From Financial Crisis to Global Recovery - Essay Example

? The global foreign direct investment flows declined during the recent economic crisis. However, the FDI flows are currently increasing due to slow recovery of the global economy. The Spanish crisis was mainly caused by the collapse of the construction and real estate sector, the high employment and banking system losses. This paper will discuss the recent trend in global FDI flows, the FDI flows and balance of payment of the US economy and lastly the Spanish crisis of 2012. Introduction The global FDI flows were estimated at $ 1,114 trillion in 2009 and slightly climbed to about $ 1,122 trillion in 2010 (Breitfeld, 2010). Despite the global economic turmoil, the global FDI inflows rose significantly by 17 percent in 2011 in most of the economies to $ 1.5 trillion. The FDI flows increased in major economic groupings such as developing economies, transition economies and developed economies. Developing and transition economies recorded $ 755 Billion FDI inflows that were driven mainly by robust investments (Lapavitsas, 2012). FDI flows in Europe increased by 18 percent while the flows in the United States declined by 8 percent. Ireland experienced the largest FDI flows due to movements in debt and equity financial markets. The increase in FDI flows in Europe was mainly driven by cross-border corporate restructuring, mergers and acquisitions, and stabilization of the economies (Ramamurti & Hashai, 2011). However, this trend was not even in all European countries since Greece and Germany experienced a decline while countries like France saw an increase in FDI flows. Developing counties accounted for most of the global FDI flows in the first half of 2011 (Shambaugh, 2012). The FDI inflows in developing countries were at $ 684 billion. The FDI flows in transition economies rose by 6 percent in 2011 to reach $ 92 billion. FDI inflows in the Latin American countries rose by about 17 percent in 2011 to $ 150 billion due to foreign investors demand for natural resources exploitation and expanded consumer markets (Ramamurti & Hashai, 2011). West Asia countries experienced a 16 percent decline in FDI flows mainly due to cancellation of large-scale projects. In Africa, the FDI flows have kept falling since 2009 to 2011 due to disinvestment in North America. The Sub-Saharan African region witnessed $ 37 FDI inflows in 2011 (Shambaugh, 2012). The FDI outflows from Africa were 50 percent lower in 2011 and amounted to $ 3.5 billion and mainly came from Egypt and Libya. FDI outflows from the United States reached $ 397 billion in 2011 due to appreciation of Japanese Yen since Japan was the second largest investor in the US (Shambaugh, 2012). From the above graph of global FDI flows, it is evident that the recent financial crisis negatively affected the global FDI flows. The global FDIs flows are currently on the increasing trend (Breitfeld, 2010). US economy FDI flows and balance of payments The global financial crisis of 2007-2009 led to the decline of the US trade deficit due to slowdown in imports. The US exports increased by 16 percent from 2010 to $ 1,497 billion in 2011 due to increasing economic growth in the economy. The imports also increased by the same percentage during the same period to $ 2,236 billion (Richardson, 2011). Though the two increased at the same percentage, the net effect was an increase in the trade deficit by 15 percent or $ 93 billion. In 2009, the recession led to an 18 percent in US merchandise exports and 26 percent decline in imports (Richardson, 2011). The figures however reversed in 2010 when exports in merchandise increased by 21 percent while the imports increased by 23 percent. In 2011, the trade deficit in goods was $ 738 billion on the BOP but was still lower than the previous peak of $ 836 billion in 2006. The deficit on the current account which includes the trade plus investment income and any unilateral transfers grew from $ 442 billion in 2010 to $ 466 billion in 2011 thus leading to an increase in the current account deficit by $ 24 billion. The US GDP declined by 3.5 percent thus reducing the FDI inflows. In 2007 and 2008, the dollar strengthened against other major currencies such as Canadian dollar and Yen since it was considered as a “save haven demand”, but it subsequently lost some value due to lowering of the Fedral Reserve interest rates in order to spur investments in the economy in November 2009. The weaker US dollar reduced the foreign investors demand for US investments thus lowering the foreign direct inflows (Richardson, 2011). YEAR EXPORTS (In billions of US dollars) IMPORTS (In billions of US dollars) TRADE BALANCE DEFICIT (In billions of US dollars) 2007 1,164.00 1,982.80 818.9 2008 1,307.50 2,137.60 830.1 2009 1,069.70 1,575.50 505.8 2010 1,288.90 1,934.00 645.1 2011 1,497.40 2,235.50 738.4 From the above table, the US trade deficit has been increasing over the years; the increase in the trade deficit is responsible for the US FDI flows since many foreign investors have little evidence in investing their funds in US economy. The US real GDP growth rate fell by 7.8 percent between 2007 and 2011 thus reducing the FDI inflows. The slow recovery of the US economy from the devastating effects