GLOBAL ECONOMIC FLOWS Global Flows of Capital Chapter

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GLOBAL ECONOMIC FLOWS - Global Flows of Capital Chapter 5 Dr. Senem SÖNMEZ SELÇUK

GLOBAL ECONOMIC FLOWS - Global Flows of Capital Chapter 5 Dr. Senem SÖNMEZ SELÇUK

FINANCIAL GLOBALIZATION O The world’s economies have become more tightly interconnected as a result

FINANCIAL GLOBALIZATION O The world’s economies have become more tightly interconnected as a result of globalization. O One reflection of that is the well-known phrase, “When the American economy sneezes, the rest of the world catches a cold”. O However, dramatic economic events in other parts of the world also have an impact on most, if not all of, the world’s economies. 2 Global Economic

O This is clear, for example, in the global impact of the financial crises

O This is clear, for example, in the global impact of the financial crises that struck Asia and Russia in the 1990 s. O However, it remains the case that the more powerful the economy, the greater the effect of its crises on the rest of the world. O The corollary is that problems in weaker economies have less of an effect across the globe. O Thus, Argentina had a serious financial crisis in the late 1990 s and early 2000 s, but its impact on the global economy was 3 comparatively small. Global Economic

The Sub-Prime Mortgage Crisis O Thus, when the US suffers a financial crisis it

The Sub-Prime Mortgage Crisis O Thus, when the US suffers a financial crisis it does have a profound effect on the rest of the world’s economies. O This was demonstrated most recently in the sub-prime mortgage crisis (and the associated great financial crisis of late 2008) which had its roots in problems associated with a dramatic increase in the issuing of highly risky “sub-prime” mortgages by American banks. Global Economic 4

O These were mortgages sold primarily to relatively low-income people (whose ability to repay

O These were mortgages sold primarily to relatively low-income people (whose ability to repay those loans was not checked closely) in order to allow and induce them to buy homes. O They were offered low interest rates (rates below the prime interest rate), or the possibility of paying only on the principal with no interest payments, payments but those highly attractive terms lasted for only a few years. O After that, the interest rates were to “float” rising to the higher rate prevalent at the time. This served to raise homeowners’ monthly 5 payments, sometimes substantially. Global Economic

O Many of those who bought homes at the sub-prime rate did not realize

O Many of those who bought homes at the sub-prime rate did not realize that such an increase would occur or how much more they would need to pay each month. O They also believed that they would be able to refinance their homes at an attractive fixed interest rate when the initial lowinterest rate ended, but they found that the emerging crisis had left banks unable or unwilling to offer them new credit at low rates. 6 Global Economic

O The crisis began in earnest when large numbers of comparatively low-income homeowners were

O The crisis began in earnest when large numbers of comparatively low-income homeowners were unable to make their monthly payments and the banks foreclosed on their homes. O Banks would ordinarily sell foreclosed homes, but the booming housing market of the early 2000 s had collapsed and many banks were left with far too many valueless properties and this translated into large write-offs and huge losses. O More importantly, many low-income homeowners were ruined as a result of losing 7 their homes and their investments it. Globalin. Economic

O The losses experienced by American banks contributed to a global banking crisis and

O The losses experienced by American banks contributed to a global banking crisis and other financial and economic institutions were adversely affected, as well. O This was a big factor in the huge bailout of the financial system by the US government in late 2008. Global Economic 8

O An underlying cause of the global crisis is the fact that American banks

O An underlying cause of the global crisis is the fact that American banks no longer hold many of the mortgages that they write, but rather they “securitize” (bundle) them with other mortgages and sell the bundles as “mortgage-backed securities” to other banks and financial institutions, often throughout the world. O Those who bought these bundles of debt rarely fully understood, or even cared about, the details of the securities that were in the bundles. 9 Global Economic

O The assumption was that mortgages were generally safe and if there were some

O The assumption was that mortgages were generally safe and if there were some risky investments in the bundle, they were more than compensated for by the safe ones. O When the sub-prime crisis developed, financial institutions in the US and throughout the world came to realize that a large portion of the bundles of debt that they had purchased was valueless. O This led financial institutions to mark down billions of dollars in assets and some nearly went bankrupt. 10 Global Economic

O Not surprisingly major banks (e. g. Citicorp, Washington Mutual) and other financial institutions

O Not surprisingly major banks (e. g. Citicorp, Washington Mutual) and other financial institutions (e. g. Fannie Mae, Freddie Mac, AIG – all eventually nationalized in whole or in part by the US) in the US experienced severe difficulties either because they had issued sub-prime mortgages or had invested in bundles of securitized mortgages. Global Economic 11

O However, the crisis was not restricted to the US. For example, the Northern

O However, the crisis was not restricted to the US. For example, the Northern Rock bank in Great Britain was saved from bankruptcy in late 2007 by an infusion of money from the Bank of England. O In early 2008 the British government reluctantly took control of (nationalized) nationalized Northern Rock, at least temporarily. The crisis continued to expand in 2008 and 2009 involving the global economy to an ever-increasing degree. Global Economic 12

O Throughout late 2007 there was much discussion of whether and how much the

O Throughout late 2007 there was much discussion of whether and how much the subprime crisis, and the related implosion of the housing market, was going to affect the overall American economy. O By early 2008 it became clear that the impact was going to be profound with indications increasing that the US economy was facing a recession later in 2008. O The US Stock Market dropped dramatically to more than 15 percent below its peak in late 2007, and after a slight recovery dropped again in late 2008. Global Economic 13

