Crisis Talk - The World Bank Group

World Crisis Index

Intrade, one of the most popular prediction markets out there, has put together a world crisis index that aggregates markets that indicate the probability of recessions, unemployment, falls in the stock market, and the like. The index opened at 50.0 on January 27. Unfortunately, Intrade hasn't published a graph to track the index over time, but as of 2pm GMT today, the index had creeped up to 51.0, meaning that propsects for 2009 have gotten just a little bit worse over the last two weeks.

Enforcing Transparency

The financial crisis gave new impetus to demands for more transparency and more accountability. “The global financial crisis [is caused] in part by greed and corruption,” was the announcement last December by the United Nations Secretary General Ban Ki-moon. How to enforce transparency? 
 
There might be a few good ideas to learn from the American experience of setting up a transparency watchdog. These ideas were presented by Walter M. Shaub of the US Office of Government Ethics (OGE), the main speaker at a brown bag lunch at the World Bank last week.
 
The work of the OGE is focused on prevention. Assets and interests disclosure is the main tool to identify conflicts of interest among government officials. If a conflict of interest is apparent from the declaration, the agency works with the official on resolving such conflict before it creates prejudice. Increasingly complex conflict-of-interest legislation increases the probability of inadvertent violations. The right advice is important - independent from law enforcement bodies and tax authorities, the ethics agency is conscientious of the trust that its clients place in it.
 
Promoting transparency comes before fighting corruption. It is generally true that a psychological stance of promotion creates acceptance while struggle against something incites resistance. Transparency might be just like healthy food and a healthy lifestyle – it requires steady effort to build up the right habits.

A Return of the Investment Banks?

Not likely, or at least not very desirable, according to a new working paper from Asli Demirguc-Kunt and Harry Huizinga. In Bank Activity and Funding Strategies, the authors look at an international sample of 1,334 banks to get a handle on the risk-return tradeoff of various activity and funding strategies. Their findings suggest that the failure of investment banks in the U.S. was not really a statistical outlier or a once-in-a-century event:

The main contribution of this paper is to provide evidence on what bank income and funding strategies perform well in terms of producing profitable and stable banks. In particular, we examine how a bank’s income and funding mixes affect the rate of return on its assets and Z-score or distance to default. Our basic regressions suggest that at low levels of non-interest income and non-deposit funding, there may be some risk diversification benefits of increasing these shares, although at higher levels of non-interest income and non-deposit funding shares, further increases result in higher bank risk...

...The evidence presented in paper suggests that traditional banks – with a heavy reliance on interest-income generating and deposit funding – are safer than banks that go very far in the direction of non-interest income generation and funding through the wholesale capital market. Our results provide a strong indication that banking strategies that rely preponderantly on non-interest income or non-deposit funding are indeed very risky.

Figure 2: Trend of the fee income share

(The fee income share is the share of non-interest income in total operating income. This figure displays the trend of the fee income share from 1999 to 2007. The fee income share data are yearly averages. The data are from Bankscope.)

Increasing University Enrollment as Crisis Response

My friends in economics departments around the United States tell me that applications to PhD programs have trippled this year relative to last year. Some law schools have also reported a large increase in applications. This is because the unfolding crisis is putting lots of young people - particularly Wall Street types - out of jobs. What better time to get a graduate degree?

Even business schools report higher demand, even though one wonders what they really teach students there. Some "modesty" courses may be in order.

Increasing university enrollment is a good anti-cyclical device. In a country like the United States, this happens naturally as people with dimmed work prospects upgrade their skills. In smaller countries, this may be trickier as universities may be less prepared to meet increasing demand. Especially if they depend on government subsidies for financing a share of their operations. Hence, the need for a possible public policy.

Georgi Angelov, a senior economist at the Open Society Institute in Sofia, and I have just written a short paper on this topic, using data for Bulgaria as an example. The policy proposal is relevant for any country, however.

We develop a proposal for expanding university enrollment in Bulgaria by 30,000 students (or about 12% over 2008 enrollment). This is done by creating a student loan program guaranteed by the government. Student loans, offered competitively by commercial banks, would cover up to 50% of the cost of education. The remainder is covered by direct government subsidies (as is currently the case) and household income. The proposal is budget neutral – the government spends as much money on university education as in previous years.

Trade Still Weak but Not Worse in December

More than 60 countries have now reported trade data for November and they are uniformly weak, with imports on average down 14 percent and exports down 17 percent, as compared with the same month last year. In addition, 22 countries have now reported December data. While trade continues to be weak, there is little change since November, and nearly half of the countries show some improvement. So, while conditions did not improve in December they did not worsen significantly either.

