US Financial Crisis

Great Lakes- H4 G8 & 9

Prepared by
• -Nirmaan Parikh
[FT11436]
• -Omkar Barve [FT11437]
• -Porag Dutta [FT11438]
• -Praveen Patil [FT11439]
• -Prasad Nair [FT11440]
• -Priyank Sinha [FT11441]
• -Purnendu [FT11442]
• -Rachna Saini [FT11443]
• -Rahul Jain [FT11444]
• -Rahul Raj [FT11445]
Questions
11
Current Account deficit in USA- Why? Will the world continue
to fund the US CAD?

22
Is Current Account deficit a cause for the financial crisis- Yes/No-
Why?

33
USA hegemony in the world today

44
Can $ be the currency of the future? Or USA in post USA era or
Is USA over?
 Q1. Current Account deficit

The broadest measure of trade in goods and services and income

and transfer payments. Is a sum of balance of trade, net factor and
net transfer payments.
The Current Account Deficit is the country’s trade deficit plus
interest payments on what the country borrows from foreigners to
finance the trade deficit.
Current Account Deficit occurs when the net imports of goods,
services and transfers is greater than exports of the same.
This situation makes a country a net debtor to the rest of the
world.
 Causes of US Current Account Deficit
US consumer spending was rising rapidly due to a combination of
Tax cuts
Low interest rates
Rising house prices
With rising consumer spending the US has been increasing the value of
imports bought into the economy.
This caused a large influx of exports with a disproportionate sale of
domestic products.
Decline in competitiveness: US manufactured goods have been losing
comparative advantage to Asian economies due to the wage costs in US
being much higher. In particular China has seen its trade surplus with
America grow due to its low labor costs.
 Causes of US current account deficit contd.

American corporations have moved production facilities to other

countries; greatly reducing the influence and scope of U.S. exports.
Relatively high value of dollar: Dollar has not devalued as expected
for an economy with a large current account deficit. The US has
remained an attractive location for Capital investment.
This inflow of capital has financed the current account deficit and
encouraged America to keep buying imports.
The inflow of capital has also enabled interest rates to remain low.
Because China has bought so many US government bonds the US has
been able to finance its national debt whilst keeping interest rates low.
 Causes of US current account deficit contd.
Low interest rates have encouraged consumer borrowing and consumer
spending; a major cause of the current account deficit.
Other countries, especially China, are investing billions in American
assets. USA is the world’s largest debtor and China now holds a significant
amount of those bonds.
In the past 12 months the dollar has been in decline but to reduce the
current account deficit it would need to fall by more than 20%
 Current Account Balance (% to GDP)
Country 1990-94 1995-99 2000-04 2005 2006 2007 2008
China 1.4 1.9 2.4 7.2 9.5 11.0 10.0
India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8
Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1
Saudi Arabia -11.7 -2.4 10.6 28.7 27.9 25.1 28.9
UAE 8.3 4.6 9.9 18.0 22.6 16.1 15.8
United States -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7
Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7
Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8
Source: World Economic Outlook Database, April 2009, International Monetary Fund.

Note: (-) indicates deficit.