of recent financial crisis and recession can be attributed to the increase in the negative FDI flows from the economy (Richardson, 2011). The trade deficits are a major concern since they slow economic growth, affect interest arrest and weaken the domestic currency. Between January and July 2012, the exports increased by 6 percent while the imports increased by 5 percent but the overall trade deficit worsened by 2 percent. The US foreign direct investments abroad increased by 13 percent in 2011 after an increased of 8 percent in 2010 (Ramamurti & Hashai, 2011). The reinvested earnings also grew by 12 percent in 2011 due to steady growth in foreign affiliated earnings. The net equity investment increased by 27 percent in 2011. The reinvested earnings moved from $ 59.6 billion in 2010 to a high of $ 80.3 billion in 2011. Another notable figure was the increase in the net intercompany debt investment from $ 6.7 billion in 2010 to about $ 53.4 billion in 2011 (Shambaugh, 2012). The foreign direct investment outflows increased from $ 304.4 billion in 2010 to $ 396.7 billion in 2011. The US net equity investments in the foreign affiliates moved from $ 41.1 billion in 2010 to a high of $ 52.4 billion in 2011 (Ramamurti & Hashai, 2011). At the end of 2010, the US net foreign direct investments were -$ 2,473.6 billion which worsened to -$4,030.3 billion in 2011. The net change can be attributed to negative net direct financial flows of -$ 556.3 billion and negative net price changes of -$ 802.1 billion (Shambaugh, 2012). The increase in the prices of the US treasury bonds and securities and subsequent decline in the stock market prices increased the values of foreign direct investments in the US economy and lowered the value of US foreign direct investments abroad. Most of the changes were reflected in the foreign acquisitions of US assets and appreciation of the US dollar against the trade weighted index of other major currencies (Shambaugh, 2012). The appreciation of US dollar led to -$ 23 billion in the net foreign direct investments positions of the US. The US acquisition of financial assets abroad stood at $ 483.7 billion which was lower compared to $ 939.5 billion in 2010. The foreign acquisition of financial assets in the US economy excluding the derivative instruments was $ 1,001.0 billion in 2011 compared with a value of $ 1,308.3 billion in 2010 (Ramamurti & Hashai, 2011). The foreign purchases of the US government securities exceeded the sales but the direct financial inflows were partly offset by the increase in foreign sale of the agency and corporate bonds that exceeded the new purchases (Breitfeld, 2010). While compared with the GDP, the deficit declined from 3.5 percent to 3 percent of the GDP. During the same period, the deficit on international trade in goods declined to $ 185.8 billion from $ 194.3 billion due to increase in exports and decline in imports. The international trade in services experienced an increase in the surplus from $ 45.9 billion to $ 46.5 billion in the second quarter of 2012 (Shambaugh, 2012). The net financial inflows stood at $ 88.5 billion in the second quarter which is a decline from $ 164.7 billion during the first quarter of 2011. The foreign direct investments inflows decreased by $ 118.7 billion in the second quarter of 2012. The US FDI outflows stood at $ 206.8 billion in second quarter (Ramamurti & Hashai, 2011). The net foreign direct investment inflows in the US were $ 88.5 billion in the second quarter which was a decline from $ 164.7 billion in the first quarter. The sale of foreign securities exceeded the purchases of foreign securities by $ 5.5 billion in the 2nd quarter (Shambaugh, 2012). The net purchase of the foreign stocks was thus at $ 21.0 billion from $ 14.8 billion in the first quarter. The US direct investment in foreign economies was thus at $ 79.2 billion in second quarter from a high of $ 116.1 in the first quarter of 2012 (Shambaugh, 2012). United States Foreign direct investments flows graph US balance of payments graph Part two Spanish crisis 2012 Spain is the fifth largest economy in European Union according to the per capita income. In order to become a member of European Union, Spain had to adhere to Maastricht Treaty that requires the members to meet some minimum standards like inflation rates, government deficit and interest rates (Lopez &Miguel, 2004). In the 1990s, Spain experienced budget deficits of as high as 6.5 percent but6 started posting budget surplus in the year 2005. Spain also reduced the interest rates and private borrowing increased thus fueling a boom in the construction sector. Before the onset of the crisis, the economy was characterized by high private debts and weakening competitiveness among the trading partners (Bishop, 2011). The economy was also characterized by high unemployment rate that skyrocketed from 8.3 percent in 2007 to over 20 percent in 2011. Unemployment among the youth was over 50 percent. Spain started aggressive building of homes in 2007 whereby more than 800,000 homes were built but the global economic crisis halted the funding and led to decline in property prices (Young & Murphy, 2012). The collapse of the construction sector due to global economic crisis was one of the triggers of