Lessons from the Financial Market Crisis: Priorities for the World and for the IMFSpeech by Dominique Strauss-Kahn
Managing Director of the International Monetary Fund
to the Indian Council for Research on International Economic Research (ICRIER)
New Delhi, India February 13, 2008
As Prepared for Delivery
1. It has become increasingly clear that the macroeconomic effects of the financial market crisis will be serious and that no regions will escape entirely unscathed. Today, I would like to explore with you the prospects for the global economy and emerging markets like India, and the challenges this outlook poses for policymakers, both in industrial countries and emerging markets. And I will also discuss the evolving role of the IMF as it carries out its mandate of promoting global financial stability. It is a pleasure to be able to talk about these issues at ICRIER, a research institute which has made a distinguished contribution to the policy debate.
2. Let me begin with a historical perspective on the Fund and on the current crisis. The Fund's goal has not changed in essence since its birth more than 60 years ago. I can sum this up in a single sentence. Our goal is to promote a cooperative approach between nations to secure economic stability and growth.
3. The challenges that the Fund and its members face, however, have changed. In its early years, the crises that our members faced were mostly current account crises. Large scale capital movements between countries were relatively rare, and financial institutions tended to be national rather than international. And transmission of problems from the national to the global level was relatively slow. Obviously that is no longer the case.
4. If we look now at the current financial crisis from this perspective we can see that what began as a problem in a single sector in a single economy—the housing market in the United States—has become a global problem. And what was first manifested as a problem for financial institutions is now becoming a problem for economies. This is obviously the case in the United States. I believe that the effects will be felt increasingly in Europe. And I do not think the emerging economies are immune from this crisis.
5. The lesson I draw from this is that we have to look for both the causes and the cures of crises in the interaction of national and global developments and in the interaction of economic and financial market developments.
6. Let me be more specific. The present crisis is the result of a perfect storm: a macroeconomic environment with a prolonged period of low interest rates, high liquidity and low volatility, which led financial institutions to underestimate risks, a breakdown of credit and risk management practices in many financial institutions, and shortcomings in financial regulation and supervision.
• This environment both fueled a U.S. housing boom and encouraged banks and other institutions to take on excessive leverage to generate high returns.
• Financial institutions weakened their lending standards and took on excessive risk. The most obvious example is the US sub-prime mortgage market, but the holders of these risks were not only in the United States, and problems may also surface in other kinds of lending—for example leveraged loans and consumer credit—or other countries. Nor is the problem confined to industrial countries. For example loose credit in some emerging economies may lead to problems down the road.
• Supervisory and regulatory frameworks have also not been up to the task. This applies to both crisis prevention frameworks and crisis resolution frameworks. To give an example relating to crisis prevention, in the United States, unregulated entities that originated mortgages were not subject to appropriate disclosure and consumer protection requirements. But supervisors and regulators in other countries have to ask whether their frameworks are adequate, too.
7. The interaction of economic and financial market developments is also influencing the way the crisis unfolds.
• The financial problems of banks raise the risks of a credit crunch. The housing correction is already lowering growth in the United States. A credit crunch would worsen the outlook further, and could also affect Europe and potentially other countries worldwide.
• A bleaker economic outlook would in turn make it more difficult to get out of the financial crisis, because it worsens the prospects of businesses and individuals. This is one reason that equity markets have fallen as the risks of a U.S. recession and a global downturn have grown.
8. Just as the origins and development of the financial crisis lie in the interaction of macroeconomic and financial market policies, the resolution of the crisis will require action in both areas. Let me talk first about what should happen in industrial country economies and financial markets. I will turn to emerging economies in a few minutes.
9. With regard to economic policies, I have urged that monetary policy be the first line of defense. Indeed, it already is. The major central banks are doing their part in providing liquidity and monetary easing while continuing to stabilize inflation expectations. But governments may also need to deploy fiscal policy. Unless the situation improves, the fiscal authorities in countries with low fiscal risks should prepare to exploit the headroom for timely and targeted fiscal stimulus that can add to aggregate demand in a way that supports private consumption. Of course, it has to be temporary—maintaining a sustainable medium-term fiscal position is still very important. But in a sense, medium-term fiscal policy is all about saving for a rainy day. It is now raining.
