Challenges to the International Monetary System: Rebalancing Currencies, Institutions, and Rates
October 5, 2007Presentation by Mr. Takatoshi Kato
Deputy Managing Director, International Monetary Fund
Salzburg Global Seminar, Salzburg, Austria,
September 30, 2007
It is a pleasure to address such a distinguished audience here in Salzburg for yet another exciting seminar. Slide 1. We have gathered at a time of great fluidity in financial markets, with the outlook for the global economy more uncertain than in the recent past. The title of this seminar series is "Challenges to the International Monetary System: Rebalancing Currencies, Institutions, and Rates". But as I will elaborate in more detail below, the recent events in financial markets point to a rebalancing of the assessment and pricing of risk, which will likely lead to a rebalancing of currencies and growth in the foreseeable future.
I would like to begin my talk by first giving you an overview of the global setting as I see it now. I realize that most of you will be interested in my views on the recent turbulence in financial markets, so I will turn to that next. I will then conclude by discussing several ways in which the IMF's mission is being redefined and adapted to the changing global economy.
I. The Global Setting
The global expansion has been underway for five years, and global growth is strong and broad-based. Slide 2. Emerging markets are the engine of growth currently, and growth has become better balanced. This year, for the first time, China will be contributing the largest part to the increase in global growth, measured at market exchange rates as well as in purchasing power terms. Growth in many emerging market countries has been exceptionally strong in the first half of 2007. This has counterbalanced a period of softness in the United States. The Euro area and Japan had seen solid growth earlier in the year, with some weakening since the second quarter.
The recent turmoil in financial markets has now led to a much more uncertain situation. Although market liquidity problems should recede in the coming months, wider credit spreads would persist, reflecting a welcome reappraisal of risk following a period of unusual compression. Inevitably, there will be some impact from tight credit conditions on activity, and we are now preparing to lower our growth projections moderately. Accordingly, our growth forecast for 2008 will be marked down, but growth will nonetheless remain at a strong level. We expect the macroeconomic impact to be greatest in the United States, where the housing correction is likely to be more prolonged than we thought previously. Tighter credit conditions could also dampen domestic demand in Europe and Japan, and there may be trade and financial spillovers elsewhere too.
Overall, I believe that a combination of solid fundamentals and appropriate action by central banks and other authorities should help to calm rough financial waters and provide resilience to the global economic expansion.
• In advanced economies, economic fundamentals remain solid. The balance sheets of core financial institutions were strong at the onset of the current market turbulence, while the financial positions of corporations remain robust. These economies also entered into the period of turmoil with positive levels of business confidence, and generally healthy situations in labor markets and household net wealth.
• As for emerging market countries (EMCs), recent growth momentum has been very strong and improved balance sheets and policy frameworks have provided resilience in the face of the current turmoil. Slide 3. Many EMCs now have current account surpluses, and have built up substantial international reserves. Fiscal and monetary policy frameworks have also improved in many of these countries. Price stability has become the cornerstone of monetary policy, and a number of countries have adopted, or are moving to adopt, inflation targeting. Many also have flexible exchange rate regimes, which can act as a shock absorber to rapid changes in external circumstances. And their direct exposure to the U.S. subprime market remains quite small. As a result of these positive factors, EMCs have been relatively less affected by the recent turbulence. Slide 4.
• That said, there are "pockets of vulnerability"-particularly in countries that have depended heavily on external flows to finance large current account deficits and rapid credit growth. Slide 5. These cases, which I will discuss in more detail later on, merit close attention and scrutiny.
Let me now discuss financial market conditions, and how I see them unfolding; and the risks to the global outlook.
II. The End of Complacency?
Turbulence in Financial Markets
Looking back, the past decade or so has been a period of rapid and far-reaching change for the global economy, as the process of globalization has accelerated. Slide 6. But this impressive progress has been interspersed with episodes that were difficult, and even threatening, at times. National policymakers, regulators, and international financial institutions-including the IMF-have had to adapt to keep pace with these changes. And the latest financial market volatility has brought new challenges.
