Scanning the Horizon: Monitoring and Managing Financial Market RisksSpeech by Rodrigo de Rato, Managing Director of the International Monetary Fund, at the Economic Club of Toronto,
Toronto, Canada, June 19, 2007
As Prepared for Delivery
1. I would like to thank Mark Adler for that very kind introduction. It is a pleasure to be here in Canada, especially at this season when I envy your long summer days. The world's economy is itself enjoying a kind of extended summer, an expansion which has already given us the best season of growth and stability since the 1960s and seems likely to continue.
2. As Managing Director of the International Monetary Fund, it is part of my job to scan the economic horizon and to identify the cloud no bigger than a man's hand which might one day turn into a storm. Here the analogy breaks down though, because if economists can identify clouds early and clearly enough, then—unlike weathermen—we can not just predict but also prevent the storm. It is in this spirit that I would like to offer today a few thoughts on some economic and financial market issues, which are important for Canada and important for the global economy.
3. Canada is a highly successful participant in the global economy, with growth which over the past decade has exceeded that of the United States, the euro area and Japan. And that success has been founded in large part on its openness to trade, and its openness to investment. Canada has traditionally benefited greatly from being an importer and exporter of capital. But in a competitive world, if Canada is to build on its success in growth, productivity and technology it will need to continue adapting, and to make sure that its investment framework is second to none.
4. Investment in the financial sector is likely to be particularly important over the next few years. Canada's banks are already sound and well capitalized. If markets such as those for high-yield bonds and venture capital are developed further the financial sector could be an even stronger engine for economic growth. Canada can improve competition in the banking system by making it more open to foreign investment and mergers. And Canada can encourage domestic and foreign investment by strengthening its investment framework and supporting legislation. One important element of this would be to update the regulation of securities. Canada is currently the only G-7 country without a common securities regulator, and Canada's investors deserve better. Establishment of a common securities regulator would be good policy, and it would be conducive to mutual recognition of securities regulation with other countries, including the United States.
5. This takes on added significance, given the importance of the United States' economy to Canada. It is estimated that a 1 percent change in U.S. output affects Canada's GDP by somewhere between 0.3 and 0.7 percent of GDP. We believe the true figure is at the higher end of that range. As I turn to discuss the current situation in the global economy, let me therefore begin with the United States. We believe that U.S. economic prospects are good. We expect the U.S. economy to regain momentum gradually as the drag from the current housing correction and softness in the business sector dissipates. Data released over the past couple of months support this projection, with indications of a recovery in manufacturing during the first quarter of this year. The situation in the U.S. housing market remains more ambiguous. But two important pieces of good news are that there has been a striking fall in the risk premia on sub-prime mortgages in recent months, and that the effects on general financial market conditions seem to be limited so far.
6. From a global perspective, the last few years have seen a significant broadening of the pattern of world growth. We have seen a revival in Europe and Japan, and this has continued in recent months, with consumer confidence rising and unemployment falling in Europe, and with growth remaining solid in Japan in the first quarter of 2007. More striking still has been the growing importance of China and India as engines of global growth. We see this trend continuing too, with growth in China likely to be around 10 percent in 2007 and 2008, while growth in India is likely to be around 8 percent. In both countries this implies a continuation of the very strong growth of 2006.
7. Global economic success has also been founded on good macroeconomic policies. This includes fiscal consolidation in many countries. Canada is a good example. In the mid-1990s there were serious concerns about the sustainability of Canada's public debt. But over the past decade, through good fiscal management, Canada has reduced public debt by 30 percentage points of GDP. Canada's economic success, and that of many other industrial countries, has also been based on more flexible and forward-looking monetary frameworks. Increasingly, governments are recognizing the benefits of central bank independence, and central banks are following the pioneering examples of New Zealand and Canada in adopting inflation targeting. Their reward has been credibility. This has reduced the inflation risk premium, and led to lower real interest rates, which have supported higher growth.
