The global financial crisis and the coming changes in global economic power Raghuram Rajan Chicago Booth School of Business Presentation to the XLIV Convención Bancaria de Colombia at Cartagena, Colombia, July 10, 2009

Outline  Main takeaways  Meta-causes for the crisis  Micro-causes  What needs to be changed in the global economic architecture?  What needs to be changed in the global financial architecture?  What are the emerging opportunities and risks for emerging markets?

Main takeaways  This is not your father’s recession nor even your grandfather’s recession. −Financial −Global −Policy response  The Great Recession will have more persistent effects than the average recession.

Meta causes: Insufficient global demand  Root cause of crisis is insufficient global demand

Meta causes: Excessive willingness of US to stimulate  US led the way in fiscal and monetary stimulus to boost economic growth in  Coupled with regulatory relaxation encouraging widespread homeownership  Why is US in forefront? −The U.S. as emerging market?

Meta causes: Emerging market focus on export led growth  Seared by past crisis, emerging markets focus on export led growth  Puts the burden of demand stimulus on industrial countries

Micro-causes: Unfettered financial sector in U.S.  Encouragement to expand credit  Fundamental problem in financial sector – get paid for taking on risk but some risks are observable only in the long run −Similar to writing earthquake insurance!  Aided and abetted by easy financial conditions  Where were −Risk Management? −Corporate Governance? −Regulators?

What needs to be done  As government stimulus is withdrawn in industrial countries, households will still be constrained  Emerging markets will need to step up demand −Allow exchange rates to appreciate −Open up to foreign investment −Remove impediments to domestic consumption

Need for global economic dialogue  As slow growth persists, developed countries could become more protectionist −Towards trade −Towards inward investment  Emerging markets could resist exchange rate appreciation as well as capital inflows  Need to revitalize global dialogue via organizations like the G-20 and the IMF. −Governance reform −Liquidity facilities

Changes in global financial architecture  Governance in large financial firms broke down  Had large spillover effects throughout the world  But limited appetite for a global regulator  Instead −More cooperation in monitoring large multinational banks −Some coordination on new capital and liquidity regulations −Extremely limited movement on sharing losses across borders if a large bank fails => less cross-border branching, more room for domestic banks

Changes in domestic regulation  Focus on the system and regulatory gaps  Capital adequacy  Compensation and governance  Too big to fail

Opportunities for emerging markets  As demand shifts, opportunities for emerging market companies in domestic markets −Understand market better −Closer to customers: For example, Tata Nano or Standard Bank −Especially important for services associated with goods −Also for services – e.g., financial  And emerging-emerging trade (and corporate mergers)

However risks exist for emerging markets  Domestic demand-led growth harder to manage −Booms and bust in the past −Have to improve domestic institutions  But also have to create human capital capable of servicing the new exciting opportunities  Bottom line: This crisis will accelerate the shift in global economic power towards emerging markets. It is time for companies to position for that change.

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