The recent developments in financial markets came at a time when spreads and volatility were at historic lows. Slide 7. The "search for yield" led to a relaxation of credit standards, most notably in the U.S. subprime housing market. Securitization and financial innovation made it easier to transfer credit risk. But they also appear to have encouraged lenders to focus more on the volume of business and less on credit quality. This, coupled with the creation of very complex credit structures that were viewed as diffusing risks, led to a general sense of complacency. In this environment of complacency and yield-seeking, creditors did not adequately assess risks in many cases-they may not have had sufficient tools with which to conduct due diligence, or they may have been overly reliant on third party assessments, such as those of ratings agencies. Seen in this light, if financial market developments represent a return to greater market discipline compared with the recent past, this should be good for the global economy in the longer-term. More realistic asset valuations-a "rebalancing" of the assessment and pricing of risk-should provide the foundation for medium-term global strength.
That said, the correction has been extremely turbulent. Slide 8.The rapid repricing of risk and the lack of transparency regarding exposures of financial institutions to distressed assets has raised a host of uncertainties. With markets drying up, it has become difficult, if not impossible, to value some structured credits. This has been particularly problematic for investors who funded purchases of these credits with short-term loans. The reliability of credit ratings has been called into question. Reputational risks may have forced banks to internalize losses of otherwise independent entities, and relatively new and opaque structures may have masked off-balance sheet exposures and contingent liabilities. We have seen this particularly in the case of some German banks, where there was considerable surprise at the extent of their exposure to the U.S. subprime market. This has raised the question about whether the relevant perimeter for risk consolidation is larger in this complex financial world than the usual accounting or legal perimeter.
As a result of the dramatic drying up of liquidity in some funding markets, several central banks-including the ECB, the Fed, and most recently the Bank of England-have taken steps to facilitate access to their discount windows in order to restore the smooth functioning of markets. Slide 9. The Fed also lowered the federal funds rate to help forestall negative effects on output. But, it still may take some time until market liquidity returns to normal. This is because there is still significant uncertainty about the size and distribution of losses, and about the pricing of many structured products.
That said, we cannot rule out further unpleasant surprises, and I will turn now to these risks.
Where Do the Key Risks Lie?
The key risk is that of a sustained deterioration in financial conditions We could be faced with a prolonged set-back in investor appetite for asset-backed securities, as their limitations have become clear. A broad pull-back from risky assets is also possible. And credit conditions could become substantially tighter for households and corporates. The macroeconomic consequences of such a deterioration in financial conditions are hard to calibrate, however. This is partly because financial linkages have been underdeveloped in macroeconomic modeling. But, beyond this, markets themselves have changed rapidly in recent years. Until now, many of the new instruments-particularly complex derivatives-have been untested at times of stress. However, we can identify key areas of risk that would have a macroeconomic impact if they were to materialize. I will briefly discuss these now.
Although we have already marked down our growth projection for the United States, a weaker housing market and a sustained tightening of credit conditions could further depress economic activity. Slide 10. Many housing indicators are still weak, and inventory-to-sales ratios are high. The tightening of credit conditions has spread beyond the subprime mortgage market, with jumbo prime mortgages also affected. Many mortgage finance companies have been shut out of funding markets as a result of ratings downgrades. Credit card users and high-yield corporate borrowers are also feeling the pinch from higher spreads. Going forward, in the housing market, delinquency rates are expected to continue to rise as interest rates on adjustable rate mortgages are reset upwards. A continued tightening of mortgage credit would further reduce the demand for housing and depress prices even more. Consumption and residential investment could be adversely affected, dragging growth down further. On the corporate side, increased uncertainty, coupled with continued tight credit conditions, could adversely affect investment.
The Euro area and Japan are also likely to be affected. Slide 11. Growth in both of these economies was solid earlier in the year, but has weakened since the second quarter. The Euro area has been most directly affected by spillovers from turmoil in the U.S. subprime market, and we will be marking down our growth forecast. But more bad news in financial markets, or evidence of pervasive spillovers, could reduce growth even more. In Japan, we will also modestly reduce our growth forecast. There appears to be much less direct exposure to the U.S. subprime market, but the yen has appreciated sharply as carry trades have been unwound, and a disorderly unwinding could have adverse effects on growth. Economic activity could also be affected by the fall in equity prices and slower global growth.
