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ECN 440 (2)


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Ryerson University
ECN 440
Teresa Fung

Bretton Woods System (1946-1971)  1944: Bretton Woods conference (44 countries)  Creation of the IMF and the World Bank  Each country set a fixed value of its currency in terms of the US$ (par values), and the US$ fixed its value in terms of gold (1 ounce of gold = US$35)  Official exchange rate was determined by the par values of the two currencies.  If 0.5 Pound = US$1; 200 Yen = US$1; then this implies 0.5 Pound = 200 Yen or 1 Pound to 400 Yen  Convertibility of US$ into gold on demand: limited to US Federal Reserve and other member central banks (not to general public) Four serious problems in the 1920s and 1930s:  Worldwide depression  Collapse of world trade  Collapse of the international monetary system  Collapse of international lending Founding principles of the Bretton Woods institutions:  Trade should be open in all countries  Nations should not discriminate against other nations  Countries should not limit the buying and selling of currency when its purpose is to pay for imports  Exchange rates should be fixed but with possibility of periodic adjustment  UK: John Keynes  US: Harry White  Keynes saw the international institution as a kind of world central bank which could create money on its own and thus give countries financial support  An international lender of last resort  Largely independent so that no political influence could be exercised over its decision- making  White advocated the provision of financial assistance from member countries’ contributions  A tighter grip on the policy of the country receiving the credit  Central banks held international reserves in convertible currencies (US$-denominated assets)  The aim of the system was to strike a balance between the objective of stable exchange rates and domestic macroeconomic goals  To reduce the likelihood of competitive devaluations  To reduce the likelihood of exchange controls and other trade restrictions  To reduce the high cost of adjusting for payment imbalances in the form of unemployment and recession Bretton Woods System - Adjustment Mechanism A system of adjustable pegged exchange rates (Dollar Standard):  there were about 10 major realignments between 1946 and 1971  Each member country contributes reserve assets according to a quota system to finance temporary balance of payments disequilibria The U.S. (reserve-currency country):  cannot revalue or devalue its currency against other currencies  Can finance its external deficits by issuing liabilities on itself How Bretton Woods Worked  Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)  Loans from IMF to cover loss in international reserves  IMF encourages contractionary monetary / fiscal policies  Recession  Devaluation only if IMF loans are not sufficient  No tools for surplus countries  U.S. could not devalue currency  Adjustment mechanism: Central bank intervention in the FX markets  For example: there was an excess supply of francs relative to the US$, the value of francs fell (depreciation)  To support the par value of francs, the Bank of France bought francs and sold US$ until there was no more excess supply  Collapse of the Bretton Woods System  Market price of gold: rising  rising demand for gold in postwar era  supply not increasing enough to meet the higher demand  US’s liabilities to foreigners (particularly in the 1960s): rising (1950-70: US$39 billion)  US’s gold reserves: falling (1949-1960: $8 billion) Collapse of the Bretton Woods System  US: persistent external deficits  1971: US$30 billion Many factors:  military and economic aids (Vietnam War in the 1960s)  fiscal deficits  inflationary pressures  private capital outflows  rising productivity of trading partners (Germany, Japan),  Expectation of major devaluation of the US$  Speculative attacks on the US$  Collapse of the Bretton Woods System  Smithsonian Agreement in 1971: US$ devaluation against gold, from US$35 per ounce to US$38 per ounce (later changed to US$42 per ounce), but failed to save the system 1971: Nixon closed the US gold window 1971: Germany floated the German mark 1972: UK floated the Pound 1973: Japan and other European countries floated their currencies The IMF  Founded in 1945 at the Bretton Woods meetings between the Allies in July 1944  187 members (2010): IMF is the central monetary institution in today’s international economy  Funding comes from member quotas, or “deposits”  depend on member’s size and status  determine member’s voting weight  determine the member’s access to loans The IMF: Functions  Prevent crisis in the system by promoting sound macroeconomic policy, which includes:  Balanced expansion of trade  Stable exchange rates  Avoidance of competitive devaluations  Orderly corrections of Balance of Payments problems (trade deficits) The IMF Conditionality  Financial crisis  Occurs when a country runs out of foreign exchange reserves—a major currency or gold that can be used to pay for imports and international borrowings  Members can borrow against IMF quotas in the event of financial crisis  IMF conditionality: requirement for the borrowing member to carry out economic reforms in exchange for a loan Key features of IMF lending  Conditional on policies to correct balance of payments problems  IMF funds will be deposited in the Central bank of the borrowing country, cannot be used to finance projects  loans may be disbursed over periods as short as six months and as long as four years, with repayment period ranges from three to seven years (10 years for low-income countries)  all but the low-income developing countries pay market-related interest rates and service charges, plus a refundable commitment fee  Low-income countries borrowing under the Poverty Reduction and Growth Facility pay a concessional fixed interest rate of 1/2 percent a year Financial Liberalization  Latin American debt crises in the 1980s  Global Information Revolution and International Finance  Explosion of information technologies parallel the explosion of international finance  Both money and documentation are moved by information technologies at a faster speed 1947: invention of the transistor 1960s: integrated circuits 1970s: fax machines 1980s: personal computers 1990s: internet Global Information Revolution and International Finance  Question: Does the improvement in communication technology create better-informed investment behaviour and more stable financial market?  