IFE FINALS REVIEW
IFE FINALS REVIEW BADM 2201
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This 10 page Study Guide was uploaded by Katherine Ahn on Tuesday February 10, 2015. The Study Guide belongs to BADM 2201 at George Washington University taught by Yoon Park in Fall. Since its upload, it has received 169 views. For similar materials see International Financial Environment in Business at George Washington University.
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Date Created: 02/10/15
Svmptoms and Policv Measures Symptoms of impending financial crises Budget deficits Chronic and rising current account deficits Rising foreign debt esp shortterm debt ie Argentina s gov t Excessive gov t debts over 40 of GDP for LDCs Weak financial supervisory framework Lack of robust local capital markets Banking system only provides shortterm funds capital markets provide long term funds Washington Consensus IMF World Bank US Treasury Developed in the 1980s to cope with Latin American debt crisis overvalued currencies high budget deficits amp hyperinflation Mexico s export is not competitive country does NOT like devaluation 0 3 pillars of Fiscal austerity Reduce budget deficit to zero Liberalization Economy should be liberalized Privatization No more gov t owned companies hire only politicians huge operating losses gian Financial Cris of 1997 Unlike Latin American countries facing foreign debt crisis in the 1980s most affected Asian countries did not have chronic budget deficits and high inflation even though they suffered from current account deficits IMF should have change their medicine to apply to Asian countries Current account deficit a measurement of a country39s trade where IMPORTS gt EXPORTS AKA calculation of a country39s foreign transactions Both Thai amp Korean currencies lost half their values during the crisis Their growth rates suffered in 1998 Lessons of Asian Financial Crisis Harmful impact of overvalued currencies Freer international capital movements and financial market opening to foreign capital may also lead to speculative overinvestments Tight fiscal and monetary policies in the midst of a crisis may be counter productive for capital flight and exchange rate stabilization IMF forced Korean gov t increase interest rate to almost 30 to slow down and stop the capital flight No company can survive a No banks could pay back the loans a People lost jobs Known as IMF crisis in Korea Capital flight occurs when assets or money rapidly flow out of a country due to an event of economic consequence Mentine39s Financial Cris of 2001 In 1990 the currency board system1 1 P was adopted thus bringing in low inflation and interest rates and subsequent economic boom through new investments ln 1990s prevented from printing more money due to the currency board system however the gov t engaged in massive foreign borrowing to engage in reckless public spending 101 Gov t declared the largest sovereign default at that time on almost 100 billion foreign debt Late 2001 bank holidays declared in Argentina 102 The currency board system was abandoned In 2004 gov t announced the largest bond restructuring to swap 103 billion defaulted bonds for 3 types of new bonds with foreign bondholders getting about 30 cents on the dollar 70 haircut 2 phases of the Recent Global Financial Crisis Phase 1 August 2007 September 7 2008 Subprime Mortgage Crisis 1st half of 2007 The market for subprime mortgagerelated securities started to crack due to the bust of US housing market bubble 807 Subprime mortgage crisis produced its first financial casualties when 2 German banks IKB and Sachsen LB that had invested heavily in subprime mortgagerelated securities through their offbalance sheet vehicles and suffered huge losses had to be bailed out by the German authorities 907 Northern Rock Britain s 5th largest mortgage lender experienced liquidity crisis triggering the 1St British bank run in 150 years 308 Bear Stearns had to be merged w JP Morgan Chase and since then other financial institutions had to announce huge writedowns of their subprime mortgagerelated investments At this first stage of crisis however mostly longterm bonds were affected Subprime mortgage crisis appeared to reach its climax with the US gov t rescue of Fannie Mae and Freddie Mac on 9708 Phase 2 September 15 2008 2009 Global Financial Crisis 91508 New Financial Crisis started with the bankruptcy of Lehman Brothers On the same day Sept 15 Merrill Lynch was merged into BOA through stock swap Gov t should have stepped in and protected Lehman Brothers Democrats were accusing Republicans that they bail out rich people aka banks To save the Republican s image Bush decided not to save Lehman Brothers