The World after the Crisis in the Credit Markets: Economic Outlook and ChallengesSpeech by Rodrigo de Rato
Managing Director of the International Monetary Fund
At the 30th Anniversary of the Valencian Business Confederation
Valencia, Spain, October 25, 2007
As prepared for delivery
1. Thank you very much. Let me begin by thanking José Vicente González, President of the Valencian Business Confederation, and also Francisco Camps, President of the Valencian government, for being our hosts. It is a pleasure to be with you today.
2. We are living through a period of uncertainty. Over the past few months the credit markets have experienced their most serious disruption in a decade. The origins of the crisis lie in the United States, where a downturn in the housing markets exposed the frailty of a number of financial instruments backed by sub-prime mortgages. But the repercussions have been felt in many other advanced economies. For example, in August the European Central Bank found it necessary to inject liquidity into interbank markets on an unprecedented scale. And last month the United Kingdom witnessed its first bank run in a century.
3. Yet so far most businesses and individuals have been observers to these events rather than participants in them, and most governments have not needed to reflect any effects of the financial dislocations in their own budgets. This raises the question: has the crisis in the credit markets fundamentally changed the economic world as we know it? Or will life go on, for most people, more or less as usual? The answer to this question depends on what effect the financial turmoil has on global growth. Let me then give you the perspective of the International Monetary Fund on this question.
4. The world economy has the advantage of starting from a very strong position. Over the last five years we have seen a period of sustained growth unlike any since the 1960s. Most advanced economies, including Spain, have enjoyed steady and strong growth throughout this period. Growth in many emerging and developing economies has been even more rapid, as they have benefited from the opening up of global markets, from financial globalization, from high commodity prices in some cases, and also from improved policies. This combination has helped to produce growth which is in or near double digits in China and India, for example, and the best sustained period of growth in sub-Saharan Africa in decades.
5. Growth like this conveys a momentum of its own. Because of the robust expansions in major emerging market economies, global growth was rapid through the first half of this year, and we expect it to again surpass 5 percent for 2007 as a whole. We think that the crisis in the credit markets and the downturn in the housing market in the United States will have a significant effect on growth in 2008, and we have marked down our projection for global growth in 2008 by almost half a percentage point to 4.8 percent. But even this growth would be relatively high by historical standards. Let me explain some of the factors that underlie this projection of continued high growth, drawing on the analysis in the Fund's recently published World Economic Outlook.
6. Among the major economies, the United States is the country on which we have made the largest downward revision to our growth projection. The main problem is the weak housing market. Because of this, and despite the fact that so far spillovers to other sectors have been limited, we believe that the U.S. economy will grow at only a moderate pace in 2008. So we have marked down our U.S. growth projections for 2008 to 1.9 percent.
7. In the euro area and Japan, we have also marked down growth in 2008, to 2.1 and 1.7 percent, respectively. In Europe, tighter credit conditions and slower export growth are the main reasons why our expectation of growth has diminished. Japan has been less directly impacted by recent financial disruptions, but weaker external demand for its products and some softness in domestic spending, particularly consumption, are expected to slow growth.
8. On the other hand, we expect growth in emerging market and developing countries to remain strong across all regions.
• China and India have grown very rapidly, and will be very substantial contributors to global growth this year. In fact, if you were to measure economies in purchasing power parity terms, they would be the largest contributors to global growth. And we would expect this to continue in 2008.
• In Latin America, the pace of activity is likely to moderate slightly in 2008, partly reflecting spillovers from the U.S., but strengthened policy fundamentals should limit the impact of market turbulence.
• In Emerging Europe and the CIS countries, we expect growth this year to remain close to last year's pace, although some countries that have relied heavily on large-scale bank inflows may be more affected by fallout from the recent financial turmoil.
• In Africa, the near-term outlook remains positive, with growth this year and next expected to about 5½ percent. In some countries this reflects expectations of rising petroleum production.
The overall picture then is that we expect growth in the advanced economies to slow but not stop, and growth in emerging and developing economies to continue at a rapid pace.
9. Having said all this, we believe that downside risks to growth are much higher than they were six months ago. The main risks are further disruptions in financial markets and a possible weakening of asset prices—especially housing prices, but possibly the prices of other assets too. Obviously the two are related: problems in the U.S. housing market triggered the crisis in the credit markets, and a tighter lending environment is already having feedback effects on the housing market in the United States. This could also become a problem in other countries that have experienced rapid rises in house prices in recent years. Globally, a combination of financial market problems and falling asset prices could lead to a loss of confidence which in turn could have an adverse impact on economic activity. And if there is an economic downturn, other risks already present will loom larger.
10. For example, there is the continued risk of a disorderly unwinding of global imbalances. We have already seen some movements in exchange rates. Up to now, these have been orderly and in line with fundamentals. In particular, the depreciation of the U.S. dollar should help to reduce the U.S. current account deficit. But there are risks that an abrupt fall in the dollar could either be triggered by, or itself trigger, a loss of confidence in dollar assets. In addition, so far the dollar has not adjusted much against the currencies of key surplus countries. Instead, the counterpart of its depreciation has been exchange rate appreciation in countries with flexible exchange rates-including the euro area. There is a risk that this could hurt their growth prospects, and that in these circumstances protectionist pressures could worsen.