8. But as someone once said of liberty, the price of credibility is eternal vigilance. To retain their credibility, central banks must remain alert to inflationary pressures and act swiftly to relieve them. In fact, central banks have been taking such action for some time. Most recently, a couple of weeks ago, the European Central Bank raised policy rates. The Bank of Canada has also signaled concern about increased inflation risks and indicated that it may need to raise rates in the near future. The global economy is now in a position where pre-emptive action to contain inflation risks may be particularly important. This may have significant implications for the financial market issues that I would like to talk about today.
9. The growth and dynamism of capital markets has contributed greatly to the prosperity of recent years. The combination of new technology and the development of new financial instruments has led to an upsurge in productivity in the financial sectors of many countries. The United States and the United Kingdom are the acknowledged leaders in the field, but the phenomenon is worldwide. I have already suggested some ways in which further developing Canada's financial sector Canada could support productivity and growth. Many other countries are also working to make their capital markets more efficient and flexible.
10. The global economy has also become substantially more integrated. Financial globalization, measured by the sum of gross external assets and liabilities as a share of GDP, has increased threefold since the mid-1970s, with the most dramatic increases occurring in high-income countries, and accelerating since the mid-1990s. Fund calculations show that as of 2004, the average sum of external assets and liabilities was more than 100 percent of GDP in low-income countries, more than 1½ times GDP in middle-income countries, and more than 5½ times GDP in high-income countries. This financial globalization has had many good effects. It has given global savers a wider pool of investments to choose from. It has given borrowers access to a much broader market for savings and so lowered their cost of capital. In some cases it has encouraged development of local capital markets and financial sectors. And especially when flows have taken the form of foreign direct investment, it has accelerated technology transfer, improved productivity, and provided employment opportunities.
11. So far so good, but I am concerned about attitudes to risk in some areas of the financial markets. On the face of it, there appears to be a greater willingness to take risks in financial markets, motivated in part by the search for yield and in part by greater ease in transferring risk. So one concern is whether a shift in monetary policy in the major economies will produce a significant change in willingness to accept risk and, if so, how this will play out in the markets.
12. However, I am less concerned about a general shift in risk preferences than I am about places where markets still seem unduly complacent about risks. This may reflect not so much a conscious decision to take risks as an underestimation of the extent of risks by some market participants and a reckless disregard of risks by others. Developments in the sub-prime and Alt-A parts of the U.S. mortgage market can be interpreted in this way. Many borrowers in these markets appear to have been so confident that housing prices would continue rising that they ignored the consequences of a downturn. And many lenders appear to have cynically encouraged them, with the aim of making a quick return while passing most of the risks off to other investors.
13. Some lenders may have become complacent about credit risks, because of the rapid development and growth of risk-transfer markets. Global issuance of loan securities has expanded from around $0.5 trillion in 2000 to $2.75 trillion in 2006; and it has become far more geographically widespread. This has naturally influenced banks' behavior in many countries, not just the United States. Banks' willingness to lend and the rate at which they do so is increasingly being driven by the price they will receive for the loan when they sell it in the securities market.
14. New risk transfer markets can enhance financial stability, because the holders of risks—for example, bondholders, pension funds, and life insurers—individually have less exposure to short-term liquidity pressures and a greater ability to share losses more broadly. But there is often a lack of transparency about such arrangements. We know credit risk is being transferred, but it is often not clear who it is being transferred to, or whether the ultimate holders of these risks fully understand them and can manage them prudently.
15. There are also systemic questions to which we do not yet have good answers:
• First, we do not know how well liquidity in credit risk transfer or securitized loan markets will hold up if the credit cycle turns down sharply and defaults become more common.
• Second, we know that individual market participants have increasingly sophisticated risk hedging strategies. But we do not know the effects that these strategies—combined with high leverage—have on the ability of the system as a whole to dynamically hedge risks.