from bankruptcy TBTF Toobigtofail a impact is bad if left to fail When 2 big banks fail on the same day BAD for US economy so Merrill Lynch was allowed to merge with BOA But the damage was already done 91608 The world s largest insurance company AIG was bailed out by the US gov t 0 Proof that damage was already done because the crisis spread to Eurodollar market Eurodollar interbank market frozen 3month LIBOR London Inter bank of rate more than doubled from 225 to over 5 in a week 225 l 5 DOUBLED BIG DEAL everything was about to collapse 0 if they had bailed out Lehman Brothers from the start this would have NOT happened On 921 both Goldman Sachs and Morgan Stanley were turned into BHCsBank Holding Companies thus ending the 75year history of US monoline investment banks On Friday Oct 3 after initial failure on 929 Congress passed 700 billion bank bailout package but the US stock market experienced the worst weekly decline of 18 the following week GlassSteagall Act of 1933 a 1999 AKA Banking Act which prohibited commercial banks from participating in the investment bank business a The Act was passed as an emergency measure to counter the failure of almost 5000 banks during the Great Depression Repealed in 1999 Conventional Explanation for the Caus of the Recent Financial Crisis Global imbalance bw the US and the rest of the world esp East Asian countries such as China and Japan Global imbalance the world is divided into 2 blocks on one side is East Asian countries China Japan Hong Kong Korea 0 In the East Asian countries they have a huge trade surplus balance trade surplus In the West Countries they have a huge trade deficit ie China has 4 trillion dollars l invest in foreign liquid investment US gov t treasuries US gov t has AAA credit ratings Massive FX reserves accumulated in East Asia were promptly recycled back to the US resulting in excessive liquidity there The flood of foreign capital into the US lowered interest rates inducing Americans to run down their own savings and to keep excessive spending US FRB s prolonged low interest rate policy also contributed of the crisis by encouraging banks and investors around the world to search for high yields at greater risks Strong US political pressure for home ownership even in lowincome areas eventually leading to widespread subprime mortgage lending Alternative Exnlanation for the mug of the Recent Financial Crisis However the world had lived with global imbalances in previous decades without necessarily having a massive global crisis A deeper reason can be found in the phenomenal growth of finance in recent decades compared to the real sector of the economy The share of the profits of the financial services industry in the US rose from 10 of total corporate profits in early 1980s to 40 in 2007 4 times in less than 3 decades Conversion of Wall Street firms from partnership into corporation also led to explosive growth of their balance sheet largely funded by overnight repos For example Goldman Sachs balance sheet exploded from 100 billion in 1995 to 11 trillion in 2007 an increase of 11 times over 12 years 0 Such a rapid growth in the financial sector has been made possible through revolutionary new financial products and techniques Overall financial innovations have played a constructive role in global financial markets 0 In recent years however there had been an increasing abuse of new and sophisticated financial innovations Even if only a small portion of such massive market is misused it can result in catastrophic losses for impacted financial institutions and investors CDOs Collateralized Debt Obligations The Real Villain of the Current Crisis CDOs are called Structured finance products and packaged as pav throuah securities MBS mortgage backed securities CMOs Collateralized Mortgages Obligation CDOs first emerged in the 1990s due to banks desire to offload highrisk loans such as leveraged loans used in MampAs Can use anything as a collateral derivatives MBS CMOs Because of CDOs Wall street was able to make A LOT of money a Wall street firms acting as CDO underwriters earned fees of 25 35 Merrill Lynch alone launched about 150 billion CDOs during 200407 earning fee income of over 4 billion Citibank Bear Stearns Goldman Sachs and other US banks made tons of money the same way 0 Wall street investment banks were eager to create and market more CMOs but their new volume was constrained by the availability of mortgage loans which are used as the collaterals for CMOs Wall Street had unsatiable appetite for more collaterals thus resulting in an increasing demand for even subprime mortgage loans and then Wall Street finally proceeded to create CDOs which do not need mortgage loans as