Another indicator that the trade situation did not deteriorate further in December comes from the Baltic Dry Index. (The BDI is issued daily by the Baltic Exchange, which canvasses brokers around the world about the cost of shipping cargo of raw materials on various routes.) After a 93 percent drop since the early summer, November is the month when the Baltic Dry Index (BDI) appears to have bottomed out, suggesting that demand for shipping was at a low in that month.   

While this is not exactly positive news, it could have been a lot worse.

The Man with the Two Trillion Dollar Plan

On Monday, World Bank Chief Economist Justin Lin proposed the establishment of a $2 trillion Global Recovery Plan. A new Marshall Plan, of sorts. You can listen to his presentation and read about it here.
 
The issue is that the United States of today is in a different position than the United States after the Second World War. It is hard to imagine Congress giving much money for causes abroad when the domestic economy is hurting. The same applies to the other rich economies. If anything, one may expect some lean years in development aid.

Trained to Be Dull

Nassim Taleb, author of the bestseller The Black Swan, doesn't have a very high opinion of bankers:

...think of a bank chairman whose institution makes steady profits over a long time, only to lose everything in a single reversal of fortune. Traditionally, bankers of the lending variety have been pear-shaped, clean-shaven, and dress in possibly the most comforting and boring manner, in dark suits, white shirts, and red ties. Indeed, for their lending business, banks hire dull people and train them to be even more dull. But this is for show. If they look conservative, it is because their loans only go bust on rare, very rare, occasions. There is no way to gauge the effectiveness of their lending activity by observing it over a day, a week, a month, or...even a century!

Taleb will be speaking at the opening session of the upcoming Financial and Private Sector Development Forum at the World Bank, along with Tim Harford, a columnist at the Financial Times, and World Bank President Robert Zoellick. I expect the discussion will be lively. 

Remittances: Not as Bad as Predicted

Writing on the World Bank People Move blog, Dilip Ratha points out that not all the dire predictions about the crisis have come to pass. At least in the cases for which we have data, remittances have proven resilient. Mexico - one of the most important recipients of remittances and a country for which there is good data - is a case in point:

Remittance flows to Mexico dropped 10 percent year-on-year in December 2008, bringing the 2008 12-month total to $25 billion, a 3.6 percent decline compared to $26 billion registered in 2007. This decline is much smaller than the 8 percent decline projected by Mexico in August 2008.

As long as this is not a blip on the screen, remittances should help cushion the blow of the retreat of other forms of private capital flows. The Institute for International Finance warned late last month that "the outlook for private capital flows to emerging economies has deteriorated significantly in recent months." The fate of stimulus packages in rich countries consequently becomes all that more important for the rest of the world, as migrants will have a hard time keeping or finding jobs in the face of rising unemployment rates. 

Russia: Corruption Prevention during the Financial Crisis

Editor's Note: Larisa Smirnova is a consultant at the World Bank and is currently working with the Transparency indicator team. She previously worked with the United Nations High Commissioner for Refugees in Russia and Japan.

Experts at Troika Dialogue Group, a Russian investment company, estimate that the financial crisis may naturally decrease corruption in the country due to… lower oil prices! As the Russian economy is largely dependent on oil exports, lower oil prices means less money and therefore… less bribes?

Among fears that government anti-crisis money may become another easy prey for corruption, Russia adopted a new anti-corruption law in December 2008. After heated debates, financial disclosure requirements were extended to family members of government officials. However, the content of the declarations is confirmed to be not just publicly unavailable but constituting a "state secret".

The conclusions of a recent paper, Disclosure by Politicians, which compared financial disclosure procedures in 175 countries, suggest that Russia’s corruption prevention measures might not be the most effective ones. Analysis showed that family members’ disclosure does not correlate with lower perceived corruption. Publicity of disclosure, on the contrary, appears to be the crucial imperative for political accountability.

Creating Jobs for Ukraine’s Migrant Workers

It seems that Ukraine won’t be seeing a massive return of its migrant workers due to the economic downturn, as was predicted last fall. At least, not from EU member states. Officials from the state employment service say the migrants who have returned from abroad due to lay-offs are mostly construction workers that were employed in neighboring Russia. Overall, the migration experts estimate between 200,000 and 250,000 Ukrainian migrants returning home.

