Dealing with the Financial Turmoil: Contingent Risks, Policy challenges, and the Role of the IMFSpeech by Mr. John Lipsky
First Deputy Managing Director of the International Monetary Fund
At the Peterson Institute
March 12, 2008
The growing financial turbulence of the past several months represents a massive stress test for the global financial system—one that has become more pervasive and more worrisome in recent weeks. The financial crisis that started in a relatively small part of the U.S. financial system today has grown into a global challenge. A problem that seemed at first to be essentially financial in nature by now has evolved—through the increasingly complex interlinkages between financial markets and the real economy—into a threat to the sustained and stable global growth that has prevailed over the past five years.
By now, there is little doubt that risks of further escalation of this crisis are rising and decisive policy action will be required to put the global financial system and global economy on a firmer footing. The first priority must be to reverse the spreading strains in global financial markets, and to restore the normal functioning of the financial system in advanced economies. For public authorities, this will require making available adequate short-term liquidity, while striking the right balance between market solutions and public sector intervention. The actions taken yesterday by several central banks are helpful, as they reflect recognition of this critical need to assure market liquidity.
With regard to actions of a more structural nature in the financial sector, steps are needed to make sure that banks are adequately capitalized, as well as to increase financial institutions' transparency, and to improve their disclosure. Even as these financial sector policies take hold, the global economy—and advanced economies in particular—will continue to face pressures from tightening credit conditions. If so, there is likely to be a role in some countries for stepped-up countercyclical macroeconomic policy measures to help support demand. Already, the U.S. authorities have enacted a temporary fiscal stimulus, while several central banks have eased their monetary policy stance.
However, the steps announced already may not prove to be adequate if low probability but high impact events materialize that jeopardize global financial stability. The implication is straightforward: With cross-border economic and financial linkages having become both more potent and more complex, careful attention needs to be paid to contingent risks. Moreover, such risks need to be evaluated in a global context.
In other words, policy makers as a matter of course need to "think the unthinkable," and to consider how they would plan to react if contingencies arise. The need to prepare systematically for potential risks has been demonstrated amply during the past few months. After all, the failure of both financial institutions and public authorities to anticipate the current challenges already damaged some core institutions, undermining confidence and weakening economic prospects. Moreover, to be effective in a globalized world, such contingencies—and the potential remedies—need to be addressed in a global context.
For our part, the IMF is using our expertise to determine which countries might have space for countercyclical macroeconomic policies, should these risks materialize. But even macroeconomic policies may not be enough, and we are also starting to think—on a contingent basis—about what other types of public sector intervention may be needed. We are also cooperating with other institutions—such as the Financial Stability Forum—in developing measures to help repair the financial system. The Fund also stands ready to use its record liquidity—if needed—to help cushion the global economy.
I will return to the issue of the Fund's role at the conclusion of my remarks, but first I will address our diagnosis of the current challenges and then describe a three pillar strategy for responding to them.
II. Diagnosis: The Importance of Contingent Risks
As we now know all too well, what was initially considered to be an isolated- and widely anticipated—weakening in the US housing market spread unexpectedly across markets and economies. Of course, there is no question of returning to the unsustainable market conditions of early last year, when spreads and market volatility were exceptionally low by historical standards.
Instead, we need to consider what new challenges might lie ahead, and what actions might be required if new risks materialize.
The potential transmission channels of these contingent risks reflect the reality of globally integrated economies.
• Financial-macro linkages are at the core of this crisis. The two key sectors of the financial system—traditional banking activities and securities markets—have faltered simultaneously. There has been a spiraling loss of confidence in the risk management practices of some of the leading financial institutions and in some of the innovative products that they have created.
Thus, certain sectors of the securities markets have become virtually immobilized at the same time that several major banks are suffering large losses. This differs from past crisis episodes, where one of these two sectors usually was able to help compensate for weakness in the other. Moreover, monetary policy support typically proved to be highly effective in the past, as reductions in policy rates facilitated the normalization of credit conditions.
At present, the effective intermediation of savings has been hampered and there is a risk of a broader and more intense tightening in credit conditions—with potentially significant macroeconomic consequences—notwithstanding aggressive efforts by central banks.
• A world of financially integrated markets also implies more rapid and stronger spillovers across economies—through traditional as well as novel channels. Spillovers through the traditional trade channel remains a central transmission mechanism of disturbances, even though global trade patterns have become more diversified. At the same time, financial spillovers have become more important. Moreover, the impact of such linkages can become progressively more pressing, as confidence and balance sheet effects can become relatively more serious as an initial disturbance grows in scale. In other words, the effects could be nonlinear. The high and rising correlation of global equity prices and the potential for sudden capital flow reversals imply that shocks at the core can be transmitted rapidly throughout the entire global financial system.
These are the potential transmission channels, but what are the main risks—the "unthinkables" —that might be considered today in contemplating contingency plans?
