UNITED N ATIONS CONFERENC E ON T RADE AND D EVELOPMENT COPING WITH GLOBALIZED FINANCE: Recent Challenges and Long-term Perspectives UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT COPING WITH GLOBALIZED FINANCE: Recent Challenges and Long-term Perspectives Edited by Heiner Flassbeck and Massimiliano La Marca UNITED NATIONS New York and Geneva, December 2007 Note Symbols of United Nations documents are composed of capital letters combined with figures. Mention of such a symbol indicates a reference to a United Nations document. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the UNCTAD secretariat. The designations employed and the presentation of the material in this publication do not imply the expression of any opinion whatsoever on the part of the Secretariat of the United Nations concerning the legal status of any country, territory, city or area, or of its authorities, or concerning the delimitation of its frontiers or boundaries. Material in this publication may be freely quoted; acknowledgement, however, is requested (including reference to the document number). It would be appreciated if a copy of the publication containing the quotation were sent to the Publications Assistant, Division on Globalization and Development Strategies, UNCTAD, Palais des Nations, CH-1211 Geneva 10. UNITED NATIONS PUBLICATION UNCTAD/GDS/2007/2 Copyright © United Nations, 2007 All rights reserved Contents Page INTRODUCTION..................................................................................................................................................................... 1 I. GLOBALIZATION: “GETTING THE PROCESS RIGHT” FOR CONVERGENCE AND RISING WORLD INCOME Heiner Flassbeck and Massimiliano La Marca ................................................................................................................. 3 A. Introduction: the age of diverging integration .............................................................................................................. 3 B. The integration process in the traditional view ............................................................................................................ 4 C. Integration through liberalization of the capital account? ............................................................................................ 6 1. Capital integration in theory ..................................................................................................................................... 6 2. Some empirical evidence .......................................................................................................................................... 7 D. The role of policies and institutions in the development and integration process ....................................................... 8 E. Getting the “macro prices” right: short-run conditions for long-run development.................................................... 10 F. Conclusions ................................................................................................................................................................. 12 II. CARRY TRADE AND FINANCIAL FRAGILITY Massimiliano La Marca .................................................................................................................................................... 13 A. Introduction: strategy, players, financial returns and real losses ................................................................................ 13 B. Asymmetric effects: winding and unwinding ............................................................................................................. 14 C. Credit cycles, financial fragility and real effects ........................................................................................................ 17 III. THE 2007 GLOBAL FINANCIAL TURMOIL Raja Khalidi, Massimiliano La Marca, Ugo Panizza, Matthias Rau-Göhring and Dusan Zivkovic .............................. 23 A. The economic background of the liquidity crunch ..................................................................................................... 23 B. Has securitization made things worse? ....................................................................................................................... 26 C. Amplifying factors: carry trade and currency misalignments .................................................................................... 27 D. What will happen to emerging markets? .................................................................................................................... 27 E. Lessons learned ........................................................................................................................................................... 31 Annex 1 to chapter III: Chronology.................................................................................................................................. 35 References ............................................................................................................................................................................ 37 Coping with Globalized Finance: Recent Challenges and Long-term Perspectives iii List of figures Page 1.1 GDP per capita (log scale) in selected developing countries and regions compared to the G-7, 1970–2005.................. 4 1.2 Direct and indirect determinants of development ............................................................................................................. 9 1.3 Number of developing and transition economies with current account deficit in selected regions, 1990–2005 ........... 11 2.1 Yen carry trade on the Icelandic krona and United States dollar between 2005 and summer 2007............................... 15 2.2 Yen carry trade on the Brazilian real and Turkey lira, between 2005 and summer 2007 ............................................... 15 2.3 Recent yen carry trade unwinding and currency volatility with the United States dollar .............................................. 16 2.4 Recent United States dollar carry trade unwinding and currency volatility with the Brazilian real .............................. 17 2.5 Recent Swiss franc carry trade unwinding and currency volatility with the Hungarian forint ...................................... 17 2.6 Recent yen carry trade unwinding and currency volatility with the Korean won .......................................................... 17 2.7 Brazil: uncovered interest returns, exchange rate changes, inflation and interest rates differentials, 1995–2007 ....... 18 2.8 Turkey: uncovered interest returns, exchange rate changes, inflation and interest rates differentials, 1995–2007 ....... 19 2.9 China: uncovered interest returns, exchange rate changes, inflation and interest rates differentials, 1995–2007......... 19 3.1 Expected volatility of United States stocks as measured by the VIX index ................................................................... 29 3.2 Emerging market spreads................................................................................................................................................. 30 3.3 Weekly EMBI+ spreads ................................................................................................................................................... 30 3.4 United States high-yield bond spreads ............................................................................................................................ 31 3.5 Selected emerging markets stock market indices ............................................................................................................ 32 List of boxes 3.1 Structured investment vehicles ........................................................................................................................................ 24 3.2 Quantitative hedge funds ................................................................................................................................................. 28 iv Coping with Globalized Finance: Recent Challenges and Long-term Perspectives Notes on contributors Heiner Flassbeck graduated in economics from Saarland University, Germany and has a Ph.D. from Free University, Berlin. He is an honorary professor at Hamburg University. He has been working with the UNCTAD secretariat since 2000. He has been the Director of the Division on Globalization and Development Strategies since 2003 and is the leader of the team preparing the Trade and Development Report. He was Germany’s Vice Minister of Finance and Chief Economist of the German Institute of Economic Research in Berlin. Raja Khalidi received his B.A. in Politics Philosophy and Economics from the University of Oxford and his M.Sc. in Economics from University of London (School of Oriental and African Studies - SOAS). He has conducted research and published for over 20 years on Palestinian economic conditions in Lebanon, Israel and the occupied territories. He joined UNCTAD in 1985 and was Coordinator of its Programme of Assistance to the Palestinian people, contributing to numerous UNCTAD reports and studies on the Palestinian economy. He has been in charge of UNCTAD’s Debt and Development Finance Branch since 2007. Massimiliano La Marca has a Ph.D. in Economics from the New School for Social Research (New York, United States of America) and a Ph.D. in Economics from the University of Pavia (Italy). He has been working in the Division on Globalization and Development