The risks to EMCs are likely to depend on country-specific circumstances. Slide 12. The main downside risks come from the deterioration in the external environment, and the possibility that investors will shy away from the EM asset class. However, increasing trade and financial linkages also make them susceptible to a more insidious slowdown in global growth. Even so, the reasons for concern are much greater in some countries than in others. A number of countries have relied on large external inflows-particularly bank flows-to finance current account deficits, credit growth, and rapid asset price increases. These inflows could be affected by a general retrenchment of risk, especially if market liquidity remains limited. But even in some surplus countries, reliance on bank flows to fund credit growth has increased countries' vulnerability to reductions or reversals of these flows. This phenomenon has been particularly apparent in emerging Europe and the CIS. In contrast, EMCs in Asia and Latin America appear much less vulnerable than in the past to a tightening of credit conditions. High levels of international reserves, stronger public sector balance sheets, and improved macroeconomic management should provide resilience to these economies.
These are the key risks that I see in the immediate horizon. And while other concerns have taken a back seat during the recent bout of turbulence, they could return to the fore as conditions become more settled. Inflation pressures, for example, had been rising through the summer, but they now appear to be easing as growth is slowing. Slide 13. However, high food and commodity prices may still pose problems in the period ahead as supplies remain tight. Global oil markets also remain very firm and spare capacity is limited. Slide 14.
So far, I have mainly spoken about risks to the short-term global outlook. But there are also key medium-term vulnerabilities that are important to bear in mind. The most pressing of these is the issue of global imbalances, which are projected to be large and persistent for the foreseeable future Slide 15. An orderly rebalancing of the pattern of current account balances and of currencies-as highlighted by the title of this seminar series-is needed to resolve global imbalances.
Financial globalization has allowed the smooth financing of persistent imbalances between savings and investment. Most dramatically, low savings in the United States have been financed by excess savings in Asia and in oil exporting countries. Slide 16. Under current policies, these imbalance will persist well into the medium-term. More specifically, the U.S. current account deficit is projected to remain close to 1½ percent of global GDP in 2012. At the same time, emerging Asia's projected current account surplus will reach 1¼ percent of GDP in 2012-almost completely counterbalancing the U.S. deficit.
This raises a key question about whether the U.S. current account deficit can continue to be financed easily. Put differently, will the world's net savers continue to be willing to finance the world's net dissavers? To date, the U.S. current account deficit has been easily financed. Investors have been attracted by the apparent sophistication and security of the U.S. financial system. However, low yields in traditional assets have led some of these investors to seek higher returns in riskier assets. Slide 17. For example, purchases of asset-backed securities by foreigners accounted for almost 1/3 of the external financing flows to the United States in 2006. But, during the recent market turmoil, investors shifted away from these riskier and complex instruments, and sought "safe haven" in U.S. government bonds-in other words, they reallocated their dollar assets, but did not unwind their dollar positions. While this "flight to quality" is likely temporary and related to problems in some funding markets, it remains to be seen whether the disillusionment with complex, structured products is here to stay. If it does prove to be enduring, and investors shun a subset of dollar assets, the financing of the U.S. current account deficit may be more difficult going forward.
This raises the risk of a disorderly adjustment of global imbalances. Although exchange rates have been moving in broadly the right direction-the dollar has depreciated by nearly 20 percent in real effective terms since the beginning of 2002-global imbalances persist. Under an "orderly adjustment" scenario, the U.S. current account deficit would be lowered gradually from just under 6 percent of GDP currently, through a combination of demand rebalancing and further exchange rate movements. And it would be smoothly financed. However, a sustained shift in investor sentiment away from U.S. dollar assets, or a sea change in market expectations about the trajectory or the dollar, could contribute to a possible disorderly unwinding.
