Impact of the Global Financial Crisis and Its Implications for the East Asian Economy, Keynote Speech by Mr. Takatoshi Kato, Deputy Managing Director, International Monetary Fund, At the Korea International Financial Association, First International Conference
IMF News, October 21, 2009
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- Impact of the Global Financial Crisis and Its Implications for the East Asian Economy, Keynote Speech by Mr. Takatoshi Kato, Deputy Managing Director, International Monetary Fund, At the Korea International Financial Association, First International Conference
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- Published: October 21, 2009
I. The impact of the crisis on East Asia — key findings
- The intensity of the downturn was much larger than anticipated based on historic correlations with advanced western economies.
- In the fourth quarter of 2008, GDP in Asia (excluding China and India) plummeted by close to 15 percent on a seasonally adjusted annualized basis.
- Crisis transmission and domestic effects:
- International bank flows to Asia turned negative due to sudden deleveraging.
- External bond issuance came to a halt.
- Equity markets and local currencies—with the exception of the yen—recorded large losses as capital flowed out.
- Shortages in dollar funding briefly spilled over into domestic money markets.
- Exports collapsed by around 30 percent in many Asian countries, and more than 40 percent in Japan.
- The external shock fed through to domestic demand with sharp contractions in investment and, in some instances, consumption.
- The rebound:
- Asia is leading the global recovery; industrial production in export-dependent Asia regained most lost ground since September 2008, returning to pre-crisis levels in a few countries, including Korea.
- The rebound was driven by a sharp rebound in export volumes and by domestic demand.
- Global financial conditions eased: corporate credit spreads narrowed and net equity inflows picked up.
II. Lessons for financial regulation and supervision — findings and policy implications
- Bank capital frameworks:
- The crisis exposed major shortcomings in regulatory frameworks for bank capital.
- Agreed corrective actions by the Basel Committee and the G20 at Pittsburg include:
- Common shares and retained earnings likely to become the predominant form of tier 1 capital (implications for Japanese banks holding hybrid bonds and preferred shares).
- The capital adequacy ratio based on risk weighted assets to be complemented by a leverage ratio likely based on simple assets (implications for Japanese and Indian banks holding large amounts of government paper, which has a zero risk weight under Basel II but would enter the leverage ratio at face value).
- Introduction of counter-cyclical capital buffers above minimum capital requirements (macro-prudential regulation requiring banks to build capital buffers based on variables that vary over the business cycle, such as credit growth or bank earnings).
- Liquidity management:
- Shortcomings in regulation and supervision of liquidity management were revealed.
- The Basel Committee and the G20 plan to introduce a longer-term structural liquidity ratio.
- Excessive reliance on wholesale funding has been an issue in some Asian countries, particularly Korea, Australia, and New Zealand; New Zealand has introduced a core funding rule to reduce reliance on short-term financing.
- Institutional arrangements and central bank role:
- The crisis highlighted the interconnectedness of financial stability and lender-of-last-resort facilities, often handled by different agencies.
- Debate reignited over whether central banks should be in charge of financial supervision and regulation to better perform lender-of-last-resort functions and access required information.
- Countervailing concerns: assigning financial stability mandates to central banks could jeopardize central bank independence and the credibility of inflation targeting.
- Monetary policy and financial stability:
- Many believe lax monetary policy played a role in creating the credit bubble; few believe it is easier to clean up after a bubble.
- Debate on whether central banks should prevent asset bubbles; prudential regulation should be the first line of defense, but central banks may need to use traditional monetary policy tools to lean against unsustainable increases in credit and indebtedness.
- Regulatory perimeter and supervision capacity:
- Insufficient regulatory perimeter allowed banks’ leverage to be larger than assumed via exposure to off-balance sheet entities.
- Korea’s Financial Investment Services & Capital Markets Act (enacted this February in the speech’s timeframe) removes restrictions separating financial service providers and introduces a negative list for new financial products — a welcome development but one that must be matched by supervisory capacity to prevent regulatory arbitrage.
- Regulatory and supervisory capacity needs to keep pace with market growth and rapid innovation.
III. Sustainability of the current upswing and exit policies
- A. Sustainability of the current upswing — assessment
- The current recovery is unlikely to maintain the momentum of recent months; growth may not return to pre-crisis levels soon.
- Much of the rebound is driven by restocking of global inventories after production fell more than final demand at the crisis peak; this is partly unsustainable unless final demand recovers.
- Asia’s fiscal response has been larger than in the average G20 country; exports and industrial production benefited from car scrapping schemes and fiscal stimulus abroad, but car scrapping schemes may bring forward sales and lead to lower than normal sales in 2010.
- Fiscal stimulus in major advanced economies cannot go on for long where debt levels are projected to rise to 115 percent of GDP by 2014.
- Exchange rate devaluations supporting recovery are not likely to last; Korea’s strong exports partly reflect gains in market share rather than increased global demand.
- Asia remains very dependent on demand from U.S. consumers; Asia’s dependence on demand from outside the region has not changed markedly since the 1990s and has increased in some instances.
- Dependence of Korea and Taiwan POC on final demand from China has increased steeply and now rivals their exposure to the U.S.
- Demand in advanced economies is projected to remain weak for some time, with advanced economies growing below potential and unemployment rising well into 2010; Western consumers need to repair overextended balance sheets.
