Global Economic Crises

The current financial crisis is the worst the world has seen since the Great Depression of the 1930s. For younger generations, accustomed to mild recessions of the new phase of globalization, the misery of the Great Depression is hitherto nothing more than a distant legend. However, the collapse of two Bear Stearns Hedge funds in summer of 2007 exposed what came to be known as the subprime mortgage crisis, reintroducing the world to an era of bank failures, a credit crunch, private defaults and massive layoffs. In the new, globalized world of closely interdependent economies, the crisis affected almost every part of the world, receiving extensive coverage in the international media. “In an Interconnected World, American Homeowner Woes Can Be Felt from Beijing to Rio de Janeiro,” observed the International Herald Tribune at the onset of the crisis. “Chinese Steelmakers Shiver, Indian Miners Catch Flu,” noted the Hindustan Times. “US and China Must Tame Imbalances Together,” suggested YaleGlobal, as the frenzied search for a solution continues around the globe.

In this special report, YaleGlobal offers essential information on why the crisis started, how it affected the industries and consumers around the world, and what solutions have been proposed by experts and regulators across countries.

Many causes for the financial crisis have been suggested, with varying weight assigned by experts. The U.S. Senate's The U.S. Senate's 

Levin–Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street". The 1999 repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depository banks in the United States. Critics argued that credit rating agencies and investors failed to accurately price the risk involved withmortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets. Research into the causes of the financial crisis has also focused on the role of interest rate spreads.

Background

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. Already-rising default rates on "subprime" and adjustable-rate mortgages (ARM) began to increase quickly thereafter. As banks began to give out more loans to potential home owners, housing prices began to rise.

Easy availability of credit in the U.S., fueled by large inflows of foreign funds after the Russian debt crisis and Asian financial crisis of the 1997–1998 period, led to a housing construction boom and facilitated debt-financed consumer spending. Lax lending standards and rising real estate prices also contributed to the Real estate bubble. Loans of various were easy to obtain and consumers assumed an unprecedented debt load.

Subprime

During a period of intense competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited, mortgage lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers. In the view of some analysts, the relatively conservative Government Sponsored Enterprises (GSEs) policed mortgage originators and maintained relatively high underwriting standards prior to 2003. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The worst loans were originated in 2004–2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs.

Stabilization

The U.S. recession that began in December 2007 ended in June 2009, according to the U.S. National Bureau of Economic Research (NBER) and the financial crisis appears to have ended about the same time. In April 2009 TIME Magazine declared "More Quickly Than It Began, The Banking Crisis Is Over. The United States Financial Crisis Inquiry Commission dates the crisis to 2008. President Barack Obama declared on January 27, 2010, "the markets are now stabilized, and we've recovered most of the money we spent on the banks.

The New York Times identifies March 2009 as the "nadir of the crisis" and notes that "Most stock markets around the world are at least 75 percent higher than they were then. Financial stocks, which led the markets down, have also led them up." Nevertheless, the lack of fundamental changes in banking and financial markets, worries many market participants, including the International Monetary Fund.

Media coverage

The financial crises generated many articles and books outside of the scholarly and financial press, including articles and books by author William Greider, economist Michael Hudson, author and former bond salesman Michael Lewis, Kevin Phillips, and investment broker Peter Schiff.

In May 2010 premiered Overdose: A Film about the Next Financial Crisis, a documentary about how the financial crisis came about and how the solutions that have been applied by many governments are setting the stage for the next crisis. The film is based on the book Financial Fiasco by Johan Norberg and features Alan Greenspan, with funding from the libertarian think tank The Cato Institute. Greenspan is responsible for de-regulating the derivatives market while chairman of the Federal Reserve.

In October 2010, a documentary film about the crisis, Inside Job directed by Charles Ferguson, was released by Sony Pictures Classics. It was awarded an Academy Award for Best Documentary of 2010.

Time Magazine named "25 People to Blame for the Financial Crisis”.

