International Financial Markets—Stability and Transparency in the 21st CenturyKeynote speech by John Lipsky, First Deputy Managing Director
International Monetary Fund
At the Social Democratic Party Caucus
Berlin, June 20, 2007
I would like to begin by thanking the organizers for their kind invitation to participate in this event. It is an honor to appear together with such distinguished presenters, and in front of such an important audience.
In any case, I always look forward to my visits here. And this visit is a special one from a personal viewpoint, as this is the first public event in Germany that I have participated in since taking up my current position at the IMF.
In fact, my first visit to Berlin took place in 1990, just as momentous changes were beginning to unfold. I remember that visit vividly—and I am astonished at the progress that has been achieved here since that time. Moreover, what began in Berlin at that time started a transformation of Germany, of Europe and in a very real sense, ultimately helped to propel important global changes.
What began here marked the beginning of what I think of as the second wave of modern globalization. The first phase was the Bretton Woods Era, in which globalization was only partial in every sense. In contrast, the hallmark of this second phase is its universality. The changes associated with this second phase of globalization underpin my remarks tonight, as their economic and financial impact has been profound, even in our daily lives.
Since 1990, the world economy has become substantially more open and integrated. In fact, for the first time in a century, we can speak meaningfully about a truly global economy and global financial markets.
Of course, in many ways the first decade or so of this second phase of modern globalization was notable more for the problems that it engendered than for the benefits that it bestowed. Just think of the strains and sluggish growth in Europe during the 1990s, the Asian crisis of 1997/98, Russia's debt default and disorder, the LTCM hedge fund collapse, the Brazilian devaluation, the dot.com bubble and its collapse, and the Argentine crisis.
Despite these challenges, international trade nonetheless expanded at rapid pace, helping to power sustained rapid economic growth in many emerging market and developing countries. At the same time, the changes in international finance have been nothing short of revolutionary. Not only has the value of cross-border financial transactions increased almost at an explosive pace, but markets also have incorporated innovative new risk transfer instruments—including all sorts of derivative securities—and new financial institutions—including hedge funds and private equity funds—that previously were virtually unknown.
Since 2002, the benefits of this phase of globalization have become more apparent. Global growth has persistently exceeded consensus expectations, and it has been unusually well-balanced. According to the IMF's World Economic Outlook forecast, growth this year and next should remain solid at an annual rate of around 5%. If our forecast is correct, this would mark the fastest sustained global expansion in more than four decades. Rapid growth in several key emerging economies has created an historic success in poverty reduction. And despite the challenges of sharply increased energy prices, global inflation pressures appears to remain contained.
I don't need to remind you of Germany's significantly improved economic performance, or of its role in helping to power stronger growth throughout the euro zone and beyond.
Financial innovation has played a role in promoting this unexpectedly good economic performance. Net cross-border financial flows have roughly doubled since 2002, and they have at least tripled since the early 1990s.
The development of new risk transfer markets—that is, derivative securities—has helped to spread risk more broadly and with more accuracy. This, investors are able to control their risk profile with much greater efficiency than previously.
At the same time, new institutions—such as hedge funds and private equity funds—have been willing to utilize these new instruments and new risk management tools to broaden their investment horizons. If successful, these innovations should have helped to raise global growth and to have made the economy more flexible and more resilient.
To be sure, financial innovation and globalization also bring challenges with them. They have made the tasks of supervisory and regulatory authorities more complex. They have raised concerns—some well-founded, and others less so—that financial stability and transparency may be jeopardized.
My remarks tonight are going to focus briefly on two related themes: First, on the challenges of financial market innovation—especially the growth of hedge funds—and second, on how the IMF is responding to these challenges, and more broadly, to this second phase of modern globalization.
I have two central messages: First, we should make sure that we reap the benefits of financial globalization, while insuring that regulatory and supervisory authorities are able to exercise prudent and necessary oversight. Second, I will summarize how the IMF is a critical element in maintaining a rules-based multilateral financial system, and how it is adjusting its structure and practice in order to fulfill its systemic role.