- IMF projections (outlook summary):
- World output to contract by 1.1 percent in 2009 and grow by just over three percent in 2010.
- Asia is projected to grow by 5¾ percent in 2010, with China recording 9 percent, India 6.4 percent, Korea 3.6 percent, and Japan 1.7 percent.
- B. Exit policies — recommendations and considerations
- Timing exit policies is challenging; distinguishing a policy-driven rebound from a self-sustaining private-sector expansion is difficult.
- The Fund’s view: the risk of premature exit from monetary easing far outweighs the risk of sustained monetary accommodation.
- With output gaps projected to remain large and negative, the risk of inflation is negligible.
- Asset prices do not seem out of line with fundamentals and can be contained through prudential regulation (as done in China and Korea); letting exchange rates appreciate would also help contain asset bubbles.
- It seems too early to exit from accommodative fiscal policies in Asia, where there is substantial scope for fiscal stimulus in many countries, in contrast to many advanced economies.
- Postponing fiscal adjustment does not mean inaction: governments can signal commitment to fiscal sustainability by announcing medium-term fiscal consolidation plans and reforming pension entitlements.
- International coordination of exit strategies is key:
- The synchronicity of the crisis facilitated coordinated introduction of unprecedented policies, but the recovery may be less synchronized.
- Leakage from fiscal policies could lead to free-rider problems and sub-optimal provision; spillovers from monetary policies also require careful international coordination.
- G20 leaders in Pittsburg agreed on a process of mutual assessment; the IMF is asked to report regularly to the G20 on global economic developments, patterns on growth, and suggested policy adjustments, building on bilateral and multilateral surveillance.
IV. Medium-term sources of growth and reserve accumulation
- A. Medium-term sources of growth — observations and policy directions
- U.S. consumers powered recent global and Asian growth by reducing savings rates dramatically; with the housing bubble burst, U.S. household saving to disposable income has increased to over 5 percent, from close to zero in 2007.
- Asia and other emerging markets have relied on an export-led growth strategy, but this strategy may be less successful going forward; it is not possible for all economies to boost current account balances simultaneously.
- Asia may need to rely more on domestic sources of growth.
- China:
- Scope to raise domestic demand via better social insurance and improved access to credit to reduce precautionary saving and boost household consumption.
- Addressing governance at state-owned firms could lead them to retain less earnings.
- Letting the exchange rate appreciate would shift activity from capital-intensive export sectors to labor-intensive nontradables, raising the labor share of income and the contribution of consumption to GDP.
- Korea and Japan:
- Less room to increase demand; Korea’s household savings rate is already quite low and both countries face large demographic pressures likely to reduce saving.
- The nontradables sector could become a significant source of growth after long neglect under export-led strategies.
- Key ingredients for rebalancing towards nontradables:
- Level the playing field between tradables and nontradables (e.g., address tax incentives favoring manufacturing in Korea).
- Open the service sector to competition, including from abroad (health and education remain largely closed in Korea).
- Boost productivity of small and medium-size enterprises (SMEs), which account for the lion share of service sector output; curtailment of SME credit guarantee schemes (expanded in response to the crisis in Japan and Korea) may be required as conditions improve.
- B. Reserve accumulation — assessment and alternatives
- Official reserves played a crucial role during the crisis; some observers conclude countries should accumulate more reserves, but this can be questioned.
- Ways to reduce the need for self-insurance:
- At the country level: sound economic policies to enhance policy credibility and confidence in currencies.
- At the regional level: bilateral and multilateral swap arrangements can diversify risks; extension of the Chiang Mai reserve pool is welcome.
- At the global level: largest degree of risk diversification could be achieved.
- G-20 and IMF resource issues:
- G-20 leaders at their April Summit called for a near tripling of the IMF’s lending resources to $750 billion, with Asian countries among the main contributors.
- Steps have been taken to reform and expand the Fund’s lending facilities over the past year, but the Fund’s resource base could be increased further; even after its recent tripling, it is smaller as a share of global GDP—and even smaller as a share of global capital flows—than when the Fund was created.
- A top priority for the Fund’s legitimacy and effectiveness is increasing the quota and voice of underrepresented emerging market economies; reforms agreed in April 2008 need prompt approval.
- The G-20 called for completion of the next step in improving representation for emerging and developing countries by January 2011.
- In Istanbul, IMF members supported a shift in quota share to dynamic emerging market and developing countries of at least five percent from over-represented countries to under-represented countries.
Concluding remarks — summary of policy messages
- Financial sector supervision and monetary policy tenets have been called into question; the central bank focus on inflation fighting should not be abandoned but adjusted pragmatically.
- Reforms are needed in liquidity management, adopting a systemwide view, and expanding the regulatory perimeter.
- The global economy has turned the corner largely due to massive policy support; exit policies should be formulated now but implemented only after clear signs that the recovery is firmly underway.
- The crisis may represent a structural break from the decade when the U.S. consumer was the major source of global growth, with important implications for Asia’s export-led model and for international institutions like the IMF as policy coordinator and provider of insurance.
Keynote Speech by Mr. Takatoshi Kato, Deputy Managing Director, International Monetary Fund, Seoul, Korea, October 16, 2009 — published October 21, 2009.