collaterals Class A bonds AAA Class B bonds AA Class C bonds A Evolution of EU Monetarv Svstem 1971 Smithsonian agreement and a wider band from 1 o to 225 A meeting of central bank mayors governors at the Smithsonian Castle they agreed to widen the band PV 225 against widen band Countries around the world still wanted to maintain the Bretton Woods System To save the fixed exchange rate system they agreed to widen the band 1972 Snake in the Tunnel arrangement in Europe Worm in the snake for Benelux countries Applied to only EUROPEAN countries 1st tempt at European monetary cooperation in the 1970s aiming at limiting fluctuations bw different European currencies Attempt at creating a single currency band for the European Economic Community EEC The tunnel collapsed in 1973 when the US dollar floated freely The snake proved unsustainable with several currencies leaving and in some cases rejoining 1973 Snake in the Sea arrangement Applied to all countries 1979 European Monetary System EMS ECU European Currency Unit 9currency basket Acts like US ERM Exchange Rate Mechanism 1992 EMS crisis British pound and Italian lira dropped out of ERM 1992 Maastricht treaty in the Netherlands 1993 ERM exchange rate mechanism band widened from 225 to 15 o around ECU 1999 Replacement of ECU by Euro Economic and Monetarv Union EMU Stage 1 throughout 1993 Closer economic and monetary cooperation Stage 2199498 Move toward economic and monetary convergence to join Stage 3 Convergence Criteria Inflation no more than 15 over best 3 average Budget Deficit 3 of GDP Outstanding gov t debt 60 of GDP Interest rate not to exceed best 3 averages by 2 Exchange rate no devaluation for 2 years Stage 31999 Creation of Euro which s to replace all EMU domestic currencies from 2002 EU Financial Svstem EU 28 countries Croatia joined EU on July 1 2013 as 28th member EMU Economic and Monetary Union of EU 18 countries of 28 EU members creating Eurozone or Euro area European Central Bank ECB created 1998 European system of central banks ESCB composed of ECB and 28 EU member country central banks Eurosystem composed of ECB and 18 EMU member country central banks Problems amp Prospects in the Euro Area Benefits and costs of a common currency 0 Positive effects on trade and employment 0 Loss of independent monetary and fiscal policy thus losing economic policy flexibility to deal with inflation or recession Loss of power to print money gt manipulating the money supply Euro zone crisis gt to have a true single effective currency you need 1 independent monetary amp fiscal policy which they don t and causes problems Countries have strong pride over their currencies Preconditions for a successful currency area 0 Full labor mobility Workers should be able to move from one country to another Legally if you re Greek you can move to Germany and can get a job there In practice there s a lot of problems due to language barriers 0 Fiscal integration Tax and spending should be at Eurozone level Right after euro creation convergence of borrowing costs in the Eurozone 0 Thus countries like Greece overborrowed benefitting from low interest costs After Eurozone was created Greece does not have their own currency But Greek gov t has complete freedom to set how much gov t spendingborrowing they want to Because of independent fiscal policy they overborrowed When foreign countries bought the treasury bonds they didn t look at the specific Eurozone country s credit rating Greece Greece ended up not being able to pay back Other Eurozone countries helped Greece to pay back their debt SCENARO lF Greek abandons the euro currency and goes back to their old currency their currency will be devalued 100 and be able to be a cheap country for hotels tourists etc Spain follows and others will too like a chain reaction 0 Similar to Argentina in the 1990s under the currency board system Prospects of the Eurozone crisis either debt restructuring default andor abandoning the euro like Argentina abandoning the currency board Differences between Eurozone and Subprime Mortgage Cris Subprime mortgage loan crisis 0 Micro crisis with bad assets of financial institutions such as CDOs CDS etc Eurozone crisis 0 Macro crisis with some Eurozone countries such as Greece Spain Portugal and Italy engaging in huge budget deficits financed by gov t borrowings So far Eurozone has pursued fiscal tightening such as reducing budget deficits amp gov t spending along with tax increases New approach attempted with the new French President Francois Hollande focusing also on economic growth and job creation Debate over Eurozone bonds Euro bonds Germany Finland Netherlands vs France Italy Spain Greece Euro bonds result in interest rate subsidies for the