Macroeconomic and Financial Risks - Research Paper Example

? Macroeconomic & Financial Risks 11th April Contents Contents 2 Introduction 3 List of Risks 3 Discussions4 Public Debt 4 Nature of the risk 4 Causes of the risk 4 Consequences of High Public Debt 5 Solutions 6 Economic Stagnation 7 Nature of the Risk 7 Causes of the risk 8 Consequences of the Risk 9 Solutions to the risk 10 Balance of Trade & Competitiveness 11 Nature of Crisis 11 Consequences of the crisis 11 Solutions 13 Interest Rate risks 14 Nature of Risk 14 Consequences of Increasing Interest rates 14 Solutions 16 Inflation Risk 17 Nature of the Risk 17 Consequences of the risk 17 Works cited 20 Introduction This paper considers some of the macroeconomic and financial risks which are faced by the developed countries .The risks are listed in the next section which is followed by the detailed discussion of each of the risks. List of Risks Macro Risk 1: High Public Debt Macro Risk 2 : Economic Stagnation Macro Risk 3 : Negative Balance of Trade Financial Risk 4 : Interest Rate Risk Financial Risk 5 : Inflation Risk The above 5 risks have been discussed in detail in the later section. Discussions Public Debt Nature of the risk Public debt means the amount of money which the government of any country owes to its creditors ; both foreign and domestic. The total debt for OECD countries has risen from 73 % of the GDP in 2007 to 106 % of the GDP in 2012 (OECD 2011).There are some developed countries like Greece , Italy and Portugal and Japan which have had historically higher level of debt. However the worry is that even countries like USA and UK are have now levels of debt which may be unsustainable in the long run. The debt level of United States has risen from 60 % in 2006 to 109% in 2012.The Euro zone is already suffering from the debt crisis and no immediate solution to the problem seems to be in sight. Causes of the risk The first question which comes to mind is reasons due to which high public debt exists. The simple reason for the high debt situation is because government of a country spends more than it earns. Public Debt can actually boost long term growth of the economy if it is used in building productive assets like infrastructure which invite more investment and increases the GDP of the country. However the problem in the developed countries has been that increasing amount of debt has been used to finance non productive activities. United States has been engaged in the decade long war on terrorism which has led to increased military spending and thus higher debt. High levels of pension and social security have been blamed for the Euro zone crisis which is again an unproductive spending (Sanderatne). The immediate reason for the debt levels of developed world to raise post 2006 has been the financial crisis of 2008 and the stimulus packages given by governments to bail out banks and to kick-start the economy (OECD 2011). The US government provided a fiscal stimulus package of $831billion.The problem could have been solved if this stimulus led to an increased growth but the world suffered from a double dip recession which has caused the developed countries to be in a precarious situation – GDP levels still remain low and the countries have a high debt on their hands. Consequences of High Public Debt High public debt has shown to have impact on the following areas – private savings , public investment , total factor productivity and the real interest rates. When government borrows more, it means that there is limited amount of money available to private investors which leads to lower private investment, lower growth of industries and thus lower employment and wages (Checherita and Rother.). Studies conducted by various researchers such as Manmohan Kumar and Jaejoon Woo for the IMF illustrate that once countries breach the 90 % level of debt , their GDP growth declines by as much as 30 %.Similar results have been obtained by studies which were conducted by the National Bureau of Economic Research (Kumar and Woo.). Debt taken by the government also needs to be repaid. The government can repay the debt in 2 ways. It can either reduce the amount of spending or it can increase taxes in order to be able to repay the debt. Reduced public spending hurts the most depressed sections of our economy – those who depend on government handouts for survival. It also effects public spending on health , education, infrastructure and pensions which brings unrest in the population. Increase in taxes levied on individuals and corporate has a negative effect on the growth of the economy. High taxes reduce the return on investment made by private individuals who discourage them to invest in the economy (Kumar and Woo.). Thus a high debt situation forces the country into a catch 22 situation. High Public debt also affects the common man with increased inflation. The relation between public debt and inflation is controversial. Some economists claim that inflation has nothing to do with public debt whereas others claim that high debt increases inflation. John H.Cohrane in a report published in The National Affairs has claimed that high debt and low growth means that the government does not have money to repay its debt. So it prints more money leading to a higher fiscal deficit. High fiscal deficit reduces the value of dollar. As dollar is worth less , so more amount of dollars are required to purchase the same thing which causes inflation in the economy (Cochrane). The most extreme manifestations of high debt can be seen in the European sovereign debt crisis