Opening Remarks at the High-Level Regional Symposium on “Monitoring and Managing Financial Stability: Lessons From and For the FSAP” Min Zhu, Deputy Managing Director, IMF
December 9, 2011Min Zhu, Deputy Managing Director, IMF
Shanghai, December 9, 2011
As prepared for delivery
Good morning, distinguished guests, and welcome to our symposium on the Financial Sector Assessment Program. I am so pleased that you are able to join us here in Shanghai. It is a rare opportunity for us to gather senior decision makers in the region to exchange views on efforts to respond to the global crisis and on the IMF’s role in promoting financial stability. This meeting would not have been possible without the collaboration of the People’s Bank of China. I would like to express my sincere gratitude to Governor Zhou and his staff for their hard work and generous hospitality.
We are gathered here today as policymakers around the globe are switching back into firefighting mode. What had begun as a financial sector crisis turned into a sovereign debt crisis and has now morphed into a fully-fledged crisis of confidence. Markets are particularly worried about the continuing adverse feedback loop between sovereign risk and financial sector weaknesses. Big and bold political decisions are needed to reduce sovereign risk. But we also need increased efforts to bolster the financial systems both in advanced and emerging economies. We believe that our improved FSAP can play an essential role in this process. And your views and recommendations will help us to further develop the FSAP into an effective surveillance and crisis prevention tool.
Before I delve into the details of the FSAP, I would like to say a few words about the impact of the current crisis on both advanced and emerging economies. Major advanced economies seem to have entered a vicious cycle of weak economic activity, financial distress, and high public debt and deficits. Emerging economies, by contrast, show stronger fundamentals that have underpinned global economic growth so far. But these economies are not immune. In fact, vulnerabilities are increasing, and potential spillovers from advanced economies are weakening their economic outlook. It is not surprising that many Asian policymakers have publicly warned about growing downside risks and have begun to adjust their policy stances.
Financial markets have been weighed down by the combination of weaknesses in major advanced economies and cyclical cooling in emerging economies—even though investor fears have somewhat eased due to the coordinated action last week by the world’s top central banks to provide dollar liquidity to the global financial system. The Euro Stoxx 50 index has dropped by more than 15 percent since the beginning of this year. Even those investors who diversified by “buying the world”, as measured by the MSCI world equity index, are down nearly 7 percent for the year. And markets have become increasingly volatile, as seen in the sharp increase in the VIX—the so-called “fear index”—since June1. Some are even beginning to wonder whether the global economy is heading for a bust that is greater than the one in 2008-09.
At the heart of the problem is the euro area crisis. Core European countries are now coming under pressure. Foreign investors are fleeing Europe’s sovereign debt markets, pushing up long-term yields on Spanish and Italian debt to 6 percent—near levels that are normally considered sustainable. German bund asset swap spreads have recently reached levels not seen since the aftermath of the Lehman Brothers collapse
With conditions deteriorating in the sovereign debt market, Europe’s banks are finding it increasingly difficult and expensive to borrow money in the wholesale market. At the same time, they are facing a wall of maturing debt—which some analysts estimate at over €600 billion for next year.2 This has meant that Europe’s banks are increasingly reliant on the European Central Bank for short-term liquidity, with latest estimates suggesting that ECB funding has increased by about €125 billion since June and by about €50 billion since September.
Under these circumstances, it will be difficult for Europe’s banks to meet the European Banking Authority’s new 9 percent core tier 1 capital targets. The scope for tapping equity markets is very limited, given that European financial stocks have dropped by nearly a fifth since the beginning of this year3. The risk is that banks will be more likely to cut lending or sell assets. Because of this deleveraging trend, there is a serious risk of intensifying adverse feedback loops between the financial sector, the real economy, and fiscal positions within and beyond the euro area.
These real economy strains are already evident. Europe’s broad Economic Sentiment Indicator has deteriorated in recent months, as has the Business Climate Indicator, while capacity utilization is expected to fall in the fourth quarter. And we have seen significant marking down of growth forecasts both by governments and, most recently, by the OECD to levels that are nearly recessionary.
The euro area crisis is threatening to spill over to the rest of the world through financial and trade linkages.
In the United States, the revised estimate of third-quarter GDP growth of 2 percent was below expectations. Even this level may be difficult to sustain in the fourth quarter, given weak income growth, high unemployment, declining house prices, and the fact that higher consumption was financed primarily through reduced savings. Continuing political disagreement over fiscal policy is weighing on market sentiment in the U.S. The recent failure of the U.S. super-committee to reach an agreement on reducing the fiscal deficit has raised the prospect of across-the-board spending cuts of $1.2 trillion—a massive fiscal adjustment that would hit economic growth. This has prompted further warnings by rating agencies of a downgrade.