• For one, the possible emergence of a global financial decelerator could amplify the impact of the financial turmoil on the real economy. A downward credit spiral, driven by rising defaults or margin calls that force asset sales even as the value of collateral deteriorates could produce new rounds of deleveraging and asset price deflation. Such a development could have broad, even global, consequences, especially since corporations and banks in many emerging economies have tapped international markets and may eventually prove to be vulnerable at wider risk spreads or could face a retrenchment in capital flows.
• Although the current distribution of risks to global growth appear to be skewed to the downside, the possibility cannot be ignored that an upside risk exists as well. In particular, we cannot simply ignore the possibility, given the uncertainties, that what now seems to represent appropriate fiscal stimulus and monetary policy easing would turn out to be overly aggressive, leading to excessive global liquidity growth and subsequent overheating. Unexpectedly strong domestic demand growth or supply constraints could result in further increases in energy and commodity prices, perhaps accelerating inflation pressures and deteriorating inflation expectations. In other words, we need to be ready to consider all relevant risks.
In considering contingent risks, I can assure you that we have not lost sight of the challenge posed by still-large global imbalances. So far, a disorderly unwinding of these imbalances has been avoided; exchange rate movements have raised understandable concerns, but so far these have been orderly, in the sense that exchange rates have not moved perversely relative to shifts in interest rate differentials between the major markets. However, the lack of movement in currencies of key surplus countries, notably in Asia, adds to concerns of potential future stress.
Last year, the five participants in the Fund's Multilateral Consultation on Global Imbalances unveiled specific economic policy plans that were intended to help sustain global growth while reducing global imbalances. The Fund has been monitoring progress on these policies in the context of its regular bilateral and multilateral surveillance activities. The Consultation participants acknowledged that the inevitable international adjustment process would involve a slowing of domestic demand growth and a strengthening in net exports in the principal deficit countries—mainly the United States. This shift is now underway.
The participants also recognized that if a global growth slowdown were to be avoided as this shift was occurring, there would have to be a quickening of domestic demand growth and a decline in the savings rate in those large economies running current account surpluses. However, the policy plans, originally promulgated at the 2007 IMF Spring Meetings retain their relevance, despite changing circumstances.
III. Financial Sector Policies: Stemming the deterioration
Against this background, a strategy to deal with these potential challenges could rest on three pillars—financial sector policies to stem the deterioration; macroeconomic policies to cushion demand; and a multilateral perspective. The first of the three pillars involves acting to halt the deterioration of the financial sector, and to restore its effectiveness. The overarching, near-term goal has to be to rebuild confidence in the financial system. Having said that, the policies we would consider to be appropriate in this context would also be helpful from a longer-term perspective, as they would increase the resilience and efficiency of the financial system.
First, market liquidity needs to be maintained at a level that is sufficient to avoid pressures on economic activity.
• Thus far, the Fed, the ECB and others have adopted innovative and appropriate strategies to contain the stresses in the interbank markets. Nonetheless, spreads remain uncomfortably high. Central banks, nonetheless, need to tread a careful line between providing liquidity flexibly and sowing seeds of future excessive risk-taking through moral hazard.
• The way that liquidity risk is dealt with by banks and supervisors also should be re-examined. Banks should have incentives to sufficiently self-insure against adverse liquidity events. And supervisors need to refocus their attention on liquidity shocks—whether they arise from the way institutions fund themselves or from substantial commitments to off-balance sheet entities.
• Central banks, too, need to re-assess their ability to provide liquidity. Their facilities should enable rapid provision of funds to a broad range of counterparties, at a range of maturities, in multiple currencies, and against a wide set of collateral. The stigma attached to accessing existing standing facilities should be removed. More generally, central banks should conduct a coordinated review of their liquidity arrangements to ensure a more harmonized approach.
Second, disclosure must be improved while efforts are stepped up to recapitalize troubled banks.
• Now is not the time to introduce regulatory changes that permit losses to be hidden. Indeed, banks need to improve their disclosure practices so investors and counterparties can better understand what assumptions and positions lie behind their balance sheets. Regulators should ensure that there are no incentives for banks to hide assets and liabilities off their balance sheets; and supervisors should take a hard look at the systemic consequences of how fair value accounting is working in practice. In particular, more timely disclosures by large institutions worldwide are needed, wherever this is material.
• In combination with greater disclosure, weakened financial institutions need to continue to replenish capital. Pressures on institutions to deleverage, including at banks that have suffered the greatest losses, need to be kept orderly. Contingency plans need to be considered in the case that balance sheet contraction by non-bank financial institutions creates new pressures on bank balance sheets, but investors are not willing—as they have been up to now—to provide capital injections. Only by maintaining capital cushions can banks confidently resist pressures to reduce credit excessively, much less to undertake new lending.
