The Financial Crisis, Capital Flows, and Global LiquidityKeynote Speech by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund
Bank of Korea International Conference 2013
Seoul, Korea, June 3, 2013
As Prepared for Delivery
It is my honor and pleasure to speak to you today at the outset of this conference organized by the Bank of Korea on Global Liquidity in a Global Framework. This is an important topic that has aroused renewed interest in recent years, particularly in light of the 2008 global financial crisis. Ample global liquidity has been singled out as a potential factor behind the pre-crisis accumulation of financial vulnerabilities. Similarly, in the wake of the crisis, liquidity has been at the center of the debate about the implications of general monetary easing in advanced economies. This discussion has focused not only on the immediate spillovers from particular measures, but also on the implications for global financial stability from prolonged accommodation.
I would like to take a few minutes to set the scene, by summarizing where the IMF sees the global economy at this point; where some of the major vulnerabilities and risks lie; and the policy challenges that need to be addressed. I will pay particular attention to capital flows, exchange rates, and the role that unconventional monetary policy in warding off global tail risks. I will then try to explain why the monitoring of global liquidity indicators is important, and link global asset price developments with changes in global liquidity.
Global Economic Prospects
Almost five years since the collapse of Lehman Brothers and the start of the global financial crisis, the global economy continues to feel the aftershocks. Policymakers continue to grapple with the policy response.
The start of 2013 saw tail risks recede in the global economy, thanks to policy actions in the U.S. and euro area. While financial market conditions have improved markedly across the board for the last half year or so, the real economy continues to lag. We still are not seeing the levels of growth needed to drive a real global recovery, and we are not generating the jobs needed for the millions who have fallen into unemployment over the past five years.
The latest IMF forecasts show that the world economy is strengthening. But this is happening only little by little. World growth is expected to reach 3.3 percent in 2013, improving slightly to 4 percent in 2014. However, data for the first quarter of 2013 suggest a softer pace of real activity, underscoring the downside risks for global growth. For instance, activity in Europe shrunk more than expected, and persistent weakness in the periphery and policy uncertainty is increasingly affecting confidence in the core; China reported sluggish activity in the first quarter; and investment in India, Russia, and South Africa continues to be sluggish.
Now, coming back to the broad global economic prospect, there is significant divergence in prospects across countries. There are countries that are doing well, particularly among the emerging and developing economies. There are countries that are on the mend, such as the U.S, Sweden and Switzerland. Last, there are countries that still have some way to go—including the Euro Area and Japan.
For the past half decade, the emerging markets and developing economies have led the world’s recovery. Today, the two fastest-growing regions of the world are developing Asia and Sub-Saharan Africa. We at the IMF are projecting that these regions to grow at 7.1 and 5.6 percent, respectively, this year.
At the same time, many emerging markets, while recognizing the importance of unconventional monetary policy to support demand and contain risks in advanced countries, have worried about adverse side-effects. Policymakers have been concerned that this could affect exchange rates and capital flows, and threaten financial stability through high asset prices and rapid credit growth. I will return to this theme in a moment.
Countries on the mend
First let me just talk about the countries on the mend, focusing on the U.S., where a modest growth recovery is envisaged, to about 2 percent in 2013 and 3 percent in 2014, as private demand firms up. The most recent indicators from the housing market have been most encouraging, although growth this year is still not likely to be strong enough to have a significant impact on unemployment. But it will be achieved despite the strong fiscal consolidation equivalent to about 1.8 percent of GDP.
There is a real need for the U.S. to help drive world demand. As long as Washington avoids another deep and sudden fiscal adjustment, a plan focused on medium-term adjustment can provide room for the needed recovery of private demand.
Countries still lagging
As we all know, recovery seems to be eluding some crucial economies, most importantly the euro area, where we are forecasting a mild contraction of one-quarter of a percent this year. Germany’s growth is strengthening, but it is still likely to be only 0.6 percent this year. France’s growth will be slightly negative this year, while Spain and Italy will experience substantial contractions.
For European policymakers, there is still much to do, despite all they have accomplished over the past year or so. While these countries are adjusting, including through structural reforms, those measures so far do not compensate for weak internal demand, struggling banks, the absence of credit to drive investment, and deep unemployment.
