Global economics
mxglor
Unit10.pdf
Unit 10 - Balance Of Payments and Debt Crises
u• The balance of payments (BoP): current account, capital and financial accounts
u• Imbalances around the world
u• Sovereign debt
u• Currency, financial and economic crises
u• Latin-American debt crisis
u• Asian financial crisis
u• 2008-2009 economic crisis
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“The balance of payments (BOP) is the record of any payment or receipt between one nation and its nationals with any other country. The current account, the capital account, and the financial account make up a country's BOP. Together, these three accounts tell a story about the state of an economy, its economic outlook, and its strategies for achieving its desired goals.” (Segal 2021)
The balance of payments (BoP): current account, capital and financial accounts
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• “A country's balance of payments is made up of its current account, capital account, and financial account.
• The capital account records the flow of goods and services in and out of a country, while the financial account measures increases or decreases in international ownership assets.
• Positive capital and financial accounts mean a country has more debits than credits making it a net debtor to the world. Negative accounts make the country a net creditor.”(Segal 2021)
The balance of payments (BoP): current account, capital and financial accounts
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“Countries, like households, may spend above their incomes sometimes, and below them at other times. A country that spends above its income imports more goods and services than it exports and is said to have a current account deficit. It finances this deficit by incurring liabilities to the rest of the world, or by borrowing from it.
A country with the opposite imbalance—a current account surplus— is accumulating claims on the rest of the world. Because all borrowing must be matched by lending, the sum of all the world’s current account deficits is equal the sum of its surpluses—a principle known as multilateral consistency.” (Obstfeld 2017)
Imbalances around the world
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Economic Crisis
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“Sovereign debt is debt issued by a central government, usually in the form of securities, to finance various development initiatives within a country.
The most important risk in sovereign debt is the risk of default by the issuing country. For this reason, countries with stable economies and political systems are considered to be less of a default risk in comparison to countries with a history of instability.
Measurement and assigned ratings for sovereign debt can vary between agencies.” (Chen, 2020)
Sovereign Debt
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In https://www.britannica.com/list/5-of-the-worlds-most- devastating-financial-crises
5 of the World’s Most Devastating Financial Crises
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An economic crisis is “A situation in which the economy of a country experiences a sudden downturn brought on by a financial crisis. An economy facing an economic crisis will most likely experience a falling GDP, a drying up of liquidity and rising/falling prices due to inflation/deflation. An economic crisis can take the form of a recession or a depression. Also called real economic crisis. See also collapse, recession, depression.”
Read more: http://www.businessdictionary.com/definition/economic-crisis.html
Have a look on the video ‘What is an Economic Crisis?’
https://youtu.be/zCX7ArwLfrA
Anufrijev, Ana & Dašić, Goran. (2013). STRATEGIC PLANNING IN THE GLOBAL ECONOMIC CRISIS AND RECESSION. Socioeconomica. 2. 315- 328. 10.12803/SJSECO.246013.
Have a look on the paper:
“Strategic planning in the global economic crisis and recession” https://www.researchgate.net/publication/275933272_STRATEGIC_PLANNING_IN_THE_GLOBAL_ECONOMIC _CRISIS_AND_RECESSION
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You can also have a look on Kitching, Blackburn, Smallbone, Dixon 2009 Business strategies and performance during difficult economic conditions
https://eprints.kingston.ac.uk/5852/1/Kitching-J-5852.pdf
u “When a central bank does not have enough official international reserve assets to maintain a fixed exchange rate, a balance of payments crisis/currency crisis results. u To sustain a fixed exchange rate, the central bank must have
enough foreign assets to sell in order to satisfy the demand of them at the fixed exchange rate.”
