3.1 As discussed in the previous chapter, the systemic risks posed by the immensely complex financial system were overshadowed by the benign macroeconomic outcomes observed for a sustained period of time before the crisis. The complex nature of new financial instruments and the inability to assess counterparty risks in financial markets in an environment of rapid growth in credit and booming asset prices made the financial system vulnerable. Due to the rapid global integration and deep and complex interconnections between financial institutions, the crisis which emerged in the US sub-prime housing market manifested itself across assets, markets, and economies. During the initial stages of the crisis, the impact was manifested in mounting losses on the exposures of banks and financial institutions to the sub-prime mortgages and structured finance products. These losses were exacerbated by illiquidity in the markets for those instruments, which led to substantial reductions in their mark-to-market valuations.

3.2 With the collapse of Lehman Brothers, the crisis entered a turbulent new phase in September 2008, after which the crisis rapidly developed into a crisis of confidence and engulfed the whole financial system in the US. Subsequently, it spread to other developed economies, resulting in a number of European bank failures, declines in various stock indices with consequent large reductions in the market value of equities and commodities, failure of key businesses, declines in consumer wealth and a significant decline in economic activity. Moreover, the deleveraging of financial institutions, as assets were sold to pay back obligations that could not be refinanced in frozen credit markets, further accelerated the liquidity crisis. In this phase, bank losses and writedowns became more closely linked and the impact was felt in terms of a surge in borrower defaults on the back of worsening macroeconomic performance.

3.3 Global trade and financial integration had given the US financial market crisis a global form as the increasingly integrated global trading and financial system magnified and accelerated the transmission process. There had been rapid transmission of shocks from the US and Europe to the rest of the world. The impact of the crisis was felt in almost all the economies of the world in varying degrees. The crisis spread to EMEs through all four channels – trade, finance, commodity and confidence channels. In the EMEs, the slump in export demand and tighter trade credit caused deceleration in aggregate demand; reversal of capital flows led to equity market losses and currency depreciations; global liquidity tightening resulted in lower external credit flows; and market rigidities and erosion of confidence led to widening of credit spreads.

3.4 The crisis that originated in the financial sector was transmitted to the real sector through several channels. The depth and spread of the crisis can be gauged from the successive revisions in the estimates of write-downs, decline in trade and, finally, the contraction in economic activity. The financial sector deleveraging, in conjunction with weak credit markets, falling production and rapidly shrinking global trade, led to a situation of a more prolonged recession, especially with the growth in EMEs showing significant moderation. In the financial sector, the estimates for global write-downs of loans and securities held by banks over 2007-10 amounted to US$ 2.3 trillion (WEO, April 2010). On the trade front, according to the IMF (WEO, April 2010), world trade volume (goods and services) has declined by 10.7 per cent during 2009 as against 2.8 per cent growth witnessed in 2008. In the real economy, the final impact of the crisis was reflected in deteriorating global growth outlook as can be observed from the successive revisions in the growth projections for 2009 from 3.8 per cent in April 2008 to (-) 1.1 per cent in October 2009 which was revised further to (-)0.6 per cent in April 2010.

3.5 However, there are incipient signs of recovery in the global economy, while financial conditions are stabilising. According to the IMF, emerging and developing economies are further ahead on the road to recovery, led by resurgence in Asia. Already there are signs of strong revival in capital flows in line with improved macroeconomic conditions in these economies, sound policy framework and rebound in the risk appetite of global investors and financial market sentiments. The quick and strong policy responses across advanced and emerging economies played an important role in limiting the stress in the global economy as compared to earlier crises (see Chapter 2).

3.6 Against this backdrop, this chapter analyses the impact of the crisis on various sectors of the economy, such as financial markets, financial institutions, international trade, international capital flows, remittances and the real economy in a global context. Section I discusses the impact of the crisis on financial markets, while Section II covers the impact on the financial system. The impact on the external sector covering trade, services, current account deficit and capital flows is described in Section III. The impact on the real economy is discussed in Section IV, while some concluding observations are given in Section V.

I. IMPACT ON FINANCIAL MARKETS

3.7 Global financial markets have witnessed rapid changes during the past decade in terms of evolution of new products and instruments and increase in turnover volumes. Certain types of financial innovations turned increasingly complex and their usage increased dramatically in recent years, generating speculative bubbles. These products included adjustable rate mortgages (ARM), mortgage backed securities (MBS), collateralised debt obligations (CDO) and credit default swaps (CDS). Interestingly, these complex products were assigned safe ratings by credit rating agencies. Also, the strong demand for these instruments in an environment of easy liquidity and strong credit growth drove down lending standards. Eventually this speculative bubble proved unsustainable and manifested in financial market turmoil in the US, which in a year’s time reached unprecedented heights.

3.8 The crisis moved rapidly from the US subprime market to the financial markets of Europe and other advanced economies. After the onset of the financial crisis, a number of features became common across the financial markets of the most affected economies, particularly in the US and Europe. These were a broad re-pricing of risk, severe shortages of market liquidity in many security and commercial paper markets, a shortage of funding liquidity in the interbank market, and, for some European financial institutions, a shortage of US dollar funding. Although the crisis started spreading across financial institutions, markets and countries from August 2007, the closing of the large US investment bank, Lehman Brothers, in September 2008 aggravated panic in the financial markets. The collapse of Lehman Brothers distorted the financial intermediation process – it gave rise to rapid increase in the cost of intermediation between financial organisations as well as counterparty risks.

3.9 Initially, the EMEs were much less affected by the recent crisis than during previous crisis episodes. Some spillovers were evident in financial markets, particularly associated with the rise in global risk aversion. However, as the financial market upheaval in developed economies persisted, particularly after the Lehman failure in September 2008, EME financial markets came under severe strain with increased volatility. Post-September 2008, as global investors scaled back their holdings of emerging market assets amid continued financial system deleveraging, Asian equities and external funding conditions became severely affected. Asian stock markets collapsed even more sharply than the mature markets and sovereign credit spreads widened significantly. Heightened financial volatility and a sharp reversal in risk appetite together with elevated funding costs narrowed external funding sources for Asian borrowers. This was accompanied by a sharp drop in Asian offshore bond issuance, massive capital outflows and unwinding of carry trade. As a result, the region’s currencies depreciated sharply. The impact of the crisis on various segments of the financial markets in advanced economies and EMEs is discussed in detail in the following sections.

Impact on Interbank/ Money Market

3.10 One of the first financial market segments to be affected by the crisis was the interbank market. The first symptoms of the crisis appeared in August 2007, when serious disruptions took place in the interbank market, putting pressures on liquidity. As uncertainty reigned over the extent of subprime-related losses and their concentration, banks became concerned about counterparty risk. Banks increased their demand for liquid funds and became reluctant to lend to one another. This resulted in severe tightening of funding conditions in the interbank credit markets. The illiquidity and increase in perceived credit risk caused spreads on interbank rates to widen. Later this crisis spread to the money markets, taking the form of abnormal levels of spreads, the shortening of maturities, and the contraction, or even closure, of some market segments. Through contagion, these tensions also affected non-financial corporations and the financing of the economy.

Spreads in Advanced Economies

3.11 An indicator of the severity of liquidity pressure in the interbank market is the spread between the interest rate in the London interbank offered rate (LIBOR) and the overnight indexed swap (OIS) rate of corresponding maturity. In principle, this spread provides a measure of the risk premium, which includes both credit and liquidity factors. This spread hardened from early August 2007 but reached unprecedented highs of 361 basis points in the US, 244 basis points in the UK and 199 basis points in the Euro area in the post-Lehman period (Table 3.1). The interbank market in Japan, however, was relatively less affected during the crisis with its spread peaking at 80 basis points at the height of the crisis.

3.12 In the post-Lehman period, this sharp rise in spread reflected heightened concerns about liquidity risks, particularly for US dollar term funding as also concerns about an increase in the credit risk of the banking sector, following the collapse or near-collapse of some large financial institutions. Similar trends were noted in the financial markets in Europe. Strains were particularly evident for foreign exchange swaps, where rising financial sector credit spread and the rising global demand for US dollar funds raised the implied cost of dollars to historically high levels above LIBOR. With the viability of key players at stake and perceptions of counterparty risk rising, the benchmark US investment grade CDX credit default swap index spread jumped by 42 basis points and US highyield spreads rose by 118 basis points on September 15, 2008 alone. The resulting turmoil quickly spread through the intensely integrated global financial system leading to widening of credit spreads in other major markets (Chart III.1).

3.13 The funding problem in the interbank market quickly spilled over into the markets for commercial paper (CP) and bank certificates of deposit (CDs), where money market funds are a key investor group. Commercial paper markets suffered due to redemptions/ reallocations and illiquid secondary markets for these securities. Unsecured financial paper suffered the largest outflows: total outstanding CP volumes in the United States plummeted by more than US$ 325 billion between September 10, 2008 and October 22, 2008, from a total of about US$ 1.76 trillion. Foreign banks and those US institutions without their own retail deposit base thus lost access to an important source of funds at a time when they needed to support or take onto their balance sheets the money market funds that they sponsored. In response, the demand for US dollar interbank funds surged, causing shortterm credit and money markets to seize up.

