"Global Challenges to Financial Stability: the Global Outlook and the Role of Macroprudential Policies" Speech by International Monetary Fund Deputy Managing Director Min Zhu
March 1, 2012Speech by International Monetary Fund Deputy Managing Director Min Zhu at the Opening of the High-level Conference on Macroprudential Policies to Achieve Financial Stability
Punta del Este, Uruguay, March 1, 2012
As prepared for delivery
Please let me welcome you to this conference on “Macroprudential Policies to Achieve Financial Stability” that we are co-hosting with the central bank of Uruguay. I am pleased to see such a distinguished group of experienced policy makers, not only from Latin America, but also from the United States, the United Kingdom, Korea, and New Zealand. Let me also welcome a distinguished former official of the Bank for International Settlements. Many thanks to all of you for travelling to this beautiful city and I hope to have the opportunity to speak with each you individually during the rest of the conference.
This conference is taking place at a very challenging moment for the global economy.In my talk today, I want to discuss how the Fund sees the current global environment, which is likely to remain a source of uncertainty for some time, and then turn to the implications for Latin America and the important questions this outlook raises for the implementation of macroprudential policies.
The current global environment
First, let me explain our views on the current global environment. We project global growth to slow to 3¼ percent in 2012, marked down from 4 percent in the September 2011 WEO. The euro area is expected to enter a mild recession in 2012, while other major advanced economies face the prospect of weak and bumpy growth. In the U.S., the recovery is likely to remain tepid, even though growth accelerated in 2011Q4 and the recent flow of data has been positive. Growth will also moderate in emerging economies, from high levels.
In the United States, downside risks dominate.Our key messages are that monetary policy should remain supportive; a fiscal plan attuned to the cycle should be agreed on; and further policy measures should be introduced to heal the labor and housing markets.
These downside risks are both in the short- and medium term. The recent broad-based strengthening in job creation presents some upward potential for household income and growth. However, there are also key downside domestic risks, stemming from housing markets and fiscal policy. House prices could fall again, hurting household balance sheets and consumption, and a large fiscal withdrawal could occur amidst political gridlock. At the same time, the absence of a credible and comprehensive fiscal consolidation plan remains a major medium-term risk. The credit rating agencies have already stated that, in the absence of such a plan, they would likely downgrade the U.S. sovereign rating. A sudden rise in longer-term interest rates thus remains a possibility.
We welcome the Fed’s intention to maintain accommodative monetary conditions through mid-2014 given the output gap and stable inflation expectations. The Fed is also continuing its program of extending the maturity of its securities holdings and rolling over maturing Treasury securities into new issues, while reinvesting the principal of maturing maturities into agency mortgage-backed securities. These actions will continue to put downward pressure on longer-term interest rates.
On the fiscal front, we believe that U.S. policymakers should try to reach an early agreement on a comprehensive consolidation framework, but at the same time must not reduce the deficit too rapidly to avoid undermining the U.S. economic recovery. Fiscal policy in 2013 could become very contractionary because of the simultaneous expiration of the stimulus measures and the Bush tax cut at the end of this year, as well as the automatic spending cuts triggered by the failure of the Congressional Committee on deficit reduction. And finally, there is a lack of consensus in the United States on whether the medium-term adjustment that all agree is needed should come through spending cuts or higher taxes. In our view, both revenue-raising provisions and savings in core entitlements such as health care and public pensions will be necessary.
In the Euro zone, while the recent actions by the ECB and the Euro group’s recent decision to support the second program for Greece should help calm tensions in the near term, the region still faces important challenges.
The measures adopted by the European Central Bank (ECB) in December 2011, especially the introduction of three-year Long Term Refinancing Operations, proved instrumental in calming market fears that European banks would be unable to satisfy their rollover funding needs in 2012.
A strategy for Greece has now been articulated, which should gradually restore growth and secure improvements in debt sustainability. Over the past two years, Greece has already achieved a significant fiscal adjustment, bringing its primary deficit down from about 10 percent of GDP in 2009 to about 2 percent in 2011 (projected in the December 2011 review of the program), in a very challenging economic and political climate. But, of course, much more work needs to be done. Private creditors have agreed to considerable debt reduction, the government has committed to further fiscal adjustment, and is implementing productivity-enhancing structural reforms which are essential to restoring economic growth and achieving fiscal sustainability. Of course, the success of this strategy crucially hinges on full and timely policy implementation and long-term support by euro area member states. We need to recognize that the challenges remain massive given Greece’s huge debts, large financing needs, and weak competitiveness and growth.
It will be important for Europe to adjust its policy mix to provide stronger support for growth. With decreasing inflationary pressures, there is some scope for further easing of monetary policy. Given persistent market tensions, the ECB should not hesitate to use unconventional monetary policies. Also, countries that are not under market pressures should allow full play of automatic stabilizers, while countries with fiscal space should reconsider the pace of their fiscal adjustment. Over the medium term, demand policies need to be supported by growth-enhancing structural reforms, especially to improve labor market efficiency and competitiveness.
