Global Imbalances and Global Financial Strains: Implications for AsiaAddress by John Lipsky
First Deputy Managing Director, International Monetary Fund
Tokyo, Japan, May 20, 2008
As Prepared for Delivery
Two forces—financial market turmoil, and the sharp rise in energy and commodity prices—have combined over the past year to push the global economy off the path of solid growth and low inflation that had prevailed since 2003. According to the IMF's latest World Economic Outlook forecast, growth in all of the G-7 economies will have slowed to a below-trend pace by this year's final quarter, while headline inflation in all cases other than Japan will exceed monetary policymakers' medium term goals. Moreover, according to the IMF forecast, growth in emerging economies will slow as well, even though their average growth pace will remain substantially faster than in the advanced economies.
Thus, the principal goals of the IMF's 2006-2007 Multilateral Consultation on Global Imbalances—that is, to sustain global growth while reducing global payments imbalances—are not being attained as hoped. Indeed, there is a risk that global growth will weaken even more than is generally anticipated.
Taking this challenging context as the starting point, I would like to address three issues today. The first, and most basic, issue is whether the desired path of solid global growth and low inflation can be restored any time soon, and whether new policy initiatives will be required in order to attain this goal.
Second, I would like to discuss the reforms that appear necessary in order to restore normal functionality to global financial markets while reducing to an acceptable degree the risk of future financial market turmoil.
Third, I will address briefly the implications of the changing global economic and financial landscape for Asia.
Global Imbalances and the Global Growth Slowdown
In addressing the first issue—that is, the prospect for a return to solid global growth and low inflation—my Fund colleagues and I have concluded that, despite the significant near-term challenges, current broad trends remain consistent in many important ways with the global adjustment path mapped out by the Multilateral Consultation. You may recall that the Consultation participants included senior officials from Japan, the United States, the euro area, China and Saudi Arabia who engaged in a series of confidential policy discussions that began in late 2006. This effort culminated in the April 2007 promulgation of a set of mutually consistent policy plans intended to attain the Consultation's dual goals of sustaining global growth while reducing imbalances.
Despite the current challenges, my IMF colleagues and I are convinced that a return to the global economic progress achieved earlier in this decade remains an attainable goal, but achieving it will require both time and new policy initiatives. Moreover, risks of a less favorable outcome remain significant, making the need for appropriate policy measures all the more compelling.
The basic premise of the Consultation's policy discussions was that for global growth to be sustained while reducing global imbalances, the principal sources of growth would have to shift in both surplus and deficit economies. In other words, attaining the Consultation's dual goals was understood by the participants to be a shared responsibility that will require important structural alterations in all major economies.
In particular, the individual policy plans of the Consultation's participants in broad terms anticipated both the likelihood of—and a need for—a sustained rise in the rate of US household savings out of current income, an associated slowdown in the trend growth rate of US consumer spending, and a relative shift in the source of US growth away from domestic demand in favor of net exports. In fact, it was anticipated at that time that the boom-like conditions in the US housing sector inevitably would ebb as part of this process, at least in the near term.
It also was expected that this fundamental shift likely would be accompanied by some weakening of the dollar. At the time that the Multilateral Consultation was initiated, IMF analysis indicated that the US currency remained overvalued on a real trade-weighted basis, when viewed from a medium-term perspective, even though the degree of overvaluation had declined notably since peaking in 2002.
In fact, all of these anticipated shifts have been occurring, although in a more brusque and volatile fashion—and in a less favorable global context—then had been intended. Nonetheless, the current broad economic trends are those that were viewed by the Consultation participants as both inevitable and potentially desirable.
Despite widespread concerns about the dollar's recent decline versus some currencies, the US currency is at present only at—or slightly stronger than—its medium-term equilibrium on a broad trade-weighted and inflation adjusted basis. As is well known, this conclusion reflects the United States' substantial ties with Asian and other economies whose currencies are undervalued according to Fund analysis.