which has engulfed Greece , Ireland , Portugal , Spain and Cyprus. Although one reason for the default of these countries is the lack of fiscal consolidation of European Union, but the main reason of the problem has been the unsustainable levels of debt maintained by these countries. High national debt caused a shadow over the ability to repay; which forces creditors to demand higher interest rates in order to cover their risks (Haugh, D. et al.). The high interest rates coupled with low economic growth made it almost impossible for European nations to finance and repay their debt , leading to a sovereign debt crisis and call for help from third countries. Solutions A report by IMF gives an indication on the ways in which public debt can be reduced and the impending sovereign crisis looming over the developed world can be averted. The first and the most obvious solution are to encourage expenditure which boosts growth and cut expenditure which is non-productive. Public debt needs to be targeted at sectors such as infrastructure in order to increase the growth of the economy. Apart from this unproductive expenditure such as high pensions and huge military spending need to be cut down drastically. Thus fiscal consolidation needs to be complemented with measures which support growth and allows the country resources to finance the debt. The monetary conditions of the countries also need to be supportive of investment by private sector. Thus the message is clear. In order to prevent further sovereign debt crisis like the one witnessed by European economies , the developed world needs to walk a tight rope – it needs to spend on areas which will boost growth and also identify areas where wasteful spending is taking place and strictly curtail the expenses in these areas even against an adverse public opinion (Sanderatne). Economic Stagnation Nature of the Risk Economic stagnation is a controversial topic with no commonly accepted definition of what economic stagnation means. However one of the most common one which is used is a period of 6 or more years in which economic growth per capita grows by less than 1 % per year. Reddy and Minoiu in 2009 have defined stagnation as period in which country’s real income stands lower than the previous 2 years and higher than the next four years. This definition does not use the 1 % criteria and thus views stagnation as a relative term which varies from country to country. Some of the stagnation episodes which have been witnessed lately in the developed world include the stagnation of the 1990s in Japan , Italy from 2004 – 2009 and Portugal from 2003 – 2009.There are fears that many more developed countries may be facing stagnation in the next 5 years due to varied reasons (Reddy and Minoiu.). Causes of the risk Some of the reasons due to which fears of stagnation have engulfed the developed world have been discussed below. Banking Crisis Through an extensive research Haugh , ollivaud and Turner had come to the conclusion that stagnation of 1990s in Japan was caused due to banking crisis (Haugh, D. et al.). The current economic crisis has also been preceded by banking crisis in all OECD countries. Banking crisis which occurs due to bursting of asset bubbles lead to an increase in the non performing assets of banks. This increase in NPAs put a financial burden on the banks which are unable to remain viable or lend money to fuel economic growth. This leads to a collapse of the financial system , makes money dear , stops the flow of easy credit and thus puts brakes on the growth of the economy leading to prolonged periods of slow growth. After the recent bust of the property bubble the NPAs of banks in OECD countries have significantly increased. It varies from 60 % NPAs in Iceland to 1.8 % in Japan with an average of about 8% which is on the high side leading to fears of an economic collapse (Haugh, D. et al.). Credit Boom Portugal’s stagnation episode began in 2003 and was preceded by a credit boom just like the credit boom which preceded the recent economic crisis. Credit boom leads to increased amount of borrowing by households and corporate in order to finance their spending. This credit boom can fuel a short term rapid growth in the economy leading to higher GDP. However an adverse effect of this credit boom and easy money is that loans which should have been rejected are approved. It also increases the current account deficit of the country if external borrowings are allowed as is the case in developed economies. However when it becomes clear that long term high growth rate cannot be sustained, creditors start demanding a higher interest rate leading to a collapse of the credit boom. Once the boom collapses , money becomes scarce , monetary policy tightens and the country is led into a period of economic stagnation . Rising Government Debt As it has been explained in the previous section , increased amount of government debt edges out private entrepreneurs which leads to lower economic growth. All developed countries have been heavily indebted in the aftermath of the economic crisis. The high levels of debt present a challenge to the recovery of growth and can contribute to a long term economic stagnation (OECD 2011). Consequences of the Risk Economic stagnation over a period of 6 years or more has several consequences for the country concerned. The biggest fall out of increased stagnation is the rise in the unemployment rate during the period. Japan’s unemployment rate increased from 2.6 % to 4.6 % during the period of economic stagnation. Portugal also saw an increase