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The global financial crisis: Causes, threats and opportunities. Introduction and overview
Journal of International Money and Finance 28 (2009) 1243–1245
Contents lists available at ScienceDirect
Journal of International Money and Finance journal homepage: www.elsevier.com/locate/jimf
The global financial crisis: Causes, threats and opportunities. Introduction and overview Michael Melvin a, *, Mark P. Taylor b, c a b c
Barclays Global Investors, 400 Howard St, San Francisco, CA 94105, USA Barclays Global Investors, Murray House, Royal Mint Court, London EC3N 4HH, UK Warwick Business School, Coventry CV4 7AL, UK
a b s t r a c t JEL classification: F31 F33 F41 G15 Keywords: Financial crisis Foreign exchange market Global equity markets Bond markets Financial regulation
This essay introduces the papers presented at a conference held in April 2009 on the global financial crisis. The issue begins with four articles that survey the key events and analyze important issues around the crisis from the context of four asset classes: the equity market, fixed income market, foreign exchange market, and emerging markets. The goal is to provide readers with a reference source for understanding what happened in each asset class, when and why it happened, and the consequences. The second group of papers provides in-depth analysis of specific aspects of the crisis. These studies include issues such as the FX carry trade, macro shocks and capital flows, Taylor rules in a low-inflation environment, and the credit boom that preceded the crisis. Ó 2009 Published by Elsevier Ltd.
1. Introduction The financial crisis that began in 2007 has created the greatest financial dislocations since the Great Depression of the 1930s. A body of scholarly literature is now developing that addresses the causes of the crisis, the threats to economic well-being, and opportunities that may exist as a result of the crisis. In response to the need for an overview of the crisis in each asset class and serious analysis of important aspects of the crisis, we organized a conference held at Warwick University Business School on April 6, 2009. The conference was jointly sponsored by Warwick Business School and the Journal of International Money & Finance. In this brief introduction to the special issue devoted to the conference, we will provide an overview of the contributions of the contributed papers. The conference, and this
* Corresponding author. E-mail addresses: [email protected] (M. Melvin), [email protected] (M.P. Taylor). 0261-5606/$ – see front matter Ó 2009 Published by Elsevier Ltd. doi:10.1016/j.jimonfin.2009.08.002
1244
M. Melvin, M.P. Taylor / Journal of International Money and Finance 28 (2009) 1243–1245
issue, may be viewed as being organized in two sections. First, four papers survey the key events and provide related analysis in four different asset classes: equity, fixed income, foreign exchange, and emerging markets. Second, five papers provide in-depth analysis of specific aspects of the crisis. We believe that the assembled papers will be of great interest to policymakers, practitioners, and scholars. 2. What happened in each asset class? The first four papers address the crisis from the perspective of the equity market, the fixed income market, the foreign exchange market and emerging markets. The goal is to provide a reference source for readers who want to understand what happened in each asset class, when it happened, and why, along with the likely consequences. The first paper, by Sohnke Bartram and Gordon Bodnar, addresses the crisis in the equity market. The authors provide a comprehensive view of the value destruction that occurred during the crisis and compare this episode to earlier market crashes. They show that the crisis was truly global, so that the high correlations between markets resulted in no benefit from international diversification when it was most needed. The second paper by Gerald Dwyer and Paula Tkac addresses the crisis from the fixed income perspective. A review of events shows how contagion from falling home prices leads up to the crisis and how subprime loans rippled through the markets peaking with the fall of Lehman Brothers. An important aspect of this paper is the description and analysis of government policy as it evolved through the crisis period. The third paper by Michael Melvin and Mark Taylor deals with the crisis as experienced in the foreign exchange market. A crisis timeline is presented where the beginning of the crisis in the foreign exchange market is identified as August 2007. Periods of peak volatility are related to the events that drove the market. The dramatic changes in exchange rates and costs of trading currencies are detailed and explained in the context of ongoing crisis developments. The last section of the paper proposes a financial stress index and then demonstrates how investors could condition their carry trades to minimize drawdowns from crisis events. The final review-oriented paper by Michael Dooley and Michael Hutchison addresses emerging markets in the crisis. In addition to the what and why of emerging market events during the crisis, a particular focus of this paper is the process by which the U.S. subprime crisis was ultimately transmitted to emerging markets. The authors conduct an event study of the impact of U.S. shocks on emerging market CDS spreads and conclude that the ‘‘decoupling hypothesis’’ is supported through mid-2008, but then financial markets recoupled dramatically. 