Answer: YES and NO  Chancellor:  “The wider availability of financial information has tended to attract impulsive new players to the speculative game.”  “In the era of global 24-hour trading, money didn’t sleep, nor did those who pursued it.” The Rise of Economic Liberalism  By early 1970s, Keynesian economics was under sustained attack  Milton Friedman (University of Chicago): Free Market ideology (laissez-faire)  He argued that the market was fundamentally a self-correcting mechanism  Government attempts to interfere with market operation were doomed to failure  All government intervention, however well-intentioned, had harmful side effects  Friedman: Great Depression was not caused by speculators but by a sharp contraction of the money supply due to the monetary policy of the Fed  Friedman: against capital controls and fixed exchange rates, in favour of floating exchange rates and free movement of capital  1980s: Reagan (U.S.) + Thatcher (U.K.) in power: government policies favoured “de-regulation” and tax cuts (to reduce the size of government) Stagflation in the 1970s  1970s: Oil Crises  Most economies suffered stagflation (stagnation + inflation) because of rising costs of production  Emergence of “Supply-side” economics  To increase growth and reduce inflation, government should cut taxes to provide incentives to households and firms to supply more labour and capital for production  Supply  Prices  Production  Jobs   Early 1980s: Reagan government cut US income tax rates by 25% to stimulate growth  Deregulation and International Finance  In the capital markets, deregulation was replacing supervision  Globalization of financial markets has been encouraged by government deregulation  Governments removed ceilings on interest rates, reduced taxes and brokerage commissions on financial transactions, gave foreign financial firms greater access to their home financial markets, allowed increased privatisation and securitization of assets, and free international movement of capital Deregulation in the U.S.  1974: U.S. abolished the Interest Equalization Tax ( US lenders were no longer taxed for lending overseas)  1975: fixed commissions were abolished on the NYSE  1980s: dismantled interest rate ceiling (Regulation Q) Deregulation in the U.K.  UK deregulation in the 1980s paralleled those in the US  1979: UK removed all inward and outward barriers to capital flows  1980-83: Britain experienced an annual portfolio investment outflow that was 1,800 times higher than in the 1975-78 period.  1986: the Big Bang: scrapped 85 years of fixed commissions for brokers  Competition increased immediately: 49 firms including American, European, Asian financial giants signed up to market British stocks and government bonds (only 19 firms before the change) Deregulation in Other Countries  Anxious not to lose business to New York and London, other countries embraced the international financial markets in the 1980s  By 1984, Japan had given US banks virtually free access to many of the Tokyo financial markets including the underwriting of Japanese government bonds  Germany: liberalized foreign exchange controls in March 1981, abolished its withholding tax on interest payments on foreigners in 1984 (one month after the US had removed its withholding tax) Effects of Financial Globalization  Global competition  efficiencies   Financial intermediaries must adopt the cheapest information-based technologies if they are to profitably survive  They must be well informed about the needs of their customers, to keep them satisfied and not shifting to their competitors  Fewer restrictions  global interest rates are lower than the average of all the old national interest rates  Expansion of the volume of loans (domestic and foreign)  Effects of Financial Globalization  Globalization provided the biggest benefits to the borrowers who had historically paid the highest interest rates  In the 1970s and early 1980s, it was the US interest rates which were the highest  Eurobonds issued by American corporations grew from $7 billion in 1983 to $35 billion in 1986  Structural integration of stock markets began to encourage foreign buying of American business assets in the mid-1980s ($5 billion in 1985, $25 billion in 1986, $30 billion in 1987, $500 billion in 1989) Effects of Financial Globalization  In just 4 years (1982-1986), US reversed its position as the world’s biggest “creditor” nation and became the world’s largest debtor country, the first time since 1914.  Question: Why Americans borrowed from foreigners?  Lower personal savings rates after 1981  Record federal government budget deficits  Question: Which country emerged as the largest “creditor” nation?  Answer: Japan Interest Rates in the 1970s and 1980s  Two oil crises in the1970s: Inflationary period   restrictive monetary policy   “High” domestic interest rate   Recession in 1982  Real interest rates charged on US dollars:  1975-79: average of 0.4%  1980-86: average of 6.5%  UK: negative real interest rates in the 1970s but turned positive from 1981 to 1986 (average 5%)  International Borrowing by LDC  1972-1979: Less-developed countries (LDCs) had increased their international indebtedness at an average rate of 21.7%  Why?  Answer: Inflation > Nominal interest rates  real interest rate was negative Petrodollar Recycling  Middle East oil exporters deposited their dollar profits in US and European banks, which, in turn, granted enormous amounts of credit to the governments and state institutions in the developing countries, especially in Latin America, eager for cheap loans.  