Case Study

622 Part 7 Cases

corruption, it is hard to see how the IMF supported pro- gram can continue to be successful." Lagarde's com- ments followed the resignation of Ukraine's economic minister after he accused a senior aide to the president of blocking anticorruption reforms. Following Lagarde's comments, the Ukrainian government pledged to step up its efforts to fight political corruption and introduce eco- nomic reforms but cautioned that changes could not be made overnight. In April 2017, the IMF unlocked another $1 billion of support for the Ukraine after the govern- ment had taken IMF-mandated steps to rein in the bud- get, crack down on corruption, and improve the investment climate. However, the IMF stressed that fur- ther structural reforms are necessary to achieve faster economic growth, including reforming government pen- sions, tougher corruption measures, and privatizations.

Sources Andrew Mayeda, "IMF Approves Ukraine Aid Package of about $17.5 Billion," Bloomberg Businessweek, March II, 2015; "IMF Signs Off on $17.5 Billion Loan for Ukraine in Second Attempt to Stave Off Bankruptcy," Reuters, March II, 2015: "The New Greece in the East," The Economist, March 12, 2015: Larry Elliott, "IMF Warns Ukraine It Will Halt $40 Billion Bailout Unless Corruption Stops," The Guardian, February 10,

2016: Angela Bouznis, "Ukraine: Fresh IMF Funds Unlocked, but Economic Blockade Sours Recovery," Focus Economics. April 4, 2017.

Case Discussion Questions

I. Why do you think Viktor Yanukovych walked away from a trade agreement with the EU in favor of closer ties with Russia? What did he gain by doing this? What did he lose?

2. What were the root causes of Ukraine's currency cri- sis? Without help from the IMF, what might have happened?

3. Were the policy recommendations made by the IMF reasonable?

4. Why do you think the Ukrainian government balked at fully implementing the lMF policies?

5. Was the IMF right to suspend disbursement of monies under its loan program in October 2015? Under what conditions should the IMF resume making loans?

6. What might happen if the lMF discontinues its loan program to Ukraine, as it has threatened to do?

7. Could the IMF have done anything differently to avoid the situation it now finds itself in?

The Global Financial Crisis and Its Aftermath: Declining CrossBorder Capital Flows

For decades, cross-border capital flows-including lend- ing, foreign direct investment flows, and purchases of equities and bonds-advanced relentlessly, reflecting the increasing integration of national capital markets into one single massive global system. Cross-border capital flows surged from $0.5 trillion in 1980 to a peak of $11.8 trillion in 2007; then they collapsed. By 2014, cross-border capital flows were around 66 percent below their former peak. The global capital market, it seemed, was in retreat.

To understand why, we have to go back to 200:8, when a major crisis swept through the global capital market that very nearly froze the financial pipes that lu- bricate the wheels of the global economy. Financial in- stitutions and corporations around the world routinely lend and borrow trillions of dollars between themselves. Most banks and corporations issue unsecured notes known as commercial paper with a fixed maturity of be- tween I and 270 days. This is a way for those firms to get access to cash to meet short-term obligations, such as meeting payroll and paying suppliers. Because the notes are unsecured, and not backed by any specific as- sets, only banks and corporations with excellent credit

ratings are able to sell their commercial paper at a rea- sonable price. This price is set with reference to the London Interbank Offered Rate (LIBOR). The LIBOR is the rate at which banks lend to each other. In normal times, the LIBOR is very close to the rate charged by national central banks, such as the U.S. Federal Reserve for the dollar.

Early in 2008 banks in several countries had started to run into trouble as it became clear that the value of the mortgage-backed securities that they held was collapsing. This was due to a fall in housing prices, and rising default rates on mortgages, most notably in the United States and Great Britain, where lenders had written increasingly risky mortgages over the preceding few years. These mort- gages were bundled into securities and then sold to other financial institutions. Also, many institutions held com- plex derivatives, the value of which was tied to the under- lying value of mortgage-backed securities. Now these institutions were facing large write-offs on their portfolios of mortgage-backed securities and the associated deriva- tives. One of these institutions, Lehman Brothers, had taken aggressive positions in the market for mortgage- backed securities. In September 2008, the firm collapsed

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Cases 623

into bankruptcy after the U.S. government decided not to Five years after the crisis hit, the global capital mar- step in and save the company. ket had still not fully recovered from its 2007 peak.