3.14 Responding to such tightness in the market, the Federal Reserve acted to relieve money market tensions with various credit facilities, which were extended and enhanced on July 30, 2008. The impact of these efforts, however, was partly offset by increased uncertainty following the default of large financial companies. In the euro area, the spreads between deposit rates and OIS rates were influenced by strong demand from European banks for US dollar liquidity, because funds borrowed in Euros had to be swapped for US dollars to support euro area banks’ investment positions that were denominated in this currency. The European Central Bank (ECB) provided ample liquidity in its regular weekly operations in order to allow banks to meet their reserve requirements during maintenance periods. In addition, the ECB renewed its supplementary longer-term refinancing operations for maturities of three and six months.

3.15 Quantitative and credit easing policies, extraordinary liquidity measures and government guaranteed funding programs have helped to improve the functioning of short-term money markets. The money market conditions have continued to improve in the early months of 2010, accompanied by a decline in market and liquidity risks as asset prices have continued to recover across a range of asset classes (IMF, GFSR, April 2010).

Spreads in Asian Economies

3.16 The liquidity strains in major international interbank markets spilled over to several Asian interbank markets—particularly in the key Asian financial centres of Hong Kong, Singapore and South Korea, where short-term interest rates increased significantly in the second half of 2008. The rise in local currency interbank market rates prompted the monetary authorities in those countries to inject liquidity to normalise market operations. The domestic liquidity pressures in Asian money markets reflect several factors, including arbitrage across foreign and domestic currency markets, rising uncertainty about the economic outlook and increased risk aversion. Overall, domestic interbank markets in Asia, however, did not seize up as severely as their counterparts in developed countries. With authorities’ support, domestic interbank markets in all three of these economies saw a return to normality.

3.17 The creation of a number of new central bank facilities and the willingness on the part of central banks to provide necessary liquidity appeared to alleviate concerns among banks about the availability of short-term liquidity. However, money market spreads increased for maturities longer than three months, suggesting growing counterparty credit risk concerns. Such cross-currency activity and the high correlation between changes in equivalent spreads of other major currencies indicate that global money markets have become increasingly interlinked as a result of the market turmoil.

Impact on Credit Market

3.18 Declining credit growth, particularly in the advanced economies, worked as a catalyst to aggravate and spread the impact of the crisis from one market to another. Unlike the money market, credit flows, however, had been impacted by the crisis with a lag as credit flows were robust during the early stages of the crisis. However, to a large extent this reflected special circumstances. First, during the initial stages of the crisis, there was market and supervisory pressure on banks to consolidate previously off-balance sheet exposures to securitisation vehicles. This tended to swell balance sheets even without any fresh extension of credit. Second, borrowers pre-emptively raised funds in anticipation of credit tightening by drawing down credit lines that had been granted before the crisis, often at very favourable terms.

Slowdown in Credit Growth

3.19 A sharp slowdown in credit growth to the private sector was noted during the post-Lehman phase in many of the advanced economies, where banks sought to reduce leverage and rebuild capital bases (Chart III.2). The overall deceleration in lending to the private sector was broad based across the various money-holding sectors, although the level of adjustment varied from sector to sector. Lending standards tightened across all types of loans, although more sharply in the case of household credit, including mortgages. Nominal housing credit (excluding home equity loans) contracted at an annual rate of 1–2 per cent from the second quarter of 2008 to the first quarter of 2009 in the US, and it stopped growing in the euro area by March 2009. On account of tightening of lending standards, even households with good credit histories faced difficulties in obtaining mortgage loans or home equity lines of credit. Consumer credit growth also slowed significantly in many advanced countries, the exception being the US, where it grew at an annual rate of 9 per cent in the first quarter of 2009. Banks reduced credit card limits and increased refusals of automobile loan applications. Although business credit continued to expand in many countries, it was mainly driven by an increase in the use of existing credit lines rather than by new lending. In addition to the supply-side credit constraints, decline in credit growth to some extent also reflected a slowdown in demand as the major economies entered into recession with firms and households refocusing towards capital preservation as well as towards managing excess capacity and high levels of debt.

3.20 Credit growth continued to remain sluggish in the advanced economies during the early months of 2010, notwithstanding the improved private sector credit risks. Constraints on bank capital and sluggish non-financial credit growth continued to impair the supply of credit in those economies. The outlook for credit growth in the advanced economies remain sluggish and uneven, as banks continue to delever and private demand remains weak.

3.21 Within EMEs, the limited exposures of Asian banks to sub-prime and CDO assets, coupled with well-capitalised balance sheets allowed Asian interbank markets to remain relatively calm. There was no noticeable reduction in the growth of private domestic credit in most countries in the region during the initial phase of the crisis (Table 3.2). However, as the crisis deepened, credit growth in many countries weakened. Credit growth continued to remain sluggist in many of the emerging Asian economies during the second half of 2009. Credit to the household sector increased by 7.8 per cent in Singapore, 11.5 per cent in Indonesia, 2.4 per cent in Korea, 2.7 per cent in Taiwan and 5.7 per cent in Malaysia between June-December 2009. Credit growth to the corporate sector remained lower than the household sector for all these economies. (Regional Economic Outlook: Asia and Pacific, April 2010). Credit growth started accelerating in many of the emerging Asian economies in the recent months, while in emerging Europe, credit continues to contract though at a decelerating pace (IMF, GFSR, April 2010).

Widening of Credit Spreads

3.22 Credit default swap (CDS) indices in the US had reached historical highs across all categories, for both the financial and the non-financial sectors. At the same time, issuance of asset-backed securities (ABSs) and collateralised debt obligations (CDOs) remained sluggish. The US government’s plans, the Troubled Asset Relief Program (TARP), which aimed at restoring confidence in the ABS market by authorising the US Treasury to take troubled assets off the balance sheets of financial institutions, followed by capital injections to banks, helped to reduce the perceived risk of further defaults, resulting in a tightening of banks’ CDS spreads (ECB, 2009) (Table 3.3). Nevertheless, CDS premia for global large and complex banking groups (LCBGs) remained at relatively high levels, reflecting market uncertainty about the implementation of the programme, its influence on particular institutions and concerns over the impact of higher funding costs in the banking sector.

3.23 In sum, in view of soaring demand for liquid funds in the wake of the contraction in the money market mutual fund sector, global inter-bank markets came under pressure, squeezing banks’ access to short-term funding. Money markets, which were already strained, failed to recuperate, despite massive central bank liquidity injections. As a result, interbank rates spiked to historic highs. The movements in other major markets, such as those for euro and sterling funds, also showed similar signs, albeit moderately. Thus, the turmoil transcended from credit and money markets to the global financial system more broadly. The contagion also spilled over to the emerging markets, which saw broad-based asset price declines amidst depressed levels of risk appetite. While policy intervention on an unprecedented scale helped to stabilise the money market conditions, credit growth, however, continued to remain sluggish, particularly in the advanced economies, even in the recent months.

Impact on Stock Market

3.24 The stock market is another segment of the financial sector that has borne much of the heat of the global financial crisis. During the recent financial crisis, equity markets all over the world witnessed high volatility and sharp declines in prices. However, in contrast to other markets, the impact of the crisis was more pronounced on the EME stock markets compared to their matured counterparts.

Advanced Economies

3.25 From the beginning of the year until mid- March 2008, equity prices in the euro area, the United States and Japan followed a declining trend. This trend was partly reversed when JPMorgan Chase took over Bear Stearns in March 2008. The Bear Stearns rescue package was favourably perceived by market participants, who changed their risk perceptions, thereby contributing to sustaining equity markets. Against this background, from mid-March to the beginning of June 2008 the Dow Jones EURO STOXX increased by almost 10 per cent, the Standard & Poor’s 500 by around 8.5 per cent, and the Nikkei 225 by 22.5 per cent. Stock price fluctuations, however, became pronounced from September 2008, reflecting uncertainties generated in global financial markets following the collapse of Lehman Brothers and the failure of many other significant financial institutions. Growing concerns about the health of loss-making financial institutions and the deteriorating economic outlook and its impact on company earnings put downward pressure on major stock indices during the last quarter of 2008. Moreover, declining actual and expected earnings growth also contributed to the negative performance of stock markets in the US and the euro area.

3.26 Along with sharp declines in prices, the stock markets of the matured economies have also experienced high volatility since September 2008. In September 2008, volatility in the S&P 500 spiked to levels not seen since the 1987 stock market crash. Overall, at the end of 2008 equity prices in the euro area, the United States and Japan, as measured by the Dow Jones EURO STOXX, the Standard & Poor’s 500, and the Nikkei 225 indices, respectively, were lower by around 46 per cent, 39 per cent and 42 per cent, respectively, as compared with their levels at end-2007.

Emerging Market Economies

3.27 The severe impact of the crisis was felt in the EME stock markets, mainly in terms of a collapse in stock prices. There were significant selloffs by FIIs in most of the emerging Asian equity markets from October 2007. Equity flows to the EMEs declined substantially during 2008, with the decline being more pronounced during the last two quarters of the year. Equity flows to EMEs declined sharply from US$ 207.8 billion in 2007 to US$ 54.2 billion in 2008. Within equity flows, while inflows under FDI remain relatively resilient during the crisis, portfolio flows were the worst sufferers. Equity flows, however, have bounced back strongly during the second quarter of 2009 (Table 3.4).