Early 1980s: US interest rate  and US$   The cost of servicing the foreign debt denominated in US dollar   Petrodollar recycling contributed to the expansion of LDC external debt  LDC: International Borrowing Before 1970s:  creditors were mainly foreign governments, international financial institutions such as World Bank, IMF  Loans were created as a compromise or goodwill terms (low interest rates, long repayment periods)  Purposes were mainly for development projects (infrastructure construction) and/or imports of capital goods LDC: International Borrowing Late 1970s to 1980s:  Commercial banks played a larger role in international lending  Loans were on non-concessionary terms: variable market rates of interest, shorter maturity  Recycled OPEC petrodollars to LDCs in the form of general purpose loans  1976-82: $350 billion recycled from OPEC to LDCs  External debt of LDCs increased from $180 billion in 1975 to $406 billion in 1979  Non-concessionary loans as a percentage of total loans increased from 40% in 1971 to 68% in 1975 to 77% in 1979  Debt service payment tripled from $25 billion in 1975 to $75 billion in 1979  1973-79: with average income growth of 5.2%, no problems with servicing external borrowing  Latin America: International Borrowing  Between 1975 and 1982, the debt owed by Latin American countries to private commercial banks increased at an average annual rate of 20 percent  External debt of Latin America quadrupled from $75 billion in 1975 to more than $315 billion in 1983, or 50 percent of the region's production and income (GDP).  Debt service (interest payments and the repayment of principal) grew even faster, reaching $66 billion in 1982, up from $12 billion in 1975 Total Latin American Debt  The debt increased more rapidly from the middle of the 1970s Debt Crisis of the 1980s 1979: Second oil shock  Worsened terms of trade with the decline of commodity prices by 20%  Rise in US interest rates 1982: recession in developed countries  Exports from less developed countries (LDC) to developed countries  Prices of LDC exports  Problems with external debt servicing Example: Mexico  A one-dollar drop in world oil price reduces Mexico’s export earnings by a half billion dollars per year.  Debt Indicators - 1983  External Debt / Export Ratios Recap  Post-war period:  Advancement in information technology  Economic policies: free market, de-regulation  1970s: Oil crises: stagflation, petrodollar recycling  1980s: Financial Liberalization and Globalization  Latin American LDC:  Infrastructure building: Government budget deficit   Inflation  real cost of borrowing   International borrowing   Recession in the developed countries: exports   Debt servicing cost on international loans  Debt Crisis in the 1980s  US prime interest rate discounted by the price of non-fuel exports of the LDCs:  1975-79: 5.7%  1986: 19.5%  an increase of almost 14% in real cost of financing  Many of the old loans were affected (particularly those on variable interest rate)  New loans could rarely be justified  Increase in Interest Rates  Interest rates started to rise sharply in late 1970s and early 1980s  During that period, many developed countries governments adopted restrictive monetary policy  Capital Flight  Higher interest rates in developed countries attracted capital flows from LDCs  1976-1985: $200 billion from just 5 countries: Argentina, Brazil, Mexico, the Philippines, Venezuela  Some of those capital flows were not just to seek for higher returns but also safety  1976-1985: Capital flight accounted for almost 50% of total borrowing by LDCs  Destinations: US and Switzerland (primary safe havens)  Capital Flight From Latin America: 1980s Debt Crisis in the 1980s  August 12, 1982: Mexico stopped its repayment of foreign debt (around US$80 billion), announced unilaterally, a moratorium of 90 days  it also requested a renegotiation of payment periods and new loans in order to fulfill its prior obligations  Other indebted LDC countries followed  By end of 1982, around 40 countries were in arrears in their interest payments  By 1983 October, 27 countries owing $239 billion had rescheduled their debt or in the process of doing so  16 were from Latin America, including the four largest Latin American economies (Mexico, Brazil, Venezuela and Argentina) with $176 billion owed to various private commercial banks (74% of total LDC debt)  Several of the world’s largest banks faced the prospects of major loan default and failure  Creditor countries were worried because their banks did not have enough capital to make up for the potential insolvency of these developing countries  The solvency of many US banks was at stake  Nine major US banks had 176.5% of their capital in heavily debt-burdened Latin American countries at the end of 1982  If they had to write-off a majority of this debt, then these major US banks would be left with insufficient capital to remain in business  August 12, 1982: Mexico stopped its repayment of foreign debt (around US$80 billion), announced unilaterally, a moratorium of 90 days  it also requested a renegotiation of payment periods and new loans in order to fulfill its prior obligations  Other indebted LDC countries followed  By end of 1982, around 40 countries were in arrears in their interest payments  By 1983 October, 27 countries owing $239 billion had rescheduled their debt or in the process of doing so  16 were from Latin America, including the four largest Latin American economies (Mexico, Brazil, Venezuela and Argentina) with $176 billion owed to various private commercial banks (74% of total LDC debt)  Several of the world’s largest banks faced the prospects of major loan default and failure  Creditor countries were worried because their banks did not have enough capital to make up for the potential insolvency of these developing countries  The solvency of many US banks was at stake  Nine major US banks had 176.5% of their capital in heavily debt-burdened Latin American countries at the end of 1982  If they had to write-off a majority of this debt, then these major US banks would be left with insufficient capital to remain in business Baker Plan  1985: US Treasury Secretary, James Baker, proposed the Baker Plan  Primary emphasis: protect the short-run solvency of US banks  No call for debt reduction or any other effective means of ultimately reducing the debt burden in the LDCs  Baker called for private sector involvement through voluntary rescheduling of bank loans as well as new loans to service existing LDC debt so that US banks could continue to receive normal payments and not have to classify a significant portion of their LDC debt as bad debt Emergency Measures in Debtor Countries  Bailouts: private external debt was taken on by the government. If private debtors who borrowed are not paying back the banks, taxpayers are now on the hook for this debt.  