Another critical step is to implement a comprehensive crisis strategy, which would include increasing the resources available through the ESM and establishing a credible timetable for making this mechanism operational. Banks also need to achieve the agreed capital buffers, ideally through private solutions and in a manner that does not curtail credit growth.
More broadly, to anchor confidence in the European project, the region will have to achieve deeper fiscal and financial integration. The recently-agreed Fiscal Compact provides a pan-European umbrella law that, for the first time, mandates the adoption of specific fiscal rules at the national level and can be an important ingredient to fiscal discipline over the medium term. However, this compact is silent on the sharing of fiscal risks across countries. Along the same lines, the Euro area needs to move toward closer financial integration through the adoption of unified supervision, with a single deposit insurance framework and a single bank resolution authority with a common backstop.
Finally, the Chinese economy—which has been a bright spot for global growth—is undergoing a modest deceleration. In our baseline scenario, real GDP growth in China is expected to fall to 8¼ percent from 9¼ percent in 2011, largely reflecting declining external demand. While exports and related industrial production are slowing, consumption remains strong. Monetary policy is being eased, and inflation remains manageable.
China’s financial linkages with the rest of the world are minimal, in view of China’s capital controls. However, China does have extensive trade linkages with Europe and the U.S., which account for nearly 50 percent of China’s total exports. A collapse in global demand would impact negatively Chinese corporate and financial sector balance sheets.
China has clearly not decoupled from the fortunes of the advanced economies.You recall that, as global growth dropped by 6½ percentage points, after Lehman, growth in China fell by 5 percentage points, even after a very considerable credit and fiscal stimulus package was implemented. We have also estimated that, if the crisis I have just described in Europe were to unfold, Chinese growth could, in the absence of a policy response, fall by up to 4 percentage points relative to the baseline.
In such a downside scenario, however, China still has policy space to respond. A well-designed package could mitigate (but not fully offset) the negative impact on growth. Front-loaded fiscal measures of around 3 percent of GDP, focused on cushioning the impact to the most vulnerable through transfers and social programs, could help contain the growth impact of a Euro area crisis to around 1 percentage point of GDP. This would also help support the much needed rebalancing toward private consumption. However, residual concerns from the 2009–10 stimulus about credit quality and the strength of bank balance sheets would mean that the monetary response to an unfolding European crisis would be limited.
The government is taking a number of steps to reduce financial risks. Property prices in some regions are high, creating also social concerns. Local government borrowing associated with the stimulus package is large. The good news is that the government is taking a number of structural and financial measures to cool the property market, and local government borrowing has generated actual physical capital, helping productivity growth.
Let me highlight three critical areas going forward.
- Inflation. China is at the inflection point, where income growth will begin to periodically create upward pressures on prices. These upward pressures will likely be especially visible in food prices.
- Investment. At 47.8 percent of GDP, investment is excessive. Such high level of investment, accumulating over years, is creating overcapacity.
- The growth model. In the medium run, China needs to switch from export-driven to domestic consumption-driven growth. This will help reduce the external imbalances as well as excessive investment.
Turning to the global arena, I would like to highlight three challenges.
The first challenge is the global financial deleveraging. Debt levels are excessive in many financial systems, governments, and households around the globe. These high debt levels need to come down to levels that are more consistent with the incomes of the debt holders. As this deleveraging takes place, this adjustment requires actual capital to be put on the table.
The second challenge is excess global liquidity. Many countries are resorting to monetary easing, since there is little fiscal space left in these economies to stimulate economic activity. As a result, global liquidity has surpassed the excessive levels observed in 2007. While excess liquidity appears to initially help support prices of financial assets, withdrawal of this stimulus reverses these gains.
The third challenge is large capital flows. Emerging markets have significantly stronger growth rates compared with advanced economies, lower unemployment rates, lower debt, and stronger fiscal and monetary buffers. Moreover, while emerging markets produce close to half of global output, they hold only 19 percent of global financial wealth. All these factors create lasting pressures for funds to flow to these emerging economies, as money chases growth and profits. However, critically, these flows are volatile and are expected to remain so in the medium term. Indeed, while capital flows to emerging markets were strong in early 2011, the flows begun to reverse in the second half of the year as the crisis in Europe worsened.
Let me now turn to the region. Fortunately, most—but not all—of the region has entered this period of turmoil from a position of strength.
Many countries now have in place strong policy frameworks that have gained credibility and have provided a crucial anchor for confidence during the recent global turmoil. With credible policy frameworks, many countries have been in a position to run countercyclical policies to mitigate the recessionary effects of the global challenges. The key elements of such credible policy frameworks include:
- Flexible exchange rate regimes backed by strong international reserve cushions, which provide countries with a more flexible range of options in a crisis.
- Credible medium-term fiscal frameworks. Many countries in the region now have legislation that links fiscal policy to medium term objectives, such as the level of public debt, and these frameworks can be crucial to reassuring the public that fiscal policy will not spin out of control and ultimately lead to high inflation or an unsustainable public debt burden.
- A strong commitment to low inflation: With well-anchored inflation expectations and credible monetary policy, central banks can adopt countercyclical policies without fueling fears of higher inflation.
