts approved by the House and the Senate are quite complex (http://s.wsj.net/public/resources/documents/st_finregcompare0610_20100607.html ). It is difficult to technically justify the individual provisions. The end product of “reconciling” both laws will not improve functioning of financial markets, increasing interest rates and reducing loan volumes. The final law would not have prevented the credit/dollar crisis because it is based on an interpretation that solely blames private financial institutions when government policy was more important in creating the crisis. Near zero interest rates by the Fed and lower mortgage rates by suspending auctions of 30-year Treasuries combined with a housing subsidy of $221 billion per year and purchase or acquisition of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac to create a housing surplus, eventual collapse of housing prices causing underwater mortgages, excessive risks and low liquidity by banks and households and unsound credit that caused the collapse of finance and the general economy (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The Institute of International Finance (IIF) calculates that the implementation of global financial regulation would cumulatively reduce US GDP by 2.6 percent in 2011-2015 and employment by 4.6 million. The euro zone GDP would be lower by 4.3 percent and employment by 4.7 million and Japan’s GDP would be lower by 3.1 percent and employment by 0.5 million (http://www.iif.com/ ). A law growing from 1500 pages has inexplicable provisions such as mandating the Fed to determine rates of 0.75 to 1.25 percent charged by banks on debit cards to vendors of transactions sold to bank customers (http://professional.wsj.com/article/SB10001424052748704256604575295072627703504.html?mod=wsjproe_hps_LEFTWhatsNews ). The concern of banks is that technological costs would be excluded by the wording of the bill such that in the future bank customers would have to return to stone-age times when they withdraw cash from their bank accounts to pay for transactions after the demise of the debit card and/or its technological inferiority. A more likely occurrence is higher bank costs, resulting in lower credit volumes at higher interest rates. There are no explanations of how such controls of debit cards by the Fed would have prevented the credit crisis and improve markets or why credit cards and not only debit cards are singled out by the law.
III Economic Indicators. There are encouraging signs of economic recovery but labor markets may still be under stress. The report by the Fed on the Flow of Funds Accounts of the United States provides encouraging information that household net worth, or value of assets less value of liabilities, increased by $1.1 trillion to reach $54.6 trillion in the first quarter of 2010 (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). Household debt fell for the seventh consecutive quarter at the annual rate of 2.5 percent. State and local government debt increased at the 4.25 percent annual rate while federal government debt rose at the annual rate of 18.5 percent, which was much higher than 12.6 percent in the earlier quarter but lower than annual rates ranging from 20.6 percent to 28.2 percent in the first three quarters of 2009. Another encouraging sign in similarity with other economies is that US exports of goods and services increased by 19.9 percent from Apr 2009 to Apr 2010 and imports by 23.9 percent, that is, trade is growing at very high rates, suggesting growth in the world economy (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The trade deficit in Apr was $40.3 billion, or exports of $148.8 billion less imports of $189.1 billion, slightly higher than $40.0 billion in Mar. The trade deficit is deteriorating from the lower levels during the recession, causing again concerns about joint trade and fiscal imbalances. Sales of merchant wholesalers grew by 0.7 percent in Apr relative to Mar and by 16.3 percent from a year earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Combined sales and shipments of manufacturers in Apr grew by 0.6 percent relative to Mar and by 13.1 percent relative to Apr 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Revenue of the US information sector in the first quarter of 2010 grew by 1.1 percent over the prior quarter and 2.3 percent relative to the first quarter of 2009. Revenue of US professional, scientific and technical services increased by 3.1 percent in the first quarter relative to the prior quarter and by 3.4 percent relative to the first quarter of 2009 (http://www2.census.gov/services/qss/qss-current.pdf ). Advanced estimates of US retail and food services for May fell by 1.2 percent from the prior month but were higher by 6.9 percent relative to May 2009. However, sales in the Mar to May 2010 period were higher by 8.1 percent relative to the same period in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf ). New initial claims of unemployment insurance fell by 3000 in the week ending Jun 5 to 456K relative to the revised 459K in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. The flight out of risk exposures continued to drive the downward shift of the US yield curve. The 10-year Treasury was 3.23 percent on Jun 11 almost identical to 3.21 percent a week earlier but 22 bps below 3.55 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). A similar force is apparent in the sharp decline of the yield of the 10-year German government bond to 2.57 percent, trading at a negative spread of 66 bps relative to the US 10-year Treasury yield at 3.21 percent.
V Conclusions. Trade information of individual countries suggests rapid growth of world trade and economic activity. Financial market turbulence is casting shadows of a global debt and financial crisis. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )