Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund at the 37th Washington Conference of the Council of the AmericasWashington DC
May 2, 2007
As Prepared for Delivery
1. Thank you very much. It is a pleasure to be here, in such distinguished company, and also to see some old friends in the audience.
2. In a globalized world, the greatest opportunities and the greatest risks lie in two areas.
• The first is trade. Trade has been the lynchpin of global growth since the Second World War. And the world is on the brink of a once-in-a-generation agreement that could expand opportunities even further. But if the chance is not taken, both prospects for future gains and the achievements of the past may be threatened by a rising tide of protectionism.
• The second is financial globalization. The development of financial markets worldwide over the past two decades has been revolutionary. And the United States has been in the forefront of financial innovation. A strong and competitive financial system has both contributed to growth in the United States and enabled the external deficit to be financed smoothly and cheaply. Financial innovation remains a major source of potential growth in the global economy. But there are also risks in the financial markets which, if unaddressed, could erode confidence in financial institutions, and set back growth around the world.
3. I will speak mostly about financial markets today, and in keeping with the focus of this conference, mostly about financial market risks in the United States and their implications for Latin American countries. But my comments also apply to other countries of the global economy: financial market risks are present in other advanced and emerging economies. I will also say a few words about trade, an issue which affects every country in this world and in which the United States and some major Latin American countries can play a pivotal role.
4. First let me provide some context for what I will say on financial markets. A few weeks ago, the International Monetary Fund published its World Economic Outlook. One of the main conclusions of our review of the global economy was that while the potential for spillovers from economic slowdowns in the United States to the global economy continues to exist, the spillovers from the current U.S. downturn may be less important than previously thought.
• We found that mid-cycle slowdowns in the United States have only limited effects on other countries.
• We also found that the most serious recessions were the result of global events: for example, the oil shock of the 1970s and the bursting of the IT bubble after 2000, rather than spillovers from the United States.
5. But in published reports released at the same time, we also flagged some risks and some concerns.
• In our Global Financial Stability Report we talked about some credit and market risks in the global financial markets.
• And in our Regional Economic Outlook for the Western Hemisphere, covering the United States, Canada, Latin America, and the Caribbean, we covered the potential spillover effects of adverse events, including a tightening of financial market conditions in the United States, for major Latin American economies.
6. What financial market developments in the United States should most concern policy makers here and in Latin America? I see three areas which bear watching.
• We are all aware of the problems in the adjustable rate segment of the subprime mortgage market, which may also be affecting similar "Alt-A" loans. These problems may not yet have played out fully in terms of financial distress and foreclosures, and may well extend the downturn in the housing market.
• I also see significant risks in the recent increase in large private equity buyouts financed by a rising proportion of debt, as well as the deteriorating credit quality of leveraged loans. From a financial stability perspective, if some of these deals were to turn sour, it could trigger a reappraisal of risk which would curtail market access more broadly for lower-rated corporate borrowers. This could adversely affect investment and growth prospects.
• Then there is the proliferation of hedge funds. Globally, there are now estimated to be more than 9,500 hedge funds—fourteen times more than in 1990. Hedge funds can bring considerable benefits in terms of market efficiency, because they improve market liquidity and help spread risks to those investors most prepared to take them. However, recent developments call into question whether some of these benefits are actually being delivered. Returns of some equity based hedge funds may have become more correlated with market returns recently, casting doubt on their contribution to risk diversification. Moreover, about 30 percent of investment in hedge funds now comes from pension funds. It may be that pension funds are using hedge fund investment to diversify their own risks, but a situation where almost one-third of the capital for institutions on the cutting edge of financial risk comes from institutions whose first priority is safe investments certainly bears watching.
7. What are the implications of these concerns for the United States and for other countries in the Americas? The risks for the United States of disruption in the financial markets are fairly clear. If it made the external deficit more difficult to finance, and if this triggered a disorderly unwinding of global imbalances involving a sharp depreciation of the U.S. dollar and, in response, increases in U.S. interest rates, the ramifications would be very serious.
8. Such an eventuality would also be very damaging to other countries, and especially to the major Latin American economies. As part of our Regional Economic Outlook for the Western Hemisphere we modeled a number of scenarios. This analysis suggests that while Latin America would be fairly resilient to most global risks, a disorderly unwinding of global imbalances would have a large impact on growth in the region. Compared to a baseline growth forecast of just over 4 percent in each of 2007 and 2008 for six of the largest Latin American economies—Argentina, Brazil, Chile, Colombia, Mexico, and Peru—which collectively represent 90 percent of Latin American output, a disorderly unwinding of global imbalances would reduce growth in 2007 to about 2¾ percent and growth in 2008 to about 1½ percent. Much of the impact comes from a tightening in financial market conditions, simulated by a widening of the high yield corporate bond spread in the United States by 400 basis points.
