The US Financial Crisis
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Order Code RL34742 The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy November 18, 2008 Dick K. Nanto, Coordinator, Martin A. Weiss, James K. Jackson, Ben Dolven, Wayne M. Morrison, and William H. Cooper Foreign Affairs, Defense, and Trade Division J. Michael Donnelly Information Research Specialist Knowledge Services Group The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy Summary What began as a bursting of the U.S. housing market bubble and a rise in foreclosures has ballooned into a global financial crisis. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially. In October 2008, credit flows froze, lender confidence dropped, and one after another the economies of countries around the world dipped toward recession. The crisis exposed fundamental weaknesses in financial systems worldwide, and despite coordinated easing of monetary policy by governments and trillions of dollars in intervention by governments and the International Monetary Fund, the crisis continues. The process for coping with the crisis by countries across the globe has been manifest in four basic phases. The first has been intervention to contain the contagion and restore confidence in the system. This has required extraordinary measures both in scope, cost, and extent of government reach. The second has been coping with the secondary effects of the crisis, particularly the slowdown in economic activity and flight of capital from countries in emerging markets and elsewhere who have been affected by the crisis. The third phase of this process is to make changes in the financial system to reduce risk and prevent future crises. In order to give these proposals political backing, world leaders have called for international meetings to address changes in policy, regulations, oversight, and enforcement. Some are characterizing these meetings as Bretton Woods II. On November 15, 2008, a G-20 leaders’ summit recommended several measures to be implemented by participating countries by March 31, 2009. The fourth phase of the process is dealing with political and social effects of the financial turmoil. The role for Congress in this financial crisis is multifaceted. A major issue is how to ensure the smooth and efficient functioning of financial markets to promote the general well-being of the country while protecting taxpayer interests and facilitating business operations without creating a moral hazard. In addition to preventing future crises through legislative, oversight, and domestic regulatory functions, Congress has been providing funds and ground rules for economic stabilization packages and informing the public through hearings and other means. The largest question may be how U.S. regulations should be changed, if necessary, and how closely any changes are harmonized with international recommendations. Other questions include: should the United States promote global regulatory standards to be voluntarily adopted by countries or should a supranational regulatory institution be created that would impose rules on international financial markets? Where would enforcement authority reside; at the state, national, or international level? Congress also plays a role in measures to reform international financial institutions and in recapitalizing the International Monetary Fund. Also, should U.S. policies be designed to restore confidence in and induce return to the normal functioning of a self-correcting financial system or has the system, itself, become inherently unstable? This report will be updated periodically. Contents Recent Developments and Analysis ....................................1 The Global Financial Crisis and U.S. Interests ...........................2 Origins, Contagion, and Risk .........................................6 Risk .......................................................11 The Downward Slide..........................................12 Effects on Emerging Markets .......................................15 Latin America ...............................................22 Mexico.................................................23 Brazil..................................................24 Argentina...............................................25 Russia and the Financial Crisis ..................................26 Effects on Europe and the European Response ..........................28 The “European Framework for Action”............................34 The British Rescue Plan ........................................35 Collapse of Iceland’s Banking Sector .............................36 Impact on Asia and the Asian Response ...............................38 Asian Reserves and Their Impact ................................41 National Responses ...........................................42 Japan ..................................................42 China ..................................................43 South Korea.............................................45 Other Countries’ Moves ....................................46 New Challenges and Policy in Managing Financial Risk ..................47 The Challenges...............................................47 Policy......................................................51 Bretton Woods II .........................................51 G-20 Meeting............................................52 G-7 Meeting.............................................54 The International Monetary Fund ............................55 Changes in U.S. Regulations and Regulatory Structure ...........58 Selected Legislation...............................................64 Appendix A. British, U.S., and European Central Bank Operations April-Mid-October 2008 .......................................65 Appendix B. Major Recent Actions and Events of the International Financial Crisis ..............................................67 2008 .......................................................67 2007 .......................................................74 Appendix C. G-20 Declaration of November 15, 2008 ...................75 List of Figures Figure 1. Origins of the Financial Crisis: The Rise and Fall of Risky Mortgage and Other Debt.................10 Figure 2. Selected Stock Market Indices for the United States, U.K., Japan, and Russia........................................12 Figure 3. Exchange Rate Values for Selected Currencies Relative to the U.S. Dollar......................................14 Figure 4. Current Account Balances (as a percentage of GDP) ..............17 Figure 5. Global Foreign Exchange Reserves ($ Trillion) ..................18 Figure 6. Capital Flows to Latin America (in percent of GDP)..............20 Figure 7. Capital Flows to Developing Asia (in percent of GDP)............20 Figure 8. Capital Flows to Central and Eastern Europe (in percent of GDP) ...21 Figure 9. Asian Current Account Balances are Mostly Healthy .............39 List of Tables Table 1. Selected Government Financial Support Actions .................15 Table 2. Projections of Economic Growth in 2008 and 2009 and Price Inflation in Selected Regions and Countries (in percent) ..............30 Table 3. Losses on Selected Financial assets ...........................31 Table 4. Problems, Targets of Policy, and Actions Taken or Possibly to Take in Response to the Global Financial Crisis .....................61 The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy Recent Developments and Analysis1 November 15. At a summit of leaders from the G-20 nations (including the G- 8, the European Union, Australia and 10 major emerging economies), leaders agreed to continue taking steps to stabilize the global financial system and improve the international regulatory framework. The leaders’ announced action plan (intended to be implemented by national regulators by March 31, 2009) included pledges to (1) address weaknesses in accounting and disclosure standards for off-balance sheet vehicles; (2) ensure that credit rating agencies meet the highest standards and avoid conflicts of interest, provide greater disclosure to investors, and differentiate ratings for complex products; (3) ensure that firms maintain adequate capital, and set out strengthened capital requirements for banks’ structured credit and securitization activities; (4) develop enhanced guidance to strengthen banks’ risk management practices, and ensure that firms develop processes that look at whether they are accumulating too much risk; (5) establish processes whereby national supervisors who oversee globally active financial institutions meet together and share information; and (6) expand the Financial Stability Forum to include a broader membership of emerging economies. *********** — The crisis in credit markets and the threat of bankruptcy by major financial institutions appears to have eased somewhat, but what began as a financial crisis has evolved into a global macroeconomic downturn. The Euro zone and Japan are officially in recession, and although the U.S. economy has not been declared to be in recession, many observers assert that one already has begun. According to the IMF, activity in advanced economies is expected to contract by ¼ percent in 2009 — the first annual contraction during the postwar period — and in emerging economies, growth is projected to slow appreciably to 5%. — The G-20 summit illustrated the growing complexity, interconnectedness, and shifting balance of economic power