3. Asset pricing, transmission, and policy studies Naohiko Baba and Frank Packer study deviations from covered interest rate parity (CIP) in the foreign exchange swaps market before and after the Lehman Brothers bankruptcy. They find that as credit conditions deteriorated in the United States, deviations from CIP increased. This is consistent with a dollar funding shortage that appeared post-Lehman Brothers as financial institutions hoarded liquidity. Central bank liquidity provision actions aimed at addressing the dollar squeeze were successful at reducing deviations from CIP. The relationship between FX carry trade returns and exchange rate volatility is studied by Richard Clarida, Josh Davis, and Niels Pedersen. They document a significant relationship between excess returns to the carry trade and both realized and implied volatility. By decomposing the data into volatility quartiles, the authors show that uncovered interest rate parity appears to hold better in high volatility quartiles. Finally, they relate currency risk premia to risk premia in the bond yield curve and find that the risk factors that drive bond yields are also reflected in carry trade currency pairs. Many people were surprised by the strong appreciation of the U.S. dollar during the height of the crisis. Marcel Fratzscher addresses this issue by examining U.S. macroeconomic shocks and the role of global capital flows during the crisis. He finds that currencies of countries with large financial liabilities to U.S. entities depreciated more against the dollar than other countries. This is consistent with U.S. investors repatriating assets home during the crisis. An additional finding is that countries with smaller
M. Melvin, M.P. Taylor / Journal of International Money and Finance 28 (2009) 1243–1245
1245
FX reserve holdings depreciated more than countries with large holdings of reserves. A final result, not independent of the first two, is that countries with larger positive current account balances, depreciated less than other countries. Matthew Dorsten, Vineer Bhansali, and Mark Wise study the Taylor rule in a low inflation, low interest rate environment. They construct a model with an asymmetric policy response that is more accommodative in a very low inflation environment. They then analyze the impact on the yield curve of this central bank ‘‘deflation put.’’ The result for economies like the United States is that the deflation put lowers yields at all maturities. It is fitting to conclude the issue with a policy-oriented analysis by two central bankers, Michael Hume and Andrew Sentance. Hume and Sentance show that the credit boom was unusually long and, in a break with historical tendencies, was associated with neither particularly strong growth nor rising inflation in the economies in which it took hold. They argue that this type of credit and financial cycle is hard to reconcile with existing economic theory and the conduct of monetary policy and perceptions of declining macroeconomic risk were more important drivers. They conclude their contribution by identifying some of the challenges now facing macroeconomic researchers and policymakers. 4. In conclusion The events of 2007–2008 have provided an experience that most economists, practitioners, and policymakers never thought they would witness. While the costs imposed on society have been large and are still rippling through the world economy as this issue goes to print, the experience has also provided a great experimental data set for analysis. The papers in this issue are among the first to provide a comprehensive view of what happened and why, along with deep analysis of many important issues raised by the crisis. We hope that the reader finds these studies of the crisis to be as illuminating as we have. In closing, we would like to thank the Journal of International Money & Finance and Warwick Business School for their support of the conference and special issue. In particular, we are glad to acknowledge the enthusiastic support of the Dean, Professor Howard Thomas, as well as of the Business School faculty members who participated in the conference. In addition, we are also grateful to our highly efficient local organizers at Warwick Business School, Rhona MacDonald and Jenny Kirkwood.