3.28 The fall in equity prices in EMEs was particularly strong from the middle of 2008 in contrast to matured economies, where the fall began in the middle of 2007. Within Asian EMEs, the stock market valuation declined by 35 per cent in Korea, 33 per cent in India, and 36 per cent in China between June and December 2008, reflecting the wide-ranging effect of the world financial crisis (Table 3.5). The fall in equity prices took place amid heightened volatility and some EMEs even temporarily halted trading on their stock exchanges.

3.29 Overall, emerging market equity valuations lost about 50 per cent between May 2008 and end- November 2008. The Emerging Market Bond Index Global (EMBIG) spread widened by more than 400 basis points, and yields on long-term domestic bonds declined by 60 basis points. Risk aversion, repatriation of foreign capital and, in some cases, falls in commodity prices have weighed down on equity prices in EMEs (Table 3.6). Such effects have also weighed down on a range of EME currencies against the US dollar.

3.30 Amidst the decline in equity prices, there was a significant decline in global stock market turnover in 2008, though the decline was more pronounced in the case of emerging market economies compared to the advanced economies. Moreover, the decline was sharper during the last two quarters of 2008 than in the earlier quarters.

3.31 In line with the decline in turnover, the market capitalisation of major stock exchanges,which started declining from the first half of 2008, continued the same trend till the first quarter of 2009. However, with the improvement of the general health of the global stock markets, there are indications that market capitalisation began to recover from the second quarter of 2009. Despite substantial recovery, stock market capitalisation remained lower than the 2007 level, for most of the emerging economies at the end of 2009 (Table 3.7).

3.32 From a sectoral perspective, both in the euro area and in the United States, stock prices of the financial industry suffered the heaviest losses between December 2007 and December 2008, declining by about 57 per cent and 51 per cent, respectively (Chart III.3). Stock prices of the non-financial sector also fell significantly, decreasing by around 41 per cent in the euro area and 36 per cent in the United States . There appears to have been greater initial contagion effects across financial stocks than total stocks in EMEs, perhaps reflecting the reliance of some of their financial institutions on external funding. A marked decline in the stock market performance of banks and finance companies in emerging East Asia relative to the overall stock market index reflected fears that banks in emerging East Asia could incur substantial losses in the aftermath of the crisis as economic growth slows. In general, most indexes of listed banks and finance companies on the Asian stock markets have performed below overall market indexes since August 2007.

3.33 In early 2009 the deteriorating global economic outlook as well as renewed concerns about the health of the financial system led to further declines in matured economy stock prices. Between the end of 2008 and February 27, 2009, the Dow Jones EURO STOXX and the Standard & Poor’s 500 indices declined by around 17 per cent and 19 per cent, respectively. In the second half of 2009, however, the matured economies’ stock prices posted some recovery with major stock indices in Japan, the euro area and the US gaining in the range of 10-15 per cent between December 2008 and October 2009. The Dow Jones Industrial Average crossed the 10,000 mark for the first time in a year on October 14, 2009 on the back of indications about US economic recovery. Between December 31, 2009 and June 16, 2010, however, the stock indices of Japan and Euro area declined by 5 per cent and 7 per cent, respectively, partly due to the uncertainty in the euro area growth prospects.

3.34 In contrast, the EME stock markets rebounded strongly in the first half of 2009, with the MSCI (All Country) Asia ex-Japan Index rising 68 per cent over its November 2008 trough, showing some return of risk appetite. During the year 2009 till October, the composite stock market index of China increased 66.4 per cent, perhaps reflecting the effects of China’s huge fiscal stimulus package. Despite the rebound across emerging East Asian equity markets, they remained below their levels at the beginning of 2008. Moreover, notwithstanding stock market recoveries, financial share prices have performed less favourably than overall market indices. India’s BSE crossed the 17,000 mark after a gap of 16 months (for the first time since May 2008) on September 30, 2009. As per the latest available trend, some of the emerging market stock indices recorded a decline over December 2009. For example, stock indices of China, Hong Kong and Brazil declined by 22 per cent, 8 per cent and 6 per cent, respectively, between end-December 2009 and June 11, 2010, while the others recorded marginal gains.

Corporate Bond Market

3.35 Corporate bond issuance from the EMEs declined sharply during the financial crisis amidst heightening of spreads, from the second half of 2008. In contrast, the corporate bond markets of advanced economies exhibited relative resilience during the crisis.

Advanced Economies

3.36 In the advanced economies, disruptions to non-financial corporate bond markets had been less severe than those seen in the credit or housing market during the recent financial crisis. However, there had been episodes of volatility in issuance and widening of spreads during periods of increased uncertainty in the global financial markets (Chart III.4). Overall, US corporate bond issuance has been much less affected than the US mortgage market, though there are reports that lower-rated firms have faced some difficulties in raising funds in bond markets during the crisis.

Emerging Market Economies

3.37 In recent years, cross-border corporate bond issuance in the form of Initial Public Offerings (IPOs) from some EMEs such as China, Brazil and Russia has rivalled developed economies in terms of their scale. Since the onset of the financial turmoil, international corporate bond issuance from EMEs fell sharply on account of both demand and supply factors (Table 3.8 and Chart III.4). On the demand side, firms might have decided to delay issuance in the hope of a return of more normal conditions in the coming months. Second, firms may have had access to other funds and, therefore, were reluctant to issue bonds into a relatively illiquid market. On the supply side, there may have been some reluctance to lend, as there was a desire by lenders to hoard liquidity in the face of uncertainty. In such a situation, lower-rated firms became most vulnerable to the global reassessment of risk, which often rely on raising funds in external markets where investors are generally more willing to bear the risk.

3.38 Emerging market bond spreads reached historical highs during the recent financial crisis, touching their peaks following the collapse of Lehman Brothers in September 2008 and continued to remain at elevated levels in the first and second quarters of 2009. The spreads, however, narrowed down substantially during the third and fourth quarters of 2009, with the pick up in the corporate bond isssuance from the emerging market economies (Table 3.9).

3.39 During the second half of 2009 the corporate bond markets functioned more normally, which is critical for countries like the United States that rely heavily on non-bank market financing. Corporate credit and asset-backed spreads had tightened significantly and issuance had risen as firms seek alternatives to scarce bank credit. High-end issuance had also increased though still restricted to higherquality credit, and spreads remained historically wide (IMF, GFSR Update, July 2009). In line with tentative signs of improvement in economic conditions, corporate bond issuance increased for most of the emerging market economies of Latin America and Asia in 2009, though some of the economies of emerging Europe, like Hungary and Russia have experienced some moderation (Table 3.8).

Impact on Government Bond Markets

3.40 Government bond markets all over the world were characterised by large swings in yields during the crisis period, driven mainly by direct and indirect consequences of the intensified financial crisis. During the recent crisis, due to declines in confidence levels and increases in counterparty risks, investors sought their way out mainly in the government instruments which at a certain point had a negative yield.

Advanced Economies

3.41 Amid high day-to-day volatility, long-term government bond yields in the euro area and the United States declined markedly, largely reflecting investors’ ongoing preference for highly liquid and safe securities, significant reductions in monetary policy rates, and eventually sharp downward revisions in the market’s outlook for economic activity and inflation.

3.42 As the crisis deepened, with continued decline in yields in government securities, a number of measures were announced both in the US and the euro area that aimed at supporting the financial system, strengthening consumer confidence, sustaining economic activity and ensuring credit availability for households and the corporate sector. Despite these measures, the declining trends in longterm government bond yields continued as investors shifted from stocks and other risky assets to sovereign bonds. In the US, the decline in bond yields was more pronounced than in Europe as US government bonds were viewed, on average, as being more liquid than euro area government bonds. At the end of 2008, euro area and US ten-year government bond yields stood at around 3.6 per cent and 2.2 per cent, respectively, which were 75 and 184 basis points lower than the levels prevailing a year ago (Chart III.5).

Emerging Market Economies

3.43 Within EMEs, generally, CDS spreads tended to rise earlier in countries with some external vulnerabilities or where governments rely on external debt financing or have lost some market confidence (Table 3.10). In the EMEs, until August 2008, sovereign debt bond spreads generally rose proportionately with CDS spreads, implying that repricing of risk was an important factor driving the rise in bond spreads over this period.

3.44 Since September 2008, however, spreads have risen sharply in the EMEs, reflecting a rise in global risk aversion that partly stemmed from concerns that slowing growth and financial turmoil in developed economies would increasingly spill over into EMEs. However, in contrast to developed economies, risk spreads for many EMEs remained below levels previously reached during periods of financial crisis in these economies.

Later on

3.45 Sovereign yield curves steepened considerably as conventional monetary policy easing anchored short-term rates, while the longer end of the curve rose sharply, reflecting in part improved recovery prospects, and reduced risk of deflation. With public debt levels expected to rise significantly in many mature market economies, increased focus on fiscal sustainability may have been reflected in sovereign credit default swap spreads remaining well above their pre-crisis levels (GFSR, July 2009 update, IMF). There has been a decline in sovereign debt spreads which has been driven almost entirely by improved global risk appetite and core market liquidity, whereas domestic economic fundamentals continued to deteriorate in many countries through the second quarter of 2009. More recently, some fundamentals have started to turn around, such as the external balance and official reserves, as well as growth prospects.