I will turn now to financial markets, and the growing presence of hedge funds. We welcome the discussion on this subject during Germany's Presidency of the G-8. We also welcomed the Financial Stability Forum's update of its 2000 report on Highly Leveraged Institutions, and support the broad thrust of its recommendations. We look forward to seeing the Forum's follow-up report to Finance ministers later this year.
Hedge funds are leveraged private investment funds that utilize a wide range of investment strategies with the goal of producing superior absolute rates of return. They have grown very rapidly over the last few years. Assets under management were estimated at more than $ 1.4 trillion at the end of 2006, or more than three times their 2000 level. Still, by various estimates, the assets under management of hedge funds constitute less than 5% of global financial assets.
On the face of it, this is not a large share. Yet, because of leverage, and their active trading and management styles, hedge funds account for a much greater share in terms of market turnover. The "newer" the market—such as those for credit default swaps, structured credit and other related products—the higher their share of the turnover. This allows hedge funds to frequently act as the marginal price setter. This explains, in part, why they have been important drivers of financial innovation and market liquidity, despite their relatively small size. This also explains why hedge funds' rising influence has generated interest—and concern—in public circles.
Through the use of risk transfer instruments, hedge funds can adjust their exposures without necessarily undertaking any transactions in the underlying "cash" market. Such advances in risk transfer instruments have lowered the cost and raised the speed of entering, liquidating, and hedging an investment position, in a manner that would have been impossible even five years ago. This in turn, favors those with an "active" trading management style.
From this point of view, it is easy to understand the hedge fund's attractions, as it is reasonable to expect that they should be able to outperform a traditional asset manager—in terms of risk-adjusted returns—that does not use these new instruments. In other words, the new tools should make those that use them more efficient.
However, hedge fund investment in many countries is largely confined to more sophisticated investors with higher risk tolerance. This also has encouraged hedge funds to pursue active strategies, amplifying their importance to the regulated financial institutions—including prime broker dealers and banks—that are their trading counterparts and who supply the hedge funds with the overwhelming proportion of their available leverage.
Thus, hedge funds' rapid growth has reflected their ability to use innovative instruments, while their special source of capital investment has encouraged them to follow relatively more adventurous investment strategies that promise potentially high returns. This helps to define the principal concern of financial regulators: To ensure that the regulated institutions that effectively finance hedge funds' leveraged positions do not end up exposed to unanticipated price volatility and liquidity risks that exceed their limits, and therefore risk systemic stability.
One positive factor regarding the ability of the existing regulatory regime to cope with the new challenges is that regulators already possess clearly defined authority over the financial institutions that effectively control the hedge funds' ability to obtain credit. Thus, it is agreed generally that the principal regulatory focus should be—and in fact is—on ensuring that prime broker dealers and banks are able to adequately monitor and manage their hedge fund exposures. At the same time, it is clear that due attention should be paid to the soundness of the derivative markets on which hedge funds (and others) rely.
It is widely agreed that monitoring of hedge fund exposures by counterparties should be complemented by measures that could be agreed with hedge funds to increase appropriately the transparency of their operations, with the goal of allowing the counterparties to exercise market discipline more effectively. Another supervisory complication is that major investment banks and other regulated entities are starting their own hedge funds (or buying them). Others have announced the availability of investment instruments which replicate the risk-return profile of the hedge fund industry for a fraction of hedge fund fees. In other words, the world is restructuring at a rapid pace, even for hedge funds.
While retail, and other relatively less sophisticated investors do not currently have significant direct exposures to hedge funds, it is likely that this could become an issue in the near future. If hedge funds exhibit superior risk adjusted returns, there is likely to be increasing retail investor demand for hedge fund-type exposure. In this case, policymakers should anticipate the need to consider investor protection issues with regard to future hedge fund-like exposure by retail and other institutional investors.
From the IMF's perspective, it is also important that there is adequate international cooperation among supervisory authorities, so that potential spillovers from market strains could be quickly identified and addressed.