The data on Ukrainians working abroad are very ambiguous. According to the official statistics, slightly over 2 million Ukrainians are currently employed abroad, with around 48 percent in Russia and almost the same in EU countries, mainly Spain, Poland, Czech Republic, Italy and Portugal. Alternative estimates that include illegal migrants reach figures that are almost three times as high. There are also different assumptions as to amounts sent home by the migrants in remittances, ranging from Euro 2 to 8 billion annually.

In the mid-1990s it was common to hear politicians and social workers complaining about “brain drain” – the mass emigration of Ukrainian scholars, technicians, doctors and other highly qualified staff. The profile of Ukrainian migrant workers has changed significantly during this last decade. A few are leaving with the intention to settle for a lifetime, while most people seek to earn money and come back. Now it’s mainly construction and agricultural workers (mostly men) and also women employed in the area of household and nursery services. Ukrainians with advanced degrees and sufficient work experience are often ready to accept much lower-skilled jobs than they occupied at home. One example is a teacher of physics who is now working as a hotel maid in Italy.

Competitive Devaluations?

Kazakhstan’s central bank devalued the tenge by 18 percent yesterday. The central bank is letting the tenge weaken for the first time since it started managing the currency in 2007. Kazakshstan joins Russia, Ukraine, and Belarus in abandoning attempts to prop up exchange rates as currency reserves dwindle and economies stagger. A number of other resource-rich countries have also seen their currencies fall substantially against the dollar over the last few months, including Brazil, Mexico, and South Africa. 

Maintaining a currency’s value under pressure is costly. Kazakhstan spent $3.5 billion, or 16 percent, of its foreign-exchange reserves supporting the tenge. Russia spent between $7 and $8 billion in one day last month defending the already weakened ruble. And the longer the process lasts, the more money that goes down the drain. Argentina’s net reserves fell by $20 billion in 2001 before the currency board eventually collapsed the following year. 

Some countries attempt to maintain currencies because of a history of inflation. Sudden and large depreciations can be destabilizing, leading to inflation and higher interest rates. Depreciations also increase the cost of foreign currency debt. But depreciation is not necessarily bad for growth. Depreciation mimics an export subsidy and import tax, boosting exports and consumption of domestic goods. This can help countries to grow when domestic demand is weak or declining. 

But what happens if many currencies collapse simultaneously? This puts downward pressure on import prices, fueling deflation in foreign markets. Kindleberger has argued that such competitive devaluations are part of what led to the Great Depression. 
 
Volatile currency movements are already aggravating uncertainties in global financial markets. But at least so far, most of the these currency declines are understandable. Sharp declines in commodity prices have worsenened the terms of trade of the resource exporters at the same time as western capital has dried up. If depreciations spread to the large manufacturing countries then there could be real trouble.

Guerilla Trade Tactics

In 1930, the Smoot Hawley tariff was implemented in the United States, raising tariffs on nearly 900 goods. The Europeans retaliated with similar tariff hikes. World trade fell by two-thirds from 1929 to 1934 largely as a result of declining demand during the world depression, but also because of the increased tariffs. Such conventional trade warfare finally came to an end with the advent of the GATT in 1947.

Thanks to the rules provided in the WTO, the successor to the GATT, a conventional trade war is now unthinkable. But as demand is plummeting, countries are seeking ways to shift it to domestic goods. This is where guerilla trade tactics come in. The WTO Secretariat reported that in the first half of 2008 (the most recent data available) there was a 39 per cent increase in antidumping investigations among members as compared with the same period in 2007. Subsidies around the world are being directed at specific domestic industries. Now, the U.S. stimulus package appears likely to include a “buy American” clause. 

Such guerilla trade tactics may be just as dangerous as a conventional trade war. A key issue is the non-transparency of these antidumping duties, countervailing duties, and targeted domestic subsidies. If these modes of discrimination explode it will take a long time to disentangle them and reopen the trade system. Not to mention the resources wasted and uncertainty they generate for importers (for example, in the United States, it takes the ITC and ITA between 235 to 390 days to reach a final conclusion in an antidumping investigation!). 

The WTO has been among the most successful of the international institutions. The ongoing Doha Round—with all its promises—may be able to claim victory after all if it can simply prevent protectionism from surging during the global recession.

Share Prices and Accounting Reclassifications

Editor's Note: The following post is a joint contribution by Costas Stephanou and Haocong Ren.