11. Emerging and developing economies have so far not been directly affected by the turbulence in the credit markets. But even the fastest-growing economies would not be immune to a generalized downturn in advanced economies which reduced their import demand. Some emerging economies are also more directly at risk. We see some pockets of vulnerability, especially in Eastern Europe, among countries that have relied on external financing to fund large current account deficits and credit booms. If these countries also face reduced demand for their exports and tighter financial market conditions, it could tip them into crisis.
12. Other problems are also likely to emerge or to become more difficult to deal with in the event of a downturn. For example, if there is a downturn most governments could expect tax revenues to fall, and some could expect spending pressures to rise, as automatic stabilizers take effect. For those with strong fiscal positions this is manageable, but others may have to make difficult adjustments to discretionary spending. And longer-term problems would become more difficult to address. For some time, the International Monetary Fund has been emphasizing the importance of a combination of fiscal and structural measures to prepare for the time when populations age and labor forces shrink. But most governments have done little so far. They should be careful not to put themselves in the position of the grasshopper in Aesop's fable, who enjoyed himself in the sunshine instead of storing up food for the winter. It is not too late for governments to act, but the days are getting shorter. In addition, over the past year, the need to adopt measures to mitigate and adapt to dangerous climate change has become clearer. This too will have implications for budgets, and again governments should act to mitigate climate change now to avoid having to take more difficult actions later.
13. Let me now return to my main theme of the implications of the recent turbulence in credit markets for the global economy. I want to emphasize two points. First, the risks I am drawing attention to are just that—risks, not certainties. Second, we are not helpless in the face of them. By taking sensible and vigorous actions, policy makers can limit the damage that has already been done by the crisis in the credit markets and reduce the risk that more damage will follow. Let me talk now about a few areas in which action would be useful.
14. The risks of a disorderly unwinding of global imbalances can be reduced if all of the major economies take actions that reduce imbalances gradually. The International Monetary Fund organized a Multilateral Consultation with major economies designed to do exactly this, and the major economies involved—China, the euro area, Japan, Saudi Arabia, and the United States—set out in April of this year plans for how they would achieve it. These plans include steps to boost national saving in the United States, including fiscal consolidation, further progress on growth-enhancing reforms in Europe, and reforms to boost domestic demand in emerging Asia, together with greater exchange rate flexibility leading to currency appreciation in a number of surplus countries. The key now is implementation. Since the consultation discussions, each participant has made some progress toward putting into effect its policy intentions, but much remains to be done. Implementation has become more important as the risks of an economic downturn have grown.
15. The risks faced by vulnerable emerging economies can also be contained. Central banks in emerging markets need to remain on the alert, and make sure that they have good information about the risk profile of major financial institutions. Governments in countries where private credit has grown rapidly and current account deficits are large should exercise fiscal restraint to reduce demand pressures and risks.
16. We can also take action to improve the resilience of financial systems. Let me give a few examples.
• The crisis in the credit markets arose in part because investors did not exercise sufficient due diligence. But they were also impeded in exercising due diligence by a lack of transparency and disclosure about the risk profile of new structured credit instruments. This suggests that we should look for low-cost ways of improving transparency in credit markets.
• Financial innovation seems to have increased banks' abilities to move risks off their balance sheets, but not their ability to avoid taking them back on again. This suggests that assessments of banking soundness and capital by supervisors and ratings agencies should pay more attention to off-balance sheet exposures.
• Banks' growing reliance on securities markets for financing has increased their vulnerability to liquidity risk. Regulators need to reflect this new reality in their assessments of liquidity requirements.
• In some areas, and especially in mortgage markets, the crisis reveals a need for better consumer education and protection, and simpler disclosures.
• And there may also be a need for better coordination between supervisors, regulators, central bankers, and finance ministries. In some countries, there may also be a need to simplify the regulatory infrastructure.
17. More generally, the way in which the crisis in the credit markets has spilled over between countries also carries some important lessons on how we should respond to this kind of crisis and to others. Perhaps most importantly, it points to the vital importance of multilateral cooperation. On financial market issues, while it is possible for a few countries to get together and come up with regulatory changes, they are unlikely to come up with the best global solution, because they do not represent all of those affected. Similarly, attempts to meet other challenges—from climate change to longstanding problems of global poverty—are likely to be most successful if they involve all countries that will have to live with the solutions proposed. Many of these challenges are best considered in a multilateral setting. This suggests an important role for the International Monetary Fund. It also underlines the need for close collaboration between the Fund, other multilateral organizations, and individual countries.
18. The challenges that I have talked about today are ones which the International Monetary Fund, national governments, and also businesses and individuals all around the world will need to grapple with. But I am confident that these challenges can be met. In the three and a half years I have been at the International Monetary Fund, I visited many countries, met many people, and found many reasons to be optimistic. I have found people wiling to talk and—even more importantly—willing to listen to each other. And when representatives of different countries meet at the Fund, I have often found that they have the will to turn conversation into action. I said at the outset that we are in a time of uncertainty. But dialogue can give us the knowledge we need to reduce uncertainty. And cooperation can help us agree on the actions we need meet the challenges we face. If we have the patience to listen to each other and the courage to cooperate with each other, I am confident that we can realize the potential of the global economy.
19. Thank you very much.