Nationalization of banking debt in Mexico, Argentina, and Chile  International banks refused to refinance the short‐term loans to other Latin American governments  Exchange controls to block capital flight  Reserve requirements on banks were increased (tightened credit, monetary contraction)  Sharp devaluation of exchange rate to confront trade deficits  Slashed wages and drastic cuts in public expenditures to deal with massive budget deficits IMF Stabilization Program  Loans and assistance are contingent on commitments to economic reforms and restructuring (conditionality):  Trade Liberalization  Abolition or liberalization of exchange or import controls (free trade stimulate growth)  Devaluation of the exchange rate  To stimulate exports and correct any overvaluation of the exchange rate  Anti-inflation program  Increase interest rates or reserve requirements  Control fiscal deficit by decreasing government spending and/or increasing taxes  Control wage increase  Relaxation of price controls (free market reduces market distortions)  Greater openness to foreign investment  Privatization of state-owned enterprises  Short term stabilization involved adjustments which caused lower growth, higher unemployment, rising poverty and widening income inequality  1982-88: IMF programs failed to work well in 28 out of 32 countries  Many countries adjusted but did not grow  Short term measures cannot resolve external debt problems which are structural and long term in nature  Politically unpopular  Political instability and social unrest Debt Relief  Defaults adversely affect international banks  International commercial bank loans to LDCs dropped from $67 billion in 1987 to $19 billion in 1992  Creditors: incentives to provide some forms of debt relief or to negotiate debt restructuring to ensure repayments  Debt relief: merely postpone payments, not really solve the external debt problems of LDCs  Rumors of defaults led to currency speculation  pushing up the demand for US$ and raising the value of US$ in terms of LDC currencies Brady Plan  1989: new US Treasury Secretary, Nicholas Brady, proposed another debt relief plan Debt restructuring measures:  Partial cancellation  Reduced interest rates  Extended maturity of payments Brady Plan - Mexico  Covers $48 billion of the $100 billion of Mexico’s external debt  Agreement between Mexico and 15 banks  Debt-to-bonds swap:  exchange their loans for new 30-year Mexican Government bonds at a discount to face value of 35% (discount bonds with same interest rate as the old loans)  exchange their loans for new 30-year Mexican Government bonds with the same face value but lower interest rates Brady Plan Results Results: (1990)  49% of banks exchanged $22 billion in debt for lower interest fixed rate bonds  41% of banks exchanged $20 billion for discounted floating rate bonds  Mexico saved $1.3 billion per year  Between 1989 and 1994, the forgiveness of existing debts by private lenders amounted to about 32% of the $191 billion in outstanding loans: $61 billion for the 18 nations that negotiated Brady Plan reductions Successful in several aspects:  Substantial reductions in the overall level of debt and debt service  Diversifying independent risk away from commercial bank portfolios  Encouraged LDCs to adopt and pursue economic reform programs  Enabled LDC to regain access to the international capital markets for financing needs The End of the Debt Crisis  In 1991, for the first time after the beginning of 1982 crisis, foreign capital inflows to these countries exceeded the related outflows.  1980s are often referred to in Latin America as the “lost decade”  Depreciation + higher interest rates  Tightening credit expansion  slowed investment  Latin America shut off from FDI and portfolio capital inflows during the 1980s  Deep recession, high unemployment and massive migration to USA The Rise of Cowboy Capitalism  1970s: decade of chronic financial instability (floating currencies, rising inflation and declining growth)  The volatility of the stock market made it a dangerous place for investors  1970s: bearish stock market condition  Speculation shifted to commodities and precious metals which offered best hedge against chronic inflation  During the 1970s, several leading US investment banks, including Morgan Stanley, went public  Institutionalized speculation became an appealing route to quick profits and large bonuses  The rapid growth of “securitization” (the process of turning illquid assets into tradable securities) further enhanced the role of these trader-salesman  There was also rapid growth of hedge funds, private investment partnerships which were highly leveraged and relatively “unregulated” (evaded SEC’s regulation)  Example: the Quantum Fund founded by George Soros in 1973 - produced average annual returns in excess of 25% from its leveraged positions in a variety of stock, bond, and currency markets  Investment Partnerships: highly leveraged, looked for profit from the sharp price movements associated with corporate takeovers. Privatization of Public Companies  Governments with budget deficits: had a new and ready source of funds in the international capital markets  Mrs Thatcher (UK Prime Minister) pioneered the privatization of state-owned “public” corporations by floating them on the stock market  Leveraged buyout (LBO): acquire a company with the maximum amount of debt  The principal and interest on the LBO debt was to be paid off as quickly as possible with the cash flow generated by the company  Once the leverage had reached a conventional level the company was put up for sale or refloated on the stock market  Example of LBO  1983: Flotation of Gibson Greeting Cards  Before the flotation, William Simon, together with a partner, purchase the company for $1 million in equity and $79 million of debt  When the company was offered in the stock market, its market capitalization was $290 million  Simon’s personal investment of $330,000 had turned into a fortune of over $66 million! Leveraged Buyout Factors which favoured LBO:  Falling interest rates  Rising asset prices  Tax system which did not tax corporate interest payments but tax the dividend payments  While the Fed prevented speculators from buying shares on a margin of more than 50%, there were no restrictions on the amount of leverage applied in a LBO  Advantages of a participant in LBO (relative to a margin speculator):  Interest payments were tax-deductible  He was not subjected to margin calls  He was not personally responsible for the LBO debt, which was packaged as bonds and sold on to other investors  If the company went bankrupt, he could walk away with little loss, but if the deal was a success, his