Emerging and developing economies drive global economic growth

The financial crisis has caused the "emerging" and "developing" economies to replace "advanced" economies to lead global economic growth. Previously "advanced" economies accounted for only 29% of incremental global nominal GDP while emerging and developing economies accounted for 71% of incremental global nominal GDP from 2007 to 2013 according to International Monetary Fund. In this graph, the names of emergent economies are shown in boldface type, while the names of developed economies are in.

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Responsibility accounting

  

Responsibility accounting is dividing into organization and similar units, each of everyone is to be assigned particular responsibilities. These units may be in the form of divisions, segments, departments, branches, product lines and so on. Each department is comprised of individuals who are responsible for particular tasks or managerial functions. The managers of various departments should ensure that the people in their department are doing well to achieve the goal. Responsibility accounting refers to the various concepts and tools used by managerial accountants to measure the performance of people and departments in order to ensure that the achievement of the goals set by the top management. It represents a method of measuring the performances of various divisions of an organization. The test to identify the division is that the operating performance is separately identifiable and measurable in some way that is of practical significance to the management. Responsibility accounting collects and reports planned and actual accounting information about the inputs and outputs of responsibility centers.

Responsibility

Responsibility accounting lies on the responsibility centers. A responsibility centre is a sub unit of an organization under the control of a manager who is held responsible for the activities of that centre.

The responsibility centers are classified into three category:

Í Cost Centers

Í Profit Centers

Í Investment centers

Cost Centers

Cost center is measured inputs only not measured the outputs of money. In a cost centre records only costs incurred by the centre/unit/division, but the revenues earned  are excluded form its purview. It means that a cost centre is a segment whose financial performance is measured in terms of cost without taking into consideration its attainments in terms of "output". The costs are the planning and control data in cost canters. The performance of the managers is evaluated by comparing the costs incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control.

Profit Centers

The manager responsible for both Costs and Revenues it is called a profit centre. The profit center measured both inputs and outputs of money. The difference between revenues and costs represents profit. The term "revenue" is used in a different sense altogether. According to generally accepted principles of accounting, revenues are recognized only when sales are made to external customers.

The profit of all the departments so calculated will not necessarily be equivalent to the profit of the entire organization. The variance will arise because costs which are not attributable to any single department are excluded from the computation of the department's profits and the same are adjusted while determining the profits of the whole organization. Profit provides more effective appraisal of the manager's performance. The manager of the profit centre is highly motivated in his decision-making relating to inputs and outputs so that profits can be maximized. The profit centre approach cannot be uniformly applied to all responsibility centers. The following are the criteria to be considered for making a responsibility centre into a profit centre. A profit centre must maintain additional record keeping to measure inputs and outputs in monetary terms. When a responsibility centre renders only services to other departments, e.g., internal audit, it cannot be made a profit centre. A profit centre will gain more meaning and significance only when the divisional managers of responsibility centers have empowered adequately in their decision making relating to quality and quantity of outputs and also their relation to costs.

Investment Centers

The manager is responsible for costs and revenues as well as for the investment in assets, it is called an Investment Centre. In an investment centre, the performance is measured not by profits alone, but is related to investments effected. The manager of an investment centre is always interested to earn a satisfactory return. The return on investment is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre.

Transfer Pricing

The profit centers are used, when the transfer prices become necessary in order to determine the separate performances of both the 'buying profit centers. the measurement of profit in a profit centre is further complicated by the problem of transfer prices. The transfer price represents the value of goods/services furnished by a profit centre to other responsibility centers within an organization. When internal exchanges of goods and services take place among the different divisions of an organization, they have to be expressed in monetary terms which are otherwise called the transfer price. Thus, transfer pricing is the process of determining the price at which goods are transferred from one profit centre to another profit centre within the same company.