the Spanish crisis. Between 2004 and 2007, the banking system expanded its credit to the booming housing sector at an annual average of 24.6 percent. Loans to both the real estate and construction sector accounted for about 50 percent of the outstanding loans in the banking system (Loungani, 2008). The unbalanced growth of the construction sector and expansion of credit in the economy led to concentration of risks in property development sector and construction sector (LaBrosse & Singh, 2011). Due to inadequate risk policies and supervision, the credit supply finally exceeded the demand thus leading to excess stock of the real estate assets that were mainly financed through imprudent loans (Bishop, 2011). The Spanish crisis of 2012 began as part of the global 2008-2009 financial crisis and continued as part of the European sovereign debt crisis. The crisis was mainly generated by the housing market crash, bankruptcy of several financial institutions and long-term loans. Spain had a huge trade deficit of about 10 percent in 2008 due to loss of competitiveness among the trading partners (Duthel, 2011). The collapse of the housing sector led to massive unemployment since the construction sector accounted for about 13 percent of the unemployment in the economy (Loungani, 2008). With the high unemployment, the Spanish government had to provide generous unemployment benefits thus further draining the government tax revenues that mainly came from the housing sector. This led to a budget deficit of 4 percent thus contravening the Euro pact limits (Suarez, 2010). Spanish savings and loan banks (cajas) accounted for half of the banking system were poorly regulated and had highly lend to risk investments due to non-disclosure rules of the banking system. After the crash of the housing sector in 2009, the bad loans increased and debtors became bankrupt (Krugman, 2009). The bad loan exposure to the banking system was almost EUR 181 million in mid 2010. The collapse of the caja banking system made the Spanish government to bail the financial system by injecting 50,000 million Euros in order to aid private bank lending (Praussello, 2012). This move by the government led to budget deficit of 11.2 percent in 2011 from a surplus of 2 percent in 2006 and deficit of 4.2 percent of the GDP in 2008 (Bishop, 2011). This event led to high unemployment rates, failure of the banking system and the eventual increase in government debt that led to financial and debt crisis in the Spanish economy (Loungani, 2008). Impact on the local economy The domestic demand fell by 7.6 percent between 2008 and 2010. The fall in GDP by 6.3 percent in 2009 led to loss of more than 800,000 jobs in the economy (Lynn, 2011). The unemployment rate in the economy rose from 8.3 percent in late 2007 to about 20.1 percent in late 2010. The unemployment rate among the youthful population between 16 to 25 years was 41 percent while that of unskilled workforce ranged 24 percent to 45 percent during the crisis. In 2009, the public investments grew by 11.2 percent but subsequently contracted by 17 percent due to need of controlling the public deficit (Grauwe, 2012). The public debt increased from 36.1 percent in 2007 to about 60.1 percent in 2010. In 2010, the Spanish government increased VAT collection to offset decrease in tax revenues associated by declining direct taxes. The government was forced to increase pension expenditures due to the high unemployment rates in the economy (Lynn, 2011). The interests of debt increased steadily to account for about 1.9 percent of the gross domestic product (Knight, 2012). As of 15th June, 2012, Spanish public debt was 72.1 percent of the gross domestic product. The non-financial firm’s debt of Spain is almost 750 percent (Young & Murphy, 2012). Extend of contagion and credit rating downgrades Contagion occurs when speculators and investors perceive commonalities of a country with financial crisis and others (Gaillar, 2011). The affected countries usually share the same features with the country where the crisis has originated. For instance, some shared financial features in the Euro zone include shared currency, shared financial links, low economic growth, under-regulation of the financial systems and large public debt (Knight, 2012). Some of the negative effects of the Contagion downgrades include the refusal of lending by international lenders, losses by debt holders of the affected countries and demand for high returns by the bond holders (Richardson, 2011). In December, 2011, credit rating agency S & P reduced the sovereign lending of fifteen countries in the Euro Zone to “credit watch” due to tightening of credit in the Euro zone (Gaillar, 2011). Other reasons for the contagion degrade was disagreement in European policy makers on how to ensure financial stability and reduce the high level of government indebtedness. The contagion will negatively affect the major holders of Spanish debt like German and France (Loungani, 2008). In early June 2012, Credit rating agency Fitch downgraded the sovereign debt of Spain from “A” to “BBB” which is lowest in the investment grade. Fitch pointed out the bailout of Spain would cost up to EUR 100 million thus prolonging the economic recession until 2013. Fitch also