Governments must continue with the urgent task of fixing their banking systems, by prompting banks to repair balance sheets. This is crucial because the problems of the banking system are preventing low interest rates from translating into the credit needed to lift growth.
The problems of the European financial system also require collective solutions. This should include bank recapitalization through the European Stability Mechanism, a comprehensive banking union that adds a single resolution authority to the recently established supervisory authority, and a deposit insurance fund. There is also a need for greater fiscal integration. All of this is essential if Europe is to climb out of a cycle of crisis and decline.
Meanwhile, in Japan, which has faced a generation of economic stagnation, it is good to see the country forging a new strategy. Japan’s new government has announced a three-pronged approach to revive the economy. These are a higher inflation target and more aggressive quantitative easing, flexible fiscal policy, and structural reforms to raise long-term growth. Immediate action has included setting a 2 percent inflation target with sizable quantitative easing and fiscal stimulus of about 1½ percent of GDP over two years. This is reflected in our forecast of 1.6 percent growth this year and 1.4 percent in 2014.
Japan’s new approach has our support. However, given Japan’s very high level of public debt, fiscal stimulus without a medium-term plan for fiscal consolidation is a cause for concern. It increases the possibility that investors will require a risk premium, and it raises the specter of unsustainable debt further down the road. Moreover, it is key to also proceed with the planned growth-enhancing structural reforms to ensure the complete policy package succeeds in delivering lasting reflation.
Macroeconomic Policy Challenges
The continued problems in the euro area certainly create near-term risks. For the emerging market economies, the primary challenge relates to economic forces they have limited control over. These include weak demand from their traditional markets, managing the pressures from exceptionally loose monetary policy in advanced economies, and preparing for the period ahead when conditions normalize and the price of risk returns to more normal levels.
Role of unconventional monetary policy
In this period of unprecedented economic turmoil, unconventional monetary policy has helped ease tail risks of a market breakdown, restored investors’ appetite for risk, and encouraged a resumption of flows.
Perhaps since unconventional monetary policy is a comparatively new instrument, its impact is not yet fully understood. As such, it may have occasionally added to uncertainty and fueled volatility in capital flows. These risks do appear to be under control right now. But we must be alert to any warning signs.
Some episodes of unconventional monetary policy also have been associated with appreciating emerging-market currencies. However, the resulting drag on competitiveness needs to be balanced against the positive effect of stronger advanced-economy demand, as well as potential terms-of-trade gains from higher global commodity prices.
To better gauge the impact of unconventional monetary policy, we have worked on various macroeconometric models. Our work suggests that a general unconventional monetary policy easing supports sizable output gains in advanced economies and some emerging markets. However, for emerging-market countries that are already facing inflationary pressures, the scale of this impulse can represent a sizable policy challenge. Moreover, in countries where the exchange rate has been allowed to appreciate, this has supported internal demand at the cost of exports.
Implications for Global Liquidity
Now let us turn briefly to the main focus of this conference on global liquidity. As I said at the start, there has been much focus on this issue. But there is also a surprising lack of consensus on how it should be defined and measured. The common element in most definitions appears to center on the “ease of financing” at a particular point in time. This, in turn, is shaped by the macroeconomic environment; the stance of monetary policies; financial regulation; and other factors that guide the actions of market participants. Those factors include the pace of financial innovation and risk appetite.
It has been typical to look at price-based measures to get a sense of liquidity conditions–– including policy rates, as well as those from secured and unsecured money markets, and swap and bond markets. But to supplement prices––especially when markets may not clear, or when stability concerns arise––attention has also been placed on quantity-based measures. In times of turmoil, it is often useful to look at both.
Key quantitative measures of global liquidity have typically focused on the asset side of the balance sheet, and so have generally tracked the evolution of cross-border and foreign currency credit. Complementary measures that focus on the funding side of the balance sheet have also been developed.
This allows a system of classification that is particularly useful in exploring the financial-stability implications of liquidity expansion. Specifically, it allows the distinction of “core” liquidity, which captures the use of traditional deposit-based funding, from “non-core” liquidity, which captures the use of securitization and collateral-based funding. Core liquidity approximates traditional monetary aggregates, such as M2 or M3, whereas non-core liquidity measures the growing role of the shadow banking system.