from 5.2 % to 7.6 % (OECD 2011). Similar rise in unemployment levels is expected if economic stagnation occurs during the current economic slowdown. High levels of unemployment can lead to social unrest and major political changes in the country concerned. Economic stagnation over a period of 6 years or more can also increase the level of government debt further. Lack of growth means lower income to the government from taxes. Some government spending like social security , pension etc. cannot be easily cut. In the absence of revenue from taxes, government has to resort to borrowing to fund these obligations which can increase the level of debt. High debt further reduces the chances of an economic rebound and increase in growth. Thus prolonged economic stagnation in developed countries poses a huge risk both economically as well as socially to the developed countries. The economic risks may be contained but the social costs may prove to be too high to be contained easily. We have seen ethnic conflicts in London and an increasing amount of attack on minorities in USA .Minorities who locals believe are responsible for hijacking their jobs are usually targeted. Thus the developed world needs to work together in order to prevent periods of very low economic growth and stagnation Solutions to the risk Lessons can be learned from the failure of Japan during its banking crisis and the success of the Nordic governments in dealing with a similar crisis. Japan responded to the banking crisis by injecting capital in to the banks without dealing with the non performing assets. This led the banks to pile up assets which were a drag over long periods of time. Thus the most insolvent banks were allowed to continue without addressing their asset problem. This led Japan to a period of extreme slow growth during the 1990s which is called as the Japan’s lost decade. In complete contrast, Nordic governments did not inject capital into the banks but asked them to recognize NPAs and transfer them to state owned asset management companies. The banks were nationalized and taken over by the government. This led to the resolution of the crisis as the bank’s balance sheet was clean which caused investor confidence to grow (OECD 2011). Similar approach can be used by developed countries to solve the current banking crisis. Simply injecting capital and leaving the banks to fend for themselves; as is being done now ; is not the ideal solution. Government needs to intervene more in order to solve the crisis more effectively. Weak structural policies can be said to be the main reason for the stagnation episodes which struck Italy and Portugal. Relative to other OECD countries Portugal and Italy had low educational attainment, high public ownership of businesses and restrictive barriers to entry in various businesses. Many economists are crying for a greater government role in all spheres of economy in order to stem the present economic crisis. However this leads to structural imbalances which can lead to long periods of slow economic growth and thus needs to be avoided at all costs. The answer lies in a strong regulatory environment to prevent future defaults and not in a more socialist economy. Balance of Trade & Competitiveness Nature of Crisis The balance of trade varies widely among the developed countries, with Germany having a net surplus while USA running a deficit for a number of years now. However the general trend across the developed world has been an increase in the deficit over the recent years. The trade deficit of USA in 2012 was a staggering $535 billion which is more than the total GDP of many developing countries (Autor and Dorn).UK has also seen a constant rise in its trade deficit. One of the main reasons for this deficit has been the manufacturing industry in China. Due to the extreme low cost of production, China has literally become the manufacturing house of the world leading countries like USA to run huge trade deficits. The deficit in goods caused by China was being serviced by net surplus in export of services .However countries like India are now targeting the service industry of USA and other developed countries which can cause a further increase in deficit in the coming years. Consequences of the crisis Loss in Jobs It is estimated that China has taken away around 2.7 million of US manufacturing jobs in the last decade since it entered the WTO (Bailey and Lawrence.). The effect on the manufacturing jobs of other developed countries is also similar. More and more companies are shifting their manufacturing facilities to China leading to loss of jobs in the developed countries which present a gloomy scenario for the macroeconomic development of these countries. Reduction in Pay Loss of jobs to workers in China and other developing countries is not the only impact of a negative balance of trade; it also leads to a reduction in the salary of workers in developed world. Due to competition from workers of developing countries and with threat of outsourcing looming large over their heads, workers are forced to take a cut in their wages which leads to reduction in living standards of people. The population working in lower end jobs such as manufacturing have been the most effected due to these pay cuts. A research by Bivens in 2008 has shown that an average American worker has lost $1400 per year in salary cuts in 2006 (Bailey and Lawrence.).The persistence of this trend may cause social unrest in some of the developed countries. Increase in Debt The negative balance of payment for the developed countries has