3.46 Bond yield curves shifted upward and also steepened in most of the emerging East Asian markets in the first half of 2009. The upward movement and steepening of the yield curves could be due to several factors, including (i) additional market liquidity as governments issued new debt to finance fiscal stimulus; (ii) expectations that the new liquidity could add to future inflationary pressures; and (iii) improved investor expectations about economic recovery. In China and Korea, where economic growth has been strong, there has been a significant upward shift and a slight steepening in the bond yield curves. In Malaysia and Thailand, concerns about the size of fiscal deficits may have caused the yield curves to steepen significantly as well as pushing them upward.

Recent Developments

3.47 Sovereign credit risk premiums have more recently widened across mature economies with fiscal vulnerabilities. Sovereign bond markets of some European economies came under renewed stress following the debt crisis in Greece. The rising investor concerns were mirrored in the Greek bonds and credit default swap markets. The possible loss of the ECB funding source pushed up CDS premia and yield spreads in Greek sovereign bonds. Yield spreads widened when the acute fiscal problems surfaced in Portugal and Spain. The spreads of Greek long-term sovereign bonds over German bonds rose to more than 650 basis points on April 27, 2010. In May, 2010, the EU and the IMF reached an agreement to assist Greece out of the crisis. The measures have been well received by the global financial markets so far, as reflected in terms of various indicators of the credit, government securities, and equity markets.

Impact on Foreign Exchange Market

Advanced Economies

3.48 Development in the forex market during the current financial crisis is a by-product of the developments in other financial markets such as money and credit markets which have tightened since August 2007. In the period immediately following the onset of the crisis, some pressures were noted in the foreign exchange swap markets, movements in which are generally guided by covered interest parity conditions. However, after the onset of the financial turmoil, there was a divergence between actual US dollar LIBOR rates and the implied US dollar rate from the LIBOR of the euro, pound and yen converted by the relevant foreign exchange swap, suggesting pressures in obtaining US dollar funding. Over time, spillovers emerged in the longer-term cross-currency basis swap markets as well (these are generally used for foreign currency obligations of one year or more), as it was perceived that dollar funding requirements were likely to persist. With the deepening of the crisis, US dollar funding once again became scarce in markets outside of the US, particularly in Europe, as reflected in the significant widening of the spread. To alleviate the demand for dollars from overseas, the Federal Reserve had significantly expanded its swap operations with other major central banks.

3.49 The increase in volatilities in the foreign exchange markets, in line with other markets, reduced the attractiveness of carry trade positions during the financial turmoil. Until early September 2008, the volatility of the currencies of the G-7 had been greater than that of EME currencies. Carry trades involve investors borrowing in a low-yielding currency and using the proceeds to invest in a highyielding one. The strategy implicitly relies on expectations that exchange rate movements will not fully compensate for the interest differential. However, volatility in markets raises the risk and reduces the rewards of carry trades. Carry trade positions have been partially unwound since the onset of the financial turmoil, and may have been a factor in some share market movements or currency movements for the destination countries, which generally have relatively high nominal interest rates – for example, Brazil, Colombia, Hungary, Iceland, Indonesia, Turkey and South Africa. On the other side of the transactions, appreciation pressures have been seen at times in some funding currencies (which are primarily developed economy currencies), especially the Japanese yen (IMF, GFSR, April 2009).

3.50 Among the advanced economies, the Japanese yen in real effective terms exhibited an appreciating trend, while the euro and the pound sterling depreciated during the initial period of the crisis (Chart III.6). Sharp appreciation of the real effective value of the yen since late 2007 has depressed Japan’s exports. In contrast, the tradable sector in the UK has benefited from a substantial reduction in the effective value of the sterling. A real depreciation of the euro also helped euro area exports in 2008, but the exchange rate appreciated during the first quarter of 2009. In the United States, however, the dollar’s appreciation during the second half of 2008 and the first quarter of 2009 implied that the exchange rate, on balance, has become more neutral in the evolution of trade over the past year. In nominal terms, both the euro and the pound sterling depreciated strongly against the US dollar betweeen March 2008 and March 2009, while the Japanese Yen appreciated against the US dollar during the same period. All these currencies, however, experienced nominal appreciation against dollar between March 2009 and February 2010.

Emerging Market Economies

3.51 Developments in the foreign exchange markets of the EMEs broadly reflected the developments in their equity markets. Capital outflows during 2008 and early part of 2009 significantly weakened currencies in some countries, notably India, Korea, New Zealand, and Vietnam. Several countries have responded by intervening to support their currencies, in contrast to the past several years when most Asian countries were concerned about the rapid appreciation of their currencies (Table 3.11).

3.52 The real effective exchange rates of Asian, Latin American and Central European currencies appreciated during the financial crisis till August 2008. Subsequently, real effective exchange rates (REER) have depreciated in line with the nominal depreciation in the exchange rate of these currencies against the US dollar (Table 3.12). The depreciations were in part the consequence of the strengthening of the US dollar with respect to the most important currencies of the world, a decline in the worldwide demand for Asian and Latin American exports, and strong negative pressures in the financial markets of the region. For the Middle East countries, however, the REER remained largely flat till October 2008 and their currencies have appreciated thereafter.

Later on

3.53 With the exception of Argentina and Brazil, the currencies of almost all the emerging market economies have reversed their decline and strengthened against the US dollar since the second quarter of 2009. In emerging Asia, the Indonesian rupiah, the Korean won, the Indian rupee and the Malaysian ringgit appreciated by 24.0 per cent, 19.4 per cent, 10.2 per cent, and 7.0 per cent, respectively, against the US dollar between end-March 2009 and end February 2010. Moreover, most Asian countries have strengthened their external positions – they are running current account surpluses, maintaining large foreign reserves, and diversifying exports to withstand the recession-induced unprecedented fall in their exports. There is clear evidence of recovery in capital flows to the EMEs, particularly, China and India. This has resulted in a appreciation of the currencies of most of the emerging market economies in the real effective terms since the beginning of 2010. With further reform in renminbi exchange rate regime announced on June 19, 2010, the exchange rate of many EMEs appreciated.

Impact on Commodity Market

Pre-Lehman: Rising Commodity Prices

3.54 The impact of the financial crisis on the commodity market has been indirect through changes in demand and supply of various commodities at various stages of the crisis. During the initial stages of the financial turmoil, commodity prices were pushed higher as investors sought to hedge against a depreciating US dollar and higher inflation. With the deepening of the financial crisis, as uncertainties and risk aversion in financial markets increased, investors switched to commodity markets. This reinforced a build-up of the commodity price bubble up to July- August 2008. The price of oil nearly tripled from US$ 50 in early 2007 to over US$ 140 in July 2008. Brent crude oil prices peaked on July 11, 2008 at US$ 147.5 per barrel. The case was similar with many other commodities which recorded multi-year peaks during the first half of 2008 (Chart III.7).

Post-Lehman: Declining Commodity Prices

3.55 The deepening of the financial turmoil since the collapse of Lehman Brothers in September 2008 and deteriorating global economic prospects ended the commodity price boom. The magnitude and volatility of price changes rose to unprecedented levels in the case of certain commodities. By the end of 2008, the IMF primary commodity price index had declined by almost 55 per cent from its peak in July 2008. Brent crude prices declined to around US$ 40 per barrel on account of lower demand due to the economic slowdown. OPEC’S decision to cut supply by a sizable portion failed to prevent prices from falling, amid expectations of an expansion in OPEC production capacities in 2009 and 2010 when new fields are expected to come online (ECB Annual Report, 2008). For the year as a whole, however, the average price of Brent crude oil was US$ 98 per barrel during 2008, which was 35 per cent above the average of the previous year.

3.56 Like oil, the prices of non-energy commodities were volatile throughout 2008. During the second half of 2008, as energy prices started to decline, non-energy commodity prices followed. Metal prices, which started to decline in 2007, dropped more sharply in the second half of 2008 and in early 2009. Food prices have also fallen, although not as dramatically as oil prices because of their relatively weak link to global growth.

3.57 After bottoming out in February 2009, commodity prices recorded sharp recovery thereafter. By the end of 2009, the IMF commodity price index had risen more than 40 per cent from its trough, mainly due to large increase in the petroleum and metal prices (Table 3.13). Petroleum prices strengthened with improved global economic and financial conditions. The sharp price rebound in metal was mainly driven by stronger than expected recovery in the emerging economies (China in particular), as well as sustained cut in production.

Impact on Housing Market

Advanced Economies

3.58 The decline in US home prices was the most important trigger for the market turmoil which has persistently affected many mature economy financial systems since August 2007. In most euro area countries, the deceleration in property price inflation, which characterised 2007, continued in 2008 with prices (including commercial property prices) even falling in some countries. On the positive side, the deceleration in the growth of loans to the household sector and a decline in house price inflation contributed to a moderation of the risks. However, a less favourable outlook for the labour market and for households’ disposable income points to a possible emergence of risk in the ability of households to service their debts (Box III.1).