Contents lists available at ScienceDirect
Journal of International Money and Finance journal homepage: www.elsevier.com/locate/jimf
The global financial crisis: Causes, threats and opportunities. Introduction and overview Michael Melvin a, *, Mark P. Taylor b, c a b c
Barclays Global Investors, 400 Howard St, San Francisco, CA 94105, USA Barclays Global Investors, Murray House, Royal Mint Court, London EC3N 4HH, UK Warwick Business School, Coventry CV4 7AL, UK
a b s t r a c t JEL classification: F31 F33 F41 G15 Keywords: Financial crisis Foreign exchange market Global equity markets Bond markets Financial regulation
This essay introduces the papers presented at a conference held in April 2009 on the global financial crisis. The issue begins with four articles that survey the key events and analyze important issues around the crisis from the context of four asset classes: the equity market, fixed income market, foreign exchange market, and emerging markets. The goal is to provide readers with a reference source for understanding what happened in each asset class, when and why it happened, and the consequences. The second group of papers provides in-depth analysis of specific aspects of the crisis. These studies include issues such as the FX carry trade, macro shocks and capital flows, Taylor rules in a low-inflation environment, and the credit boom that preceded the crisis. Ó 2009 Published by Elsevier Ltd.
1. Introduction The financial crisis that began in 2007 has created the greatest financial dislocations since the Great Depression of the 1930s. A body of scholarly literature is now developing that addresses the causes of the crisis, the threats to economic well-being, and opportunities that may exist as a result of the crisis. In response to the need for an overview of the crisis in each asset class and serious analysis of important aspects of the crisis, we organized a conference held at Warwick University Business School on April 6, 2009. The conference was jointly sponsored by Warwick Business School and the Journal of International Money & Finance. In this brief introduction to the special issue devoted to the conference, we will provide an overview of the contributions of the contributed papers. The conference, and this
* Corresponding author. E-mail addresses: [email protected] (M. Melvin), [email protected] (M.P. Taylor). 0261-5606/$ – see front matter Ó 2009 Published by Elsevier Ltd. doi:10.1016/j.jimonfin.2009.08.002
1244
M. Melvin, M.P. Taylor / Journal of International Money and Finance 28 (2009) 1243–1245
issue, may be viewed as being organized in two sections. First, four papers survey the key events and provide related analysis in four different asset classes: equity, fixed income, foreign exchange, and emerging markets. Second, five papers provide in-depth analysis of specific aspects of the crisis. We believe that the assembled papers will be of great interest to policymakers, practitioners, and scholars. 2. What happened in each asset class? The first four papers address the crisis from the perspective of the equity market, the fixed income market, the foreign exchange market and emerging markets. The goal is to provide a reference source for readers who want to understand what happened in each asset class, when it happened, and why, along with the likely consequences. The first paper, by Sohnke Bartram and Gordon Bodnar, addresses the crisis in the equity market. The authors provide a comprehensive view of the value destruction that occurred during the crisis and compare this episode to earlier market crashes. They show that the crisis was truly global, so that the high correlations between markets resulted in no benefit from international diversification when it was most needed. The second paper by Gerald Dwyer and Paula Tkac addresses the crisis from the fixed income perspective. A review of events shows how contagion from falling home prices leads up to the crisis and how subprime loans rippled through the markets peaking with the fall of Lehman Brothers. An important aspect of this paper is the description and analysis of government policy as it evolved through the crisis period. The third paper by Michael Melvin and Mark Taylor deals with the crisis as experienced in the foreign exchange market. A crisis timeline is presented where the beginning of the crisis in the foreign exchange market is identified as August 2007. Periods of peak volatility are related to the events that drove the market. The dramatic changes in exchange rates and costs of trading currencies are detailed and explained in the context of ongoing crisis developments. The last section of the paper proposes a financial stress index and then demonstrates how investors could condition their carry trades to minimize drawdowns from crisis events. The final review-oriented paper by Michael Dooley and Michael Hutchison addresses emerging markets in the crisis. In addition to the what and why of emerging market events during the crisis, a particular focus of this paper is the process by which the U.S. subprime crisis was ultimately transmitted to emerging markets. The authors conduct an event study of the impact of U.S. shocks on emerging market CDS spreads and conclude that the ‘‘decoupling hypothesis’’ is supported through mid-2008, but then financial markets recoupled dramatically. 