Dealing with the Financial Turmoil: Contingent Risks, Policy challenges, and the Role of the IMF
IMF News, March 12, 2008
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- Published: March 12, 2008
I. Introduction
- Speech by Mr. John Lipsky, First Deputy Managing Director of the International Monetary Fund, At the Peterson Institute, March 12, 2008.
- Key framing:
- The financial crisis that began in a relatively small part of the U.S. financial system has grown into a global challenge, threatening sustained and stable global growth of the past five years.
- Risks of further escalation are rising and decisive policy action is required to restore normal functioning of financial systems in advanced economies.
- Immediate priorities: make available adequate short-term liquidity and strike the right balance between market solutions and public sector intervention.
- IMF role: assess which countries have space for countercyclical macroeconomic policies; consider contingent public sector interventions; cooperate with other institutions (e.g., Financial Stability Forum); stand ready to use record liquidity if needed.
II. Diagnosis: The Importance of Contingent Risks
- Core observations:
- Initial U.S. housing-market weakening spread unexpectedly across markets and economies.
- Financial-macro linkages: traditional banking and securities markets faltered simultaneously; spiraling loss of confidence in risk management and innovative products.
- Impaired intermediation of savings and risk of broader tightening in credit conditions despite central bank actions.
- Faster and stronger cross-border spillovers via trade and financial channels; potential nonlinear amplification through confidence and balance sheet effects; high and rising correlation of global equity prices and risk of sudden capital flow reversals.
- Specific contingent risks ("unthinkables"):
- Emergence of a global financial decelerator: downward credit spiral from rising defaults or margin calls, deleveraging, asset price deflation, broad global consequences including vulnerability of corporations and banks in emerging economies to wider spreads or retrenchment in capital flows.
- Upside risk: overly aggressive fiscal stimulus and monetary easing leading to excessive global liquidity growth, overheating, rising energy and commodity prices, accelerating inflation pressures and deteriorating inflation expectations.
- Global imbalances:
- Disorderly unwinding avoided so far; exchange rate movements have been orderly relative to interest rate differentials.
- Concerns about lack of movement in currencies of key surplus countries, notably in Asia.
- Multilateral Consultation on Global Imbalances: participants unveiled policy plans to sustain growth while reducing imbalances; acknowledged the adjustment involves slowing domestic demand and stronger net exports in principal deficit countries (mainly the United States).
- If global growth slowdown is to be avoided, surplus economies must quicken domestic demand growth and reduce savings rates.
- The Consultation's policy plans from 2007 IMF Spring Meetings "retain their relevance."
III. Financial Sector Policies: Stemming the deterioration
- Three-pillar strategy overview (pillar 1: financial sector policies):
- Overarching near-term goal: rebuild confidence and restore financial system effectiveness; policies should also increase longer-term resilience and efficiency.
- Market liquidity:
- Central banks (Fed, ECB, others) adopted innovative strategies; spreads remain uncomfortably high.
- Need to balance flexible liquidity provision with avoidance of moral hazard.
- Re-examine how banks and supervisors deal with liquidity risk; banks should have incentives to self-insure; supervisors must refocus on liquidity shocks from funding profiles or off-balance-sheet commitments.
- Central banks should reassess liquidity provision capabilities: rapid funds to broad counterparties, range of maturities, multiple currencies, wide set of collateral; remove stigma from using standing facilities; conduct coordinated review for harmonized liquidity arrangements.
- Disclosure and recapitalization:
- Improve disclosure practices so investors and counterparties understand assumptions and positions behind balance sheets.
- Regulators must ensure no incentives to hide assets/liabilities off balance sheets; supervisors to examine systemic consequences of fair value accounting.
- Need for more timely disclosures by large institutions worldwide where material.
- Weakened institutions should replenish capital; keep deleveraging orderly.
- Contingency plans if balance sheet contraction by non-bank financial institutions creates new pressures and investors are unwilling to provide capital injections.
- Maintaining capital cushions is essential to resist pressures to reduce credit excessively and to support new lending.
IV. Macro Policies: Cushioning the Blow
- Role of macro policies (pillar 2):
- Monetary policy: first line of defense, especially in advanced economies; complicated by high commodity prices and inflation risks.
- Federal Reserve has taken aggressive action; central banks in Canada and the United Kingdom reduced policy rates; ECB kept rates on hold but could respond flexibly.
- Effectiveness of monetary policy may be limited where spreads on consumer and corporate products (e.g., jumbo mortgages, higher-risk corporate and consumer loans) remain high and offset policy-rate reductions.
- Fiscal policy and IMF assessments:
- IMF argues countercyclical fiscal policy may be needed; U.S. temporary and targeted fiscal stimulus should help support demand.
- IMF advising members to consider room for temporary fiscal measures if needed; preliminary assessment suggests:
- Major advanced and emerging economies—accounting for two-thirds of global GDP—could allow automatic stabilizers to operate fully in the event of a deeper downturn.
- A smaller number—accounting for nearly one half of global GDP—have already or would have fiscal room to implement a discretionary stimulus, if needed.
- Policy consistency and global context:
- Multilateral collaboration and policy consistency represent pillar 3 and need strengthening.
- Fiscal stimulus in the United States should be strictly temporary due to longer-term fiscal challenges.
- For some countries (e.g., China): shift policy mix to allow tighter monetary policy supported by exchange rate appreciation and looser fiscal policy with emphasis on social safety net spending.
- For oil exporters in the Middle East: boost government spending but focus to avoid further inflation pressures.
- Contingent use of public funds:
- Keep all options on the table, including potential use of public funds to safeguard the financial system after market solutions exhausted.
- Not advocating taxpayer funds to aid individual institutions; balance moral hazard considerations against need to safeguard the financial system.
- IMF is thinking about contingent interventions and what policies might prove most effective.
V. Role of the Fund
- IMF responsibilities and positioning:
- Issues require global solutions; IMF offers global membership, multilateral perspective, and technical expertise.
- IMF role in current turmoil: identify contingent risks and develop potential policy responses; use expertise to analyze global developments.
- Lines of defense:
- The Fund is not the first line of defense—this lies with central banks, supervisors, and regulators (close partners).
- The Fund is not the second line of defense—this lies with fiscal authorities; IMF maintains deep knowledge of members' fiscal policies via surveillance.
- Third line of defense: public intervention to safeguard financial systems at times of extreme distress—options may need consideration if contingent risks materialize.
- Commitment:
- IMF’s Articles of Agreement charge it with responsibility for sustaining global economic and financial stability.
- IMF intends to help members anticipate and deal with current challenges and those that might lie over the horizon.
Speech by Mr. John Lipsky, First Deputy Managing Director of the International Monetary Fund, March 12, 2008.