Emerging Market Economies

3.59 Housing prices in emerging Asia have not experienced the sharp decline witnessed in the US or EU (Chart III.8). The declines in emerging Asian housing prices have been moderate and are nowhere near as pronounced as those seen in the region’s equity markets. Intuitively, property prices are determined by local conditions and there is much less scope for contagious effects from industrialised countries, in particular the US.

3.60 To sum up, almost all segments of the global financial markets experienced tremors of the financial crisis, though to varying degrees. The interbank market was one of the first financial market segments to be affected by the crisis. The interbank markets of the mature economies suffered from a severe liquidity crisis as banks became reluctant to lend to one another for fear of counterparty risks. Later, the crisis spread to the money markets taking the form of abnormal level of spreads, shortening of maturities, and contraction, or even closure, of some market segments. The sharp slowdown in credit growth worked as a channel for transmitting the crisis from financial institutions to the real economy, particularly in the advanced economies where banks seek to reduce leverage and rebuild capital bases. Global stock markets, particularly the emerging stock markets, have borne much of the heat of the crisis as equity markets all over the world witnessed high volatility and sharp declines in prices, turnover volumes and market capitalisation. During the second half of 2009, however, there have been some signs of recovery in the health of global stock markets. Commodity markets have also witnessed significant corrections since the second half of 2008 following the adverse impact of the crisis. Government bond markets all over the world witnessed large swings in yields driven mainly by the direct and indirect consequences of the intensified financial crisis. Corporate bond markets of advanced economies exhibited relative resilience during the current financial crisis even though corporate bond issuance from the EMEs declined significantly amid heightening of spreads, since the second half of 2008.

3.61 Policy interventions on an unprecedented scale, encompassing quantitative and credit easing policies, extraordinary liquidity measures and government guaranteed funding programs have helped restore normalcy in the functioning of short-term money market, equity and corporate bond markets and the foreign exchange market. Credit growth on the other hand, continued to remain sluggish in most of the advanced economies and some of the emerging market economies reflecting both supply and demand side weaknesses. While commodity prices started gaining strength with the global economic recovery, sovereign bond markets have come under pressure in some of the mature market economies, with weak fiscal fundamentals.

Box III.1
Impact of Declining Asset Prices on Household Wealth

Over the past few years, a combination of factors, like the asset price boom, robust economic growth, rapid financial innovation and low interest rates generated speculative bubbles in the matured economies, which encouraged banks, other financial institutions, households and firms to leverage their balance sheets by increasing their borrowings. Therefore, during the financial crisis, once asset prices started to decline, high debt burdens turned out to be unsustainable, especially as subdued activity began to limit economic growth. This led to a sharp deterioration in household wealth, among others which, in turn, emerged as a key factor leading to the sharp downturn in economic growth.

In the aftermath of the sub-prime crisis, the wealth effect of asset prices and its relevance in conditioning consumer behaviour and decisions relating to consumption and saving have assumed major policy significance. Within asset prices, the decline in equity prices and nominal house prices had the most pronounced impact on household wealth. Declining house prices impact household wealth from both directions. While declining asset prices have a direct negative impact on household wealth, falling house prices imply a reduction in the implicit rental cost of housing, offsetting some of the negative wealth effects. Moreover, lower prices make houses more affordable for prospective homeowners, reducing their need to save for a given down payment. However, during the current financial crisis, in general, these positive effects could not offset the negative impact of declining asset prices on household wealth.

Overall, from the second quarter of 2007 to the fourth quarter of 2008, US households lost around 20 per cent (about US$ 13 trillion) of their net worth; as a percentage of disposable income; this loss was greater than the wealth accumulated over the previous five years. Wealth losses in the euro area have also become more widespread across assets and countries. Decline in household wealth, particularly in the matured market economies due to erosion of asset prices, had direct implication for consumption expenditure. The economic literature suggests that consumption expenditure of households depends on a number of factors, including real interest rate, income uncertainty, growth rate of nonproperty income, liquid assets, illiquid financial assets, and housing wealth (Muellbauer 2008). The impact of wealth contraction on consumer expenditure is likely to vary across countries depending on institutional arrangements. Although researchers disagree on the estimates of the wealth effect on consumption, the impact of housing wealth is generally assumed to be significant – ranging in several studies between 3 and 7 cents per dollar in Australia, Canada, the United States and the United Kingdom. It is assumed to be relatively small for the euro area. Equity extraction from housing wealth was significant in Australia, Canada, the United Kingdom and the United States during the upswing, so household spending is likely to be more affected in these countries than in others. Some estimates suggest that in the United States about 1.75 per cent of consumption annually was financed through home equity withdrawals during 2001– 05, or 3 per cent if withdrawals used to repay nonmortgage debts are included. In the United Kingdom, home equity withdrawal has reversed, plummeting from over 7 per cent of post-tax income in 2003 to –1 per cent in 2008. By contrast, equity extraction played a relatively minor role in household spending in the euro area as a whole because of both a low home ownership ratio and, in some countries, a less developed mortgage market.

With consumption deteriorating faster than income, household saving rates increased in several advanced economies, particularly in those where they had been low. The United States recorded a sharp rise in savings of almost 4 percentage points of disposable income (to 4.2 per cent) between the last quarter of 2007 and the first quarter of 2009. Australia and the United Kingdom also saw a jump in household savings, from almost zero and a negative saving rate in the first quarter of 2008 to 8.5 per cent and 4.8 per cent, respectively, in the fourth quarter. The propensity to save of euro area households also increased markedly, with the saving rate rising by 1 percentage point (to 15.1 per cent) in the final quarter of 2008. In addition, the steep decline in the value of pension fund assets may force individuals nearing retirement, who have defined contribution pension schemes in which benefits are linked to the market value of assets, to increase saving or defer retirement. In the case of defined benefit plans, the large funding gaps could harm the financial position of the corporations sponsoring them and reduce their ability to provide guaranteed benefits or maintain existing employment.

References

1. Bank for International Settlement. 2009. 79th Annual Report.

2. European Central Bank. 2009. ECB Annual Report 2008.

3. Muellbauer, John. 2008. “Housing, Credit and Consumer Expenditure.” CEPR Discussion Paper No. 6782. April.

II. IMPACT ON FINANCIAL SYSTEM

3.62 As discussed in the previous chapter, the flawed institutions and practices of the New Financial Architecture – characterised by a globally integrated system of giant bank conglomerates and the ‘shadow banking system’ comprising investment banks, hedge funds and bank-created Special Investment Vehicles – were possible factors behind the recent financial crisis. Naturally, therefore, the recent financial crisis had the most severe impact on financial institutions, particularly of the advanced economies. The crisis has brought to the forefront the major weaknesses inherent in the US financial system and the regulatory framework that did not recognise the systemic risks posed by the ‘shadow banking system’ and the build-up of housing and credit bubbles. Over time, the ‘shadow banking’ institutions became almost as important as commercial banks in providing credit to the US economy, but were not subject to the same regulatory controls. On the other hand, these entities were vulnerable because they borrowed short term in liquid markets to purchase long-term, illiquid and risky assets. Moreover, these institutions as well as certain regulated banks had also assumed significant debt burdens and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. All these factors together made the US financial system increasingly fragile and vulnerable to crisis.

3.63 At the onset of the crisis, as the US real estate bubble burst, rapid devaluation of mortgagerelated assets led to massive write-downs on financial institution balance sheets, eroding their capital base. Disruption in the credit markets subjected them to rapid deleveraging and sell-off of their long-term assets at depressed prices. This gave rise to mounting losses on the balance sheet of the financial institutions. The collapse of two Bear Stearns funds in June 2007 marked the onset of the sub-prime crisis. The crisis, however, turned worse in September 2008 when, within a few days, Lehman Brothers filed for bankruptcy, Merrill Lynch was bought by Bank of America, and American International Group (AIG) received a rescue package from the US Federal Reserve (US Fed). This was accompanied by the failure of a number of significant financial institutions. These developments resulted in unprecedented policy interventions including large bailouts by the US government and central banks, which led to dramatic changes in the US financial landscape.

3.64 The pressure built up in the US financial system spread rapidly to Europe. In Europe, one of the first victims of the crisis was the British bank, Northern Rock, which had to request security from the Bank of England. This led to investor panic and a bank run in mid-September 2008. In Europe, apart from the UK, the crisis was also transmitted rapidly to the euro area, which had deep financial linkages with the US. Many banks as well as other financial institutions in the euro area, such as insurance companies and asset managers, had large exposures to US assets. Many of them were over-leveraged and depended on benign conditions for liquidity to continue flowing. As a result, with the onset of the crisis in the second half of 2007, financial institutions including large and complex banking groups (LCBGs) in the euro area started getting affected. For LCBGs, financing became more expensive and difficult to access, thereby adding pressures on these institutions to reduce the size of their balance sheets (ECB Financial Stability Report, December 2008). As early as September 2007, companies and non-banking financial institutions accelerated their withdrawal even from the short-term financing of banks, and the banks were increasingly losing confidence in extending loans to one another, leading to a rapid rise in the costs of financing. As a result, credit to the real sector almost stopped and many of the institutions were only able to make overnight borrowings.