latter group at the expense of the former 0 Thus Germany amp others are not likely to support Euro bonds unless there is a firm commitment to fiscal policy harmonization in Eurozone Economic Cos of Eurozone Crisis Fragile condition of European banks due to their heavy credit exposure to affected Eurozone countries of Spain Greece Portugal etc 0 Thus many EU banks cannot borrow money from other banks in the interbank market Instead they rely on ECB Eurobean Central Bank gt lender of last resort for emergency funding ECB has relied upon Federal Reserve for dollar funds through the central bank currency swap 0 They have paid back federal reserve if not they would go bankrupt High unemployment rate in Europe especially youth unemployment Slower European and global economic growth impacting even Asian countries in addition to North America Conclusion The Eurozone crisis has a depressing impact on the world economy and global financial markets The Root Caum of Eurozone Cris 1 Eurozone design flaws original sin 0 Currency union is not accompanied by fiscal union 0 Thus each EMU country is free to pursue its own fiscal policy including budget deficit and gov t borrowing 0 Spain or Greece is similar to state of Michigan in that it cannot print its own money The dollar is protected by FRB and US treasury not by Michigan State whose main city Detroit is in bankruptcy proceedings 0 Euro has to be protected by all EMU countries together but some of them such as Ireland and Greece have overborrowed and overspent o In America Bank of America is not protected by State of North Carolina but by FRB and FDIC Without the banking union however Spanish banks have to be protected by Spanish Government alone without the power to print euros Whv such design flaws in Eurozone Initial impetus toward euro was not economic but political 1956 During the Suez Canal crisis US forced Britain and France to withdraw their forces from Egypt even though Egypt nationalized their Suez Canal without compensation 0 Although US had alliance with the European countries they backed Egypt because they didn t want the crisis to spill over further a Europe then realized that without Europewide union European countries individually were no match for US or Soviet Union a 1957 Europe launched the Common Market which is the precursor to today s European Union 0 1992 Maastricht Treaty gave rise to EMU and also west the timetable for creating a single currency euro Germany united in 1990 originally was not keen to abandon its beloved German mark DM and to join Eurozone but it was persuaded by France and Britain in the name of a united Europe 0 EMU is only half union 0 The problem was known from the beginning but their priority of EMU was a political union Efforts to Stan Eurozone BreakUp EFSF European Financial Stability Facility borrows money in the global financial markets with the guarantee of Eurozone members esp Germany Then it lends money to countries such as Greece to bail out its banks etc o Arrangement in EMU to set up this program EFSF o Borrowing money in global financial markets by issuing bonds 0 Then lends money to crisis countries 0 Greece issued bonds too much and they were about to default on the bonds Therefore Greece gov t needed an emergency funds EFSF bonds are considered an entire Eurozone bond including Germany France Low interest rate ESM European Stability Mechanism has now replaced EFSF and unlike EFSF which received only guarantees but no funds directly ESM has started out with euro 500 billion of funds ESM could become the European IMF eventually 0 Even after Asian crisis Asians want to create their own IMF gt that idea still lives on in CMIM Cheng Mai IM 0 CMIM is now an organization in Singapore may eventually full blown Asian Monetary Fund 0 Similarly ESM is believed to become the European Monetary Fund TROIKA ECB IMF and European Commission sets strict conditions on a loan recipient country such as Greece or Spain in terms of budget deficit and spending goals etc o The 3 organizations combine their effort to lend emergency money to Eurozone crisis countries 0 Eurozone crisis created a lot of organizations corporation schemes etc ASIAN CRISIS gt CMI gt CMIM LATIN AMERICA CRISIS gt Washington Consensus Internationalization of RMB The Chinese Renminbi RMB is not yet a world reserve currency like the dollar or euro 0 Reserve currency currency in which countries around the world keep their foreign currency trade reserves Requirement for a reserve currency free convertibility not just for trade settlements but also for financial transactions as well 0 This currency can be used not only for foreign trade exporters amp importers that currency can be used for OTHER