Of course, certain aspects of recent developments have been unwanted. Specifically, the recent reduction in the US current account deficit has reflected in part the virtual stagnation in US growth in recent quarters. At the same time, headline inflation almost everywhere has moved higher than consistent with the monetary authorities' medium-term goals. Finally, the terms of the capital inflows that have sustained the—albeit reduced—US deficit have become less favorable in terms of duration and cost, implying greater risks.
Certainly, one key to successful adjustment—that is, to achieving the Consultation's goals—will be to restore US growth to a trend pace. Persistently weak US growth would significantly inhibit a return to trend growth in other advanced economies, and could undermine growth in emerging economies as well.
Restoring US growth will require, among other things, an end to the price declines in US residential real estate that are still underway. It also will require the return to more normal conditions in credit markets, and a restoration of consumer confidence. Attaining these results primarily are the responsibility of the US authorities. However, restoring a sustainable global expansion—that is, trend growth accompanied by low and stable inflation and by declining global imbalances—will require stronger domestic demand growth in the advanced economies outside the US.
This need was anticipated clearly in the Multilateral Consultation discussions. The policy plans that the Consultation's participants presented to the public in April 2007 included a detailed set of policies that were designed to promote this outcome. For example, it was clearly anticipated that key Asian economies with pegged exchange rates would increase the flexibility of their currencies with respect to a basket of currencies.
At the same time, flanking policies were to be implemented in the participating economies outside the United States that would strengthen their domestic demand growth. These were to include measures that would boost productivity growth and improve the efficiency of resource allocation. In the event, these policies in many cases have not been implemented as forcefully as had been anticipated. As a result, the drop in the US current deficit has not been mirrored to date by a decline in Asian surpluses.
According to the IMF analysis underpinning the Multilateral Consultation, failure to produce sustained stronger domestic demand growth in the major surplus economies could result in both slower global growth and sustained imbalances that eventually would tend to undermine the confidence of both investors and consumers, and potentially heighten economic and financial volatility.
We therefore see a risk that the latest reduction in the U.S. current account deficit does not mark the end of large imbalances, but rather a shift to new ones. In particular, some economies with flexible exchange rates—like the Euro area—are now faced with a currency that is on the strong side relative to medium-term fundamentals. Moreover, we are concerned that new imbalances will build up in economies with less absorptive capacity, thinner financial markets, and less established policy credibility—for example, some emerging markets.
The broad implications of this analysis are reasonably straightforward. First, a key priority must be to make sure that the downside risks to growth in the advanced economies are avoided, and that their growth is restored to a trend pace. At the same time, the challenges embodied in the sharp rise in energy and commodity prices must be faced squarely. However, the pro-growth policies that may be adopted should be consistent with the underlying structural shifts in the sources of growth that will be needed if the recovery is to help reduce imbalances and promote a return to the low inflation that prevailed earlier this decade.
There are some grounds for optimism regarding this prospect. As I have claimed already, the shifts evident so far in the US economy—that is, the one has been the most seriously affected by the growth slowdown—have still been broadly consistent with the shifts contemplated in the framework embodied in the Multilateral Consultation. In broad terms, the policy roadmap exists already. What is needed now is to implement it effectively.
Restoring Stability and Progress in International Financial Markets
An important element of the strains that have clouded prospects for global growth and stability has been the ongoing turmoil in global capital markets. Although markets have seemed less volatile recently—especially since the Federal Reserve's dramatic emergency moves that averted the impending bankruptcy of Bear Stearns—risks remain.
Nonetheless, just as the Multilateral Consultation provided a roadmap for the macroeconomic and structural policies needed to restore global growth while reducing imbalances, a set of plans for dealing with the financial market disruptions has been developed by the Financial Stability Forum's Working Group—of which the IMF is an active member. The Working Group's proposals provide a multilateral basis for overcoming the current problems and for implementing structural reforms that will make a recurrence of the recent turmoil substantially less likely. Key elements of the plan indicates that:
• Central banks need to remain supportive of inter-bank markets to ensure that these markets do not seize up, while at the same time taking care to avoid taking on inappropriate credit risk. The UK authorities' recent decision to extend the term of its swap arrangements to up to three years provides a useful illustration.