Financial Crisis and Capital Flight
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Source: https://en.wikipedia.org/wiki/Foreign_exchange_reserves
u “When it comes to recessions, sometimes the best definitions are the light-hearted ones. "If your neighbor gets laid off, it's a recession. If you get laid off, it's a depression," as one economist jokingly put it. However, economists officially define a recession as two consecutive quarters of negative growth in the gross domestic product (GDP). According to the National Bureau of Economic Research, the hallmark of a recession is a "significant decline in economic activity spread across the economy, lasting more than a few months."
u Both definitions are accurate because they indicate the same economic results: a loss of jobs, a decline in real income, a slowdown in industrial production and manufacturing, and a slump in consumer spending, which drives more than two-thirds of the U.S. economy.”
The Impact of Recessions on Businesses
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Have a look on the video ‘How a Recession Affects a Business’
In https://www.investopedia.com/articles/economics/08/recession-affecting-business.asp
Source: https://www.investopedia.com/articles/economics/08/recession-affecting-business.asp
Recession Impacts on Large Business
u “Let's say an unnamed Fortune 1000 manufacturer is suffering from the effects of a recession. What happens to this firm will likely happen to other big businesses as the recession runs its course.
u As sales revenues and profits decline, the manufacturer will cut back on hiring new employees, or freeze hiring entirely. In an effort to cut costs and improve the bottom line, the manufacturer may stop buying new equipment, curtail research and development, and stop new product rollouts (a factor in the growth of revenue and market share). Expenditures for marketing and advertising may also be reduced. These cost-cutting efforts will impact other businesses, both big and small, which provide the goods and services used by the big manufacturer.”
Falling Stocks and Slumping Dividends
u “As declining revenues show up on its quarterly earnings report, the manufacturer's stock price may decline. Dividends may also slump, or disappear entirely. Company shareholders may become upset and may, along with the board of directors, call for the appointment of new company leadership. The manufacturer's advertising agency may be dumped and a new agency hired. The internal advertising and marketing departments may also face a personnel shakeup.
u When the manufacturer's stock falls and the dividends decline or stop, institutional investors who hold that stock may sell and reinvest the proceeds into better-performing stocks. This will further depress the company's stock price. The sell-off and business decline will also impact employer contributions to profit-sharing plans or 401(k) plans if the company has such programs in place.”
Credit Impairment and Bankruptcy
u A recession will also dampen a company's accounts receivable (AR). Customers who owe the company money may make payments slower, later, or not at all. Then, with reduced revenues, the affected company may be forced to pay its own bills slower, later, or in smaller increments than their original credit agreement required. Making late or delinquent payments will reduce the valuation of a corporation's debt, bonds, and its ability to obtain financing. The company's ability to service its debt (pay interest on the money it has borrowed) may also be impaired, resulting in defaults on bonds and other debt and further damaging the firm's credit rating.
u On the other end of a recession, a company's debt may need to be restructured or refinanced, meaning new terms will have to be agreed upon by creditors. If the company's debts cannot be serviced and cannot be repaid as agreed upon in the lending contract, then bankruptcy may ensue. The company will then be protected from its creditors as it undergoes reorganization, or it may go out of business completely.”
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Source: https://www.investopedia.com/articles/economics/08/recession-affecting-business.asp
Employee Lay-offs and Benefit Reductions
u “The business may cut employees, and more work will have to be done by fewer people. Productivity per employee may increase, but morale may suffer as hours become longer, work becomes harder, wage increases are stopped, and fear of further layoffs persists.
u As the recession increases in severity and length, management and labor may meet and agree to mutual concessions, both to save the company and to save jobs. The concessions may include wage reductions and reduced benefits. If the company is a manufacturer, it may be forced to close plants and discontinue poorly performing brands. Automobile manufacturers, for example, have done this in previous recessions.”