gains were outlandish Junk Bonds Guru  Michael Milken was employed in 1970 by Drexel Burnham Lambert as a trader in “junk” bonds (loan securities which paid a higher rate of interest because its issuer’s credit rating was low)  He called these lowly-rated companies “fallen angels” and considered them good investment opportunities  He claimed that a portfolio of speculative bonds would produce better returns over the long run than a portfolio of triple-A-rated debt issued by the likes of General Motors Junk Bonds and LBOs  Milken came to dominate both the primary and secondary markets for high-yield bonds, controlling about two third of the junk bond market  August 1984: started to use high-yield bonds to finance leveraged takeovers of American public companies  Examples: hostile bid for Gulf Oil, National Can, Revlon  By 1986, Drexel had stakes in over 150 companies, owned a junk bond portfolio worth several hundred million dollars  Hostile LBOs generated fees running into tens of millions of dollars for Drexel. Milken would retain one dollar in three he made for the firm.  In 1986, Milken kept $550 million of junk bond department’s $700 million bonus, making him the highest-paid individual in American history  He would demanded warrants (options to buy shares) as a sweetener when clients issued bonds during a takeover  These warrants were handed out to favoured clients, or retained by Milken’s private partnerships or by Drexel  Sometimes, the wealth amassed by Milken’s raiders was even greater  Example: Ron Perelman, the Revlon raider, turned a loan of $2 million into a fortune of nearly $3 billion a decade later Bull Market of the mid-1980s  1982 August: Fed started to relax its monetary policy  The main driving force of the bullish market was the boom in LBOs  1985: nearly 75% of takeover bids were anticipated by strong advances in share prices, a sign of insider trading  1986 November: the Securities Commission announced insider trading offences, Milken was under investigation  Dow Jones fell 43 points, junk bonds dipped sharply  The market soon forgot the scandals. Dow Jones broke through the 2,000 mark for the first time. The bull market continued upwards in 1987.  The stock market was doing quite well for the first nine months of 1987.  It was up more than 30%, reaching unprecedented heights. That was after two consecutive years of gains exceeding 20%.  By 1987, interest rates began to climb. The Stock Market Crash of 1987  1987 Aug 25, Dow Jones closed at 2,746, up 43% on the year  Japanese investors started repatriating funds (in preparation of the massive $35 billion issue of shares in NTT) by selling US Treasury bonds  Price of Treasury bonds  Yield on bonds   Shares became overvalued and less attractive  October: a series of “bad” news  October 13 (Tuesday): rumour that Congress planned to end the tax breaks favourable to LBOs  October 14 (Wednesday): a larger than expected trade deficit was announced Treasury Secretary James Baker suggested the need for a fall in the dollar on foreign exchange markets  Fears of a lower dollar led foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest rates.  October 16 (Friday):  a tanker carrying the US flag was hit by an Iranian missile in the Persian Gulf  London Stock Exchange was closed due to a freak hurricane in Southern England  The market dropped almost 12% during that week (9.6% on Friday)  October 19 (Monday): international stock market crash  Started in the East: Hong Kong, Malaysia, Singapore, followed by several European markets, were all down while New York slept  NYSE: opened at 9:30 am, there was no bids for many of the large stocks  Sell stock index futures instead  panic selling of futures caused the stock market to drop, which in turn induced further sales of futures  1929 October crash: caused partly by the forced liquidation of margin accounts  1987 October crash: partly due to the computerized program selling  The sales were induced by “portfolio insurance”, a fail-safe investment strategy which dictated buying when stocks rose and selling when they fell  Funds managed by portfolio insurers had increased rapidly during the year, reaching $90 billion  On Black Monday (Oct 19):  The portfolio insurers were responsible for over half of the sales of the stock index futures at the Chicago Mercantile Exchange in the afternoon  Even when the futures fell to a discount to the stock market, they continued selling  Aggressive traders started to short sell stocks  By the market’s close, they had sold $4 billion worth of stocks in the futures market, 40% of the day’s total volume.  Turnover on the Big Board exceeded 600 million shares, worth $21 billion, almost double the record set the previous Friday. A similar amount had been traded in the futures marke  As in 1929, the technology of the market began to collapse: NYSE’s automated trading system broke down (its printers could not cope with the flood of selling)  Brokers were left unable to confirm trades  The options market (derivatives markets) also dried up (extreme volatility  impossible to determine the price of stock options)  Dow Jones fell 22.6%, Standard and Poor (S&P 500) fell 20.5% and S&P futures contract down nearly 29%  Two of the big NYSE’s member firms failed, along with nearly 60 smaller brokers  October 20 (Tuesday): stock market climbed sharply  Federal Reserve (under Alan Greenspan): made large purchases of government securities, creating nearly $12 billion of liquidity for financial system  Bank loans to the holders of securities increased by around $7 billion  On 19 October 1987, Dow Jones fell 508 points, or 22.6%, its biggest single-day percentage decline ever  The US stock market lost $500 billion in one day!  It triggered panic selling in all of the world’s major stock markets.  On Wednesday October 21st, the day after the crash lows, the New York Composite futures had recovered exactly one half of the entire fall from the August highs.  In 1929 the Dow Jones topped out at 381 in August. After the October 1929 crash bottomed in November at 199, it took until April 1930 to make a 52% recovery, before going down for 2 ½ more years to new lows, at 41. Clearly the situations in 1987 were different.  