 Q2. Global Financial Crisis and Current
Account Deficit
Immediate Reasons for the Financial Crisis
Sub-prime lending
Originate and distribute model
Financial engineering, derivatives
Credit rating agencies
Lax regulation
Large global imbalances
Fundamental Reasons
Excessively accomodative monetary policy in the United States
after 2002 which led to the Aggregate demand surpassing the
output and led to large account deficits; mirrored in surplus in
China and other economies.
The Federal Reserve, seeking to end the technology equity bubble
recession of 2000-2002, quickly dropped its federal funds rate to
historic lows and held the rate at a low level for an extended period
of time.
The US economy became increasingly overleveraged during the
years preceding the crisis. This increased the vulnerability of its
financial institutions to the collapse of the housing bubble and
worsened the ensuing economic downturn.
This excess credit was invested heavily and narrowly in the United
States through purchases of Treasury securities and investment in
the financial derivatives market, leading to a bubble in housing
prices and commodities. 
 Will the world continue to fund the
US CAD?
Sustainability of US Current Account Deficit
US CAD will be sustainable as long as foreign nations are willing to
buy American assets.
Possible only if return on US assets is more than that of other
foreign assets.
A large CAD is not sustainable in the long run because it increases
U.S. net debt to foreigners.
Larger debts can be serviced only through higher borrowing or
higher net exports.
For net exports to rise the value of the dollar must fall. This will
affect the confidence of foreign nations to invest in US assets.
Thus at some point both the dollar and CAD will tend to fall.
 Will the world continue to fund the
US CAD? (contd.)
The depreciation of dollar could result in an economic slump.
Nations could start looking out for diversifications of their
investments.
Russia expressed desire to start increasing the amount of Euros it
holds.
Japan’s holding of U.S. treasuries is also on the decline.
The massive current account deficits of the past several years has
put the well being of US economy in foreign hands.
Foreign nations will become less willing to hold dollar denominated
assets if the CAD continues to grow.
In such a case, US will be forced to increase the interest rates to
attract foreign investments.
 Will the world continue to fund the
US CAD? (contd.)
If few foreign countries begin to diversify their dollar holdings the
rest might follow suit.
Other nations could see their dollar denominated holdings being
devalued and might begin to sell them. 
With few buyers, the dollar falls sharply and interest rates rise
rapidly. 
The falling dollar causes imports to become more expensive,
inflation spikes, and gold prices soar.
The probability of this happening increases as the current account
deficit continues to increase.
Hence, it is not likely that the world would continue to fund the US
current account deficit.
 Due to overbuying of U.S. Treasuries by Foreign investors, the yield
on those investments dropped to a level where foreign investors
sought out riskier assets to improve their return- real estate.  To
diversify the systemetic and credit risks, they invested in derivative
instruments. Thus the explosion in mortgage-backed securities and
derivatives, and the hedge funds that traded them, may find an
explanation, at least in part, in the current account deficit. 
The regulatory framework did not keep pace with financial
innovation, such as the increasing importance of the shadow
banking system, derivatives and off-balance sheet financing. Laws
were manipulated or enforcement weakened in parts of the
financial system leading to overlending.
Q3. Current scenario of US Economy
The U.S. need to take steps immediately to protect itself from
the potential loss of the purchasing power of its U.S. Dollars. It
has a $12.3 trillion national debt, $55 trillion in unfunded
obligations (programs such as Social Security, Medicare and
Medicaid) and total Federal Reserve and Treasury bailout
commitments now stands at $11.8 trillion.

The Government’s stimulus packages, financial bailouts, the

need to support liquidity in Treasuries, keeping interest rates at
the lowest level under the circumstances of low economic
growth, high unemployment and low tax collection make it print
more dollars. This leads to a high risk of substantial inflation, or
hyperinflation in a long-run.
Fundamentals of US Economy
Paul Krugman stated that a country whose fundamentals are persistently
and predictably deteriorating will necessarily have a crisis (financial) at
some point.
National Debt
Increase in the upper limit of national debt from $12.394 trillion to
$14.294 trillion.
The excessive debt results in slower economic growth and
dampening wages, and shrinking the government’s ability to reduce
taxes, invest, or provide a safety net.
Unemployment
In January, the unemployment rate fell from 10.0 to 9.7 percent.
Gallup reported in the end of February 2010 that 19.9% of the U.S.
workforce was underemployed during the month of January,
translating to close to 30 million Americans who are working less than
their desired capacity.
Fundamentals of US Economy- Contd.
Budget Deficit
The budget deficit of US reached a record $1.415 trillion in 2009.
The excess of spending over revenue in the U.S. was $42.6 billion
in January 2010, as opposed to a deficit of $63.4 billion in January
2009.
Economic impact of U.S. international military operations
• The so called war against terror in Iraq and Afghanistan pushed
the budget into the red. One of the basic non-monetary reasons
of inflation is the existence of significant non-productive
government expenses such as military expenses
China’s Peg to the dollar
• China’s peg to the dollar makes imports into the U.S. cheaper. This
supports high level of unemployment in America. 
Way Out
Some economists suggest that the U.S. anti-inflation strategy should
include
Suppression of inflation expectations and stimulation of savings
Reaching balance between budget receipts and expenditures
Increasing the mass of commodities, and
 Strengthening national currency by establishing an
unconditional priority of inflation targeting over other
government programs (such as military expenses,
unemployment rate regulation, influencing the national
currency market, etc.)
US future in post America world
The various reasons why future of USA in post America world
doesn’t look very promising are-

