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591. PolicyWatch #1396: Financial Crisis Grips Fayad Government

Author:
Mohammad Yaghi
Publication Date:
08-2008
Content Type:
Policy Brief
Institution:
The Washington Institute for Near East Policy
Abstract:
Palestinian prime minister Salam Fayad recently appealed to the World Bank in an effort to bridge the current budget gap preventing the Palestinian Authority (PA) from paying government salaries this month. Despite a three-year $7.5 billion assistance pledge from the 2007 Paris donor conference, the PA remains in a financial crisis, with a projected shortfall of $400 million for the second half of 2008, as reported by the Ad Hoc Liaison Committee in May. Since Fayad's technocratic government has no independent political base, its legitimacy stems from the PA's financial solvency. He has survived ongoing attacks from rival Fatah leaders only because Palestinian president Mahmoud Abbas recognizes him as the linchpin to Western donor assistance. If the financial crisis persists, however, Fayad's political future is in doubt.
Topic:
Government, International Political Economy, Financial Crisis, and World Bank
Political Geography:
Middle East and Palestine

592. Stress-Testing the Regulators: Market Risks and the EU Economy

Author:
Max Watson
Publication Date:
04-2008
Content Type:
Policy Brief
Institution:
Chatham House
Abstract:
Today's market turbulence and global imbalances prompt the question whether economic and regulatory policies are poorly designed or just badly implemented. The question is urgent for Europe, which has its own asset booms and imbalances to worry about as well as the backwash of US problems. The imbalances in Europe's economies in large part reflect favourable shocks, such as falling interest rates and growing financial integration. But the 'growth crisis' in Portugal underscores the fact that there can be hard landings, even without a financial crisis, if fiscal policy is unwise and if productivity fails to take off. The current global imbalances and turbulence also have a common backdrop in the long period of unusually easy liquidity and low risk premia during which today's problems built up. This suggests that central banks should be prepared more often to 'lean against the wind' in times of asset price exuberance, and that politicians should not cut taxes or boost spending permanently on the back of revenue gains that result from transient financial booms. Banks and supervisors have many lessons to draw. Some involve going 'back to basics' on issues such as liquidity, off-balance-sheet operations, and the ability to close and reopen banks. Others require a careful look at incentives – in executive pay, rating agency roles and loan production systems. Supervisors also need to take better account of boom-bust cycles when they assess risks, and address cross-border issues in EU banking. Moral hazard has been partly addressed by pain inflicted on bank managements and shareholders. But at the macro level it may be building up as policy-makers act to limit losses in a setting where they cannot trace the ultimate fallout from risks. In future, their discretionary interventions need to be truly exceptional and much more symmetrical, or the money supply and the public debt will ratchet up amid serious resource misallocation.
Topic:
Economics, Government, and Financial Crisis
Political Geography:
United States and Europe

593. Iceland on the brink? Options for a Small, Financially Active Economy in the Current Financial Crisis Environment

Author:
Daniel Gros
Publication Date:
04-2008
Content Type:
Policy Brief
Institution:
Centre for European Policy Studies
Abstract:
For small financially active countries the exchange rate assumes particular importance, not only as a shock absorber, but potentially also as a source of shocks during financial market crises. This is very much in evidence today in the case of Iceland which is being hit hard by the recent turbulence in financial markets.
Topic:
Economics and Financial Crisis
Political Geography:
Europe

594. The Banking Crisis: Causes, Consequences and Remedies

Author:
Paul De Grauwe
Publication Date:
11-2008
Content Type:
Policy Brief
Institution:
Centre for European Policy Studies
Abstract:
The paradigm that financial markets are efficient has provided the intellectual backbone for the deregulation of the banking sector since the 1980s, allowing universal banks to be fully involved in financial markets, and investment banks to become involved in traditional banking. There is now overwhelming evidence that financial markets are not efficient. Bubbles and crashes are an endemic feature of financial markets in capitalist countries. Thus, as a result of deregulation, the balance sheets of universal banks became fully exposed to these bubbles and crashes, undermining the stability of the banking system. The Basel approach to stabilise the banking system has as an implicit assumption that financial markets are efficient, allowing us to model the risks universal banks take and to compute the required capital ratios that will minimise this risk. I argue that this approach is unworkable because the risks that matter for universal banks are tail risks, associated with bubbles and crashes. These cannot be quantified. As a result, there is only one way out, and that is to return to narrow banking, a model that emerged after the previous large-scale banking crisis of the 1930s but that was discarded during the 1980s and 1990s under the influence of the efficient market paradigm.
Topic:
Economics, Markets, and Financial Crisis
Political Geography:
Europe

595. Earning from History: Financial Markets and the Approach of World Wars

Author:
Niall Ferguson
Publication Date:
02-2008
Content Type:
Working Paper
Institution:
Weatherhead Center for International Affairs, Harvard University
Abstract:
We are living through a paradox-or so it seems. Since September 11, 2001, according to a number of neo-conservative commentators, America has been fighting World War III (or IV, if you like to give the Cold War a number). For more than six years, these commentators have repeatedly drawn parallels between the "War on Terror" that is said to have begun in September 2001 and World War II. Immediately after 9/11, Al Qaeda and other radical Islamist groups were branded "Islamofascists". Their attack on the World Trade Center was said to be our generation's Pearl Harbor. In addition to coveting weapons of mass destruction and covertly sponsoring terrorism, Saddam Hussein was denounced as an Arab Hitler. The fall of Baghdad was supposed to be like the liberation of Paris. Anyone who opposed the policy of pre-emption was an appeaser. And so on.
Topic:
Cold War, Economics, Terrorism, War, and Financial Crisis
Political Geography:
America and Iran