Although $1 trillion was knocked off American stock market values during the month of October, the panic of 1987 was NOT followed by an economic crisis  1987 bull market was not really a “retail market”, so when share prices collapsed the effect on public confidence and consumption was slight  The rises in commodity prices both before and after the 1987 crash were a strong indication that the crash problem was specific to the mechanics of the stock market, and not a general monetary or economic phenomena. The Savings and Loan Crisis  Savings and Loan associations (S&Ls) were local banks originally created to provide mortgage loans to American homeowners  Early 1980s: they suffered from the deregulation of interest rates which obliged them to pay higher rates for short-term deposits, when they had already lent for long periods at low fixed rates  Deregulation: they were permitted to borrow funds wholesale from Wall Street money brokers  They were encouraged to diversify their loan portfolios to reduce their reliance on the local housing market  invest in junk bonds, and other speculative venture (e.g. property deals)  The federal deposit insurance on individual S&L accounts was raised to $100,000  dulled depositors about the risk of these financial institutions  encouraged them to seek out the highest rates offered by the shakiest institutions  By the end of the decade, the fastest-growing S&Ls had accumulated staggering losses on their loan and investment portfolio  When they failed in great numbers, government bail-outs cost around $200 billion The End of Junk Bonds Mania  More competition in the junk bond markets  quality of junk bonds   The gap between an LBO company’s earnings and the interest payments on its junk bonds widened  A slight decline in income would send the junk bonds into default and the company into bankruptcy The End of Junk Bonds Guru  Sep 1988: Milken and Drexel were charged with violating a number of securities laws  Spring 1989: Milken received 98 charges indictment which carried a potential maximum sentence of over 500 years and limitless fines  Nov 1991: Milken was sentenced to 10 years imprisonment, with fines totalled over $600 million The End of Junk Bonds Mania  The LBO craze reached its peak in early 1989  In July 1989, Congress passed a bill requiring S&Ls to dispose of their junk bond holdings  When the proposed buyout of United Airlines fell through in Oct 1989, the junk bond market collapsed (Dow Jones fell 6%)  The junk bond revolution was based on an asymmetry between risk and reward, with junk bond purchasers taking most of the risk and “takeover entrepreneurs” taking most of the rewards The Japanese Bubble Economy of the 1980s  Japan and US in the 1980s  Japan: trade surpluses  US: trade deficits  Japan: higher saving rates  US: lower saving rates  Japan: net creditor nation  US: net debtor nation  Japanese prided themselves that their system was less selfish and more stable than the West Japan in the 1980s  The Ministry of International Trade and Industry (MITI) and the Ministry of Finance controlled industries through administrative guidance  They had powers to license companies, provide tax concessions, distribute government contracts and decide which industries to support and which companies would enjoy privileged position within industry cartel and receive protection from foreign competition  They guarded the financial sector and ensured that cheap loans were channelled from Japanese savers to its highly leveraged corporations  Interest rates were kept artificially low  Companies paid only small dividends  Returns for Japanese investors were poor  Domestic consumers were similarly exploited  Imports were restricted and it was common for Japanese manufactured goods to sell for higher price in Tokyo than in New York Financial Liberalization in the 1980s  1980s: financial liberalization  enabled Tokyo to emerge as a global financial centre, alongside New York and London  1980: Japan removed its exchange controls  1980s: opening of futures markets for Japanese bonds and stock indexes  1984: Japanese banks were allowed to set their own rates of interest on large deposit accounts  Japanese invested their trade surplus in US assets  Examples: Treasury bonds and property (especially icons of American capitalism)  1986: Mitsui Corporation acquired the Exxon Building in Manhattan for a record price of $610 million  revival of Japanese self-confidence Corporate Speculation  Japanese companies began supplementing their ordinary earnings with the extraordinary profits from financial activities called zaitech (financial engineering)  1984: companies were permitted to operate special accounts for their shareholdings known as tokkin accounts  These accounts allowed companies to trade securities without paying capital gains tax on their profits  Brokerages offered services managing these special accounts, guaranteed a minimum return above the current rate of interest  The amount invested in tokkin funds increased from ¥9 trillion in 1985 to ¥40 trillion ($300 billion) in 1989  These speculation was facilitated by Japanese companies access to the Eurobond market, the offshore capital market based in London  Money raised could either be invested directly in the stock market or placed in the special account to earn guaranteed returns  Zaitech was a game with no losers!  Zaitech manufactured profits, causing share prices to rise, which further increased zaitech gains  By the end of the decade, most of the industrial companies on the Tokyo Stock Exchange were engaging in zaitech  Over half of the reported profits of the largest players (including Toyota, Nissan, Sharp) were derived from speculation  Total corporate gains from tokkin accounts rose from ¥240 billion ($2 billion) in 1985 to ¥952 billion ($7 billion) in 1987  Second half of 1980s: capital investment in Japan soared and amounted to $3.5 trillion, accounting for two-third of the country’s economic growth  Many manufacturing companies which raised capital used the money to build overseas factories in order to circumvent the problems caused by the appreciation of the yen Japan’s Economic Miracle  The capital expenditure created the illusion that Japan’s economic miracle was continuing long after its real vigour had diminished  The bubble also produced a vast misallocation of resources into unproductive investments  These were supported by government policies which intended to boost the asset (stock and property) markets to create a positive wealth effect to stimulate consumption and investment and real economic growth Japan’s Property Boom  Land holds