A separate concern is that persistent large imbalances will fuel protectionism. I see two inter-related issues here. First, in some countries, there are perceptions that the benefits of an open economy are not fully shared among different groups in society. And these sentiments may be exacerbated if trading partners are believed to be using exchange rate policy for competitive advantage. Partly as a result of this, there has been a pronounced lack of progress on the Doha Round. Countries instead have turned to bilateral trade treaties. Although protectionist pressures have so far been largely resisted, they could increase substantially in the face of a global slowdown with rising unemployment.
What can the IMF do to help resolve global imbalances? The IMF initiated the first Multilateral Consultation to focus on reducing global imbalances while sustaining strong global growth. During the 2007 Spring Meetings, the five participants-China, the Euro area, Japan, Saudi Arabia, and the United States-jointly set out their policies aimed at reducing the risk of a disorderly resolution of these imbalances. These policy plans were concrete and mutually consistent. They are also in each participant's own interests, and some progress has been made on several fronts. This includes a faster-than-expected narrowing of the U.S. budget deficit, rising Saudi public sector investment in key areas, some advance on structural policies in Europe and Japan, and China's move to increase renminbi flexibility. The key now is sustained implementation. For example, on exchange rates, I believe that a faster appreciation of the renminbi would help alleviate some of the concerns in China about rapid credit and investment growth, while at the same time contributing to an orderly resolution of global imbalances. Slide 18. For our part, the IMF will play an active role in monitoring progress.
III. Redefining the IMF's Mission
So far, I have talked quite a bit about the benefits and challenges brought about by globalization and financial innovation. We have seen the benefits most pointedly in the strong global growth of recent years-particularly in EMCs. But we have also witnessed new challenges, especially over the past few months where new channels for the propagation of shocks have become evident. This has made it even more important that the IMF's tools for monitoring and assessing risks be continuously upgraded. So, how do we do this?
We are in the process of redefining our mission to better meet the evolving needs of our membership. There are many ways in which we are doing this-including the Multilateral Consultation which I just discussed-but I will limit my remarks to two other key areas. The first is surveillance. This refers to the core of the IMF's mandate-the process through which we assess the macroeconomic policies of our members and provide advice on how to better align them with the objectives of macroeconomic stability and orderly growth. The second issue that I will discuss is reform of our governance structure to reflect changes in the economic weight and role of members (and in particular the strengthened role of emerging market members), while also enhancing the voice for low-income members.
The IMF is making every effort to strengthen surveillance of our members' economies and of the global economy. Why the emphasis on surveillance? I know that many observers believe that the IMF is mainly a "firefighter" which provides emergency financial assistance to countries during financial crises. This is one of our roles. But, thanks to improved policies and-until recently-a benign external environment, many countries have not needed to borrow from the IMF. In fact, several members have repaid the IMF. Our loan portfolio has declined dramatically since its peak in 2003. Slide 19. All of this has occurred at a time of vast changes in the global financial system.
To better respond to the challenges of an increasingly globalized economy, the IMF is in the process of reforming our surveillance framework. Slide 20. I will begin by talking about multilateral surveillance-that is, the way the IMF oversees the international monetary system as a whole. Then, I will talk about bilateral surveillance, which is how we assess our members' economic policies. I will focus mainly on our newly redefined role in assessing members' exchange rate policies.
Let me first say a few words on the key vehicles through which we conduct multilateral surveillance. We have two semi-annual publications which summarize our views on the state of the global financial system. In our two flagship publications-the World Economic Outlook and the Global Financial Stability Report-we strive to provide timely analysis on global macroeconomic and financial developments from every corner of the world and to identify the key policy challenges they pose. Surveillance at the global level feeds into our bilateral surveillance of member countries' macroeconomic position and their policy frameworks. And as the IMF has evolved over time, so to has the way in which we conduct our surveillance.
