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Financial Crisis and Sovereign Risk: Implications for Financial Stability IMF High–Level Roundtable Opening Remarks By Dominique Strauss-Kahn, Managing Director, International Monetary Fund
March 18, 2011
A. Introduction
Good morning. It is my great pleasure to welcome you here this morning. We view these High-Level discussions as an important channel for fostering an international dialogue and soliciting input for our work agenda on financial stability and capital market issues. I thank José Viñals and his team for organizing this one at such a critical juncture.
As you know, the crisis that erupted in 2008 is leaving a legacy of high public debt and sharply elevated sovereign risk. This legacy—at least in the European context—has come close to undermining financial stability and the prospects for recovery. Understanding sovereign risk and how it impacts stability in the financial sector as well as the functioning of debt capital markets has, therefore, become crucial. This is the focus of today’s discussion.
While widely used by market participants and academics alike, the multiple dimensions of the term sovereign risk have not yet been properly grasped. Neither traditional fiscal variables nor measures produced by rating agencies have been able to adequately explain the crisis-related developments and their broader ramifications. Therefore, a wider definition of sovereign risk where core fiscal variables and the macroeconomic context are complemented with elements reflecting broader balance sheet developments, debt portfolio structure, investor base, cross-border linkages, and financial assets of a country would be warranted. This is where this Roundtable comes in—to help explore the multifaceted nature of sovereign risk and set out the policy and operational challenges stemming from it.
One thing is clear: reducing sovereign vulnerabilities—however defined—has become one of the key priorities for policy makers in the aftermath of the crisis. If left unattended, concerns about sovereign risk in advanced economies can undermine the economic recovery and jeopardize global financial stability.
The high levels of debt and related vulnerabilities, and the financial system implications, are being priced in market assessments of sovereign risk. We have recently witnessed major sovereign credit downgrades, increased volatility in sovereign debt markets, and a questioning of government debt as a risk free asset. Initially, risk premia increased substantially in most economies hit by the crisis. More recently, spreads have widened in some mature economies with underlying fiscal vulnerabilities.
Sovereign risks have been transformed in a number of important ways as a direct consequence of the crisis and major fault lines in the financial sector. As the public sector intervened to support financial institutions, distinctions between sovereign and non-sovereign and private liabilities have been blurred, and public exposure to private risks has increased. Contagion channels of transmission among weaker mature market sovereigns have been revealed. Sovereign credit risk concerns have spread to other countries perceived to be afflicted by similar fiscal vulnerabilities, raising sovereign funding costs, and inducing market volatility and short-term financing strains.
Let me turn to the three topics that will be discussed today during this Roundtable.
B. Spillovers between Sovereign Risk and Financial Stability
Understanding the linkages between sovereign risk and the banking sector and how policy makers should deal with these linkages is of critical importance. As seen in this crisis, stress in the financial sector can quickly spill over into the public sector. Conversely, concerns about sovereign risk can come back to haunt the financial sector.
It is with this objective in mind that we have embarked upon the “spillover reports” for five systemic economies—China, the Euro Area, Japan, the United Kingdom, and the United States. These reports will assess the impact of policies in these economies on the rest of the world, exploring the powerful interlinkages through which they are transmitted. Among other findings, the IMF’s spillover analysis underscores the importance of financial linkages, as opposed to trade links, as the main channel through which shocks in any of the major economies could be transmitted around the world.
Several questions arise in this regard. What type of policy responses are required to mitigate the spillovers from the banking sector to the sovereign balance sheet and vice versa? What role, if any, do policies aimed at promoting economic recovery in advanced economies play for financial stability in emerging markets? What policies are needed to restore market discipline and corporate governance? What would be the conditions under which further sovereign support for bank balance sheets is provided? Could stress tests be used in managing sovereign risk as well as banking supervisory risks?
C. Sovereign Risk and Capital Markets
The crisis response across the world has highlighted the benefits of policy coordination, both nationally and internationally. By the end of March, European policymakers will present their vision of broad-ranging reforms. As the IMF said in late-2010, we believe that a comprehensive approach is needed to resolve the issues facing the Eurozone. Reassuring markets is critical to preserving the recovery and containing volatility in sovereign debt markets. If there was ever a time when sound sovereign balance sheet management practices were needed, it is now. Poorly composed and structured debt profiles could intensify debt management risks and through that raise sovereign risks. The latest Global Financial Stability Report, published by the Fund in October 2010, goes into great detail outlining sovereign balance sheet vulnerabilities and challenges to managing debt, and how they are exacerbated by the strains observed in the markets.
Here too there are ample questions. How should debt issuers position their portfolios to mitigate sovereign risk? Would maturity extension and additional cash cushions provide sufficient insurance in the face of another large financing shock? In an environment of growing inflationary concerns, is there a role for increased issuance of inflation-linked bonds? Could these instruments credibly reduce the incentive to inflate away the real size of the debt? In an environment of strong deleveraging, how serious are the concerns for crowding-out corporate issuers? Will sovereign credit differentiation ease over the medium term and will most sovereigns be able to access the market on terms comparable with the recent past?
D. Regulatory Changes
The onset of the crisis was clearly linked to insufficient financial regulation and supervision. Encouraged by rising asset prices and abundant liquidity, financial institutions took unprecedented risks. Key regulatory “gaps” allowed vulnerabilities to grow, reflecting both fast-moving market developments and the inability of regulators and supervisors to keep pace. Moreover, regulators and supervisors—who were led to believe that deregulation is best and that financial markets could police themselves effectively—were often less attentive than they should have been.
The crisis has highlighted the need for financial regulatory reform. The Basel III accord on banking regulation is a major step in the right direction and should deliver a significant qualitative and quantitative improvement in bank capital. The proposed regulatory changes are expected to carry major financial stability benefits, but may also have short term contractionary effects as banks adjust. While our preliminary research suggests that the macroeconomic costs of raising capital and liquidity requirements are likely to be quite moderate, the jury is still out on this one and more work is underway. Our attempts to gain a better understanding of the sovereign risk and regulatory reform linkages include a discussion that took place in Stockholm in July during the last round of our discussions with debt managers from mature and emerging market economies.
Here too questions remain from the point of view of sovereign risk. Will changes to banks’ business models arising from the financial regulatory reforms affect their role as market makers for public debt? What would be the impact of the requirement to hold high-quality liquid assets on the demand for sovereign debt and liquidity in secondary debt markets? Would the macroeconomic impact be different, if tighter requirements were allowed to be implemented over a period of time? Have ratings significantly affected the price dynamics of government bonds and credit default swaps?
E. Conclusion
Let me wrap up. It is clear that the crisis brought to light a number of previously underappreciated vulnerabilities in both the financial and sovereign spheres. This Roundtable offers us a good opportunity to discuss in depth some of these vulnerabilities. I hope that your inputs could play a role in developing a common understanding about the challenges stemming from sovereign risk and in moving towards a better understanding on what its implications could be, if left inadequately addressed. We look forward to your specific suggestions on what role the IMF could play in this regard.
It appears that we have so far avoided a second Great Depression, due largely to unprecedented international cooperation. But, more work lies ahead of all of us. With some hard work, the future will be brighter.
I thank you for joining us today and look forward to your deliberations.
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