Evolution of International Financial Structure and Its Impact on the Present Financial Crisis - Term Paper Example

Financial Management Evolution of international financial structure and its impact on the present financial crisis How it all began The story of evolution of international structure should best be tracked from 1970 as that happens to be the watershed year in the evolutionary process of international financial structure. Deregulation of banking sectors and capital markets in OECD countries and especially in G7 countries (the United Kingdom, the United States, Canada, Germany, Japan, France and Italy) began in right earnest from this time and it resulted in sharp growth of the overall size of financial superstructure. This rapid growth can be gauged from the simple fact that the total financial assets in these countries which was on an average four times the GDP in 1970 rose to six times by 1994. By international standards, this indeed was a phenomenal growth. The balance sheets of commercial banks exhibited rapid increase during the entire eighties decade but started showing signs of slowing down in the first half of nineties as interest differences tended to taper off and banks started depending more and more on fees as their primary source of income. There was another tell tale sign of continuous increase in the size of the international financial superstructure and that was a marked increase in the volume of securities outstanding (mainly in the form of bonds and money market papers) in the total quantum of financial claims while there was an almost parallel decline in deposits and loans. However, what all analysts and financial experts preferred at that moment to turn a blind eye to was the increased specter of massive amounts of bad debts. Things were further complicated by the fact that while household sector balance sheets started exhibiting an increase in both assets and liabilities, there was a marked decline in deposits within gross household assets and an almost comparable increase in net financial wealth in the form of securities. (Blommestein 1996) The 1990s This was possibly a direct offshoot of the remarkable innovativeness that was witnessed in the financial markets during this decade when one was overwhelmed by the sudden spurt in derivatives markets and advent of commercial papers in a very big way. Practically all forms of regulations and restrictions that were considered vital for maintaining stability in international financial markets were given a go by as almost all OECD countries abolished exchange controls. The banking sector also got rid of almost all forms interest rate controls and controls over credit expansion. The capitals markets also witnessed removal of controls over fees and commissions. In some countries, the existing restrictions and controls over foreign direct investment were also gradually diluted. (Bisignano, Paradigms for Understanding Changes in Financial Structure: Instruments, Institutions, Markets and Flows 1995) The other most notable qualitative change in the international financial markets was a marked increase in cross-border portfolio investment in the form of security flows rather than banking flows which were the norm till the previous decade. This happened due to the substantial increase in securities markets both in terms of capitalization and turnover. Though this phenomenon by itself did not forebode any harm to OECD countries in particular and other industrialized nations in general, it surely interlinked economies across the world thus making it almost impossible for any nation to isolate its economy from the volatility that might visit international financial system any time in future. (Bisignano, The Internationalisation of Financial Markets: Measurement, Benefits and Unexpected Interdependence 1993) A history of financial crises Financial crises are nothing new to financial systems and, contrary to all theorizations about free market economy and the self balancing characteristic of free markets, history is replete with examples of such crises starting perhaps with the Dutch Tulipmania in 17th century through the twin bubbles in England (South Sea Bubble) and France (Mississippi Bubble) at the start of eighteenth century, to the Great Crash of 1929 in the United States. But crises did not end there and kept visiting international financial structure with a fair degree of regularity. Scandinavian countries experienced severe financial crisis in the 1980s. In Norway asset prices started soaring and investment and consumption also began exhibiting significant upward trends right from the beginning of 1980s. Banks took full advantage of this apparently hyper healthy economic scenario and extended loans, one might say, rather recklessly, so much so that the ratio of bank loans to GDP went up from 40% in 1984 to 68% in 1988. The bubble burst with the drastic fall in international crude oil prices and Norway had to endure one of the severest economic crises in its entire history. Finland suffered the same fate when expansionary budgetary policies adopted in 1987 led to an unprecedented expansion of bank credits which resulted in increase in the ratio of bank credits to total GDP from a meager 55% in 1984 to a massive 90% in 1990. Housing prices also increased by approximately 70% during the course of a single year 1987-88. The regulatory authorities sensed impending trouble and tried to control unbridled credit expansion by increasing bank rates and reserve requirements in 1989 but these moves did not have the desired effect and the situation suddenly took a turn for the worse as trade with Soviet Union collapsed during 1990-91. The asset (most of which were financed through bank loans) prices plummeted and banks suddenly found themselves swamped with bad debts and foreclosures. The situation became so bad that most of the banks had to be supported by the Government and GDP reduced by a devastating 7%. Sweden was perhaps much luckier than her neighbors in the sense that though she suffered a lot from financial meltdown, its severity was the least