• Supervisors need to take forceful steps to enhance disclosure by banks and other financial institutions to re-assure markets that the system is sound. And while large banks have been successful in attracting additional capital, existing shareholders also should not shrink from curbing dividends to help rebuild balance sheets.
• Regulators need to be prepared to take early action to deal with stressed institutions, since the experience of the past decade illustrates that delaying action only exacerbates the risk of contagion across institutions or borders.
• And, finally, fiscal and other authorities need to develop contingency plans for dealing with potentially large stocks of impaired assets. Ongoing efforts in the United States to craft legislation that would provide scope for re-financing mortgages with an FHA guarantee provide an interesting example.
At the same time, we must not lose sight of the need for fundamental medium-term steps to help avoid future episodes. We see priority needs in the following areas:
• First, credit discipline needs to be strengthened, and recent U.S. proposals to tighten regulation and oversight over mortgage originators represent an important step in the right direction. And regulators, credit rating agencies, and financial standard setters need to look closely at how structured credit products are treated to help ensure that the unusual risks they imply are appropriately taken into account.
• Second, supervisors and regulators need to ensure that financial institutions employ better risk management. This has to involve more effective and stricter consolidated supervision, as well as other steps to reduce the incentive to move assets off their balance sheets. And at the same time, supervisors need to be more pro-active in ensuring that banks do not take on excessive liquidity risk, including by relying too heavily on short-term wholesale deposits to fund their activities.
• Third, central banks, supervisors and ministries of finance need to improve financial safety nets and crisis management frameworks. For example, central bank liquidity facilities have to be flexible enough to provide support to solvent but liquidity impaired banks, and deposit insurance and bank resolution need to be designed in ways to avoid problems in one bank eroding confidence in the system as a whole. And the recent U.S. experience has also illustrated that financial safety nets and crisis management frameworks may need to be cast wider, to take into account the growing systemic importance of nonbank financial institutions.
Encouragingly, these policy messages have been given a strong multilateral endorsement, including by the IMF's membership and by G7 finance ministers a few weeks ago. And the G7 has supported an action plan that includes several key deliverables within the next three months, with additional measures to be implemented by end 2008. Important financial sector reform plans have been put forward in the United States and the UK, and there are several promising suggestions within the EU and more broadly for establishing cross-border supervisory colleges and to enhance the coordination among countries.
These steps are welcome, and we believe that a strong and determined multilateral commitment to action on all these fronts is essential to help ensure that the macroeconomic effects of the present crisis are manageable. They also will help to "crisis proof" an international system that will need to incorporate ongoing financial innovation, rapid shifts in capital flows, and the further unwinding of still significant saving-investment imbalances.
However, the immediate focus has to be on restoring normal functionality to global financial markets. Key authorities have shown their willingness to react decisively and flexibly to evolving and unforeseen circumstances in order to promote this goal. For now, the focus remains on financial institutions recognizing losses and insuring capital adequacy. Nonetheless, additional—perhaps extraordinary—measures still may be needed.
Implications For Asia
Having covered the recent financial crisis and the broader issue of the shifting pattern of global capital flows and current account imbalances, I will turn briefly to their impact on, and implications for, Asia.
Encouragingly, the fallout to date from the sub-prime crisis on Asia has been limited. Sub prime-related losses in this region remain substantially lower than elsewhere, Asian corporations seem to have little difficulty in accessing local loan and debt markets, and investor sentiment toward Asia remains positive. And while certain segments of the credit market have dried up (such as for securitized assets), there are no signs of serious problems of credit availability in the region.
This relatively positive experience reflects several factors. The securitized finance model is less prevalent in Asia, since banks here typically provide more traditional banking services, and the financial crisis in 1997/98 also may have encouraged greater conservatism. Moreover, some financial centers, such as Hong Kong SAR and Japan, already had adopted Basel II standards, and Singapore did so this year. These actions may have helped limit incentives to create the types of off-balance sheet liabilities that created problems elsewhere.
That being said, Asia has not "delinked" from global capital markets and the turbulence of the last year. Despite the recent rebound in stock prices and narrowing of credit spreads, they have not returned to pre-crisis levels, while funding costs have risen more generally. Yen-funded carry trades have also been unwound, leading to higher volatility and a strengthening of the yen.