As some may recall, Deutsche Bank (DB) took advantage of the change in IFRS rules (under pressure from the EU Commission) and reclassified almost Euro 25 bn. of hard-to-value (toxic?) securities from its available-for-sale portfolio to the held-to-maturity portfolio in October 2008. This allowed it to improve its reported net income for 2008Q3 by more than Euro 500 million and to report a quarterly profit, as opposed to the loss that analysts were expecting. Its stock price shot up 15% on the day of the announcement (October 30, 2008) vs. 1.2% for the relevant benchmark index (S&P 500 financials), and similar behavior could be observed for its 5-year CDS spread vis-a-vis the relevant benchmark (iTraxx Europe senior financials).

This jump in the share price washes away (based on a preliminary statistical analysis - see the attached Excel file) when looking at the evolution over a longer time period vis-a-vis the benchmark. It may also be due to a perceived market relief that DB's reported tier one capital adequacy ratio (partly as a result of the accounting changes) exceeded 10% and therefore DB had no apparent need for more capital raising  that would lead to shareholder dilution. However, it is instructive to see how - at least anecdotally - accounting rules have real effects on share prices since DB's accounting reclassifications represented the main reason why analyst expectations were exceeded, as was pointed out explicitly in the financial press. (See here, here, here, here, and here.) 

Kaufmann Takes Aim At Corruption

Dani Kaufmann, one of the pioneers of the governance agenda at the World Bank, discusses the role that corruption played in the financial crisis:

There are multiple causes of the financial crisis. But we can not ignore the element of "capture" in the systemic failures of oversight, regulation and disclosure in the financial sector. Concrete examples abound.

First, the way Freddie Mac and Fannie Mae spent millions of dollars lobbying some influential members of Congress in exchange for, among other things, lax capital reserve requirements for these mortgage giants.

Second, how AIG's "small" derivatives unit located in London managed to obscure its accounts, be governed by lax regulatory oversight, and take inordinate risks that effectively brought down AIG's empire of 100,000 employees in 130 countries, accelerating the global financial crisis...

Third, how giant mortgage lenders such as Countrywide Financial switched regulators so to fall under the lax oversight of the Office of Thrift Supervision, which was funded by fees paid by the regulated banks (and which also supervised AIG's derivative unit).

Fourth, how in April 2004, during a 55-minute-long meeting at the Securities and Exchange Commission, the largest investment banks persuaded the SEC to relax its regulatory stance and allow them to take on much larger amounts of debt.

Finally, Madoff's giant Ponzi scheme, some of which appears to be plain fraud, though system-wide irregularities also point to subtler forms of corruption and capture. Years ago the SEC knew that Madoff, who had served on the commission's own advisory committee, had multiple violations and was misleading it in how he managed the funds of his customers. Yet the SEC failed in unmasking the Ponzi scheme.

Worse yet, more governance challenges are yet to come, as fiscal stimulus packages present all kinds of opportunities for the ethically challenged. Kaufmann recommends far-reaching measures to improve transparency as an antidote. I agree with that but doubt that's enough.

Disclosure by Politicians

After three years in the making, we have just completed a large research project on the disclosure of conflicts of interest and business dealings by politicians in 175 countries. The resulting paper, Disclosure by Politicians, a joint effort with Rafael La Porta (Dartmouth), Florencio Lopez-de-Silanes (EDHEC Business School) and Andrei Shleifer (Harvard), is the first to look at what disclosures are required by law, which of these are made public, in which countries someone actually checks whether the disclosures are made or not, and what penalties exist in the event of faulty or incomplete disclosures.
 
The topic will undoubtedly raise heat in countries that don't do well. More relevant for the current crisis, however, one can imagine a call for similar types of disclosures by CEOs of publicly-traded companies and perhaps even privately-held financial companies. The scandals starting to emerge from the crisis - take Madoff and Satyam - suggest there is considerable sleaze in the private sector too.
 
The good news is that the methodology now exists and can be adapted to the captains of industry.

The Ukrainian Tax Administration's Response to the Crisis

It is widely known in Ukraine that the performance of the State Tax Administration (STA) is assessed by the volume of collected tax revenues, which is tracked on a monthly and annual basis. It is these figures that matter, and not the level of taxpayer service or public opinion. A new year has just started and the STA is already asking the Government to reduce the targets on tax revenues for 2009, which are the same as last year for company profit tax and slightly higher for VAT.