among the three Scandinavian countries. The Swedish government had steadily followed a policy of credit expansion right through the 1980s that led to a property boom due to inflated values of real estate fuelled by easy availability of credit. Things came to a brink when there was a severe banking crisis and the government had to intervene to restore parity and, possibly sanity, in real estate markets. Acute recession followed and it was compounded by an associated currency crisis which took quite some time to subside. (Allen and Gale 2000) Kaminsky and Reinhart investigated in great detail the anatomy of financial crises in 15 developing and 5 developed economies and discovered some common threads between most of the crises. Prior to the crisis, there have invariably been some sort of financial liberalization and significant credit expansion in each of the situations. This was followed by about 40% increase on an average in the price of stocks within a period of eight to twelve months and a very significant increase in the price of real estate. Such a phenomenal increase within such a short period obviously caused a massive pressure of speculative demand that further fuelled the price rise. At some point the bubble burst resulting in the collapse of real estate and stock markets and within a few months a banking crisis ensued due to overexposure to stock and real estate markets. In many cases the government was caught in a bind between choosing lower interest rates to ease the banking crisis and raising interest rates to bolster the currency and finally ended up in properly helping neither. A recession associated with a significant decline in output crept in and lasted for an average period of at least two years. (Kaminsky and Reinhart 1999) Current financial crisis It perhaps started in 1994 with the passing of the Community Reinvestment Act (CRA) by the US Congress thus drastically easing the lending criteria for commercial banks. The repeal in 1999 of Glass-Steagall Act that till then categorically prohibited commercial banks from speculating in securities further added to the uncertainty of financial markets. In April 2004, in a meeting between five investment banks and the regulators at the Securities and Exchange Commission (SEC), it was decided to waive a rule that required the banks to maintain a certain level of reserves. With enormous balances of capital that had suddenly become free, investment banks started dealing in massive volumes of Mortgage-Backed Securities and substantial amounts of sub-prime CRA loans – all packaged together in apparently attractive packets, and, thanks to liberalization and globalization, very soon almost all the economies of the world got involved in this dangerously risky gamble. By the first quarter of 2007, however, rising delinquencies, defaults and bad debts on sub-prime lending started to surface but the Dow Jones, in a last ditch act of defiance, continued to rise and reached a peak of 14,164 on October 9, 2007 and remained around 13,000 throughout the month. However, the bubble finally burst in November when the stock market crashed taking along with it almost all the developed economies of the world that are still struggling to come out of the second Great Depression of the world. Why are China and India emerging as attractive centers for foreign direct investment in recent years? How has the financial crisis affected the investment strategies? Discuss the trends with the help of past 5years data. The ground reality China and India, though poles apart as far as political and social infrastructure are concerned, have become hot destinations for foreign direct investment in recent years. Global management consulting firm A.T. Kearney conducts an annual survey of executives from leading multi-national companies to construct Foreign Direct Investment Confidence Index, and, according to the latest index, global executives are more likely to invest in India and China than at any time since 1998. This augurs pretty well for these two countries as according to the latest estimates by United Nations Commission on Trade and Development [UNCTAD], global FDI inflows have grown for the third consecutive year reaching more than US$1.50 trillion in 2007 and Standard & Poor’s projects that this upward trend would continue till the end of the decade due to ongoing improvements in business environments in many emerging economies and sustained pressure for mergers and acquisitions on account of increased competition from domestic players in these economies. The other equally attractive reason for FDI to flow to emerging economies is that these economies, though nowhere near the developed economies in terms of economic development, have been able to remain relatively less affected by the recent global economic downturn that have ravaged many developed economies. China and India have been able to grab the attention of global executives who view these two countries as attractive destinations not only in the short term (maximum three years) but are also thinking in terms of longer durations of ten years or more. Thus, earlier favorites as Brazil, Mexico and Poland are slowly and surely losing the race to India and China even in terms of medium term FDI. It might not be wholly out of place to mention that FDI has a considerable positive effect on the economy of the host country. The most obvious benefit is the transfer of advanced technology by foreign companies and the consequent development and enrichment of human capital in the host country. The other trickledown effect that most surely benefits the host country is the introduction of advanced business practices that are generally not present emerging economies and strengthening of corporate institutions that usually remain only on paper in these economies. A case in point is the increased awareness about industrial safety and atmospheric pollution that has happened among Indian and Chinese industrialists. This has benefitted not only those that are directly involved with these industries but also the entire society. (Kumar 2007) China