financial transactions when company ie TOYOTA wants to invest in Brazil that currency can used for the investment China has embarked upon partial internationalization of RMB 0 Banks in selected offshore centers such as Hong Kong and London are allowed to open RMB accounts 0 Exporters to China are allowed to keep their RMB in these accounts which can be used for paying for imports from China or other purposes in China as allowed by China 0 When such offshore RMB is more expensive than domestic RMB Chinese importers settle with these offshore RMB o Offshore RMB has slight premium of about 01 over domestic or onshore RMB Offshore RMB are also allowed to be used for various investments in China Banks in offshore financial centers such as Hong Kong and London accept deposits and make loans in RMB 0 China has also fostered growth of RMBdenominated bonds in Hong Kong known as dim sum bonds 0 China s central bank People s Bank of China PBOC has increased bilateral currency swaps with foreign central banks in order to increase RMB liquidity in a move to promote wider RMB use by foreign banks and businesses 0 The fact that foreigners are keeping it s an advantage 0 Since dollars are freely kept and used by foreigners outside of US foreigners are lending US money with 0 interest rate 0 When US gov t has budget deficit they re never in risk of bankruptcy because if US cannot pay for the bonds they just print more money 0 Because foreign countries willingly buy the bonds 0 Privilege of reserve currency Latin Debt Crisis 19805 Analvsis of the Asian Economic Miracle 1982 Mexico gt Venezuela gt Brazil Argentina gt Other Asian countries gt Eastern Europe Latin America Debt Crisis and the Brady Bonds 198285 Debt crisis as shortterm liquidity crisis SHORTTERM LIQUIDITY PROBLEMS cannot pay back their foreign debt IMFmandated austerity measures Reduce budget de cits Increase taxes and reduce gov39t subsidies Raise interest rates Reduce current account de cits Currency devaluation Ignored reality ultimately this FAILED 198588 Debt crisis as longterm economic structural crisis 0 James Baker at the annual IMF meeting proposed Baker Plan reward for fundamental economic reforms Tried to organize a renewed lending program by commercial banks 0 He thought that Mexico amp other countries were facing a deeper economic problems than shortterm liquidity problems 0 Mexico is a BIG export country they sell gold 0 BUT they were still short of DOLLARS foreign money 0 The reason for their economic crisis was that their economic policies SUCKED NEEDED a fundamental change FUNDAMENTAL ECONOMIC REFORMS 0 Argentina had futile land for farming and exported A LOT of vegetation But still had the same problems as Mexico 0 They weren39t poor because their land became bad their economic system was corrupted and out of balance Encourage developing countries Privatization Deregulation and liberalization Internationalization Most developing countries don39t want foreign competitions FAILED due to Bureau a Bureaucrats Ma a amp Mo a Ministry of Finances Ma a 198992 Debt crisis as solvency crisis 0 Bush Senior president at the time 0 He prioritized to solve the international economy crisis 0 Appointed Nicholas Brady college classmate Brady Plan debt forgiveness through innovative nancial techniques Creditors were expected to restructure some of the old debt into longerterm debt with a lower interest rate and to make some additional new loans 0 The multilateral lending agencies such as the IMF were expected to provide additional loans on concessional evidence of their willingness to begin serious economic reform before any new loans would be forthcoming Countries that renegotiated their debt with the Brady Plan package were perceived by the international nancial community to have greater credibility and sounder nances Bradv Plan and Bradv Bonds 1988 IP Moroan Plan 1 Mexico buys 10 billion 20year US zerocoupon Treasury bonds for 18 billion a Zero coupon bonds gt YOU DON T PAY INTERESTS i Still has interests but its accumulated 1 Mexico issues 10 billion 20year FRNs LIBOR 1 58 with the principal backed by US 2 c Tbonds a Therefore FRNFLOATING RATE NOTE is 100 safe since it39s backed by US treasury bonds 2 Mexico offers to swap FRNs for Mexican gov39t bank debt at discount BASICALLY 1 will wipe out 10 debt Unfortunately this plan failed because 3 was optional 1989 Bradv Plan modi cations 1 20 year maturity to 30 year maturity 2 Interest also guaranteed by IMFIBRD on 19 moth rolling basis 3 Mandatory swap with 3 options a 30year FRNs LIBOR 1316 35 discount b 30year Eurobonds at 625 xed rate at par c 15year FRNs LIBOR 1316 for 25 extra exposure
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