From a financial stability perspective, both “asset growth” and “noncore funding” are particularly useful for surveillance. These two measures are highly procyclical and may serve as valuable signals of potential problems. In particular, asset growth reflects the cross-border credit extended by banks and other financial institutions that are often associated with the rapid build-up of foreign-currency denominated credit. It is this build-up that can turn around abruptly when financial conditions deteriorate.
Similarly, “noncore” funding indicators can convey information about potential risk-taking in the economy. They can also tell us about the extent to which the global financial system is prone to sudden funding reversals following a change in risk-appetite. Indeed, a key motivation for the IMF’s funding-side approach is the general observation that rapid system-wide credit growth in excess of deposits—funded, by implication, through noncore channels—is typically associated with the accumulation of financial imbalances.
In this context, global liquidity trends may have global consequences. Ongoing IMF research suggests that rising global liquidity tends to boost emerging-market asset prices. However, it also indicates that the cross-country impact of changes to noncore liquidity is somewhat larger than for core liquidity, perhaps reflecting a key funding channel through which resources are allocated to riskier asset classes.
In line with the accelerating pace of financial innovation, the largest and most procyclical component of global liquidity has been the noncore—or shadow banking—component. However, the global financial crisis resulted in a dramatic collapse in non-core liquidity. The elevated aversion to risk and the freezing of collateral-based markets forced shadow banks to sharply scale back their balance sheets.
In this context, a key role for unconventional monetary policy appears to have been to offset this decline by boosting the funding available to traditional “core” banks, resulting in a relatively flat profile for total core and non-core liquidity.
In addition, many unconventional measures were aimed directly at supporting financial stability in specific market segments—such as targeted liquidity provision to securities firms and money market funds, and the extension of repo operations to commercial paper and asset-backed securities in the United States, and the outright purchase of assets through the Securities Markets Program (SMP) in Europe. Such actions helped alleviate fears about an even more catastrophic crisis, and they are likely to have eased the contraction of the shadow banking system, protecting the global economy from the impact of a full collapse in credit.
So far, quantity indicators provide little evidence of a return of excess global liquidity. From the asset side, the crisis resulted in a collapse of cross-border credit over 2008–2009, and since 2010 international claims have remained effectively stagnant. From the funding side, noncore liquidity continues to shrink as a proportion of GDP, and there is no sign of a rebound yet.
So to sum up, unconventional monetary policy measures in advanced markets have supported growth, but raised important policy challenges for countries receiving the resulting capital inflows. These measures have been crucial to ward off global tail risks and reduce the output costs of the global crisis. They have reduced long-term interest rates, spurred growth, avoided deflation, and restored the functioning of financial markets.
But spillovers to capital flows raise important policy challenges for emerging markets, particularly those already facing inflationary pressures. Higher asset prices in emerging markets may be an unavoidable consequence of unconventional policies. But it is important to understand how these policies affect the volatility of prices, as well as their levels. Clear communication, including through forward guidance, will help lower the volatility of capital flows and help recipient countries contain the volatility of exchange rates and other asset prices. As policy makers in emerging markets manage the transition to rebuilding monetary and fiscal policy space, macroprudential and capital flow measures will continue to play a complementary role where conventional monetary management proves insufficient to address specific financial stability issues.
Liquidity trends should still be monitored carefully, and further analysis of the link between unconventional monetary policy and global liquidity measures is needed.
Similarly, given the impact of unconventional monetary policy on global asset prices, a reasonable conjecture might be that these two phenomena are related, and that unconventional monetary policy measures operate in part through global liquidity. But the nature and size of this impact needs to be better understood to gauge this alternative transmission channel.
There are also concerns that, when balance-sheet repair is complete, the previous intermediation channels could result in a rapid resumption in worldwide lending. Indeed, in an environment of low returns, there are a few tentative signs of renewed interest in structured credit products. This suggests that conditions for funding with noncore liabilities may soon improve.
To a certain extent, a revival of credit would be welcome. This would be the upside for the major advanced economies. However, a surge in global liquidity could complicate policymaking for countries already above absorption capacity, and may present challenges for the maintenance of financial stability in countries facing large and volatile capital inflows. This will require continued vigilance by central banks.
I hope that over the next two days your expert analysis and policy experience can shed some light on these—and other related—points. I look forward to the outcomes of this conference, and thank you for your attention this morning.