O This occurred in the context of a view that because of the great

O This occurred in the context of a view that because of the great strength and growth of other economies around the world (e. g. the EU, Japan, China, India), they were much less likely to catch a “cold” just because the US “sneezed”. O Another way of putting this is that a number of the more powerful economies in the world had “decoupled” from the US economy. Global Economic 14

O That is, they had become strong enough, had enough internal demand, and could

O That is, they had become strong enough, had enough internal demand, and could do business with so many other countries, that their economies were no longer closely linked (“coupled”) with that of the US. O This seemed to be especially true of emerging economies which trade a great deal with each other, as well as with countries such as China. Global Economic 15

O However, this quickly proved fallacious, at least in the short run, as many

O However, this quickly proved fallacious, at least in the short run, as many global stock markets plunged as much, or more, than the US Stock Market O Since the US is the major consumer of much of the world’s products, a recession or financial crisis there was likely to have a profoundly negative effect on many global economies dominated by the production of goods 16 exported to the US. Global Economic

O The negative effect on other economies could, in turn, adversely affect their ability

O The negative effect on other economies could, in turn, adversely affect their ability to buy American goods and services, or to invest in the US and its businesses, further worsening the crisis there. O Thus, the effects of the crisis flowed easily and rapidly back and forth throughout the world in 2008 contributing to an ever-deepening global economic crisis. O As one economist put it in early 2008: “The real fear is that there’s a kind of total systems breakdown” 17 O This fear came dangerously close to a reality in Global Economic the financial crisis later in the year.

O Even the booming Chinese economy began to feel the pinch. Sales of T-shirts

O Even the booming Chinese economy began to feel the pinch. Sales of T-shirts and knitwear declined significantly and some Chinese factories were in danger of being forced out of business. O The Chinese economy clearly remains closely tied to the American economy. This may be even truer of less robust economies than that of China (and India). Global Economic 18

O For example, the Japanese economy seemed to feel the effects of the American

O For example, the Japanese economy seemed to feel the effects of the American decline more than these other economies. Said a Japanese economist: “Now we see ‘re-coupling’. . The economy of Japan is proving disappointingly fragile to external shocks” Global Economic 19

O In another reflection of globalization, Citicorp sought to solve its financial problems caused

O In another reflection of globalization, Citicorp sought to solve its financial problems caused by the sub-prime crisis by soliciting massive investments from other parts of the world, especially the oilproducing states of the Middle East. O On the one hand, this served to make Citicorp itself a more global company. On the other hand, such foreign investments in US corporations led to increasing fears in the US of other nations buying into, and coming to control, large American 20 Global Economic corporations.

O In fact, Foreign Direct Investment (FDI) in US corporations increased greatly in 2007

O In fact, Foreign Direct Investment (FDI) in US corporations increased greatly in 2007 rising to over $400 billion (over $100 billion more than US FDI abroad). In 2006 foreign FDI in the US was about half that amount. Global Economic 21

O The biggest concern about foreign control involved financial investments in the US by

O The biggest concern about foreign control involved financial investments in the US by sovereign wealth funds (which amounted to over $21 billion in 2007). O These funds are owned by nation-states (not corporations or individual investors) and when they invest in other countries, it is in fact those nation-states that are doing the investing. O Among the largest sovereign wealth funds are the Abu Dhabi Investment Authority (ADIA), the Government of Singapore 22 Investment Corporation, and Global the China Economic Investment Corporation.

O In a sense, the activities of these funds involve a new form of

O In a sense, the activities of these funds involve a new form of state capitalism O As of early 2008, as a result in large part of the huge increase in oil prices, sovereign wealth funds (especially in the Middle East) were estimated to have almost $3 trillion dollars that they were seeking to invest. O The largest, ADIA (begun in 1976), alone may have more than $1 trillion (it is funded by Abu Dhabi’s yearly surplus of about $50 billion). Global Economic 23

O Furthermore, the likelihood is that the resources of these funds (reached $12 trillion

O Furthermore, the likelihood is that the resources of these funds (reached $12 trillion by 2015) will continue to increase rapidly as oil prices continue high, or more likely, rise further. O In just the first month of 2008, funds owned by Singapore, Kuwait, and South Korea invested a huge amount of money to prop up not only Citicorp, but another giant US financial corporation, Merrill Lynch. Global Economic 24

O In one sense the flow of money from sovereign wealth funds to beleaguered

O In one sense the flow of money from sovereign wealth funds to beleaguered companies in the US and elsewhere is just business as usual in a global world; it is just another global flow of one of the things that flows most readily around the globe – money O At the same time, it has led to cries for the creation of barriers to those flows. Global Economic 25

O In the US the worry is that through sovereign wealth funds, other nations

O In the US the worry is that through sovereign wealth funds, other nations were gaining control over its institutions (e. g. its banks and financial institutions) and its resources. O Said one US Senator: “In the short run, that they are investing here is good. . But in the long run it is unsustainable. Our power and authority is eroding because of the amounts we are sending abroad for energy and consumer goods”. O As a result, many American politicians were in favor of greater control over, and restrictions on, the flow of money from sovereign wealth funds to the US. Similar reactions have occurred in other 26 countries (e. g. France, Germany). Global Economic