The STA argues that the targets are unrealistic considering the general decline in production and trade, the reduction of exports, etc. The signal is clear – we should prepare for hard times and the STA doesn’t want to be a poor performer, with a culture that demands the set targets should be exceeded, a heritage coming from the Soviet past.

This last decade tax revenues have been growing from year to year, based on a natural tendency of inflation and GDP growth. 

Living in a Madoff World

Editor's Note: Arshad Sayed is World Bank Country Manager in Ulaanbaatar, Mongolia. 

Madoff made off with billions, Nassim Taleb kept sighting unseen Black Swans, and the global economy has been in a tailspin. Meanwhile, I have been ensconced on the Mongolian Steppe. It's so far from it all that the approaching recession looked impenetrable – until now.

The prices for Mongolia’s major export, copper, and the herder’s main sources of livelihood, cashmere and meat, are in free fall. Why?

What unleashed this financial maelstrom that threatens to besiege my neighbor’s lives seemingly so disconnected from those at the center of it on Wall Street? As I look for answers there is no shortage of raison d’êtres.

Aid to the Suffering World

William Easterly, of The White Man's Burden fame, has just started a blog on the market for development aid. His first entry discusses president Zoellick's recent proposal to have a small percentage of stimulus packages in the West be dedicated to aid for developing countries. Easterly argues that besides being unrealistic, this proposal does not offer any increased responsibility for how the money would be used. Read on.

Financial Sector Wages

There is a lot of irritation currently about salaries and bonuses in the financial sector, especially in light of recent bail-outs. Critics of the exuberance in the financial sector should not worry. According to a new working paper by Thomas Philippon and Ariell Reshef, we can expect a sharp decrease in financial sector salaries in the coming years. This prediction is based on an analysis of the wage and skill development in the U.S. financial sector from 1909 to 2006. Until 1933, the financial sector was a high-skill, high wage industry. After the Great Depression, the financial sector not only lost its high human capital, but also the wage premium compared to the rest of the private sector. It was not until the 1980s that the financial sector became yet again a high-skill and high-wage industry, driven by financial liberalization and innovation.

 

Both in the period from the mid-1920s to the mid-1930s and from the mid-1990s onwards, salaries in the financial sector were not consistent with education levels and employment risk, suggesting short-term rents for financial sector employees and an unsustainable labor market equilibrium. So, expect financial sector salaries to drop, although not immediately as the experience from the Great Depression shows, where it took several years for relative financial sector wages to drop. But given excess wages of 40%, expect big drops! These high excess wages might also explain regulatory failures in the run-up to the crisis; regulators could simply not attract sufficient talent given the high excess compensation in the private sector. So, the next question will be: what about the impact on MBA and Finance programs.

A Broken Record on East Asia

James Seward, a financial sector specialist working in East Asia and Pacific, admits that he is "beginning to sound like a broken record." Unfortunately, he has good reason. Most of the recent news coming out of East Asia does not sound good at all. Seward reports the following scary news on the East Asia and Pacific blog:

Banking problems are now increasingly expected to begin emerging across East Asia. Fitch just released a report that Chinese banks’ expected losses are mounting and projected that the loan losses would be 6 percent or more by end-2009. However, this was hedged by stating that “there are concerns with weaknesses in the banks' loan classification, the rise in hidden credit risk, and uncertainties about the reliability of collateral and guarantees, which may be contributing to widespread under-capturing of Chinese banks' credit risk exposure.” The Chairman of the banking regulator, the China Banking Regulatory Commission, stated that there will be a “reasonable tolerance” for rising bad loans in the banking system this year. Also, the various announcements by governments to push commercial banks into supportive lending may also result in additional problems.

In addition to nascent banking problems, countries across the region are seeing painful declines in trade accompanied by hits to employment. Perhaps most telling, Seward reports that some 1/3rd of crains in Singapore are sitting idle. Trade statistics see a delay of some months - crains don't. As for rising unemployment, the lunar new year is not looking too bright:

...about 10 million migrant workers [in China] lost their jobs by November, and many migrant workers are returning home for the lunar new year on one-way tickets. To round out the bad news on China, in December housing prices dropped for the first time on record and construction is projected to shrink by 30% this year.

Governments across the region continue apace with fiscal stimulus plans. How much of this will take the form of increased spending and how much the form of tax cuts? Seward doesn't offer a breakdown, although the repeated use of the term "infrastructure" suggests that most if not all will be in the form of increased government spending. If this is the case, hopefully these countries won't run into the kind of problems of 'disappearing money' that Simeon Djankov warns about in Bulgaria.