10. With regard to the financial markets, the first priority is to restore confidence. Many things are needed to make this happen.
• Central banks will need to continue to provide liquidity to ensure smooth functioning of interbank money markets. They should also take this opportunity to seek more convergence on what kind of institutions they provide liquidity to, what collateral they will accept and what maturity they provide liquidity on. For their part, auditors and supervisors need to encourage consistency across financial institutions on how assets are valued and how writedowns are determined.
• Financial institutions must also act. They need to restore confidence through full disclosure of exposures to sub prime and related securities, both on and off their balance sheets. It is also critical that large systemic institutions that have experienced significant writedowns raise capital and restore liquidity cushions to reassure investors about their financial soundness.
11. Let me now turn to the effects of the crisis on emerging economies. I believe that these effects will be felt, and probably sooner rather than later. Some may say that emerging economies have now decoupled from industrial economies. They would argue that growth in major emerging economies like China and India is now such a powerful engine that it can continue to move forward without the large industrial countries. I don't think so—at least, not yet. The industrial and emerging economies are more like two horses yoked together. If one is tired, the other can take up more of the strain for a while. But if one stops in its tracks neither is going to get very far. Let me explain why I think this is so.
• Sustained strong growth in the emerging economies has been based in part on stronger policy frameworks. But it has also been based on gains from trade and financial integration in the global economy. This is true of India as well as other emerging economies.
• As growth slows in the U.S. and Europe, emerging economies' exports to them will slow. In the past, a 1 percent decline in U.S. growth has led to a decline in growth in emerging economies by 0.5 to 1 percent, depending on trade and financial links with the United States.
• It is true that intra-regional trade has diminished, as regional trade has grown. But it is also true that many emerging economies export intermediate products to other emerging economies, which are in turn exported to the United States or Europe. So I think that the trade links that bind emerging and industrial economies together are still tight—and perhaps are tighter than they seem from a casual examination of trade figures.
• There are also complex financial linkages and spillovers. India has experienced very large capital inflows since the sub-prime crisis. This reflects both market judgments about India's good economic prospects and interest rate differentials between India and other countries. There could also be a reversal of inflows, if there is a general retreat from risk by global investors. The authorities are well aware of the risks of volatility in capital flows in the period ahead.
12. This leads me to policy advice. Obviously, the major emerging economies are not yet in a downturn. But I think they should be prepared.
• In economic policy, emerging economies could consider how they would respond to a downturn: how much scope there is for monetary easing in some countries; how much scope there is for a fiscal stimulus in others. And bearing in mind that fiscal stimulus should be timely, temporary, and targeted to those who will spend it—which often means low-income people—some emerging economies could already begin thinking about the design of a fiscal package. The appropriateness of both monetary easing and fiscal stimulus will vary country by country. I do not mean to suggest that every country should be loosening fiscal policy. For example, India already has very high growth and a still high public debt, and medium-term fiscal consolidation remains a priority.
• There is also a broader role that some emerging economies can play to help support global growth—through policies to strengthen their domestic demand as a growth engine, including greater exchange rate flexibility. These are also policies that will help to bring about an orderly unwinding of global economic imbalances.
• In financial market policies, emerging economies can learn from the risk-management and regulatory failures of industrial economies. All emerging markets should build regulatory capacities to safeguard against the risks associated with non-transparent instruments and excesses in lending. I would also advise central banks and regulatory authorities to make sure that they have the capacity to react rapidly to changes. For example, some may need to change their frameworks for liquidity management and collateral. In addition, the much smaller subset of countries whose domestic banks have borrowed excessively from foreign banks to support domestic credit should prepare for sudden changes in market sentiment that could occur if financing conditions in global markets tighten significantly.
13. Let me now turn to the lessons the Fund itself can learn from the financial market crisis.
14. Before I came to the Fund three months ago, I traveled to many of the Fund's member countries. I came here, to India. I went to Latin America—to Argentina, Bolivia, Brazil, Chile and Mexico. I went to Russia, and to Saudi Arabia and South Africa. And all around the world I heard the same thing: that our members value the analysis and advice we give them for the challenges they face. And they support our efforts to keep step with change by refocusing our activities to meet the challenges of tomorrow.