To adapt to this changing global environment, we are strengthening bilateral surveillance, including, in particular, exchange rate surveillance. The recent adoption by our Executive Board of a new Surveillance Decision—replacing an old Decision taken in 1977—was a key achievement in our effort to reform the framework for surveillance. The new Decision, which introduces the concept of external stability as organizing principle of surveillance, should help improve the quality, focus, evenhandedness, and effectiveness of surveillance. It covers not only exchange rate policies, but also domestic policies, and it crystallizes a common vision of today's best practice in surveillance.
The new Decision clarifies what exchange rate policies countries should avoid and when these policies may be of concern to the international community. The updated framework spells out the concept of "exchange rate manipulation" with the intent of gaining competitive advantage, which is proscribed by the IMF's Articles and which was already at the heart of the old Decision on surveillance. But the Decision also includes a principle recommending that members avoid exchange rate policies that result in external instability, regardless of their intent, thereby newly capturing exchange rate policies that have proven to be a major source of instability over the past decades.
Why the emphasis on exchange rates? The IMF's core mandate is to promote international financial stability. Exchange rates are a key link between countries, and often between different sectors in one economy. Movements (or lack thereof) in exchange rates provide critical information about, and have significant impact on, economic conditions in a country. At times of distress, exchange rates can move abruptly. As we have seen many times in the past, such movements can be especially painful if a country's exchange rate was overvalued prior to the period of distress. On the other hand, an undervalued exchange rate can put pressure on other countries, not to mention domestic monetary conditions. In either case, exchange rates that are substantially misaligned can lead to problems down the road. And exchange rates tend to overshoot their long-run equilibrium at times of distress, making the short-term economic and financial consequences more damaging.
For these reasons, we-along with many other observers-are interested in assessing whether exchange rates are under- or overvalued. How do we go about it? The conceptual approach that we use is to ask if the associated underlying current account is in equilibrium-that is if the current account, when stripped of temporary factors, leads to a sustainable accumulation of external liabilities or assets. In other words, we first seek to determine a country's current account "norm" consistent with its fundamentals, and then compute the exchange rate movement that would be required to move the underlying current account into equilibrium. If little movement is required, the exchange rate is deemed to be broadly in equilibrium. If the exchange rate does need to move to reestablish equilibrium, that signals over- or undervaluation.
When can we say that such over- or undervaluation reflects "fundamental misalignment"-a term which plays an important role in our new Decision? Slide 21. First, notice that the approach I have just set out already nets out temporary factors. These are generally expected to unwind in an orderly way, and thus would not inevitably create a risk of disruptive adjustment. So the kind of misalignment we are worried about is one that is likely to persist-we are not so worried about temporary misalignments, and we would not call them "fundamental." Second, we need to recognize that there are many methodologies that can be used to make such calculations, and the state of our knowledge is far from perfect. So, our estimates need to be based on careful judgment, taking into account all country circumstances, not just a mechanical application of formulae. Indeed, while our new Decision, among other things, requires us to assess the level of exchange rates in each case, it is very careful to ensure that we do not make rash judgments based on tenuous information. It requires, for instance, that we not find exchange rates to be "fundamentally misaligned" unless the misalignment is significant and we are sure "beyond any reasonable doubt."
Because of the complexity of determining equilibrium exchange rates, the IMF has developed considerable expertise on exchange rate analysis in our Consultative Group on Exchange Rate Issues (CGER). Slide 22. This has served as the framework for producing multilaterally consistent exchange rate assessments. These assessments provide an important complement to the country-specific exchange rate analysis conducted as part of our bilateral surveillance. We have recently expanded and updated the methodology, which now covers about 30 major advanced and emerging markets, and are planning further extensions to low-income countries and exporters of nonrenewable resources.
The CGER methodology relies on three complementary approaches to determining equilibrium exchange rates.
• The first approach—the macroeconomic balance approach—determines a country's current account "norm" as a function of its medium-term economic fundamentals, and compares this to the "underlying" current account. It calculates misalignment as the change in the real effective exchange rate needed to bring the underlying current account in line with the norm.
• The equilibrium real effective exchange rate (REER) approach estimates econometrically the medium-term relationship between the REER and macroeconomic fundamentals. Under this method, the equilibrium REER is evaluated based on "trend" values of the fundamentals.