9. What are the policy implications of this? One obvious one is that an orderly, as opposed to a disorderly, unwinding of global imbalances, is in everyone's interests. The Fund has been working toward this end for a long time, most recently though a Multilateral Consultation involving China, the euro area, Japan, Saudi Arabia, and the United States. Last month at our Spring meetings here in Washington, we and the participants set out detailed policy plans for each country and region, geared toward reducing imbalances while sustaining global growth. If participants implement these policies, this would be a significant step toward resolving imbalances, and hence reducing risks.
10. For their part, Latin American countries need to continue reducing their vulnerability to financial market shocks. Studies indicate that flexible exchange rate regimes are less prone to such shocks. Sound fiscal policy is also a priority. Although fiscal positions have generally improved since the 1990s, several countries have recently experienced rapid increases in current government spending. It is important that governments keep spending under control. Public debt also remains high, at over 50 percent of GDP on average. Ideally, debt should be low enough for governments to have the freedom to implement a counter-cyclical fiscal policy if they need to. Few governments in Latin America are in this position yet, although debt has declined in several countries across the region, including in Brazil, Colombia, and Peru, and the structure of debt has improved in others.
11. The United States is in a position to take more direct action to head off financial market risks. Of course, much of the responsibility must lie with individuals and private institutions: whether it is those who borrow or those who lend. But legislators and regulators set the rules of the game.
• With regard to the mortgage markets, it will be important to avoid a heavy-handed response that could unduly limit innovation or flexibility. However, from a financial stability perspective, it is important that credit discipline is restored and maintained. Moreover, consumer protection in household loan markets needs to be improved, and federal legislation may be needed to increase coverage and consistency.
• Financial education will also be important. In many areas, including pensions, individuals and families are having to take more responsibility for managing financial risks themselves. Governments and regulatory authorities, and the private sector, should help them be educated consumers of financial information—for example, by encouraging the teaching of financial literacy in schools and publicizing the best sources of advice on financial planning.
• With regard to private equity buyouts, regulators will need to ensure that the growth of the leveraged buyout market is not fueled by weakening credit standards.
• With regard to hedge funds, I broadly agree with the approach taken by the Presidential Working Group on Financial Markets that risks should be controlled mainly through investor due diligence, counterparty risk management, and the exclusion of unsophisticated investors. But continued attention needs to be paid to ensure that market risks are being comprehensively assessed in an increasing complex and leveraged financial system. I would therefore agree with the conclusions of New York Fed President Tim Geithner in a recent speech that as the structure of markets changes, supervisors may need to adapt the framework of supervision to improve investor protection and reduce systemic risks and vulnerabilities. I also believe that it will also be important to monitor developments in the global hedge fund industry from an international and multilateral perspective.
12. Before concluding, let me turn to trade issues. I am very concerned about the apparent rise in protectionist sentiment around the world. This has many manifestations, from the doctrine of national champions in Europe, to legislative proposals that aim to protect some industries through tariffs or other protectionist measures in the United States and elsewhere. One response is to be clearer about the benefits of trade. In the United States, studies indicate that trade liberalization, including trade deals under the GATT and the WTO, have lifted annual U.S. incomes by as much as 750 billion U.S. dollars. Indirect gains arising from investment and similar reforms have been of a similar magnitude. Moreover, U.S. firms engaged in trade tend to be more productive, have higher employment growth, and pay higher wages than domestically-oriented firms. Similarly, in Latin America, support for trade liberalization comes from studies based on specific industries in various countries. These studies show that trade liberalization raised labor productivity in these industries, contributing to growth.
13. The most immediate priority is to bring the Doha Round to a conclusion that delivers ambitious reforms. It will take many hands to complete this work. The United States has a particularly important role to play. Given the delays of the past year, an extension of the U.S. administration's fast track negotiating authority—at least with regard to the Doha Round—will almost certainly be necessary. The terms of such an extension are a matter for the U.S. Congress, but the results of their decision are important not only for the United States but also for the rest of the world. Governments in Latin America, especially Brazil, which is a member of the G4, can also play an important role.
14. There is also scope to expand trade within Latin America. For example, in emerging Asia, the share of exports to countries within the same region has increased steadily and is now over 40 percent. But in Latin America, the share of intra-regional trade has remained roughly unchanged at around 20 percent.
15. Bilateral trade agreements can play some part in this, and a number of trade agreements, including some between the United States and individual countries in Latin America, have led to important benefits for the region. However, bilateral agreements should contain liberal, transparent rules of origin and complement, rather than substitute for, multilateral liberalization, which offers the broadest benefits for the region and for the world.
16. The economies of the Americas are increasingly linked, by financial flows, by trade, and by common interests. All of the measures that I have proposed are in the interests of the countries that would need to take them, as well as in the broader global interest. This is a good thing: it's a basic axiom of economics that self-interest works better than altruism in generating action. So I hope that all can act in their own and in the common good.
17. I would now welcome questions and comments. Thank you very much.