Other major developed economies—notably Japan and the UK—are facing equally challenging conditions. Japanese industrial production fell sharply in September, and while October’s PMI suggests moderate expansion in the fourth quarter, growth prospects are not strong. In the UK, the forecast for economic growth in 2012 has been revised down to less than 1 percent, and it may be hard to avoid a recession if the euro area contracts.
One message I would like to underscore is that, while Asia has been relatively unscathed by the crisis so far, there is no room for complacency. We do not think that emerging Asia has “decoupled”. If anything, weaker global demand and more difficult international financial conditions could expose underlying vulnerabilities—often driven by rapid credit growth. There are already signs that economic growth in emerging Asia is slowing. PMI manufacturing reports from China and India point to moderating activity relative to earlier in the year. Weak trade numbers in other, smaller economies confirm signals that the weakening external outlook may dampen otherwise strong growth in the region.
Recent IMF spillover reports have shown that Asia is still highly vulnerable to shocks through the trade channel. Europe is one of the largest export markets for a number of Asian countries, including China, India, and the Philippines. While intra-regional trade is gaining importance, part of this intra-regional trade is on the same supply chain as trade with Europe. The experience of the 2008 crisis shows that a disruption in trade with Europe and America would also likely disrupt intra-regional trade.
And, of course, Asia is also affected through the financial channel. Foreign investors have traditionally played a significant role in Asian equity and bond markets, and many countries in the region have sizeable exposures to European banks through trade credit lines, loan syndication and other wholesale funding.4 There is growing evidence of disengagement by some major European banks that are active in emerging markets that could have a substantial impact on credit supply through these channels., Meanwhile, banks in emerging Asia continue their recent pace of deleveraging as they are seeking to build liquidity buffers
As you know, the IMF is heavily involved in the current crisis management. This is the firefighting part of our work. At the same time, we have been increasing our efforts to prevent future financial crises through improved surveillance tools such as the FSAP.
Allow me to expand on the role of the FSAP5, which we believe will become an essential underpinning of global financial stability. Launched in 1999, in response to the Asian financial crisis, the FSAP is aimed at helping national authorities to identify financial sector vulnerabilities and design longer-term policies and reforms. For advanced economies, FSAPs represent a unique opportunity to strengthen and reshape their financial sectors, based on the lessons from the current crisis. In emerging economies, FSAPs can help national authorities to prevent future crises.
Typically, the FSAP focuses on three core areas:
- First, it assesses the effectiveness of financial supervision against broadly accepted international standards. The global crisis has underscored the need for improved standards and codes to address systemic risk. These regulatory changes present challenges for both national authorities and the Fund. The question is: “Are we prepared to implement new, tougher standards, including Basel III?”
- Second, the FSAP assesses the source, probability, and potential impact of key risks to macro-financial stability. It takes a comprehensive view of the financial system and its linkages with the real economy. This involves quantitative stress testing of banks and the broader financial system. In addition to its quantitative findings, the FSAP provides a qualitative assessment of the authorities’ ability to monitor and identify systemic risks. In this context, the FSAP can be used to develop and refine macroprudential policies to limit the buildup of financial imbalances and prevent systemic risks.
- Third, the FSAP assesses the authorities’ ability to manage and resolve financial crises. It provides a framework to assess the adequacy of contingency planning and financial safety nets, including cross border issues, and defines action plans to deal with insolvent financial institutions.
Participation in the FSAP had been voluntary until last year, when G20 leaders decided to make it mandatory for jurisdictions with financial sectors that are deemed “systemically important”. Mandatory FSAPs, which take place every five years, allow the Fund to monitor more closely those members that are likely to have the most impact on systemic stability in the event of a crisis.
The decision to make the FSAP mandatory for systemically important economies is one of the key outcomes of the year-long debate on modernizing the Fund’s surveillance mandate following the global crisis. It is a landmark decision that formally brings financial sector issues to the core of the Fund’s bilateral surveillance, bridging the gap between the Fund’s two key surveillance tools: the Article IV consultation and the FSAP.
Since the creation of the FSAP, 138 countries have volunteered to participate in the program (many more than once), and about 35 FSAPs are currently under way or in the pipeline. Demand for FSAPs has risen sharply since the beginning of the 2007-08 financial crisis. In a recent survey, three-quarters of respondents indicated that they were satisfied, or very satisfied, with the overall usefulness of the FSAP.