Cuts to Quality of Goods and Services
u “Secondary aspects of the goods and services produced by the recession-impacted manufacturer may also suffer. In an attempt to further cut costs to improve its bottom line, the company may compromise the quality, and thus the desirability, of its products. This may manifest itself in a variety of ways and is a common reaction of many big businesses in a steep recession.
u Airlines, for example, may lower maintenance standards. They may install more seats per plane, further cramping the already squeezed-in passenger. Routes to marginally profitable or money-losing destinations may be cut, inconveniencing customers and damaging the economies of the canceled destinations.
u Giant food purveyors may offer less product for the same price in the same size package. The quality of food being produced may also be cut, compromising flavor and driving away cost- conscious consumers with little brand loyalty who will likely notice the change.”
Reduced Consumer Access
u “As firms impacted by the recession spend less money on advertising and marketing, big advertising agencies which bill millions of dollars per year will feel the squeeze. In turn, the decline in advertising expenditures will whittle away at the bottom lines of giant media companies in every division, be it print, broadcast, or online. As the effects of a recession ripple through the economy, consumer confidence declines, perpetuating the recession as consumer spending drops.”
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Source: https://www.investopedia.com/articles/economics/08/recession-affecting-business.asp
Recession Impacts on Small Businesses
u “Small, private businesses with annual sales substantially less than the Fortune 1000 actually perform fairly similarly to large businesses during a recession. Without major cash reserves and large capital assets as collateral, however, and with more difficulty securing additional financing in trying economic times, smaller businesses may have a harder time surviving a recession. Bankruptcies among smaller businesses typically occur at a higher rate than among larger firms.
u The bankruptcy or dissolution of a small business that serves a community — a franchised convenience store, for example — can create hardships not only for the small business owners but also for residents of the neighborhood. In the wake of such bankruptcies or dissolutions, the entrepreneurial spirit which inspired someone to go into such a business may take a hit, discouraging, at least for a while, any risky business ventures. Too many bankruptcies may also discourage banks, venture capitalists, and other lenders from making loans for startups until the economy turns around.”
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Source: https://www.investopedia.com/articles/economics/08/recession-affecting-business.asp
u “A currency crisis is brought on by a sharp decline in the value of a country's currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates, meaning one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that, from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies.
u But a currency crisis—such as hyperinflation—is often the result of a shoddy real economy underlying the nation's currency. In other words, a currency crisis is often the symptom and not the disease of greater economic malaise.”
Currency Crisis
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
u “Central banks are the first line of defense in maintaining the stability of a currency. In a fixed exchange rate regime, central banks can try to maintain the current fixed exchange rate peg by dipping into the country's foreign reserves, or intervening in the foreign exchange markets when faced with the prospect of a currency crisis for a floating-rate currency regime.
u When the market expects devaluation, downward pressure placed on the currency can be offset in part by an increase in interest rates. In order to increase the rate, the central bank can lower the money supply, which in turn increases demand for the currency. The bank can do this by selling off foreign reserves to create a capital outflow. When the bank sells a portion of its foreign reserves, it receives payment in the form of the domestic currency, which it holds out of circulation as an asset.
u Central banks cannot prop up the exchange rate for prolonged periods due to the resulting decline in foreign reserves as well as political and economic factors such as rising unemployment. Devaluing the currency by increasing the fixed exchange rate also results in domestic goods being cheaper than foreign goods, which boosts demand for workers and increases output. In the short run, devaluation also increases interest rates, which must be offset by the central bank through an increase in the money supply and an increase in foreign reserves. As mentioned earlier, propping up a fixed exchange rate can eat through a country's reserves quickly, and devaluing the currency can add back reserves.
u Investors are well aware that a devaluation strategy can be used, and can build this into their expectations—much to the chagrin of central banks. If the market expects the central bank to devalue the currency—and thus increase the exchange rate—the possibility of boosting foreign reserves through an increase in aggregate demand is not realized. Instead, the central bank must use its reserves to shrink the money supply which increases the domestic interest rate.”
Fighting a Currency Crisis
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
“Investors often attempt to withdraw their money en masse if there is an overall erosion in confidence of an economy's stability. This is referred to as capital flight. Once investors sell their domestic currency-denominated investments, they convert those investments into foreign currency. This causes the exchange rate to get even worse, resulting in a run on the currency, which can then make it nearly impossible for the country to finance its capital spending.