and India – a comparison However, one must never lose sight of the fact that India and China have very little in common as far as economic, legal and social infrastructure are concerned and foreign investors prefer these two destinations for entirely different reasons. China happens to be the world’s largest manufacturer and has the largest market for consumer goods while India is slowly emerging as the undisputed leader in providing business process and IT services and has a longer term market potential when compared with China. India is also being increasingly perceived as an R&D hub for various multi-national giants and the service oriented growth path of Indian economy has allowed it to grow in spite of palpable lack of proper infrastructural facilities in large parts of the country. But a responsive bureaucracy and lower-cost advantage will remain the key to its future growth. Paul Laudicina, vice president, A. T. Kearney feels India is on the cusp of a genuine deluge of FDI, but whether it actually materializes or not is something that all analysts are eagerly observing. Many investors favor China over India because of the former’s huge market size, favorable cost structure, easy accessibility to export markets, government incentives and generally favorable macroeconomic climate that enables foreign investors to deal with only one authority instead of a multitude of authorities, institutions and unions that is found in democratic societies like India. But these same investors choose India over China when management talent, highly educated workforce, transparency in government processes, rule of law and cultural affinity with Europe and America are brought into consideration. Thus, one cannot say for certain which one country among the two leading contenders for FDI will finally walk with away with top honors. The qualitative difference between the two destinations become apparent when we find that during the first three years of the current decade Chinas FDI flows were larger ($53.5 billion) and primarily capital-intensive, while Indian FDI flows were smaller ($4.3 billion) and skill-intensive, concentrated in information and technology areas. (domain-b.com 2004) Shift in investment strategies due to economic downturn With continuing global downturn central banks around the world are progressively moving towards a Zero Interest Rate Policy (ZIRP) environment and easing the quantitative restrictions on credit expansion that were earlier in force. This has created a scenario that offers less expected return on investment and increased complexities in handling and investing cash balances. Many investors thus have become more responsive to investment opportunities beyond domestic frontiers but the events of the last one and a half years have shaken them so much that they have become double cautious about investments in general and FDIs in particular. Investors now prefer only those countries that offer political stability, vast markets and cheaper cost of production. China, quite obviously, leads the pack on these counts and has attracted about US$70 billion in FDI in 2006 and still remains the most preferred destination of FDIs. This might have been a substantial amount for any other country but given the huge size of Chinese economy, Chinas accumulated stock of FDI in terms of GDP is only 26.7% which is far lesser than other competing emerging economies. This only proves that China can still absorb mammoth volumes of FDI without disturbing its internal economic balance or solidity. According to estimates of Standard and Poor’s; China will receive at least US$85 billion of FDI in 2010. Just in case a comparison is necessary it must be mentioned that accumulated stock of FDI in terms of GDP is only 8% in case of India and according to the same estimates India will be receiving at least US$20 billion by 2010. Thus, it is quite apparent that both these countries have not suffered in terms of FDI due to global economic downturn. (Hessel 2007) Conclusion It is an undeniable fact that China remains the undisputed leading destination of international FDIs in spite of the so-called overheating of the Chinese economy and apparent lack of transparency in Chinese bureaucracy. India, on the other hand, displaced Mexico to become the third most attractive destination of FDIs (after China and US) within the first five years of this century. Looking forward, one has a general perception that China and India will remain the biggest beneficiaries of FDI inflows for quite a few years with Hong Kong and Singapore also chipping in between these two high powered growth engines. Bibliography Allen, F., and D. Gale. "Bubbles and Crises." Economic Journal, 110, 2000: 236-255. Bisignano, J. "Paradigms for Understanding Changes in Financial Structure: Instruments, Institutions, Markets and Flows." Structural Change and Turbulence in International Financial Markets. Geneva: International Centre for Money and Banking Studies, 1995. —. "The Internationalisation of Financial Markets: Measurement, Benefits and Unexpected Interdependence." XIIIeme Colloque Banque de France-Université, 1993. Blommestein, H.J. "Structural Changes in Financial Markets: Overview of Trends and Prospects." In The New Financial Landscape: Forces Shaping the Revolution in Banking, Risk Management and Capital Markets, by H.J. Blommestein and K. Biltoft (eds), 9-14. Paris: OECD, 1996. domain-b.com. "China and India Jockey for Most Attractive Foreign Direct Investment Destination Globally While U.S. Is Challenged ." domain-b.com. October 15, 2004. http://www.domain-b.com/management/general/20041015_survey1.html (accessed July 30, 2009). Hessel, Helena. Recent And Expected FDI Trends In Emerging Market Economies. Research, New York: Standard and Poors, 2007. Kaminsky, G, and C. Reinhart. "The Twin Crises: The Causes of Banking and Balance-of-payments Problems." American Economic Review, 89, 1999: 473-500. Kumar, Anil. "Does Foreign Direct Investment Help Emerging Economies? ." Economic Letter—Insights from the Federal Reserve Bank of Dallas, Vol. 2, No. 1, 2007. Read More