596. Can Exchange Rates Forecast Commodity Prices?

Author:
Kenneth Rogoff, Yu-chin Chen, and Barbara Rossi
Publication Date:
02-2008
Content Type:
Working Paper
Institution:
Weatherhead Center for International Affairs, Harvard University
Abstract:
This paper studies the dynamic relationship between exchange rate fluctuations and world commodity price movements. Taking into account parameter instability, we demonstrate surprisingly robust evidence that exchange rates predict world commodity price movements, both in-sample and out-of-sample. Our results are consistent with a present value relationship in which the exchange rate depends on a present value of fundamentals including, for a core group of commodity exporters, the world price of their commodity exports. Because global commodity prices are essentially exogenous to these countries, we are able to avoid the endogeneity pitfalls that plague most of the related exchange rate literature. More directly, the analysis suggests that where commodity price forward markets are thin or non-existent, exchange rate-based forecasts may be a viable alternative for predicting future price movements.
Topic:
Economics, Markets, and Financial Crisis
Political Geography:
Australia and New Zealand

597. Investment Cycles and Sovereign Debt Overhang

Author:
Mark Aguiar, Manuel Amador, and Gita Gopinath
Publication Date:
02-2008
Content Type:
Working Paper
Institution:
Weatherhead Center for International Affairs, Harvard University
Abstract:
We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy, seeks to insure a risk averse domestic constituency, and is more impatient than the market. Optimal policy generates long-run cycles in both sovereign debt and foreign direct investment in an environment in which the first best capital stock is a constant. The expected tax on capital endogenously varies with the state of the economy and investment is distorted by more in recessions than in booms amplifying the effect of shocks. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang" effect. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.
Topic:
Debt, Economics, Markets, and Financial Crisis

598. Country Economic Forecasts: China

Publication Date:
12-2008
Content Type:
Policy Brief
Institution:
Oxford Economics
Abstract:
A turn in the domestic investment cycle has been coupled with a dramatic slowdown in external demand, leaving China weathering storms on both fronts. But with the government announcing an unprecedented fiscal package and with fewer structural problems to contend with than in earlier downturns, China is likely to fare better than in previous domestically-driven slowdowns such as in the early-1980s and 1990s.
Topic:
Development, Economics, Markets, and Financial Crisis
Political Geography:
China

599. Country Economic Forecasts: Germany

Publication Date:
12-2008
Content Type:
Policy Brief
Institution:
Oxford Economics
Abstract:
Germany appears to be slipping deeper into recession. The latest industrial figures are alarming: production fell 2.1% in October and orders were down 17.3%. If output remained at current levels to year-end, then Q4 would be down 3.2% on Q3, but the situation is deteriorating. The manufacturing PMI is below 40 and the expectations component of the Ifo is at its lowest level since the first oil crisis in the early 1970s. Key to the rapid decline has been an abrupt halt to investment, both in Germany and globally. Investment in machinery and equipment had stalled in Q3 and domestic orders of capital goods then dropped 6% in both October and November. Business investment will fall by over 4% in 2009. But exports have also seen a rapid decline, having fallen in both Q2 and Q3, while export expectations are near all-time lows. Export volumes are expected to drop next year, despite the depreciation of the euro. We have slashed our growth forecasts, with GDP now likely to fall by at least 1% in Q4. And we now do not expect the economy to emerge from recession until 2009H2 and for the economy to shrink by over 2% in 2009 overall – the biggest drop in over 60 years. Rapidly declining oil prices and an extended recession mean inflation could fall close to zero by next summer. Inflation has already slowed to 1.4% in November from a peak of 3.1% in July.
Topic:
Economics and Financial Crisis
Political Geography:
Europe and Germany

600. Country Economic Forecasts: Brazil

Publication Date:
12-2008
Content Type:
Policy Brief
Institution:
Oxford Economics
Abstract:
In sharp contrast to many emergers, Brazil was still growing very robustly in Q3. But the intensification of the global crisis, and its numerous repercussions – many of which were unforeseen – since September has been so great that it has stopped the economy in its tracks. The clearest sign of this is that annual import growth, which had been growing at close to 60% mid-year, dropped to only 9.2% in November. This is an indication of the extent to which previously soaring domestic demand growth, particularly investment, has slowed. Export volumes were already weakening in Q3 and the major deterioration in the global background since then is expected to lead to exports falling by nearly 3% in 2009 as a whole. This, together with the much lower commodity prices than firms will have budgeted for and the global fall in business confidence, will cause investment to shrink in 2009 after 15% growth in 2008. Consumer spending growth is also forecast to slow significantly but should at least stay positive, helped by an expected moderation in inflation. Meanwhile, given its healthy fiscal position, the government is likely to step up its spending. Overall, GDP growth is now forecast to slow to 1.3% in 2009. Although scope for the central bank to cut interest rates remains constrained by the weak BRL and 6%+ inflation, the rapid pace of the slowdown in both Brazil and the rest of the world may lead to a substantial reduction in underlying inflation pressures. This could pave the way for interest rate cuts to start in early-2009.
Topic:
Economics, Markets, and Financial Crisis
Political Geography:
Latin America