In certain circumstances, transfer pricing may have an indirect effect on overall company profitability by influencing the decisions made at divisional level. The fixation of appropriate transfer price is another problem faced by the profit centers. The transfer price forms revenue for the selling division and an element of cost of the buying division. Since the transfer price has a bearing on the revenues, costs and profits or responsibility canters, the need for determination of transfer prices becomes all the more important.

These objectives are considered for setting-out a transfer price:

Ø Division of Autonomy : The prices should seek to maintain the maximum divisional autonomy so that the benefits, of decentralization  are maintained. The profits of one division should not be dependent on the actions of other divisions.

Ø Goal congruence: The prices should be set so that the divisional management's desire to maximize divisional earrings is consistent with the objectives of the company as a whole. The transfer prices should not encourage suboptimal decision-making.

Ø Performance appraisal: The prices should enable reliable assessments to be made of divisional performance.

Transfer Pricing Methods

 Market based transfer pricing

The market is when exists outside the firm for the intermediate product and where the market is competitive then the use of market price as the transfer price between divisions will generally lead to optimal decision-making.

Cost based pricing

The systems of  Cost based transfer pricing methods  are commonly used because the conditions for setting ideal market prices frequently do not exist; for example, there may be no intermediate market which does exist may be imperfect. Providing that the required information is available, a rule which would lead to optimal decision for the firm as a whole would be to transfer at marginal cost up to the point of transfer, plus any opportunity cost to the firm as whole.

Full cost transfer pricing

This variant , and the method which is full costs plus a profit mark-up, has the disadvantage that suboptimal decision-making may occur particularly when there is idle capacity within the firm. The full cost  is likely to be treated by the buying division as an input variable cost so that external selling price decisions, may not be set at levels which are optimal as far as the firm as a whole is concerned.

Variable cost transfer pricing

Under this system transfers would be made at the variable costs up to the point of transfer. Assuming that the variable cost is a good approximation of economic marginal cost then this system would enable decisions to be made which would be in the interests of the firm as a whole. However, variable cost based prices will result in a loss for the setting division so performance appraisal becomes meaningless and motivation will be reduced.

 Negotiated transfer pricing

 Negotiated transfer prices could be set by negotiation between the buying and selling divisions. This would be appropriate if it could be assumed that such negotiations would result in decisions which were in the interests of the firm as a whole and which were acceptable to the parties concerned.

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Foreign Direct Investment

An investment made by a company or entity based in one country, into a company or entity based in another country. Foreign direct investments differ substantially from indirect investments such as portfolio flows, wherein overseas institutions invest in equities listed on a nation's stock exchange. Entities making direct investments typically have a significant degree of influence and control over the company into which the investment is made. Open economies with skilled workforces and good growth prospects tend to attract larger amounts of foreign direct investment than closed, highly regulated economies.

FDI  Components:

Ø equity capital

Ø reinvested earnings

Ø intra-company loans

It flows are recorded on a net basis in a particular year. Outflows of FDI in the reporting economy comprise capital by a company resident in the economy to an enterprise resident in another country. Inflows of FDI in the reporting economy comprise capital provided by a foreign direct investor to an enterprise resident in the economy.

Foreign direct investment  includes significant investments by foreign companies, such as construction of production facilities or ownership stakes taken in U.S. companies. FDI not only creates new jobs, it can also lead to an infusion of innovative technologies, management strategies, and workforce practices. 'The ultimate flow of foreign involvement is direct ownership of foreign- based assembly or manufacturing facilities. The foreign company can buy part or full interest in a local company or build its own facilities. If the foreign market appears large enough, foreign promotion facilities offer distinct advantages. First, the firm secures cost economies in the form of cheaper labor or raw material, foreign government incentives, and freight savings.

Types of  Foreign Direct Investment

Multinational Corporation

A country that maintains significant operation in multiple countries but manages them from the base in the home country.The MNC's are playing an important role in economic development of developing countries. First, the investment made by MNC's help in filling the saving investment gap. Secondly, it fills the foreign exchange or trade gap. Thirdly, the govt. of the developing countries is able to fill up the reserves gap by taxing the profits of MNC's. Fourthly, MNC's fill the gaps in management entrepreneurship, technology and skills in the developing countries.