15. My guiding principle as I consider reform of the Fund is that we should focus on areas and issues where it has a comparative advantage. To expand on this, there are many international and national organizations that produce economic analysis, give economic advice and provide technical and financial assistance and training, but there are issues within the Fund's mandate on which it is uniquely qualified to help its members. It is on these issues that we should concentrate.
16. Let me give an example on how we could apply this principle to the Fund's work on the current financial crises. The Fund did warn our members and warn the world about the crisis. In fact the Fund gave repeated warnings, most fully in the Global Financial Stability Report that we issued last April, and we also gave more warnings on how the crisis might unfold in another report last October. But perhaps we did not warn forcefully enough. And we, like many others, did not foresee just how the turmoil would spread and what would be the key interlinkages that I have talked about today.
17. The lesson that I draw from this is that we need to pay more attention to the links between changes in the real economy and changes in financial markets—links which go both ways. And we need to pay more attention to the links between national economic policies and international macroeconomic and financial developments—links which again go both ways. The Fund has a clear comparative advantage in understanding these linkages and assessing their implications. With our involvement in the real economy and the financial sector, we stand at the corner of Main Street and Wall Street.
18. The recent market turmoil has made it very clear that we need to pay greater attention to the links between real and financial sector developments. There is a hunger around the world, and especially in emerging markets, for greater understanding and insight on these links. The Fund is the institution with the greatest capacity to provide such insight. Only the Fund has the global membership—and the legitimacy that comes from that—and the breadth of experience to cover both economic and financial market developments. Therefore, we have to do more to meet the world's need for understanding on these issues. We also have to be prepared to act on that understanding, both through advice and, if countries experience difficulties, through financial support. This is why we are working hard to make sure that both our advice and our instruments for supporting member countries financially are the right ones.
19. We also need to sharpen our focus on the interlinkages between national economies and the global economy. This surveillance activity is our bread and butter, and it is essential that we give our members what they need. To do so, we will focus our surveillance and consultations with individual members on those issues in our mandate that matter most. And we are putting greater emphasis on cross-country and regional work and pay more attention to key links between bilateral and multilateral surveillance. We have been moving in the right direction. To give you an example, the recent staff report on India contained useful cross-country comparisons of exchange rate developments, capital flows and macroeconomic policies in India with those of Brazil, China and Russia. And we will be doing even more of this in the future
20. I said earlier that the Fund gained legitimacy from having a global membership. But that legitimacy needs to be protected and enhanced. At the moment, emerging and developing countries do not feel sufficient ownership of the Fund. In reforming the Fund we need to reflect not only the changed role of the Fund in the world but also the changed role of many of our members. Many Asian economies, including India, are now economic powerhouses. In order to strengthen the legitimacy of the Fund, the emerging economies as a group must be given a greater representation and a greater voice. Part of the story is reform of the quotas on which voting power in the Fund is largely based, and I am committed to pursue the reforms of quota and voice started by my predecessor, Rodrigo de Rato, and bring them to a conclusion soon.
21. There is another aspect of legitimacy, which relates to the Fund's own financial position. We cannot be legitimate in giving advice to our members on financial issues if our own finances are not in order. This is why we need a more sustainable income model for the Fund. And we cannot be legitimate if we do not ourselves practice the expenditure restraint that we have often urged on other countries. This is why we must cut the Fund's administrative expenses at the same time as we take steps to increase our income. I will over the next two months bring to the Executive Board proposals to do both of these things.
22. These measures—refocusing the Fund's activities, realigning quotas and enhancing the voice of emerging and developing countries, and setting the Fund's finances in order through income increases and expenditure reduction—are at the heart of my strategy for reform of the Fund. I believe that the principle of comparative advantage which guides my proposed approach to surveillance can also be applied to other areas of the Fund's activities, including technical assistance and our work on program and near-program countries, especially low-income countries, and this is a theme that I will develop over the coming months.
23. In closing, let me return to my main theme. The world economy has entered a difficult phase, with the financial crisis spreading to the real economy. This has become a global problem that requires a global solution. Emerging markets need to join industrial countries in the macroeconomic and regulatory policy response. Such a collaborative approach offers the best hope for ensuring the stability of the global economy.
Thank you very much.