IV. Macro Policies: Cushioning the Blow
While the financial sector policies that represent the first pillar are taking hold, the real economy may continue to be affected, particularly if banks cut back on lending while they rebuild their capital bases and securities markets remain under stress. Because of this, there is a role for a second pillar of macroeconomic policies to help cushion the blow from the turmoil.Monetary policy is the first line of defense, especially in advanced economies. Of course, monetary policy will become significantly more complicated if high commodity prices continue to put upward pressure on inflation and lead to a rise in inflation expectations. But for now, the Federal Reserve appropriately has taken aggressive action, and central banks in Canada and the United Kingdom also have reduced policy rates. The ECB has kept rates on hold, reflecting the differing conditions in European economies and markets but it could respond flexibly if downside risks to growth intensify and inflation risks decline.
In the current environment, there is a risk that monetary policy will prove to be less effective than in past episodes. In the United States, for example, spreads on many consumer and corporate financial products—such as jumbo mortgages and higher-risk corporate and consumer loans—remain stubbornly high, partly, or in some cases fully, offsetting the impact of lower policy rates.
This is why the IMF has been making the case that countercyclical fiscal policy also may be needed. In the United States, where growth has slowed significantly, the temporary and targeted fiscal stimulus already enacted should help to support demand. Of course, the rest of the world will not be immune to the slowdown in the United States, especially if it becomes more serious. In these circumstances, contingency planning is required. In this regard, we are advising our members to consider whether they have room to adopt temporary fiscal measures, if needed. We have analyzed which of our member countries possess fiscal space. Our preliminary assessment suggests that major advanced and emerging economies—accounting for two-thirds of global GDP—could allow automatic stabilizers to operate fully in the event of a deeper downturn. A smaller number—accounting for nearly one half of global GDP—have already or would have fiscal room to implement a discretionary stimulus, if needed.
The global nature of the challenges—underpinned by increased financial and economic integration—indicates that policy responses should be framed in a global context. Thus, multilateral collaboration and policy consistency represents the third pillar of our approach. Such efforts are evident in several fora, but they need to be strengthened and made more effective.
It is reasonable to ask whether this three pillar approach fits into broader concerns about global imbalances. As I mentioned already, the policy plans developed by the participants in the Multilateral Consultation on Global Imbalances remain relevant, as are the Consultation's twin goals of sustaining growth and supporting an orderly reduction in global imbalances.
• For this reason, any fiscal stimulus in the United States must be strictly temporary—the longer term fiscal problems are too daunting to give up the progress that has been made in recent years.
• For some countries, a move to boost domestic demand would meet both the short-term objective of lifting global activity and the medium-term goal of reducing global imbalances. In China, for example, a shift in the policy mix to allow for tighter monetary policy—supported by exchange rate appreciation—and looser fiscal policy, with an appropriate emphasis on social safety net spending, is sensible macroeconomic management for a country experiencing growing inflation pressures.
• Other countries, such as oil exporters in the Middle East, have taken action already to boost government spending. The challenge now is to ensure that such spending is appropriately focused to avoid further pressures on inflation.
But in today's world of contingent risks, macroeconomic policies may not be sufficient to cushion the blow if extreme events occur. We must keep all options on the table, including the potential use of public funds to safeguard the financial system. While I am not advocating the use of taxpayer funds to aid individual institutions, I fully recognize an appropriate role for public sector intervention after market solutions have been exhausted. At the IMF, we are giving serious thought to what can be done if contingent risks materialize, and we are using our expertise and many years of experience in helping our member countries weather crises to think about what policies might prove most effective. It is also important to ensure that considerations of moral hazard are balanced against the need to safeguard the financial system.
V. Role of the Fund
The issues that I have discussed today require global solutions. The IMF—with its global membership, multilateral perspective and technical expertise—can help in developing such solutions.
So, how do I see the evolving role of the IMF?
As I have emphasized today, the current turmoil underscores the need to identify contingent risks that could threaten global stability, and to develop potential policy responses. The IMF is using its expertise in analyzing global economic developments to help fill these needs.But what if contingent risks begin to materialize? I can state clearly that:
• The Fund is not the first line of defense—this responsibility lies with central banks, together with financial supervisors and regulators, whom we view as close partners.
• In fact, the Fund is not the second line of defense—this responsibility lies with fiscal authorities. However, we have deep knowledge of our members' fiscal policies, and consult regularly as part of our normal surveillance activities.
• But there is also a third line of defense that involves public intervention to safeguard the stability of the financial systems at times of extreme distress. This is not an action that should be undertaken lightly, and I am not advocating a particular course of action. Nonetheless, a reasonable set of options may need to be considered if the contingent risks that I have just outlined do indeed materialize.Of course, the Fund's Articles of Agreement charge us with a unique responsibility for sustaining global economic and financial stability. My Fund colleagues and I intend to meet our responsibilities by helping our members anticipate and deal effectively with today's difficult challenges, and with those that might lie over the horizon.