The Implications of Recent Financial Market Turbulence for the Global Economy, Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund

September 7, 2007

Speech by Rodrigo de Rato
Managing Director of the International Monetary Fund
at the Ambrosetti Forum
Cernobbio, Italy,
September 7, 2007

As Prepared for Delivery

1. Thank you very much. I would like to thank Alfredo Ambrosetti and Valerio De Molli for hosting the Forum, and for inviting me to join you today. I am delighted to be with you, and to participate in this important discussion with such eminent representatives of academia, finance, and business as Kenneth Rogoff, Jim O'Neill, and Amit Mitra.

2. Today I would like to offer the perspective of the International Monetary Fund on the implications for the global economy of the recent financial market turbulence and credit-related crisis. Up to now, public discussion of this turbulence has been dominated by concerns about the effects on financial markets and on investors. I believe that it is also important to consider the economic effects, which could be significant, and which could affect people thousands of miles and millions of dollars in income away from the financial centers of London and New York. This is a global issue.

3. I should preface my remarks by stating what we all know—that events are still unfolding. Based on what has already happened, our judgment is that the financial market turbulence will have some modest adverse effects on global economic growth this year, but that would still leave global growth rates similar to those we have seen in recent years. This assessment is predicated on the assumption that financial market conditions will stabilize in the coming months. If this does not come to pass, the outlook would worsen. The prospects for 2008 will depend on how market developments evolve. Let me now lay out a few of the effects and risks that we see, and also explain why at present we do not think these risks fundamentally change the global economic outlook. I will conclude with some suggestions for policy makers.

4. At the moment, liquidity is reappearing, risk appetite is tentatively returning, and investors with longer-term horizons are finding buying opportunities and deploying capital. However, even if some stability returns soon, the adjustment process and the implications of the financial market turbulence are likely to be protracted and not uniformly distributed. A speedy recovery of trust among market participants is certainly needed. The tightening in financial conditions has not just involved the repricing of credit but also the curtailment of credit to certain borrowers and in certain markets. I see two main sets of problems that could flow into the real economy from this:

• First, if restrictions on lending continue and broaden, they will likely affect both household finance and the corporate sectors in mature markets, and potentially in emerging market countries through increased credit spreads and lower capital inflows. Part of this turmoil has entailed a material contraction in demand for asset-backed commercial paper—the amount outstanding has fallen by about 15 percent from its peak. This has been an important source of funding for consumer finance and the contraction in demand has caused the cost of short-term finance to rise and its availability to fall. Effects are also being felt in the broader U.S. mortgage market, beyond sub-prime mortgage financing, with the cost of nonconforming U.S. mortgages, including Alt-A and jumbo mortgages, rising recently. In addition, while bond issuance by investment grade corporations has increased, bond issuance by sub-investment grade borrowers has diminished. This could impose some drag on new capital investment, although some issuance has been in connection with corporate restructuring and LBOs rather than new investment.

• Second, while systemically important banks began the episode well capitalized and financially strong, they may face new constraints in extending credit. Some banks and non-banks will need to focus on their liquidity management while assessing and managing the scope of potential financial losses. Some may also need to absorb a sizeable amount of commitments on leveraged loans and bonds, possibly at reduced values. And some may need to meet contingent liquidity commitments to funding vehicles. Taken together, these factors may limit—at least temporarily—the capacity of banks and other institutions to offset the flow of credit lost through non-bank channels, especially for sub-investment grade borrowers.

5. These developments would in turn have consequences for the real economy. We now expect some downward revisions to our baseline growth projections, especially next year. The downward revisions are likely to be largest for the United States, but we may also see some impact in the euro area. This will have implications for monetary policy. In the advanced economies, central banks have taken into account the impact of the market turmoil on economic activity in setting the monetary policy stance, while continuing to take actions to ensure orderly market functioning. Growth prospects for emerging markets may be affected by trade and financial market spillovers, but generally remain good. Most emerging markets have much stronger economic fundamentals and more credible monetary institutions today than they had during previous financial market disruptions. More flexible exchange rate regimes and the ability to issue debt in local currency have minimized two sources of vulnerability, compared with previous episodes of financial market strains. Many emerging markets have also built up substantial cushions of reserves. But there are pockets of vulnerability, particularly affecting countries that have relied heavily on short-term or foreign currency external financing to feed domestic credit booms. The IMF agenda envisions continuing work on the crisis prevention instruments to provide timely support to our members if needed.