Slowing down Global investment in US assets

Reducing consumer spending power
Depreciating dollar
Decreasing US stock prices
Increasing interest rates in US Govt. securities
US future in post America world contd
The emerging economies of the world like China and India will become
powerful in post US era.
China with huge market potential, rich labour resources has a comparative
advantage in terms of labour cost, sound corporate governance and stable
government and society, leading to fast growth of economy.
China is the second largest foreign holder of US treasury securities which
gives it economic leverage over US. Also the rising middle class income of
China and India will move major consumption market from US to these
nations.
Competitions for resources will increase leading to increased demand for
energy.
China and India will be major suppliers of manufactured goods in World.
Russia will lead the raw material market, making Asian nations self-
sufficing
Future Trends
W-shaped recovery – There are 30-40% chances* that the US economy
will dip into recession in the second half of 2010. the Federal Exit plan
from stimulus can trigger this event.
Reduced Bank Lendings – Banks will start hoarding cash to get rid of
the toxic assets. Rising loan defaults will further fuel this trend. This will
lead to further decline in bank lendings.
Decline of Dollar – The dollar will see a futher weakness due to the $13
trillion US debt. This high debt may lead the US to let the dollar decline.
A weak dollar will also keep the Dow afloat and will boost export.
Tamed Inflation – Withdrawl of stimulus will absorb any excess money
which has been pumped by the government. This will curb inflation even
if the Fed Fund rates are kept at near zero.
Uncertainity – Increased economic uncertainly on a global level will
remain a big issue . This uncertainty will cause increased volatility. Gold
and oil prices will rise and fall, depending on investors' moods. What it
means to you - prepare for spikes in gas prices, which could translate to
food prices.
4. Can $ be currency of future?
Diversification out of the dollar (BRIC)

A long-term trend of official reserve diversification away from U.S.

dollars, especially among the fast-growing, reserve-hungry emerging
and developing economies can be seen. Dollar nowadays significantly
depends on such developing countries as China, India, Brazil, Russia,
and others. These countries accumulate very large dollar reserves and
U.S. debt.
China- largest foreign holder of U.S. debt, diversifying its reserves
and protecting from weakening dollar.
India- the IMF sold 200 metric tons of gold to India in the
beginning of November 2009. The $6.7 billion sale is the biggest
single central-bank purchase.
Brazil-considering the gradual elimination of the U.S .dollar in
trade with China, Russia and India.
Russia- is increasing the share of Japanese Yen and Swiss franc in
reserves.
 Can $ be currency of future? (contd)
Weak fundamentals of the US economy
• National Debt
• Unemployment
• Budget deficit
• Economic impact of U.S. international military operations
• China’s peg to the dollar

resulting in dollar depreciation.

confidence in the US economy
Lack of • Post recession the world has lost its
Confidence defining feature of a currency crisis.
• Investor lack of confidence is a
What can drive $ as a future currency?
It has been the international currency for the last 70 years
and it will take time for an alternate currency to take its
place.
Currently, dollar does not seem to have a strong alternate,
although Euro, Yuan and Yen could be alternates of the
future.
Possible alternates to the US Dollar

Reserve Currencies as a Percentage of Global Currencies

Possible alternates against the Dollar
Euro:
Currently about 28 % of Global Currency Reserves are in Euro
Represented by 16 countries
GDP and trade openness of Euro Zone comparable to the U.S.
economy
The European Central Bank has kept inflation in check
However, Euro's increase in the share of the worldwide currency
reserve basket has slowed considerably since the year 2007
The market share of European trade is likely to fall significantly
over the next two decades, largely due to emerging Asian
countries
Possible alternates against the Dollar

Yuan / Yen / British Pound:

Present currency reserve share of these 3 currencies put
together is less than 10 %
Yuan’s exchange rate is not market driven. Hence this may not
be accepted as a world currency
If Chinese Yuan becomes market driven then it may hamper
their export competitiveness.
What can drive $ as a future currency?

It takes significant re-architecture of world economy trade and time

for a currency to become a global currency. Eg. U.S Dollar took almost
80 years to replace Pound as a global currency.
Present currency reserve share of the U.S Dollar is about 62 % which is
way above Euro and other currencies.
Currently, it does not seem to have a strong alternate for at least 10-
15 years, although Euro, Yuan and Yen could be alternates of the
future.
 References
1. http://useconomy.about.com
2. http://econ.economicshelp.org
3. http://www.catalogs.com
4. “The United States current account deficit and world markets” - Professor Warwick
McKibbin
5. “The US as a Net Debtor: The Sustainability of the US External Imbalances” - Nouriel
Roubini, Stern School of Business,
6. http://rawfinanceblog.com
7. http://www.iie.com/research/
8. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/
9. http://www.iie.com/publications/pb/pb09-21.pdf
10. “International Monetary Fund” -
http://www.imf.org/external/pubs/ft/fandd/2000/03/mann.htm
11. “Global Financial Crisis: Causes, Consequences and India’s Prospects” -
RakeshMohan, Deputy Governor, Reserve Bank of India
12. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/
13. http://www.iie.com/publications/pb/pb09-21.pdf
14. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/
15. “India and the Global Financial Crisis” – Y. V. Reddy
References
• http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/
• http://www.iie.com/publications/pb/pb09-21.pdf
• http://en.wikipedia.org/wiki/Reserve_currency
THANK YOU