16. Let me take a specific example, the case of hedge funds. The assets under management of hedge funds were estimated to be over US$1.4 trillion by the end of 2006, more than three times their level in 2000. And there are now estimated to be more than 9,500 hedge funds—fourteen times more than in 1990. This proliferation should itself raise concerns. Any time you see a rapid increase in the number of businesses engaged in an activity, you have to wonder about the quality of late entrants to the business. Since individual hedge fund failures would probably have more significance for the system as a whole than the disappearance of businesses of other kinds, this suggests a need for careful oversight.
17. As to how this oversight should be managed, much has been made of differences of view as to whether the main focus should be on direct regulation of hedge funds or counterparty risk management and indirect monitoring of their activities through the major banks and brokers. But the significance of these differences is overstated. In fact, there is a broad consensus around the need to preserve the risk diversification and innovation which hedge funds have brought to the financial system, while making sure that adequate precautions are taken against systemic problems. This has been reflected, for example, in recent speeches by Jean-Claude Trichet, President of the European Central Bank, and by Anthony Ryan, the U.S. Treasury's Assistant Secretary for Financial Markets.
18. Turning to the policy implications of this, there is a need for action in two areas. First, if reliance is placed mostly on monitoring by counterparties, this should be complemented by measures to increase the transparency of hedge fund operations. Increased transparency is needed to enable counterparties to exercise market discipline effectively and help regulators get a better picture of what is going on in markets. Second, there must be adequate international monitoring and cooperation, so that potential cross-border spillovers from hedge fund problems or other market disruptions can quickly be identified and addressed.
19. Let me now raise another financial sector issue, which I raised with G8 leaders at the recent summit. This is the recent dramatic growth in large private equity buyouts, which are being financed by a rising proportion of debt. The risk from a financial stability perspective is twofold. First, the banks that have underwritten deals could find themselves exposed if some of the deals fail before completion. Second, if some of these deals were to turn sour, this may trigger a reappraisal of risk which would curtail market access more broadly. This could adversely affect investment and growth prospects. In considering these deals, I would therefore urge investors to exercise due diligence, and regulators to remain vigilant about possible systemic implications and broader effects on economies.
20. A third issue in financial markets, and one of particular relevance to the International Monetary Fund, is the very substantial flows of capital into emerging markets, and in some cases into developing countries that have not previously received significant private capital flows. To the extent that such inflows reflect a reallocation of capital to productive investments, they are welcome. But they also expose the countries concerned to an abrupt reversal of flows when sudden shocks occur.
21. This is an area where investors should be careful, and recipient countries more careful still. A recent study by the Fund suggests that recipient countries are best placed to reap the benefits of foreign inflows if their financial infrastructures are strong. Large-scale foreign inflows are least likely to produce instability for countries with more developed financial sectors, stronger institutions, sound macroeconomic policies, and more open trade systems. The lesson I would draw from this is that emerging and developing economies should move quickly to strengthen their financial frameworks. In the meantime, the best macroeconomic policy response will involve a combination of reserve accumulation, nominal currency appreciation, lower interest rates, and, in some cases, fiscal tightening. The difficulties of finding such a balance underline the need to move quickly to improve financial frameworks.
22. I have raised a number of financial market issues today—the growth of risk-transfer markets and instruments, the growing importance of hedge funds, debt financing of private equity buyouts, and increased cross-border capital flows—because they are all cases in which financial market developments, which have up to now been a spur to growth, have the potential to derail our extended summer of growth, in individual countries or more broadly.
23. The potential for international spillovers is of particular concern to the Fund. As financial globalization grows deeper, so do the risks that a failure in one country's markets will spill over to others. The Fund is deepening its work on financial globalization issues. In particular, we are better integrating our work on financial market and financial sector issues with our macroeconomic policy analysis. The Fund as a global institution can also be a forum for multilateral discussions of common problems—a role that we have already played with some success on the issue of global payments imbalances.
24. Let me know conclude by inviting your comments. As the Fund sharpens its focus on financial market issues, we have much to learn from market participants. I am therefore pleased to be here in Toronto today to discuss these issues with you. And I now look forward to your questions and comments.
25. Thank you very much.