Our recent internal analysis shows that the program has played a useful role as an independent review. Before the onset of the recent global financial crisis, FSAP assessments were able to pinpoint the main sources of risk. As the crisis unfolded, FSAP teams have also been quick to adapt the scope of assessments to focus on such critical issues as crisis management, liquidity support arrangements, and cross-border contagion. FSAP recommendations have been helpful in mitigating some of the consequences of the crisis.
And of course, there are lessons to be learned. The experience of the past five years has shown that assessments need to pay more attention to liquidity risks and cross-border, or cross-market, linkages. And even when risks were accurately identified, our recent review concluded that the warnings given in FSAPs can be even more loud and clear.
I am glad to say that we are adapting the FSAP to take into account these lessons and to strengthen its effectiveness, in several dimensions:
- First, the FSAP has become more flexible, taking into account country-specific circumstances.
- Second, the FSAP includes an improved analytical toolkit, covering a broader array of risks, macro-financial feedbacks, and cross-border spillovers.
- And third, “off-site” work is being strengthened to enhance the continuity of assessments and the effectiveness of “on-site” reviews.
We believe that the improved FSAP could play a particularly important role in the Asia Pacific region. Although the FSAP was created in the aftermath of the Asian financial crisis, Asia appears to have embraced it with less enthusiasm than other regions. Only half of the Asian IMF members have completed an FSAP so far—compared with all European member countries, 68 percent of countries in the Western Hemisphere, 81 percent of countries in the Middle East and Central Asia, and 59 percent of countries in Sub-Saharan Africa.
But this situation is changing. Since the onset of the financial crisis, most Asian members with large financial sectors have completed the FSAP, or have it in the pipeline. This is consistent with the increased leadership role that Asia is playing in multilateral bodies such as the IMF and the G-20. And we at the Fund are pleased—and proud—to be able to work more intensively with our Asian members.
A case in point is our first ever FSAP of China and Indonesia in the last two years. In both countries, the FSAP praised the remarkable progress that had been achieved over the last decade in reforming their financial systems. This had helped them weather the worst effects of the 2008 crisis. But gaps still remain. China should broaden and deepen its financial markets and services to create a more diversified and innovative financial sector that is based on commercial principles, while in Indonesia, enforcing the rule of law and addressing weaknesses in transparency and governance issues are priority.
To conclude, I am convinced that the improved FSAP represents a “win-win” situation. Not only has the program significantly strengthened the capacity and effectiveness of the IMF’s surveillance function. But it has also greatly enhanced the authorities’ ability to monitor and manage financial stability.
We believe that the FSAP will continue to evolve, especially in response to the needs of authorities in this region., .and some of its future FSAPs are likely to become a source of best practices that others would want to follow
There are many questions that we have yet to address. For example:
- Should the IMF encourage its members to conduct more FSAPs and FSAP updates?
- What about the resource constraints facing the IMF and the authorities?
- What is the best way to improve the FSAP (bottom-up versus top-down approach)?
- How can we tailor FSAPs to the needs of fast-growing emerging economies?
- Are we prepared for the major regulatory changes, including Basel III?
During the forthcoming sessions, you will have a chance to discuss these, and many other, issues. I am confident that we—individually and collectively—will come away with valuable lessons. I hope your discussions will be both productive and enjoyable. Thank you!
1 VIX Index: Pre-crisis, 7/1/08: 23.65; Peak, 11/20/08: 80.86; [Today, 12/8/11]: 30.6
2 Market estimates suggest that of the €600 billion falling due, Germany accounts for €157 billion; Italy €206 billion; France €99 billion; and Spain €50 billion, with Netherlands, Belgium, Austria, Finland, Portugal and Ireland making up the rest.
3 Financial sector equity declines YTD (Dec 1): World (-21%); Europe (-19%); USA (-28%); Japan (-21%); Hong Kong (-25%); SKorea (-22%)
4 Euro zone bank claims are greater than or just under 10 percent of GDP in 3 countries: Australia, New Zealand and Vietnam. For the NIEs, ASEAN countries, Japan and India the ratio is close to 5 percent. Euro zone bank claims on China are relatively small. Euro zone banks also supply almost 50% of Asia’s trade credit.
5 The FSAP is conducted jointly with the World Bank for emerging market and developing economies, with two components: a financial stability assessment by the Fund, and a financial development assessment by the Bank. For advanced economies, assessments are conducted by the Fund and focus on financial stability.