6. Previous downside risks have also increased. If the reduced availability and increased cost of credit for housing causes a larger than currently projected downturn in the U.S. housing market, this could adversely affect consumer demand, reducing both growth and the demand for imports in the U.S. This in turn could reduce growth in countries that export to the United States. If difficulties in credit markets become worse, there would be direct effects on investment and indirect effects on confidence.

7. Despite the risks that I have just discussed, we still expect the global economy to continue performing relatively well. The economic fundamentals, both in the large industrial economies and in most major emerging economies, remain strong. Even in the United States, most directly affected by the financial market turmoil, most corporations remain highly profitable and household finances continue to be sustained by solid employment growth. Thus, the U.S. economy should continue to grow, albeit at a lower pace, this year and next. And while the U.S. economy has been a powerful engine during the global expansion, other economies are now almost equally important. Despite some slowing, growth in the euro area and in Japan is expected to continue, and major emerging markets like China and India will grow at above or close to double digit rates. Together these two countries are expected to contribute over one-fifth of total global growth in 2007.

8. The reappraisal of risks in financial markets may also prevent even larger problems from emerging in the future. For months, the Fund and others have been warning about the risks from lower lending standards, higher leverage, and lack of transparency. To the extent that these vulnerabilities, which had the potential to become much larger, are now being taken more seriously, this is good for financial stability. Also, we are now going through a test of new markets and instruments under less flexible conditions than those that prevailed over the last few years. Tests are not comfortable experiences, but so far, systemically important financial institutions and markets have come through the test well, and central banks have acted swiftly and adeptly to support them. The spillover to noncredit markets—including currencies and equities—has also been manageable so far.

9. This said, there are practices that should be changed and lessons that should be learned from the recent turbulence.

10. For policy makers in advanced economies, addressing the information asymmetries which have caused some credit markets to seize up should be a priority. Uncertainty regarding who holds certain credit exposures, and the extent or concentrations of such risks, has played a significant role in the recent financial turbulence, and it has the potential to cause new problems. One of the main reasons why counterparty risk has risen so strongly is that a large part of exposure to the subprime mortgage sector has been through off-balance sheet constructions, so that no one knows where future problems might emerge. Opaque structures may also have masked off-balance sheet exposures and contingent liabilities in other areas. To address this problem, regulators and market participants need to assess how transparency can be improved in various markets, especially for relatively new or illiquid instruments, in order to reduce uncertainty and avoid "surprises." Questions have also been raised about investors' lack of due diligence and the rating agencies' treatment of complex products. These issues need to be addressed, consumer protection needs to be enhanced, and financial education needs to be deepened.

11. Policy makers in emerging markets which have relied on portfolio and other capital inflows to finance current account deficits or surges in domestic credit need to consider how they will respond if capital inflows dry up or are reversed. I should say that we see little evidence of this happening so far—in terms of pressure on exchange rates or reserves—and no requests for assistance from the Fund have been made. If there is a need for our support, the Fund stands ready. But the first line of defense for any country concerned about its position is good policies, including having good information about the risk profile of major financial institutions. And participants should not take for granted the liquidity of markets.

12. The recent financial market turbulence presents policy makers with some new problems, but we should not think that old problems have gone away, and we should be careful not to take actions which exacerbate these problems. Governments which have sufficient flexibility to run a counter-cyclical fiscal policy may need to do so at some point, but they should continue to address long-term and longstanding problems stemming from aging populations. The problem of global imbalances has also not gone away. Indeed, while we do not expect the recent market turmoil to precipitate a disorderly adjustment, it may add to existing medium-term risks that a large U.S. external deficit may not be as easily financed from private capital inflows as it has been up to now.

13. Finally, recent developments have also underlined the potential for spillovers between markets and between countries. Many of the challenges which policy makers face would benefit from international cooperation. Cooperation is obviously needed in monitoring and regulating financial markets. The International Monetary Fund, together with other international institutions, has to play a role here, as we did in catalyzing the formulation of plans by major economies to address global imbalances. And dialogue, both in formal settings and in conferences such as this one, will also help us to shape the international response to events. So I look forward to hearing your comments on what we have said, and to our discussion.

14. Thank you very much.


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