3. Asset pricing, transmission, and policy studies Naohiko Baba and Frank Packer study deviations from covered interest rate parity (CIP) in the foreign exchange swaps market before and after the Lehman Brothers bankruptcy. They find that as credit conditions deteriorated in the United States, deviations from CIP increased. This is consistent with a dollar funding shortage that appeared post-Lehman Brothers as financial institutions hoarded liquidity. Central bank liquidity provision actions aimed at addressing the dollar squeeze were successful at reducing deviations from CIP. The relationship between FX carry trade returns and exchange rate volatility is studied by Richard Clarida, Josh Davis, and Niels Pedersen. They document a significant relationship between excess returns to the carry trade and both realized and implied volatility. By decomposing the data into volatility quartiles, the authors show that uncovered interest rate parity appears to hold better in high volatility quartiles. Finally, they relate currency risk premia to risk premia in the bond yield curve and find that the risk factors that drive bond yields are also reflected in carry trade currency pairs. Many people were surprised by the strong appreciation of the U.S. dollar during the height of the crisis. Marcel Fratzscher addresses this issue by examining U.S. macroeconomic shocks and the role of global capital flows during the crisis. He finds that currencies of countries with large financial liabilities to U.S. entities depreciated more against the dollar than other countries. This is consistent with U.S. investors repatriating assets home during the crisis. An additional finding is that countries with smaller
M. Melvin, M.P. Taylor / Journal of International Money and Finance 28 (2009) 1243–1245
1245
FX reserve holdings depreciated more than countries with large holdings of reserves. A final result, not independent of the first two, is that countries with larger positive current account balances, depreciated less than other countries. Matthew Dorsten, Vineer Bhansali, and Mark Wise study the Taylor rule in a low inflation, low interest rate environment. They construct a model with an asymmetric policy response that is more accommodative in a very low inflation environment. They then analyze the impact on the yield curve of this central bank ‘‘deflation put.’’ The result for economies like the United States is that the deflation put lowers yields at all maturities. It is fitting to conclude the issue with a policy-oriented analysis by two central bankers, Michael Hume and Andrew Sentance. Hume and Sentance show that the credit boom was unusually long and, in a break with historical tendencies, was associated with neither particularly strong growth nor rising inflation in the economies in which it took hold. They argue that this type of credit and financial cycle is hard to reconcile with existing economic theory and the conduct of monetary policy and perceptions of declining macroeconomic risk were more important drivers. They conclude their contribution by identifying some of the challenges now facing macroeconomic researchers and policymakers. 4. In conclusion The events of 2007–2008 have provided an experience that most economists, practitioners, and policymakers never thought they would witness. While the costs imposed on society have been large and are still rippling through the world economy as this issue goes to print, the experience has also provided a great experimental data set for analysis. The papers in this issue are among the first to provide a comprehensive view of what happened and why, along with deep analysis of many important issues raised by the crisis. We hope that the reader finds these studies of the crisis to be as illuminating as we have. In closing, we would like to thank the Journal of International Money & Finance and Warwick Business School for their support of the conference and special issue. In particular, we are glad to acknowledge the enthusiastic support of the Dean, Professor Howard Thomas, as well as of the Business School faculty members who participated in the conference. In addition, we are also grateful to our highly efficient local organizers at Warwick Business School, Rhona MacDonald and Jenny Kirkwood.