to be financed by increasing external debt. The increase in external debt puts the developed countries at a risk of sovereign default and also puts enormous pressure on our future generations to repay this debt. Precious foreign currency is utilized in paying off our debt which reduces the amount of money available for infrastructure development and social security reforms in developed countries. Inability to pay off this debt will lead to an increased amount of pressure on our resources and may lead to collapse of the economies in developed countries (Autor and Dorn). Solutions Prevent Currency Manipulations One of the known reasons for the competitive advantage of China is that it has pegged it’s currency to the US dollar and does not allow it float freely. If the artificial manipulation was not done , the increase in China’s productivity would have resulted in an increase in the value of Yuan and thus eased the pressure on balance of trade .However China does not allow this to happen and thus retains the competitive advantage of its exports. Policy remedies such as imposition of additional duty on import from countries whose currencies are undervalued should be adopted by all developed countries in order to save their manufacturing industries from going bust (Brock). Increasing Competitiveness Apart from addressing currency manipulations , the other thing which can be done by the developed world is to increasing the competitiveness of its industries. Countries like Germany have been able to maintain a positive balance of trade due to the high quality of products that they manufacture. Similar approach needs to be adopted by USA and UK to ensure that their jobs are not shipped off to China and India (Brock). Interest Rate risks Nature of Risk The financial crisis which struck the developed world in 2007 has pushed the world into an era of low interest rates. These interest rates have been artificially kept low by reducing the rates over a period of time. The rates across the developed world are near zero or negative in real terms.US Federal Reserve has reduced the rates 12 times to 0.75 %, Bank of Japan has also lowered its rate to 0.1% (Wehinger). These low interest rates discourages saving and encourages borrowing. This regimen of low interest rate has allowed banks and other financial institutions access to easy money. Banks have generated profits by borrowing at short term rates and investing in higher yield long term assets like treasuries. However the problem is that as the economy recovers from the crisis of 2007; interest rates have to increase since demand of money also increases in a growing economy. Consequences of Increasing Interest rates Banking system Collapse If interest rates start to increase rapidly and banks are not ready for it , it could lead to another collapse of the banking system as it happened in 2008.Players in the banking sector are expecting that federal banks will keep interest rates near 0 over a long period of time. This misconception is similar to the misconception that they were properly hedged for credit crunch before the subprime crisis. One of the reasons for the crisis has been said to be the gradual increase in rates since 2004 which ultimately created the credit crunch in 2008.Asinterest rates start to increase, banks which rely on short term funds may find it unprofitable to hold long term assets (Landier and Sraer). Due to this they may start selling securities en masse which will weaken the financial sector once again. Slow GDP Growth Interest rate increase makes money dearer. As businesses are not able to borrow money easily , they do not find it lucrative to invest in the economy as the returns on investment decreases. As cost of borrowing increases, people also have to pay more for their mortgages (Begenau and Piazzesi.).This reduces their disposable income , reduces spending and thus slows down the general economic growth of the country. Incentivises Savings & reduces bond yields Interest rate increase is very effective tool for increasing savings in the economy. As people can earn more by keeping their money in the bank , they are inclined to keep their money in banks. Investors are lured away from investment in risky ventures like equities and prefer to invest their money in banks. Interest rates also have an inverse relationship with bonds. As interest rates increases , the yield of long term bond decreases. Reduces Export Competitiveness This scenario will occur if some of the countries increase their interest rates while other do not. The countries that increase the rates become more lucrative for investors and thus invite greater investment. This increases the value of the currency and makes export less competitive as compared to other countries. Government Debt Increases As we have discussed earlier , high government debt is a major macroeconomic worry for all the developed economies. Increase in interest rates , makes the new bonds released by government more expensive and increases the debt burden of developed countries. Solutions As we have discussed in the previous section, high interest rates can be detrimental to not only financial institutions but can also play havoc with the economy as a whole. However the increase in interest rates is inevitable. They cannot remain at zero levels always. So financial institutions need to prepare themselves for interest rate increase. The governments of the developed countries need to ensure a soft lending for banks and financial institutions. Interest rates should not be increased abruptly like in 2004 