3.65 With limited direct exposures to riskier assets and derivatives, financial sectors in most EMEs were not impacted severely, although a decline in investor confidence led to fears of bank vulnerabilities in the case of some EMEs. This prompted authorities in those EMEs to take measures such as implementing deposit guarantees and making liquidity available to domestic banks to reassure depositors and counterparties. The banking system in emerging Europe was more vulnerable as it relied significantly on funding from external banks and from bond issuance. In these countries, lower-rated banks were exposed the most to drying up of external finance.

Impact on Banks

3.66 The report of the London Summit, 2009 identified three distinct phases through which the banking industry has been affected by the current financial crisis. In the first phase, market participants realised that they had underestimated the risks associated with a number of structured loans. Demand for these products fell sharply, driving down their prices. As no bank knew which other bank was more exposed to these assets, they became wary of lending to each other. In the second phase of the crisis, banks started announcing losses made on structured loans and other impaired assets. These losses, combined with deteriorating macroeconomic conditions in the advanced economies, turned uncertainty about the value of impaired assets into concerns about the solvency of a number of banks. In the third phase, the failure of the large US investment bank, Lehman Brothers, triggered a sharp intensification of the crisis. Banks stopped trusting each other and their customers stopped trusting their banks. There was loss of confidence in the international financial system. Starting with the UK’s recapitalisation plan in October 2008, a large number of governments adopted policies that restored trust in the banking system. In this phase, however, bank losses were more closely connected to borrowers’ defaults owing to deteriorating macroeconomic performance Bank losses in Asia were the least, reflecting limited direct exposures to impaired assets and relatively sound macroeconomic fundamentals (Chart III.9).

Commercial Banks

3.67 During the current crisis, the pro-cyclicality in banking, i.e., lowering of lending standards in an upturn and tightening of lending standards in a downturn, was exposed. The profitability of banks plunged in 2008 owing to the realisation of losses on mark-to-market (securities) portfolios, the progressive deterioration of loan books as the economic slump deepened, and increases in operating costs. Although the decline in bank profits was a global phenomenon, the way banks have been affected by the crisis has differed somewhat according to the circumstances in their respective home markets (Table 3.14).

Advanced Economies

3.68 The pre-tax profits of US banks more than halved in 2008 compared with the previous year. There was a surge in US bank failures in 2008 during which a total of 25 deposit-taking institutions failed; their combined assets were US$ 372 billion, about 10 times higher than during the previous peak in bank failures in 1993 (Chart III.10). The failure of Washington Mutual alone accounted for US$ 307 billion of the total and was the largest US bank failure in history. The bank was eventually absorbed by JPMorgan Chase, another large bank, with the assistance of the supervisory authorities. Besides the failed banks, the number of institutions on the US deposit insurer’s list of problem banks swelled to 252 with total assets of around US$ 159 billion. Further large bank failures were averted as weakened institutions were acquired by others with healthier balance sheets.

3.69 In Europe, profits plummeted across the board with banks in the UK, Switzerland and the Netherlands registering net losses from their exposure to structured finance investments. The slowdown in real estate markets posed large challenges to banks in Spain, Ireland and the UK. Certain German banks were also affected by real estate exposures, albeit mainly indirectly through securities positions and exposures to commercial property. In Germany, the crisis led to the restructuring of the domestic banking sector as it acted as a catalyst for a number of bank mergers (ECB Annual Report, 2008). French and Italian banks were less affected by losses on structured finance investments given their stronger focus on the domestic retail market. A number of European lenders averted outright bankruptcy through direct support from the public sector. As a manifestation of the global financial crisis, the market capitalisation of the euro area’s large and complex bank groups (LCBGs) collectively dropped by almost Euro 200 billion between mid-September and late November 2008, bringing the cumulative decline since the turmoil erupted to around Euro 450 billion, which is more than half the aggregate market value of these banks immediately prior to August 2007.

3.70 Having put the loan problems of the previous decade behind them, Japanese banks were thought to be in a position to gain from the weaknesses of their international competitors. In the initial months of 2008, the Japanese banking industry showed relative resilience to the financial crisis mainly because of smaller exposures to subprime and structured products. However, with the progress of the crisis, the profitability of Japanese banks turned poor, partly because of their structurally narrow net interest margins. Consequently, their capital base weakened. Moreover, any plans for international expansion were put on hold in the second half of 2008 when the domestic economy fell into recession and losses intensified.

3.71 In sum, during the initial phase of the crisis, banks mostly faced funding pressures and markto- market losses. As the macroeconomic situation worsened from September 2008, financial institutions faced increasing pressure on earnings and mounting losses on their credit risk exposures (Table 3.15). Bank losses witnessed a shifting pattern in line with the evolution of the crisis. Initially bank losses/write-downs were closely linked to traded portfolios of structured finance products and securitised exposures to the sub-prime mortgage market. Losses were exacerbated by illiquidity in the markets for those instruments, which led to substantial reductions in their mark-to-market valuations. While there was considerable uncertainty about the magnitude of the losses and their distribution across the system, they were perceived as being contained within a certain class of assets. At a later stage, bank losses/write-downs became more directly linked to a surge in borrower defaults and to anticipated defaults, as evidenced by the increase in the amount and relative importance of provisioning expenses on account of slowdown in economic activity. Loan loss provisions as a fraction of bank assets were higher in 2008 than in previous years. Compared with 2007, the rate at least doubled for Australian, French, Swiss and US banks and jumped even higher in the case of German, Dutch and Swedish lenders.

Emerging Market Economies

3.72 Although the banking sector of most EMEs remained sound, a decline in investors’ confidence led to fears of bank vulnerability in some of the EMEs. Moreover, the significant presence of foreign banks within many EMEs, particularly in Europe and Latin America, raised a further potential source of contagion during periods of financial stress. Banks in emerging Europe relied heavily on external financing, with the foreign banking sector being an important conduit for funds. Banks in Asia remained relatively resilient.

3.73 The relative resilience of emerging Asia’s banking and financial systems during the current financial crisis reflects a number of factors: (i) the Asian financial system was bank-dominated and banks generally had not invested in the illiquid assets, which were at the heart of the current financial crisis; (ii) Asian financial institutions had limited exposure to US sub-prime mortgages and structured credit products mainly on account of the more cautious risk management and the strengthening of the regulatory structure that resulted both from Japan’s banking crisis in the late 1990s and the 1997 financial crisis in emerging Asia (Table 3.16); (iii) relatively strong bank balance sheets with a return to profitability, as impaired loans from the 1997/98 Asian financial crisis have been worked off; (iv) improvements in risk and liquidity management; (v) strengthening of supervisory and regulatory systems; and (vi) moves by banks into new and profitable domestic business lines, such as consumer lending. The move into consumer lending implies an absence of the strong search for yield that led many banks and other financial institutions in industrialised countries to take on too much leverage and risk (Asian Development Bank, 2009).

3.74 Asian banks had limited exposures to US sub-prime mortgages and a very small percentage of the write-downs reported globally since the subprime debacle originated in Asia, the bulk of which were concentrated in Japan and to a lesser extent in China. Meanwhile, Asian banks have raised large amounts to boost their capital positions. The new capital not only replenished depleted amounts, but also cushioned against potential losses arising from future problematic loans.

3.75 Banks across the Asian region also held generally comfortable domestic currency liquidity cushions. During the current global crisis, a lower loan-to-deposit ratio (less than 1) in the case of many countries implied an absence of liquidity risk arising from foreign liabilities (Table 3.17). Loanto- deposit ratios across the region, with the exception of Korea, have been rather conservative and many banking systems report high ratios of short-term assets to liabilities. These cushions reflect the increased attention to liquidity management since the 1997-98 crisis along with relatively subdued levels of lending to the corporate sector in recent years. Various indicators suggest the overall soundness of the region’s banking systems in terms of profitability and operational efficiency. Some pressures on domestic currency liquidity were, however, seen in a number of countries during the later stage of the crisis.

3.76 In view of the emphasis on strengthening capital requirements in recent years, the riskweighted capital adequacy ratios (CRAR) were comfortable and continued to provide a strong capital cushion to the banks in emerging Asia and Latin America (Table 3.18). This was true even in Korea where the banking system was relatively more vulnerable given the greater reliance on external borrowing. During 2008, the ratio of non-performing loans to total loans generally decreased in the Asian economies, while it increased in advanced countries perhaps reflecting the impact of the crisis. Within Asia, in countries like Hong Kong, Korea, Indonesia and the Philippines, the ratio of non-performing loans to total loans was comparatively higher in 2009; the same trend was seen in emerging Europe.

3.77 Like emerging Europe, some Latin American EMEs had a large presence of foreign banks. Mexico had a concentrated exposure with around 40 per cent of its banking assets held by just two foreign banks. However, in contrast to emerging Europe, many of these foreign banks were locally funded, highly profitable and contributed to overall group income. Moreover, commercial banks in Latin America did not invest to any significant degree in ‘toxic’ financial instruments, but they had been hit by the sharp contraction in external credit. The institutions in Latin America were not exposed significantly to external risks as they focused mainly on domestic markets, which resulted in not incurring risks similar to financial institutions in the advanced countries and in emerging Europe. Latin America had also been helped by the relatively small size of the national financial systems and strong supervision and prudential regulations (ADB, 2009).