Currency crisis predictions involve the analysis of a diverse and complex set of variables. There are a couple of common factors linking recent crises:
u The countries borrowed heavily (current account deficits)
u Currency values increased rapidly
u Uncertainty over the government's actions unsettled investors”
Anatomy of a Currency Crisis
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
Latin American Crisis of 1994
“On Dec. 20, 1994, the Mexican peso was devalued. The Mexican economy had improved greatly since 1982 when it last experienced upheaval, and interest rates on Mexican securities were at positive levels.
Several factors contributed to the subsequent crisis:
u Economic reforms from the late 1980s—which were designed to limit the country's oft-rampant inflation—began to crack as the economy weakened.
u The assassination of a Mexican presidential candidate in March of 1994 sparked fears of a currency sell- off.
u The central bank was sitting on an estimated $28 billion in foreign reserves, which were expected to keep the peso stable. In less than a year, the reserves were gone.
u The central bank began converting short-term debt, denominated in pesos, into dollar-denominated bonds. The conversion resulted in a decrease in foreign reserves and an increase in debt.
u A self-fulfilling crisis resulted when investors feared a default on debt by the government.
u When the government finally decided to devalue the currency in December 1994, it made some major mistakes. It did not devalue the currency by a large enough amount, which showed that while still following the pegging policy, it was unwilling to take the necessary painful steps. This led foreign investors to push the peso exchange rate drastically lower, which ultimately forced the government to increase domestic interest rates to nearly 80%. This took a major toll on the country's gross domestic product (GDP), which also fell. The crisis was finally alleviated by an emergency loan from the U.S.”
Currency Crisis Examples (Published by Investopedia)
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
Asian Crisis of 1997
“Southeast Asia was home to the tiger economies—including Singapore, Malaysia, China, and South Korea—and the Southeast Asian crisis. Foreign investments poured in for years. Underdeveloped economies were experiencing rapid rates of growth and high levels of exports. The rapid growth was attributed to capital investment projects, but the overall productivity did not meet expectations. While the exact cause of the crisis is disputed, Thailand was the first to run into trouble.
Much like Mexico, Thailand relied heavily on foreign debt, causing it to teeter on the brink of illiquidity. Real estate dominated investment but was inefficiently managed. Huge current account deficits were maintained by the private sector, which increasingly relied on foreign investment to stay afloat. This exposed the country to a significant amount of foreign exchange risk.
This risk came to a head when the U.S. increased domestic interest rates, which ultimately lowered the amount of foreign investment going into Southeast Asian economies. Suddenly, the current account deficits became a huge problem, and a financial contagion quickly developed. The Southeast Asian crisis stemmed from several key points:
u As fixed exchange rates became exceedingly difficult to maintain, many Southeast Asian currencies dropped in value.
u Southeast Asian economies saw a rapid increase in privately-held debt, which was bolstered in several countries by overinflated asset values. Defaults increased as foreign capital inflows dropped off.
u Foreign investment may have been at least partially speculative, and investors may not have been paying close enough attention to the risks involved.”
Currency Crisis Examples (Published by Investopedia)
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
“An economy can be initially solvent and still succumb to a crisis. Having a low amount of debt is not enough to keep policies functioning or quell negative investor sentiment.
Trade surpluses and low inflation rates can diminish the extent at which a crisis impacts an economy, but in case of financial contagion, speculation limits options in the short run.
Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require near- term payments. If the government also invests in short-term debt, it can run through foreign reserves very quickly.
Maintaining the fixed exchange rate does not make a central bank's policy work simply on face value. While announcing intentions to retain the peg can help, investors will ultimately look at the central bank's ability to maintain the policy. The central bank will have to devalue in a sufficient manner in order to be credible.”
Lessons Learned From Currency Crises
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Source: https://www.investopedia.com/articles/economics/08/currency-crises.asp