• The external sustainability approach utilizes the intertemporal budget constraint-linking a country's net foreign assets (NFA), current account, economic growth, and rates of return-to derive a current account that is consistent with a stable "benchmark" NFA position. It calculates misalignment as the change in the real effective exchange rate needed to bring the underlying current account to the level needed to stabilize NFA at their `benchmark' level.
When the results of these three methodologies point in similar directions, confidence in our assessments is enhanced. That said, there are large margins of uncertainty around all econometric estimates of equilibrium exchange rates, including those produced by the CGER. This underscores the importance of complementing those estimates with country-specific information that is difficult to incorporate in a large cross-country exercise.
But all of these reforms require buy-in from our membership to be effective. The Managing Director set out a far-reaching agenda for governance reform in his Medium-Term Strategy that was endorsed by the Fund's Governors at the 2006 Annual Meetings in Singapore. Slide 23. The reform has two equally important objectives. The first is to make significant progress in realigning quota shares-which, among other important functions, determine voting power in the IMF-with members' relative positions in the world economy. The second is to enhance the participation and voice of low-income countries in the IMF. Both reforms are critical to the continued effectiveness of the Fund and to its legitimacy with its members.
In Singapore, the IMF's Governors agreed to a far-reaching package of reforms to meet these objectives. Slide 24. First, an initial round of ad hoc quota increases raised the quotas of four of the our most clearly underrepresented members-China, Korea, Mexico, and Turkey. They also agreed that the reform should include a second round of ad hoc quota increases benefiting a wider range of members. These increases are to be based on a new quota formula that is simple, transparent, and better reflects the relative positions of members in the global economy. Equally important, Governors committed to ensure that the voting share of low-income countries as a group is protected, including through at least a doubling of basic votes-which all members receive in equal number and, along with quotas, are used to calculate voting power. They also called for consideration by the Board of enabling each Executive Director elected by a large number of members to appoint more than one Alternate Executive Director. Both the increase in basic votes and a provision for additional Alternate Executive Directors would require amendment to the IMF's Articles of Agreement. The Governors set a timeframe for completion of the reforms by the 2007 Annual Meetings and no later than the Annual Meetings in 2008.
While there are still important issues to be resolved, we have made important progress since Singapore in narrowing the options for a new quota formula and in clarifying the desired outcomes of the reform. Our Executive Board has met on several occasions to discuss these issues, most recently late last week. We hope to be in a position to report significant progress to the Board of Governors at the Annual Meetings and set the stage for early resolution of remaining issues in the following months.
I have just spoken at length about two key elements of the IMF's redefined mission-surveillance and governance. Of course, there are many other areas where we are working to better align our policies and procedures with the evolving needs of our members. I will have to leave those areas to another time.
So, let me conclude now with a few final remarks. Earlier, I discussed the global setting and put forth the IMF's view that the recent turmoil in financial markets will have a dampening effect on global growth, but that overall growth will remain robust. That said, we cannot rule out further unpleasant surprises in financial markets. All of this points to the importance of the IMF's surveillance, which is a critical tool for helping countries and markets make informed judgments about their policy and investment decisions.
In recognition of the critical nature of our surveillance mandate in the new globalized economy, the IMF is taking steps to strengthen this mandate. We are currently working to implement our new Decision on Surveillance over Exchange Rates, and to improve our assessments of members' exchange rate policies. We are also continuing our efforts to help resolve global imbalances, and will actively monitor the implementation of policy commitments made by the participants in the first Multilateral Consultation. Going forward, we are in the process of determining the topic for our second Multilateral Consultation, which could focus on financial sector issues given the recent developments. These, along with the other areas highlighted in the Medium-Term Strategy, are helping to redefine the IMF's mission. But all of these efforts require greater buy-in from our membership if they are to succeed. To achieve this, we are pressing ahead with our quotas and voice reforms.
Slide 25. And with those final words, I wish to thank you for your attention today. I am now happy to take any questions that you may have.