Later on

3.78 Bank failures in the US continued in 2009 and 2010, even as the US economy showed tentative signs of recovery. As per the records of Federal Deposit Insurance Corporation (FDIC), there are reports of 83 bank failures in the US in the first half of 2010. Notwithstanding the bank failures, confidence in the US banking system has been bolstered by better-than-expected earnings, a successful stress testing exercise, the commitment by the US government to stand behind the largest banks, and a series of bank capital raising. However, the loss ratios continue to remain high. In Europe, universal banks have also benefited from better earnings and capital increases. Given largely domestically-focused business and relatively strong economic activities, the profitability of emerging Asia’s banking systems generally remained high and Asian banking and financial systems weathered the financial turmoil relatively well. Despite generally good profits and low non-performing loan ratios, increased signs of stress in the financial sector emerged in a number of Asian economies, largely due to falling income from fees and commissions amid the economic deceleration. Overall, however, the emerging Asian banks continued to remain in good health till date.

3.79 In the recent months, some of the European banks having exposure to euro area countries facing market pressures (Greece, Ireland, Portugal and Spain) have come under renewed stress. French and German banks were particularly exposed to the residents of those four countries, with a combined exposure of US$ 958 billion at the end of 2009. Banks headquartered in the United Kingdom, on the other hand, had large exposures to Ireland (US$ 230 billion). Government debt, however, accounted for a smaller part of euro area banks’ exposure to those countries than claims on the private sector.

Investment Banks

3.80 The crisis has impacted the banking industry as a whole, but investment banking seems to have taken a more severe blow than commercial banks. During the boom phase in 2004-07, the top five US investment banks (Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs and Morgan Stanley) significantly increased their financial leverage, which increased their vulnerability to a financial shock. These five institutions incurred over US$ 4.1 trillion in debt for fiscal year 2007, which constituted about 30 per cent of US nominal GDP. The crisis left deep scars on these institutions. The magnitude of their losses reached very high levels as all lines of business were affected. Securities underwriting declined during 2008 as primary market issuance slowed and associated revenues fell. In comparison, the merger and acquisition advisory business held up better, although it also slowed in the first quarter of 2009. More generally, investment banking operations were reduced across the board.

3.81 During the crisis, large holdings of highrisk structured securities and unhedged exposures in the securitisation pipeline were marked down dramatically. The illiquidity of asset and funding markets proved particularly challenging for the investment banks, which could no longer rely on an increasing volume of transactions to generate revenue growth or on cheap and readily available short-term financing to support high levels of leverage. As a result, firms’ balance sheets shrank in size and employment in these institutions declined radically. Staff strength at Bear Stearns and Lehman Brothers were cut by more than half as their operations were taken over by other institutions. Decline in staff strength at other firms broadly mirrored the size of their realised losses. The net revenue for the largest investment banking operations was estimated to have fallen by more than 90 per cent in the third quarter of 2008 compared with the same period a year earlier, as market activity seized up.

3.82 As a result of the deep impact of the crisis, Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at low prices, and Goldman Sachs and Morgan Stanley turned into commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman Brothers, all these institutions required or received government support. On the other hand, Fannie Mae and Freddie Mac, the two US government-sponsored enterprises, owned or guaranteed nearly US$ 5 trillion in mortgage obligations at the time they were placed into conservatorship by the US government in September 2008. These seven entities were highly leveraged and it is estimated that they together had US$ 9 trillion in debt or guarantee obligations reflecting an enormous concentration of risk, yet were not subject to the same regulation as depository banks.

Insurance Funds

3.83 During the crisis, insurance companies faced adverse conditions on both sides of their balance sheet due to lower long-term interest rates and asset price declines. The impact of the asset market slump was reflected primarily in the performance of financial asset portfolios of the insurance companies. Insurance companies suffered losses as prices fell across a broad array of asset classes. For life insurance companies, the decline in the level of long-term yields also meant an increase in liabilities on long-maturity policies.

3.84 The market capitalisation of insurance companies came under similar pressures as banks due to exposure to risky assets (notably, mortgagerelated securities and commercial real estate loans) and as a result of weakening macroeconomic conditions. For the majority of insurance companies, the main effect of the crisis has been on their financial performance rather than on premium income. The firms affected most by the crisis were those involved in the provision of credit risk insurance. Monoline insurers (more formally known as Finance Guaranty Insurers), which specialise in the provision of credit guarantees, have been a conduit for contagion across markets during the crisis. The protection that they offer is dependent on their maintaining a high credit rating (usually AAA). However, as losses mounted, credit ratings of most monolines were downgraded, which placed pressure on the ratings of all the debt that they had insured, reflecting the higher probability that investors will face losses. As the creditworthiness of borrowers declined, concerns about the ability of monoline insurers to honour their guarantees mounted and led to significant mark-to-market losses for banks that had purchased insurance.

3.85 Some global insurers continued to report large losses during the second half of 2008, in particular due to their insurance underwriting of credit and structured credit products. The US insurer, AIG, suffered heavy losses during the second and third quarters of 2008. These troubles led to rating downgrades in September 2008, which forced the insurer to post collateral payments on derivatives trades. AIG was unable to raise enough capital to satisfy demands for collateral quickly enough, which resulted in the Federal Reserve Bank of New York offering AIG a two-year loan of up to US$ 85 billion to give the ailing insurer the opportunity to sell some of its assets in an orderly fashion. In return, the US government received an equity interest of 79.9 per cent in AIG. The nearcollapse of AIG was directly linked to the underwriting of credit risk. Its write-downs surged along with soaring CDS spreads (Chart III.11). The size of its liabilities and the central role its credit derivatives operation played as counterparty in the over-the-counter market repeatedly necessitated extraordinary official intervention to provide substantial financial support.

Hedge Funds

3.86 Hedge funds, along with institutional investors, are considered to be a major channel of financial transmission from advanced to emerging market economies and they have been instrumental in the development of local markets. Hedge funds, in particular, have been important for providing liquidity to financial markets in EMEs and facilitating genuine hedging activities. Although hedge funds had not played a central role in shaping the dynamics of the crisis, they were also been severely affected by the financial crisis. Hedge funds performed very poorly during 2008 with almost all investment strategies showing negative results as returns in asset markets plummeted and the cost of funding soared. As counterparties pressed for increased transaction margins and investors withdrew funds on an unprecedented scale, the industry contracted sharply. Estimates of assets under management shrank by more than one-third in the course of the second half of 2008, with bad performance and customer withdrawals playing an equal role in the decline. A number of funds closed. Many fund managers attempted to preserve capital by restricting withdrawals, thereby lengthening investors’ effective lock-in period.

3.87 Outflows of foreign capital from emerging equity markets and subsequent depreciation of their currencies were attributed to unwinding of positions by some global hedge funds (Table 3.19). Interestingly, Asia-focused hedge funds have been among the worst performers worldwide, with their returns consistently below those of other emerging market funds (Finance and Development, IMF, December 2008).

3.88 On the positive side, the crisis is likely to accelerate the trend towards greater institutionalisation and transparency within the hedge fund industry. It is already evident that to avoid the fate of smaller funds that were liquidated as a result of investor withdrawals, many larger funds have oriented their marketing towards institutional investors. Such a shift demands greater transparency about the investment strategy and greater scrutiny of risk management processes. Responding to the challenges of the investment environment, some of the larger funds introduced lower fee schedules and processes that pay closer attention to the needs of large institutional clients. Finally, a number of official recommendations for the reform of the prudential framework imply tighter oversight of the industry. Such reforms include the registration of all hedge funds, more demanding reporting requirements for the larger funds and direct supervision of those whose operations have implications for systemic stability.

3.89 To sum up, financial institutions were the worst sufferers of the financial crisis. With the onset of the crisis, commercial banks suffered from a decline in profitability and large mark-to-market losses, which later gave rise to bank failures in the US and other mature economies in Europe. The banking system of the emerging market economies, on the other hand, reflected relative resilience during the crisis on account of their limited exposure to the affected asset classes and the regulatory and supervisory measures taken to strengthen their balance sheets in the aftermath of the East Asian crisis. The crisis almost sidelined the investment banking industry, which was instrumental in triggering the crisis. The crisis also heavily impacted the financial performance of monocline insurers and hedge funds and, in the case of the latter, the crisis accelerated the trend towards greater institutionalisation and transparency.

III. IMPACT ON THE EXTERNAL SECTOR

International Trade

Trade Openness

3.90 The volatilities in the financial markets along with the slowdown in economic activities in the advanced economies were transmitted to the EMEs through both trade and financial channels on account of the increased global integration witnessed in recent years. Over the past quarter-century, the growth in world trade at about 6 per cent was almost double the rate of world output. As a result, the share of world trade in world GDP increased and stood at over 53 per cent in 2008 (Chart III.12). Apart from trade liberalisation, this can also be attributed to rapid developments in financial markets which led to financialisation of global trade. But the same developments also widened the scope for economic turmoil when global conditions deteriorated. For instance, trade finance which is now being increasingly used for financing trade was severely affected during the crisis as the financial markets tumbled.

