Expanding world economy is risky business

A Commentary by Rodrigo de Rato, Managing Director, IMF
Published in Globe and Mail
June 18, 2007

The world economy is set to grow again for a historic sixth year, spurred on in no small measure by financial markets and cross-border movements of capital in recent years. But recently risks have been on the rise, particularly in financial markets.

The problem is that good times often lead to overconfidence. For example, recently we have seen a surge in loans fuelling a rapid spread of mergers across the biggest economies, including Canada. Globally, the volume of mergers and acquisitions in 2007 had already reached $2.4-trillion (U.S.) by mid-June, about 50 per cent above the figure for the corresponding period in 2006. Lending for mergers is fine. But if irrational exuberance leads to a fall in credit quality, as indeed happened in the not-too-distant past, then some of these mergers will fail and creditors will be left exposed.

What is the risk of this growth of mergers to the international financial system? I believe it is twofold. First, the counterparty banks that have underwritten deals could find themselves exposed if some of the deals fail before completion. Second, if some of these deals soured, this may trigger a reappraisal of risk that would curtail market access more broadly for lower-rated corporate borrowers. This could adversely affect investment and growth prospects. So, in looking at these deals, investors need to exercise due diligence, and regulators must be vigilant about possible broader effects of these mergers on economies.

Another example of rising risk lies in the massive international capital flows going to many emerging markets and developing countries. For example, JPMorgan estimated that inflows from institutional investors such as pension funds and endowments amounted to $25-billion in 2006, and projected a further increase to between $30-billion and $35-billion in 2007. Such capital flows are a good thing because they promote economic development. A new IMF study shows that countries with developed financial sectors, stronger institutions, sound macroeconomic policies and that are more open to trade will gain most. Indeed the benefits of sound financial sector oversight are manifested in countries like Canada, where openness to capital flows have spurred substantial economic gains.

Hedge funds are becoming key players in today's international financial markets. The assets under management of hedge funds were estimated to be over $1.4-trillion by the end of 2006, more than three times their level in 2000. And there are now estimated to be more than 9,500 hedge funds—14 times more than in 1990. This proliferation should itself raise concerns. Very often one sees a rapid increase in the number of businesses engaged in an activity. In such cases, the quality of late entrants to the business is questionable. Since the consequences of individual hedge fund failures are likely to be more significant than the disappearance of individual dot-coms, this suggests a need for careful oversight.

Although hedge funds bring benefits by diversifying risk and introducing innovation, we have to be mindful of the risks that come with this terrain, especially with new institutions. Monitoring by counterparties should be complemented by measures to increase the transparency of hedge fund operations. Increased transparency would enable counterparties to exercise market discipline effectively and help regulators get a better picture of what is going on in markets. National regulators and policy makers must continue to re-examine and carry out established best practices in order to guard against potential instability in these markets, given the potential of a ripple effect on global financial markets.

These are complex issues and the challenge of balancing the benefits and risks of capital is a responsibility shared by policy makers, and investors and borrowers alike. Today, credit risk is transferred from lenders to stock exchange markets and, through them, to investors, who become the ultimate holders of risk. This evolution, which is broadly positive for financial stability, requires better "financial education" on the part of consumers. The importance of this cannot be stressed enough. The IMF also has a role to play in ensuring that risks are properly managed, and threats to financial stability minimized.

One of our central objectives at the International Monetary Fund is to promote international financial stability. Working with other international bodies, the organization plays a key role in international discussions on these issues, and is deepening its work on them.

The potential for international spillovers is of particular concern to the IMF. As financial globalization grows deeper, so do the risks that turbulence in one country's markets might spill over to others. The IMF is focusing increasingly on mitigating these risks. At the same time, it is also helping to integrate developments in financial markets and the financial sector into economic analysis, with the aim of reducing the frequency and severity of financial crises.

While the forces of globalization can be highly beneficial to global financial stability and to economic welfare, there are risks that need to be closely monitored and managed. Policy makers must remain vigilant on several fronts in the immediate future, even—or especially—in the current benign economic conditions.

Rodrigo de Rato is managing director of the International Monetary Fund



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