Nonetheless, despite this spillover, we expect that as global imbalances are resolved Asian capital markets likely will take a greater role in intermediating saving within the region. Indeed, interesting examples of this exist already, including in the growing use by regional borrowers of the Samurai market in Tokyo, as well as in other local bond markets in the region.
In order to facilitate this process, and reduce the risk of instability, care will be needed in Asia, as elsewhere, to require effective disclosure by banks and other institutions, especially of structured and complex financial instruments, to ensure effective management of liquidity risks, and to ensure that financial safety nets are robust.
At the same time, policymakers in the region also need to be mindful of the macroeconomic environment and the signs that Asia's current account surpluses are projected to remain high over the medium-term.
As I mentioned earlier, greater exchange rate flexibility in emerging Asia, especially in China, inevitably will provide an important part of the overall solution. And the growing inflation pressures that many countries in the region are facing are providing ample illustrations of the potential costs of subordinating monetary policy to limiting exchange rate adjustments, if other flanking policies are not rigorously applied.
Of course, I want to emphasize that exchange rates are only one part of the solution. Reforms that improve the investment climate, enhance flexibility and competition, and strengthen the financial systems in Asia also will be crucial. Capital markets in many Asian countries are still relatively underdeveloped and are constrained by the limited supply of financial assets and weak infrastructure.
Indeed, despite the rapid pace of regional trade integration, financial integration in Asia has lagged behind, and Asia has relied heavily on the financial sectors of developed economies in Europe and North America to intermediate its excess savings. This suggests that there could be important opportunities to promote regional financial integration to help spur and support financial sector reforms. The priorities should be on further developing market infrastructures and harmonizing tax, regulatory, and supervisory standards in line with international best practices
Against this background several recent initiatives are promising. The ASEAN+3 is promoting regional cooperation and financial integration through the Asian Bond Market Initiative and the establishment of a reserve pooling mechanism. The EMEAP group's Asian Bond Funds are helping to catalyze regulatory and tax reforms in Asia as well as harmonizing documentation across countries.
The future obviously holds great opportunities for Asian economies and financial markets. Success in multilateral policymaking would mean a return to solid global growth with low inflation, but with reduced imbalances. A reduction in global imbalances implies reduced net cross-border capital flows—but perhaps still-larger gross flows—along with enhanced stability and dynamism in a multi-polar world. This is a world in which Asian economies and financial markets will play an ever-increasing role.
There are three key messages I would like to leave, reflecting the three issues I have addressed:
First, although we are seeing some signs of normalization in credit markets, we still see serious risks to global financial stability. Policy makers need to avoid complacency and take steps to restore confidence, while at the same time preparing for further pressures. And while it is re-assuring that Asia has so far escaped serious downdrafts from the U.S. sub-prime crisis, capital markets are now so interlinked that it would be prudent to act pro-actively to respond to the risk of spillovers.
Second, this crisis has been associated with a reduction of the United States' current account deficit. This trend likely will be durable, implying a significant shift in the pattern of global capital flows. This prospect offers Asia an important opportunity to enhance the integration of regional capital markets and to boost the returns on Asia's impressive savings. But achieving this goal, while preserving financial stability in the region, will require continued commitment to reforms, especially in financial markets, as well as macroeconomic and exchange rate policies that facilitate a more sustainable pattern of saving-investment flows.
Third, if we have learned anything from the past decade of financial crises, it is that they usually involve failures on the part of both borrowers and lenders to adequately price risk. Looking ahead, I believe that we are more likely to be successful in overcoming the present crisis and in facilitating a smooth unwinding of the remaining imbalances if we seek cooperative and multilateral solutions. It is a source of optimism that potential solutions either exist already, or are under discussion. As I stated already, a plausible road to significant progress is known already. The principal challenge is to travel down this road, avoiding the inevitable pressures and temptations of unproductive detours and distractions.
With these remarks, let me thank you for your attention and I look forward to the discussion that will follow.