Transnational Corporation

A country that maintains the significant operation in more than one country but decentralize management to the local country.

Strategic alliance

An approach to going global that involves partnerships between an organization and a foreign company in which both share knowledge & resources in developing new products or building production facilities. t is an agreement typically between a large company with established products & channel of distribution and an emerging technology company with a promising research and development program in areas of interest to the larger company. In exchange for its financial support, the larger established company obtains a stake in the technology being developed by the emerging company. Today, strategic alliance is common place in the biotechnology, information technology & the software industries.

Joint venture

An approach going global that is a specific type of strategic alliance in which the partners agree to form an independent organization for some business purpose.

A contractual joint venture between firms is usually for a specific project, such as manufacturing a component or other product for a fixed period of time. In equity joint venture is when firms hold an equity stake in the setting up of a joint subsidiary, again to produce a good or a service, for example Toyota and General Motors formed the subsidiary NUMMI to manufacture cars in the United States.

The percent of sales method for preparing pro forma financial statement are fairly simple. Basically this method assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship. When using this method, a decision has to be taken about which historical cost ratios to be used.

Neoclassical Economic Theory

Neoclassical economic theory propounds that FDI contributes positively to the economic development of the host country and increases the level of social wellbeing. The reason behind this argument is that the foreign investors are usually bringing capital in to the host country, thereby influencing the quality and quantity of capital formation in the host country. The inflow of capital and reinvestment of profits increases the total savings of the country. Government revenue increases via tax and other payments. Moreover, the infusion of foreign capital in the host country reduces the balance of payments pressures of the host country.

The other argument favoring the neoclassical theory is that FDI replaces the inferior production technology in developing countries by a superior one from advanced industrialised countries through the transfer of technology, managerial and marketing skills, market information, organizational experience, and the training of workers.

The MNCs through their foreign affiliates can serve as primary channel for the transfer of technology from developed to developing countries. The welfare gain of adopting new technologies for developing countries depends on the extent to which these innovations are diffused locally.

The proponents of neoclassical theory further argue that FDI raises competition in an industry with a likely improvement in productivity; Bureau of Industry Economics. Rise in competition can lead to reallocation of resources to more productive activities, efficient utilization of capital and removal of poor management practices. FDI can also widen the market for host producers by linking the industry of host country more closely to the world markets, which leads to even greater competition and opportunity to technology transfer.

It is also argued that FDI generates employment, influences incomes distribution and generates foreign exchange, thereby easing balance of payments constraints of the host country; Sornarajah; Bergten,  all Furthermore, infrastructure facilities would be built and upgraded by foreign investors. The facilities would be the general benefit of the economy.

The Guidelines on the Treatment of Foreign Direct Investment incorporates the neoclassical theory when it recognizes that a greater flow of direct investment brings substantial benefits to bear on the world economy and on the economies of the developing countries in particular, in terms of improving the long-term efficiency of the host country through greater competition, transfer of capital, technology and managerial skills and enhancement of market access and in terms of the expansion of international trade.

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Finance

Finance Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.

Scope/Elements

Í    Investment decisions includes investment in fixed assets (called as capital budgeting).     Investment in current assets are also a part of investment decisions called as working capital decisions.

Í      Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

Í    Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:

 i.  Dividend for shareholders- Dividend and the rate of it has to be decided.

    ii. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-

Ø To ensure regular and adequate supply of funds to the concern.

Ø To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price  of the share, expectations of the shareholders.

Ø To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.

Ø To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.

Ø To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

·        Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise.

·        Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

·        Choice of sources of funds: For additional funds to be procured, a company has many choices like-

a.     Issue of shares and debentures

b.     Loans to be taken from banks and financial institutions

c.      Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

·        Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.

·        Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways:

a.     Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.

b.     Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company.

·        Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc.

·        Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.,

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