Turning to the challenges for the IMF, the second wave of modern globalization has made the institution truly global, encompassing 185 member countries. The dynamism of the global economy since then has altered the relative economic weight of members as well. The accompanying dynamism of global capital markets also has altered the Fund's challenges. The growth of international capital markets and the scale of cross border capital flows has been revolutionary for the Fund, as the institution was originally conceived for a world of closed capital markets.
The strains in the system that appeared in the 1990s through the early years of this decade created a demand for large-scale Fund lending operations that represented an aberration from a longer-term perspective. At the time, there was no choice for the Fund but to engage in these operations, and there is little room for doubt that the Fund's involvement—even if imperfect—was far superior to a laissez faire approach. But providing massive funding operations was never the Fund's intended role. Happily, the earlier strains that led to massive Fund programs have receded, giving way to the recent more favorable environment.
Thus, I remain profoundly unconvinced when I hear it claimed that the Fund is no longer needed, because our members no longer require our credits. Rather, the Fund is called on to do whatever is required to preserve an open global economy, and to promote its prosperity under a rule of law. Thus, we should take advantage of the moment to make the structural changes to the international monetary and financial system that will anticipate potential future challenges to a non-discriminatory multilateral system.
First and foremost, we must adjust representation in the Fund membership so that it reflects accurately members' economic weight in the global economy, as the Fund's constitution—its Articles of Agreement—proscribe. We made a start last year, with ad hoc quota increases for China, Mexico, Korea, and Turkey. Currently, a new quota formula is under discussion. We must establish this formula in a way that simultaneously builds a durable consensus, and protects the voice of low-income countries. Our aim is to reach agreement before the 2007 Annual Meetings, or by the Spring 2008 meetings, at the latest.
We are also revamping our operational work. In today's world, the Funds' relations with members is focused on policy discussions in order to help preserve economic and financial stability. There are three dimensions to this:
First, the Fund's Executive Board last Friday agreed on an updating of the legal framework for our analysis of Fund member country policies—this activity is known in IMF terminology as surveillance. The goal of the new Decision is to ensure clarity, candor and evenhandedness in our assessment of whether individual member countries are living up to their obligations to the international community. This success was an important hallmark of the willingness of the international community to address the challenges of a multilateral system through compromise and mutual understanding. In this regard, the Fund is called on first and foremost to preserve the global system's stability (or external stability in the Fund's vocabulary).
Second, we are developing innovative ways in which the Fund can bring countries together in order to effect better economic outcomes through concerted action. This was the guiding principle behind the establishment of a new tool, the IMF's Multilateral Consultations, The idea is to form, on an as-needed basis, a group of systemically or regionally relevant economies to address issues of broad importance within the Fund purview. As you know, the first Multilateral Consultation address the dual challenge of sustaining global growth while reducing global imbalances. The Consultation involved five participants—the euro area, China, Japan, Saudi Arabia and the US. These participants developed specific policy roadmaps, that are in the individual participants' interest, but when fully implemented would achieve the intended global goals.
Third, with the growing role of private capital flows, the set of interlinkages—across countries and sectors—are becoming more complex. A complete assessment of the global economy is simply infeasible without explicitly integrating the financial sector into the analysis. We are ensuring that we remain abreast of the markets, and incorporating financial sector analysis into our bilateral and multilateral surveillance. In this regard, we are following what I call a "three-gap" analysis. First, addressing gaps in data, where the lack of information may produce poor decisions. Second; gaps in legislation, supervision or regulation, where the gaps may create systemic weaknesses; Third, gaps in markets, where more complete markets could create improved protection against risks.
We are also addressing the Fund's income model, to make sure that the institution is on a sound and appropriate financial basis, now and into the future.
Let me conclude by summing up the key message:
Financial globalization and innovation have brought great benefits to the global economy, and should not be treated as forces to be feared. However, old ways of understanding the linkages between the global economy and financial markets are becoming rapidly outmoded. This requires adaptation to a new environment—both on the part of institutions like the IMF, and from regulatory and supervisory bodies. The IMF is making rapid progress towards completing the reforms that will enable us to monitor, and hopefully safeguard stability in these interesting times.