- Prudent financial supervision. In the aftermath of their own banking crises in previous decades, many countries in the region have developed very cautious and close supervision of their banking systems, which has ensured that banks maintained sufficient capital and loan loss provisions and avoided poor lending decisions that could have led to high non-performing loans.
- Support from macroprudential policies. One lesson of the recent global financial crisis is that countries need to develop macroprudential policy frameworks to identify and mitigate risks to systemic financial stability, which should reduce the costs to the economy from a disruption in financial markets. Many countries in the region have a long experience with these measures, having adopted them well before the 2008-09 global financial crisis. In the past few years, these measures have ranged from countercyclical capital requirements (Peru), sector-specific additional capital requirements (Brazil), liquidity and reserve requirements (Brazil, Colombia, Peru); and limits on foreign exchange positions and measures to manage foreign credit risk (Uruguay, Peru, Colombia). Many countries in the region are also developing financial stability institutions to monitor systemic financial risk and apply macroprudential policies.
While the global slowdown is affecting the region’s external balances, domestic demand in much of the region continues to grow at a healthy pace, fueled by strong credit growth. Despite favorable terms of trade, external current account deficits have widened further, and in some countries banks are increasingly relying on wholesale funding to finance their credit expansion (although leverage is still low by most standards). Meanwhile, inflation expectations remain relatively well anchored in most countries, allowing some countries to put monetary policy on hold during the period of global uncertainties.
As a result of the global slowdown, we have marked down our 2012 growth projections in Latin America to 3½ percent, from 4½ percent in 2011. The slowdown is most noticeable in the more integrated countries in South America; Mexico and Central America have been less affected so far, owing in part to the relatively good performance of the U.S. economy. Some of the slowdown in South America is welcome, as it will help fend off remaining overheating pressures.
There are significant downside risks for the region. Beside the possible negative effect on world commodity prices, the direct effects from an intensified deleveraging episode in the euro zone could spill over into tighter credit conditions. This impact would depend not only on the relative presence of European banks in individual countries, but also on the foreign affiliates’ funding structure, the magnitude of banks’ direct cross border lending, and the size of the financial system.
Given the large downside risks, priority should be given to reinforcing fiscal policy buffers and strengthening credibility. Fiscal positions are still somewhat weaker than before the crisis in many countries, and gradual consolidation should continue to proceed. The risks to the outlook suggest that high world commodity prices may not last forever. However, fiscal consolidation should not come at the expense of social and infrastructure spending, which are crucial for growth. Monetary policy should focus on keeping inflation close to target.
Finally, let me turn to macroprudential policies. The global outlook raises important questions about how to design financial stability institutions and how to implement macroprudential policies in a credible way throughout the cycle.
In our view, macroprudential policy must deploy a wide range of tools; a single tool is unlikely to be sufficient to address the various sources of systemic risks. The macroprudential authority must be able to tailor specific macroprudential instruments to particular vulnerabilities. Among the tools being developed or refined—and already in place in some countries in the region—are countercyclical capital buffers, variations in sector risk weights, dynamic provisioning, loan-to-value ratios, targeted restrictions on foreign-currency lending, and liquidity requirements. Countries also need to address the risk of failure of individually systemic important institutions, and this is a critical area for Latin America, since most of its banking systems are highly concentrated. One option is to apply higher capital requirements to these institutions.
We recognize that macroprudential policy is at an early stage of implementation, and countries need to resolve three crucial issues to make this policy effective—building a sound institutional framework; designing an analytical framework to monitor and assess systemic risk; and establishing international cooperation.
- While reflecting country-specific circumstances, Institutional frameworks should encourage the effective identification of risks as they are developing; provide strong incentives to take timely and effective action to curb those risks; and facilitate the coordination of policies that affect systemic risk.
- With respect to analytical frameworks to monitor and assess systemic risk, a debate is still ongoing on the best way to measures systemic risks. However, policymakers are clearly moving toward employing a set of indicators, recognizing that systemic risk has more than one dimension.
- Finally, international coordination is essential in this matter, because credit booms and asset bubbles can be fed by credit market developments abroad.
This conference provides an excellent opportunity to discuss these complex issues, drawing on the rich experience in the region. In my view, critically important questions would include the following:
- Do particular frameworks for financial stability institutions carry certain advantages in managing systemic risk and adjusting macroprudential policies, especially in such a volatile global environment?
- How should macroprudential policies be coordinated with monetary and fiscal policies? How do countries ensure that macroprudential policies work in concert with credible frameworks for monetary and fiscal policy?
- Which macroprudential instruments tend to be the most effective in containing systemic risk? Do countries have useful metrics to measure systemic risk and to assess the effectiveness of macroprudential tools?
- Are rules-based macroprudential policies more effective than those applied with discretion? When are single instruments more effective and when should a country rely on multiple instruments?
Once again, let me welcome you to this important event. I am sure we will learn a great deal from your experience. As we move forward, it will be only through maintaining an open and fluid dialogue on these issues that we will gain a solid understanding of macroprudential policies. Over the next day and a half, I am very interested in hearing your views on the design and use of macroprudential tools and on how the Fund can assist you in developing this policy framework.