which can lead to credit crunch and thus challenge the health of the economy. All OECD countries should also coordinate with each other before increasing their rates so as to ensure that developing countries do not reap the benefits of a weak currency. However the biggest responsibility lies on the shoulders of financial institutions. They need to ensure that their risks are sufficiently covered. This can be done with various products such as interest rate swaps, forward rate agreements , cross currency swaps and structured investment products. These products will ensure that financial institutions are not caught off guard as they were in 2008. Inflation Risk Nature of the Risk The subprime crisis of 2008 was caused by extreme credit crunch and a loss of confidence among the investors. In order to re-ignite this confidence and ensure that banks have enough liquidity, federal banks of all the developed countries have pumped in money into banks and other financial institutions. Keeping lending rates at near 0 have been helpful in increasing the amount of cash in the market. However the point to worry is that GDP is not growing and remains low despite the easy availability of cash across the developed nations.USA is expected to grow at a rate of not more than 2.5 % in next 2 years (Spicer and Costa.). Limited growth and excessive money is sure to fuel inflation as percentage of reserves in banking system reach the level of 25 %.Various estimates have shown that inflation could rise up to 15% in next 2 years if the Fed is not able to drain off the excessive reserve in the banking system (Cunningham). Consequences of the risk Wage-Prices Spiral As inflation increases, workers start demanding more money in salary to meet their demands. However, an increase in salary increases the money in the market which again fuels inflation. This can become a never ending cycle (Moccero, D. et al.). Reduction in Savings Inflation reduces the real rate of interest from fixed interest rate instruments such as treasuries. This leads to negative real returns for the investors and can wipe out their savings. Thus inflation favors borrowers instead of those who save. Increases borrowing and especially external borrowing can be harmful for developed countries who already have high levels of debt. Decrease in Competitiveness If the exchange rate remains same , inflation leads to increased costs for businesses. High inflation thus reduces the competitiveness for exports and increases the import penetration into the economy of developed countries. This increases the already perilous balance of trade deficit in developed countries. Disrupts Business activity Inflation causes uncertainty which makes investment an uncertain activity as assumption of cost becomes a difficult activity. This can lead to fewer investment , increased unemployment and dampening of the sentiments of the market which has still not fully recovered from the worst recession in the last 70 years. Solutions The present danger of inflation in the market has been caused by easy availability of money due to negative real interest rates. This excessive money has led to an increase in the reserves of banks to 25 %.So either the GDP growth should match the money supply or the money supply in financial institutions needs to decrease. The GDP growth has remained low for a long time due to low investor confidence. So with limited chances of increase in GDP growth , the federal banks of developed countries need to drain the extra money out of the system by tightening monetary policies. Interest rates should be increases to make lending difficult and excess liquidity should be slashed out of the system. Developed world is already suffering from low GDP growth ,it can ill afford to tackle both high inflation and low growth. Works cited Autor, David H. and David Dorn. The China syndrome: Local Labor Market Effects of Import Competition in the United States. Washington D.C.: National Bureau of Economic Research, 2012. Print. Bailey, Martin N. and Robert Z. Lawrence. "What Happened to the Great U.S. Jobs Machine: The Role of Trade and Electronic Off shoring." Brookings Papers on Economic Activity, 35. 2 (2004): 211 - 284. <http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2004_2_bpea_papers/2004b_bpea_baily.pdf>. Begenau, Juliane and Monika Piazzesi. Bank's Risk Exposures. Stanford: Stanford University, 2013. 1 - 34. Print. Brock, H. Woody. American Gridlock: Why the Right and Left Are Both Wrong: Commonsense 101 Solutions to the Economic Crises. New Jersey: John Wiley & Sons, 2012. Print. Checherita , Cristina and Philipp Rother. The Impact of High and Growing Government Debt on Economic Growth . Frankfurt: European Central Bank, 2010. 5 -13. Print. Cochrane, John H.. "Inflation and Debt." National Affaird 2011: 56 - 78. Print. Cunningham, Steven . "The Inflation Risk Around the Corner." 2012. Web. 20 Apr 2013. <https://www.aier.org/article/7550-inflation-risk-around-corner>. Haugh, D. et al. What drives Sovereign Risk Premiums? An analysis of Recent Evidence from the Euro Area. OECD Economics Deaprtment, 2009. Print. Kumar, Manmohan S. and Jaejoon Woo. Public Debt and Growth IMF Working Paper. IMF, 2010. E-book. Landier, Augustin and David Sraer. Banks Exposure to Interest Rate Risk and the Transmission of Monetary Policy.. 2013. Print. Moccero, D. et al. "What Drives Inflation in the Major OECD Economies?." OECD Economics Department Working Papers , No. 854. (2011): <http://dx.doi.org/10.1787/5kgdx1jgvtf8-en>. OECD. 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