a special position for the Japanese  Reasons for high land prices:  Lack of development land  Punitive capital gains taxes: 150% for short-term property gains  Japanese banks provided loans against the collateral of land rather than cash flows (with a strong belief that land prices would never fall)  The rising value of land became the engine for the creation of credit Japanese Banking  Japanese banks: low capital adequacy ratio (ratio of assets to its loans), because they were protected from failure by the Ministry of Finance  Foreign bankers urged Japanese banks to increase their ratio to “international standard” of 8%  Japanese banks’ ability to increase credit was linked to the level of share prices in the Tokyo stock market Property Market Bubble  Japanese banks owned a large number of shares in other (non-bank)companies (keiretsu: a network of companies owning shares of each other)  Certain proportion of the profits on these shareholdings could count towards Japanese banking capital The Plaza Accord  Mid-1980s: Japan had a tight fiscal policy and a loose monetary policy  US had a tight monetary policy and loose fiscal policy  Higher interest rate in the US  US dollar was strong  hurt exporters  22 Sep 1985: representative of the US, West Germany, Japan, UK and France (G5) emerged from a secret meeting in the Plaza Hotel in New York and announced a plan aimed at depreciating the US dollar  US dollar fell to under 150 yen, from a high of 259 Japan in 1980s  Financial liberalization  Strong growth  Asset market booms: stock and property  Corporate and land speculation fueled by easy and cheap access to bank loans  Investment replaced exports as the engine of growth  Plaza Accord: strong yen led to rising overseas investment and imports  The Plaza Accord  US dollar fell to under 150 yen, from a high of 259 The purchasing power of yen had risen by 40%  Japanese shopping spree began!  However, Japanese goods were suddenly nearly twice as expensive  1986: strong yen recession - economic growth slipped to below 2.5%  Bank of Japan: cut interest rates 4 times in order to stimulate the economy (until 3%)  prices of assets   The Asset Bubble  The Nikkei index had reached 18,000, up nearly 40% since the start of 1986  The government launched its long-awaited flotation of Nippon Telephone and Telegraph (NTT), the national telephone company  Within two months, nearly 10 million persons had applied for shares, even though the government had not yet announce the issue price  The shares had to be distributed by a special lottery  1987 Feb: the shares floated freely at the price of ¥1.2 million  The Asset Bubble  1987 Feb: the shares floated freely at the price of ¥1.2 million  1987 March: interest rates were cut to a postwar low of 2.5%  NTT’s share price rose to ¥3.2 million (200 times annual earnings)  Its market capitalization was now more than ¥50 trillion ($376 billion), larger than the combined value of the West German and Hong Kong stock markets  The Asset Bubble  Privatisation of NTT was similar to the South Sea subscription in 1720  Both were intended to improve the public finance  The public applied for shares before being informed of the price  The share prices rose above the “rational” level  Speculators were led to believe that the government would not allow the share price to fall  The Japanese Stock Bubble  Late 1980s: Japanese share prices increased 3 times faster than corporate earnings  US stock market crash in 1987: the overvaluation of stock prices was just about 20 times (normal ratio: 10 times)  The Asset Bubble  Shares continued rising despite the declining profitability of Japan’s exporters  The market rewarded increases in market share rather than rises in profitability  Shares rose even when there were negative news, such as the death of Emperor Hirohito in Jan 1989  Property prices climbed on an ever-increasing supply of credit  The Asset Bubble  1985-1989: Total bank loans increased by ¥96 trillion ($724 billion)  Over half went to small businesses which invested heavily in the property sector  Consumer credit companies (“nonbanks”) also increased property loans from ¥22 trillion to ¥80 trillion ($600 billion) by the end of 1989  Sometimes, loans were provided for up to twice the collateral value of properties  By 1990, the total Japanese property market was valued at over ¥2,000 trillion, 4 times the real estate value of the entire U.S.!  The Asset Bubble  When Tokyo real estate hit a peak of $1 million per square meter, the grounds of the Imperial Palace in Tokyo were estimated to be worth more than the entire real estate value of California or Canada!  Trading prospects of high-tech firms were ignored in favour of the property on their balance sheets  NTT was valued primarily for its land assets rather than as a telecom company  All Nippon Airways soared to a price-earnings ratio of nearly 1,200, more than ¾ of the land owned was kept for the purposes of capital appreciation  Land Prices in Japan: 1980- 2005  Conspicuous Consumption  Rising asset prices  Wealth effect  Stronger yen  Craze for foreign luxury imports  Low interest rates  loans against the equity of their homes   Credit card circulation  threefold  Consumer debt per head rose to American levels  Bubbles in the Art World  Japanese collectors became the dominant force in the global art market  1986: Japanese foreign art imports quadrupled  1987: a Japanese insurance company paid just under $40 million for van Gogh’s Sunflowers, a figure three times greater than it had ever before been paid  By end of the decade, the price of French impressionist paintings had risen by more than 20 times over the past 15 years  Finance companies provided margin loans for up to half the value of the artworks  Paintings were used as collateral to raise loans to buy shares and property  The Golf Club Membership Craze  Golf was an important feature of corporate Japan’s company outing  Golf club membership showed different ranks of prestige  When land prices soared, the property rights of club membership became increasingly attractive  The total value of memberships in Japan was estimated at around $200 billion  Over 20 clubs cost more than $1 million to join  The Golf Membership Index climbed from a base of 100 to 160 in 1985 and reached a peak of 1,000 in 1990.  