pointed out that the high level of public debt made Spain vulnerable to Greece debt crisis. In June 25, 2012, Moody rating agency downgraded one of the four notches of the long-term debt rating for about 28 Spanish banks. At the same time, Moody downgraded Spanish government’s bond ratings from A3 to Baa3 on mid June 2012. According to Moody, the banks’ exposure to commercial real estates would possibly lead to higher losses thus increasing the likelihood of external bail out (Duthel, 2012). Manifestation of moral hazard Moral hazard problem was manifested in the aggressive lending practices of the Savings banks (Savona, 2011). Most of the banks did not understand the risk profile of the clients or the underlying risks of the housing sector and mortgages (Kolb, 2011). Since the risk would be borne by the financial institution, the bank managers had incentives of lending more to the construction sector without considering the ability of the low income earners to pay the loans (Kolb, 2011). Another moral hazard element was the intervention of the government through banking bailouts using the tax payers’ money. Recently, the idea of bailing out Greece and Spain through issue of “Euro bonds” to solve the public debt crisis also creates a moral hazard (Howden, 2011). This is likely to create incentives for governments to spend beyond their budgets and expect bail outs from the European Union (Overtveldt, 2011). Regulatory response The main regulatory and policy responses to Spain crisis include the increase in the VAT rate in 2009 to 18 percent and eradication of the direct personal income taxes through a deduction of EUR 400. Another fiscal response was the reduction in government ministerial expenditures by EUR 8,000 million. In 2010, the fiscal policy saw a reduction in ministries expenditure by five thousand Euros and freezing of some of pension payments (Bussing-Bucks, 2011). Another response to the crisis was suppression of the monetary incentives that were paid on childbirth and cut on medicines and reduction of the civil servants wages by 5 percent (International Monetary Fund, 2012). Surprisingly, the fiscal policy in 2010 increased the personal income tax for the wealth and reduced the ministries expenditure by thirteen thousand and two hundred Euros. In Dec 2010, the government increased the taxation on tobacco and privatized some government entities such as the National Lotteries and Airports (Richardson, 2011). In 2010, several measures were implemented in Spanish banking sector in order to improve the transparency such as stress tests and information disclosure. The Savings Bank Law was approved in order to deal with funding and governance issues in the banking sector. The manager’s professionalism standards and requirements were also strengthened and entities in the banking sector were also required to inject new and quality equity capital (Desai, 2011). Early 2011, the Bank of Spain raised the minimum bank core capital to 8 percent or 10 percent of risk-averaged assets due to continued loss of confidence in the debt markets (Lybeck, 2011). Another response was concentration of the 40 out of the 45 affected Savings banks through either mergers or institutional protection systems (SIP) or through acquisitions (Desai, 2011). The Spanish banking system has also recognized and assumed losses in the asset value of about 9 percent of the GDP. The banking sector has also established specific and general provisions and recognized losses in assets through the integration process to a tune of EUR 22,000 million (Cline & Wolff, 2012). Due to global recapitalization of banking entities, the banking sector has increased capital through the reserves to about 3.7 percent of the GDP. This recapitalization effort has improved the Tier 1 ratio that had risen from 7.6 percent in late 2007 to about 9.5 percent in late 2010 (Overtveldt, 2011). The government has also undertaken measures to reform the labor market. The labor market was initially characterized by wage rigidity and internal inflexibility within the firms. The first response is the promotion of the number of workers that can be hired through contracts and introduction of new limits of temporal working contracts (De Grauwe, 2011b). The European Union has also implemented new guideline on controlling the member economies due to high public debt across the euro zone. For instance, the countries are expected to make efforts in attaining the medium-term budgetary objectives since an interest bearing deposit of 0.2 percent of the GDP is applicable to non-compliant members (De Grauwe, 2010). On 9th June, 2012, the European Union held several meetings to discuss modalities of injecting capital in Spanish banks. The European Union announced its intention of providing about EUR 100,000 million to fund the Orderly bank restructuring of the Spanish government (Cline & Wolff, 2012). Conclusion The global FDI flows are currently on the recovery path after slow down during the recent global financial crisis. The US economy continues to experience a negative net inflow of FDI. The Spanish crisis can be attributed to collapse of the housing sector, high unemployment and moral hazards in the banking system. 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