The bankruptcy of Lehman sent shock waves through Does this signal a retreat from the globalization of capi - the global financial markets. In effect, the U.S. govern- tal or merely a reset? Most observers believe the latter ment had stated it was prepared to let large financial insti- is the case. Since 2008, the world economy has grown tutions fail. Immediately, banks reduced their short-term slowly, and economic troubles persist in many regions, loans. They did this for two reasons. First, they felt a need3particularly Europe, where several national govern - to hoard cash because they no longer knew the value of ments are burdened with high levels of sovereign debt the mortgage-backed securities they held on their owr'-.. that limits their ability to deal with persistently slow balance sheets. Second, they were afraid to lend to oth( growth and high unemployment. Notwithstanding this, banks because those banks might fail and they might not the world economy continues to become more inte- get their money back. grated, propelled by stronger growth in some develop-

As a result, the LIBOR quickly spiked. The dollar ing nations, and as this process unfolds, global capital rate, for example, had been 0.2 percent above the rate markets will inevitably start to expand again to support on three-month U.S. Treasury bills in 2007, which is a cross-border trade in goods and services, as well as normal spread. However, the spread increased to 3.3 per- cross-border investments. cent by late 2008, raising the cost of short-term borrow- ing some 16 -fold. Many corporations found that they could not raise capital at a reasonable price. Money Sources market funds, which in normal times are large buyers of Susan Lund et al., "Financial Globalization: Retreat or Reset?" commercial paper, fled to ultra-safe assets, such as U¯S McKinsey Global Institute, March 2013; "Blocked Pipes," The Treasury bills. This pushed the yield on three-month Economist, October 4, 2008, pp. 73-75; "On Life Support," The Treasury bills down to historic lows, and also led to a Economist, October 4, 2008, pp. 77-78; M. Boyle, "The Fed's sharp rise in the value of the U.S. dollar. In essence, the Commercial Paper Chase," Business Week, October 8, 2008, financial plumbing of the global economy was freezing p. 5; M. Gordon, "TARP Bailout Costs to Taxpayers Expected up. If nothing was done about it, many firms would be to Be Lower," Christian Science Monitor, December 17, 2012; unable to borrow to service their short-term financing Elaine Moore, "Cross-Border Capital Flows Return to 2011 needs. They would rapidly become insolvent, and a Levels," Financial Times, November 30, 2014. wave of bankruptcies could sweep around the globe, plunging the world into a serious recession, or even a depression. Case Discussion Questions

At this point, several national governments stepped I Do you think that something like the financial crisis into the breach. The U.S. Federal Reserve entered the that occurred in 2007-2008 could happen again? If commercial paper market, setting up a fund to purchase it did, what would the impact be on the ability of commercial paper at rates close to the rates for U.S. firms to raise capital to fund investments, and on Treasury bills. Central banks in Japan, Great Britain, the global economy? aiid the European Union took similar action. Once par- ~" In retrospect, were central banks justified in step- ticipants in the global capital markets saw that national

ping in as aggressively as they did to shore up the governments were willing to enter the commercial paper global financial system? If they had not done so, and market, they too started to ease their lending restrictions,

instead let more large financial institutions fail, what and the LIBOR started to fall again. The U.S. govern- would have been the consequence? ment established the Troubled Asset Relief Program (TARP), allowing the U.S. Treasury to purchase or in- 3/ How can the risk of occurrence of crises such as the sure up to $700 billion in "troubled assets." ¯Under 2007-2008 global financial crisis be mitigated in the TARP, the government began to inject capital into trou 'future? bled banks by purchasing assets from them that were dif- / Why do you think that global capital flows were still ficult to value, such as mortgage-backed securities. This significantly below their 2007 peak seven years after signaled there would be no more bankruptcies such as the crisis hit? What are the implications of this for Lehman's. This too helped unfreeze the market for corn- the ability of multinational firms to finance their in- mercial paper. A major crisis had been averted, but only I vestments by raising outside capital? just. Although the $700 billion price tag for TARP / What actions do you think a multinational firm can stunned people, most of the money lent to banks under take to limit the impact of future crises in the global TARP was quickly paid back with interest, and by late financial system on the ability of the enterprise to 2012, estimates suggest that the total cost to the taxpayer raise capital to pay its short-term bills and fund long- would be close to $24 billion, term investments?