The Golf Club Membership Craze  Banks provided margin loans of up to 90% against the collateral of membership certificates  These certificates were also used to raise money to invest in the stock market  Japanese developers bought most of the golf courses in Hawaii  Both the art and golf markets involved a speculation in status as well as money  The Stock Market Manipulation  1987 October: Tokyo best weathered the global stock market crash  The Nikkei lost only 19%, while the Dow Jones lost 31%  How?  The day after the crash, the Big Four brokerages (accounted over half the turnover of Tokyo SE) were summoned by the Ministry of Finance and were ordered to keep the Nikkei average above the 21,000 level.  The End of the Bubble  1989: Nikkei index approaching 40,000 mark, up 27% on the year, nearly 500% on the decade!  The price-earnings ratio was at 80 times historic earnings, having peaked at 90 in 1987  Shares yield only 0.4 % in dividend but sold for 6 times their book value  Shares worth ¥386 trillion ($2.9 trillion) changed hands, daily turnover averaging around a billion shares  The End of the Bubble  Outstanding margin loans approached ¥9 trillion ($67 billion), an eightfold increase since 1980  Mitsubishi bought Rockfeller Center for over $1 billion  Sony invaded Hollywood with its $3.4 billion purchase of Columbia Pictures  1990: New governor at the Bank of Japan (he boast in public that he had never owned a share)  His personal mission was to prick the bubble.  The End of the Bubble  May and Dec 1989: he ordered the rise in the key interest rate  Dec 30, 1989: the Nikkei reached its all-time peak  The market did not collapse suddenly, but gently let out the air like a balloon after a party  By the end of Jan 1990, the Nikkei had fallen 2,000 points  Early 1990: Bank of Japan lifted interest rates another 5 times until they reached 6% in August  Bond yield was above 7%, Stock yield was under 0.5%  The End of the Bubble  Early 1990: Bank of Japan lifted interest rates another 5 times until they reached 6% in August  Bond yield was above 7%, Stock yield was under 0.5%  No support for the stock market  Feb: Nikkei fell 1,200 points  March: Big Four were pressured not to make any further issues of shares or warrant  Nikkei dipped below 30,000 for the first time in 2 years, total market capitalization fell behind that of New York  The End of the Bubble  Sep 1990: Nikkei fell below 20,000  Brokers were ordered to purchase stocks  Margin requirements were reduced to 30% (from 50% and 70% earlier)  Price-keeping operation: life insurers wre instructed to stop selling shares, ban on new shares was extended, funds were diverted from public pension funds and postal savings accounts into the stock market  August 1992: Nikkei hit a low of 14,309, a decline of more than 60% from its peak  The End of the Bubble  By late 1992: the property prices in central Tokyo had fallen 80% from their peak  Banking crisis  Bad debts might be as high as ¥60 trillion ($450 billion)  August 1995: first bank run of the postwar period, when depositors withdrew ¥60 billion from Tokyo credit union, Cosmo Shinyo  Collapse of Hyogo, a small bank, which became the first listed bank to fail in half a century  1995: government had to bail-out several housing loan companies with losses of ¥6.4 trillion ($48 billion)  The End of the Bubble  Nov 1996: failure of Hanwa Bank  1997: failure of Sanyo Securities, the first brokerage to fail since WWII  1997 Nov: failure of Japan’s tenth largest bank + Yamachi Securities  Yamachi: the largest bankruptcy in Japanese history, with liabilities of ¥3,200 billion (US$24 billion)  Banking system was weighted down with bad debts of an uncertain magnitude!  The Nikkei Index  Japan: Real Estate Price Index  Japan: The Lost Decade  Fall in asset values (stock and land): 62% Collapse of asset prices led to the increase in bankruptcy and non-performing bank loans  1990s: a decade of slow growth + deflation  Debtors suffered continuously greater real burden with lower sales or income to service those debts  Growth fell from 2.2% to -1.0% during 1991-1993, while investment fell from -0.2% to -2.4%, accounting for 70% of the fall in the growth rate  Japan Economic Growth  Japan – Deflationary Cycle  Japan’s banking sector  Banks cover non-performing loans (NPL) problems by rolling over loans, giving interest concessions, and partially forgiving loans with grim repayment prospects, because calling loans in require the banks to recognize losses  1993-2002: Japanese banking sector recorded operating loss every year  Loans to real estate developers continued to grow in the 1990s after the collapse of land prices while those to manufacturing declined – misallocation of bank credit  Japan’s banking sector  Supporting weak borrowers (“zombie” firms) not only hurt banks’ profitability but also harm the rest of the economy  Depressing the market prices of their products (over-supply)  Raising market wages by retaining workers with lower productivity  Growing government liability that comes from guarantee for deposits of banks that support the zombie firms  Block the normal market adjustment mechanisms  Low prices and high wages reduce the profits that new and more productive entrants can earn, thus discouraging entry  Japan’s Fiscal Policies in 1990s  Expansionary fiscal policy  Nine fiscal packages from 1992 to 1999, totaled 130 trillion yen  The packages included tax cuts and purchases of land  Debt outstanding more than doubled during 1990 to 2000, reaching almost 400 trillion yen (public debt is more than 100% of GDP)  Japan’s Monetary Policy in 1990s  Bank of Japan cut the discount rate (key policy rate) from 6% to 5.5% in July 1991, and then further reduced to 3.25% by July 1992  Real credit crunch set in with the bankruptcy of big financial institutions (such as Yamaichi Securities and Hokkaido Takushoku Bank)  Desperate to raise the capital/asset ratios required to meet Bank for International Settlements capital adequacy standards, banks squeezed their assets by cutting lending  Asian financial crisis in 1997-98: uncertainty trap  Bank of Japan was forced to lower interest rates further to 0.3% in 1998 and 0.03% in 1999  Japan Interest Rates  Comparison  Question: Which earlier boom and bust cycle did the Japanese bubble resemble?  Banks counted their shareholding as capital credit creation linked to share prices  Mississippi system  Asset deflation followed by banking crisis and prolonged eco
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