3.91 The rising importance of trade in the global economy masks the underlying regional variations. For example, Asian exports grew at an average rate of above 10 per cent and those of Latin America and the Caribbean by about 7 per cent, which are higher than the world average of 6 per cent during the past quarter-century. This led to increasing openness of these economies as reflected in the share of their trade in GDP (Table 3.20). The share of international trade in developing countries’ output grew from 35 per cent in 1980 to 57 per cent in 2007. The sharp increase in trade not only created new markets for producers in the developing world but also lowered prices for consumers. The growing integration of developing economies with the global economy and the increasing importance of their firms and households in international finance over the past decade have brought enormous economic and financial benefits. But rising trade integration also widened channels through which a slowdown in economic activity in advanced economies could spread to the EMEs.

3.92 During the recent financial crisis, the evolution of international trade has mirrored that of economic activity. International trade flows, which had grown robustly in recent decades mainly on account of waves of liberalisation, suddenly abated by the end of 2008 and then strongly contracted in some areas, further propagating the effects of the crisis across countries. According to the IMF’s estimates, world trade (goods and services) contracted by 10.7 per cent in 2009 after recording a subdued growth of 2.8 per cent in 2008 (Table 3.21). World trade volumes fell on three other occasions after 1965 ( 0.2 per cent in 2001, 2.0 per cent in 1982, and 7.0 per cent in 1975), but none of these episodes approached the magnitude of decline observed in 2009. The decline in world trade volume was much higher than the earlier plunge, showing the large impact of the recent financial crisis through the increased integration of global trade across countries. According to the World Trade Organisation (WTO), the year 2009 witnessed the sharpest decline of 12.2 per cent in world trade in more than 70 years. Currently, world trade is in a recovery phase and set to rebound in 2010 by growing at 9.5 per cent (WTO, 2010).

What Explains the Steep Fall in Trade?

3.93 The declines in trade flows since October 2008 were larger than in past slowdowns due to several factors. First, the impact of the US sub-prime crisis had its first-order impact on shortages of liquidity in the advanced economies through the loss of assets. With the loss of wealth, households in the US and in European countries responded by cutting their discretionary spending. This seems to have had a particularly pronounced effect on demand for manufactured goods. The contraction in consumption demand along with investment demand in the major economies led to a sharper fall in the imports of the advanced economies. These developments were reflected in the sudden fall in exports from EMEs, particularly those where a major portion of the exports were to crisis-hit advanced countries (Chart III.13). Second, the decline in trade growth from October 2008 was due not only to volume decline but also to sharp reductions in prices in line with the decline in demand. This decline in the EMEs’ export prices was sharper than the fall in import prices of the advanced economies, which was reflected in the large decline in EME exports in value terms. Third, the sharp declines in trade flows can be attributed to the increasing presence of global supply chains in total trade; goods cross many frontiers during the production process and components in the final product are counted every time they cross a frontier (WTO, 2009). Fourth, there was a shortage of trade finance (discussed later). Fifth, the rising tendency for protective measures could contribute to trade contraction, although there is no clear evidence on this count. Sixth, the decline in spending on consumer durables in advanced countries over the second half of 2008 has sharply reduced EME exports of automobile and information technology (IT) products. In the recent downturn, the inventory-to-sales ratio of electronic goods had risen sharply in East Asia, and their exports and production had decreased.

Impact across Regions

3.94 The impact of declining trade was felt across all regions, although the extent varied depending on the importance of manufacturing exports in the economy (Chart III.14). Among developed countries, Germany and Japan, for instance, have been worse affected by their declining exports of manufactures than other countries. It is mainly the demand for investment and durable consumer goods that was severely affected. This is not only because the consumption of such goods can be more easily deferred than that of food and basic services, but also because their acquisition partly relies on credit, which was more difficult and costly to obtain. As a result, countries that have a high share of investment and durable consumer goods in their total output experienced a larger fall in industrial production and overall GDP growth than others. Australia and Canada were also affected by a fall in commodity prices. In Latin America, exports have fallen in all countries, but the impact of the crisis has been particularly strong in countries such as Mexico where GDP was contracting rapidly since the last quarter of 2008. Mexico relies heavily on exports of manufactures to the United States, and they had also been affected earlier and to a greater extent than other countries due to lower income from tourism and workers’ remittances.

3.95 Against the backdrop of increased global integration and specialisation in manufacturing production chains, developing economies in Asia experienced a strong contraction in economic activity following the slowdown in advanced economies (Box III.2). The synchronised fall in exports intensified in the first quarter of 2009 with an average year-on-year decrease of around 25 per cent in most EMEs (Table 3.22). In other Asian countries, such as China, India and Indonesia, declining exports of manufactures have had a less dramatic effect on industrial output and GDP owing to their large and still expanding domestic markets.

3.96 The global economy is now beginning to pull out of the recession. Emerging Asia is leading the global rebound and looks set to emerge from the global downturn both faster and stronger than any other region. This quick turnaround in Asia benefited greatly from policy stimulus, and public demand more than offset the drag from net exports. Going forward, Asia will not be able to count on strong external demand at least in the near term as global recovery is expected to be sluggish. It is essential to build the foundation of sustained growth through infrastructure and financial development and improvements in corporate incentives, rather than relying too much on export demand. Further, by developing or improving social safety nets and healthcare systems, many emerging and developing economies can boost domestic consumption.

Trade in Services

3.97 The global financial and economic crisis has also affected trade in services. The growth of world exports of transport, travel and other commercial services decelerated from 20 per cent in 2007 to 12 per cent in 2008 (Table 3.23). Based on available data, year-on-year global exports of commercial services in the fourth quarter of 2008 fell by 7–8 per cent (WTO, 2009). Exports of transport services rose 16 per cent in 2008, while travel services and other commercial services increased by 11 per cent and 12 per cent, respectively. Maritime transport services reacted rapidly to the slowdown of global demand. Data on the deployment of both dry and liquid bulk, as well as on container ships, confirm an increasing withdrawal of vessels from service. Accordingly, the crisis led to reduced port traffic. In addition, freight rates fell substantially during the final months of 2008. After reaching a peak in May 2008, the Baltic Dry Index plunged to its lowest level by the end of October 2008. The world export of commercial services declined by 13 per cent in 2009 with transportation services contracting by 21 per cent.

Box III.2

Why Asian Exports Were Worst Affected

East Asia has particularly benefited from trade liberalisation as reflected in the export-led industrialisation in these countries. This is perceived to have led to intra-regional spillover effects, mainly emanating from technological transfers through direct investment from Japan, and indirectly from “hollowing out” of the industrial economies. Each shift in the industrial focus of the Japanese economy, from light to heavy electronics and hi-tech industries, created market opportunities for other economies in the region such as Korea and Taiwan. Even within the electronics industries, mid-range goods gradually began to be supplied by Korea, Taiwan, Singapore, and Malaysia, and only the most sophisticated goods were produced in Japan. More recently, as Korea, Taiwan and Singapore started specialising in the heavy and hi-tech goods sectors, the light industries were picked up by Thailand, the Philippines and Indonesia.

This sequence of industrialisation, often called the “flying geese pattern”, succeeded in the East Asian economies in passing on the comparative advantages in manufacturing from a leader to the followers, and then to the followers’ followers. A sequential pattern of industrialisation was observed from the agricultural sector to the industrial sector with small capital requirements to heavy and petrochemical industries, and to precision and electronics industries, with latecomers repeating the changes in industrial composition. High exports growth in the Asian countries has been possible on the back of a strong domestic industrial sector which created a base for sustainable growth. The value added in the industrial sector during the high-growth phase exceeded 10 per cent (per annum) in these economies. Today, several developing economies in Asia are part of a manufacturing supply chain for exports to advanced economies. In some of these countries, like Malaysia, the Republic of Korea, Singapore, Taiwan and Thailand, exports of manufactures represent a substantial share of their GDP.

On the back of rising manufacturing exports as well as strong domestic fundamentals, the Asian region has become a strong economic driver for the world with a rising share in output, trade and reserves (Table). During the current crisis, however, the abrupt deceleration in growth in Asia was more rapid than in other regions, and in key countries even sharper than at the epicentre of the global crisis due to the greater integration of these economies. In many ways, this severe impact was unexpected. Asia is far from the epicentre of the crisis, not just geographically but also in the sense that it did not indulge in the financial practices that led to serious problems in advanced economies’ banking systems. Moreover, before the crisis, the region was in sound macroeconomic shape, and thus in a strong position to resist the pressures emanating from advanced economies. Therefore, what explains the outcome contrary to expectations? The answer lies in Asia’s exceptional integration with the global economy. Much of Asia relies heavily on technologically sophisticated manufacturing exports for which demand had collapsed. At the same time, Asia’s financial ties with the rest of the world have deepened over the past decade, exposing the region to the forces of global deleveraging.

Countries with a larger share of advanced manufacturing in GDP experienced sharper output declines. The underlying reason is that advanced manufacturing is more cyclically sensitive than other items. Growth in Asian economies with a lower share of manufacturing, such as commodity exporters, initially held up better, although the collapse in commodity prices hit them as well. The collapse in demand has been transmitted through the integrated supply chain with dramatic effects on intra-regional trade. The current crisis vividly illustrates that Asia has not “decoupled” from the global economy. Synchronised recession in advanced economies has further complicated the matter during the current crisis as against the experience in 1998 when the decline in domestic demand was offset to some extent by demand emanating from industrial economies.