The Growing Integration of the Financial Sector and the Broader Economy: Challenges for Policy Makers, Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund

November 23, 2006

Speech by Rodrigo de Rato
Managing Director of the International Monetary Fund
At the Colegio de Economistas
Madrid, Spain
November 23, 2006

As Prepared for Delivery

Your Excellency Madam President of the Community of Madrid
Your Excellency the Rector of Universidad Complutense
Your Excellency the Dean of the Colegio de Economistas of Madrid
Most Illustrious Vice-Deans
Ladies and gentlemen

It is for me a great pleasure that the Colegio de Economistas has thought about me and has invited me to join it in an honorary position. I would like to start by thanking the President and the rest of the Governing Council for this great honor. I also thank the Vice-Dean, Juan Iranzo, for his warm words.

The subject of my talk today is the growing integration of the financial and real sectors of the economy. While perhaps not as popular a subject for public discussion as globalization, integration between the financial sector and the broader macroeconomy is no less important. Financial and macroeconomic developments are closely intertwined at both the national and international levels, although the degree of integration varies across countries and regions according to the levels of financial and economic development. Understanding the complex relationship between the financial and real sectors of the economy is essential for the design and implementation of policies to promote macroeconomic stability and growth.

It is also important for the financial sector to assess appropriately, and incorporate into its analyses and decision-making processes, the profound changes and transformations under way in the global economy, with their paradoxes, which are sometimes difficult to explain. Examples of such transformations are the rapid increase in productivity worldwide over the past few years; the shock in the real terms of trade implied by the increases seen in raw material prices, partly related to the integration and growth of emerging countries in the global economy; and the rapid institutionalization and innovation taking place on financial markets, with the proliferation of derivatives markets and their spectacular ability to transfer risks.

However, the financial markets appear to be demonstrating the difficulty of assessing these developments and are sending seemingly mixed messages: trends in interest rates on bonds, compared with developments on the equity markets and changes in monetary policy; the low volatility of the markets in the context of such significant changes; and the structure of the capital flows in which the emerging countries receive investments, with record low risk premiums, together with income generated by their current account surpluses, which they then recycle to the developed markets through investment of their accumulated reserves. These are three thought-provoking examples, to which I shall return.

But first, a few figures help to highlight the magnitude of these developments.

Globally, financial development has taken place much more rapidly than the development of the real economy. Between 1990 and 2005, the estimated sum of equity market capitalization, outstanding total bond issues (sovereign plus corporate), and bank assets in the world economy rose from 81 percent of GDP to 137 percent of GDP.

The growth of the derivatives markets has been much more rapid. The notional amount of derivatives outstanding in over-the-counter markets tripled over the past five years to $285 trillion, that is, more than six times global output and almost 50 times the size of the U.S. public debt market. Although these notional figures grossly overstate the underlying risk, they are indicative of the accelerated process of innovation currently occurring in the financial sector.

Financial crises, such as the Asian crisis, have been wake-up calls on the need to understand better the two-way relationships between the financial sector and the wider economy. These crises brought home the idea that failure to develop and strengthen the financial sector can put an enormous brake on macroeconomic stability and economic growth. They demonstrated that in a world where capital markets are growing quickly, financial system weaknesses may trigger not only a run on deposits in the banking system but also a flight from the currency, sudden changes in private capital flows, and a situation in which financial, currency, and fiscal crises may reinforce each other.

These crises spurred interest among researchers and policymakers alike in financial stability and its relationship to overall macroeconomic stability. However, while much progress has been made in recent years in understanding the links between the financial and the macroeconomic, there is still much work to be done in this regard. Today I would like to explore the subject further, and also encourage you to do more research on it.

I will begin with a brief review of current economic and financial conditions, which will illustrate the close interaction between financial and macroeconomic developments. Then I will highlight some areas where further exploration and research would be useful. Finally, I will discuss some of the challenges that the integration of the financial and real sectors poses for policy makers, and mention briefly what the Fund is doing to help its members meet these challenges.

Recent Global Developments and Trends

I will begin with a review of global developments.

The world economy continues to enjoy rapid growth, low and stable inflation, and benign financial market conditions. Even as the U.S. economy slows, global economic expansion has become more balanced and broad-based, with the euro area recovery now more sustained, the Japanese expansion continuing, and many emerging markets growing quickly.

The strength of the global economy has provided a broad underpinning for the resilience of the international financial system. During the business cycle expansion phase, high asset prices, low levels of bad loans, and increased capital market activity have all helped to improve the profitability of financial institutions in many countries with both mature and emerging markets. Balance sheets of corporations and financial institutions have strengthened significantly, with many accumulating substantial liquid assets, and bankruptcy rates remaining near record low levels worldwide. These developments have helped put the financial sector in a strong position to cope with periods of corrections and volatility on the markets and to deal better with the cyclical challenges.

However, there are several downside risks to the global economic outlook. First, the rapid cooling-off in the U.S. housing market could lead to a pronounced slowdown in the U.S. economy. Second, an intensification of inflationary pressures, in the context of tightening productive capacity use and a possible slowdown in productivity growth, may require greater monetary tightening than currently expected. Third, although recent corrections in oil prices may mitigate inflationary pressures, those prices remain vulnerable to supply shocks and political uncertainties because of continued limited spare capacity in the oil industry. Fourth, there remains the possibility of disorderly exchange rate adjustments associated with the financing of global imbalances.

Under these risk scenarios, international financial markets could be tested in the period ahead, as occurred in May/June 2006 when investors scaled back their exposures to high-yield assets. The macroeconomic risks may be compounded by some elements of concern in financial markets themselves. Markets appear to be pricing assets solely in the benign baseline scenario, with apparently insufficient provision in their valuations for existing risks. The term structure of interest rates and credit risk premiums at record lows seem to bear this out. Also, given the complexity and size of the new derivatives markets and structured products, illiquidity or operational problems may exacerbate disruptions on the markets. Although these instruments have helped to distribute credit risk more broadly and in normal times have contributed to financial stability, we still do not have all the information required to determine their behavior in periods of serious turbulence.

Should these downside risks in financial markets materialize, their effects could disseminate rapidly throughout the global economy, given the high degree of integration of global financial markets. It is important for the markets to be able to incorporate low-probability situations with potentially major implications in their decisions, especially in light of the current profound changes in the global economy to which I referred at the beginning of my remarks, when I also pointed to the presence of apparent paradoxes that are difficult to explain.

In light of the existing risks, the persistence of such low risk premiums as observed and the low level of market volatility are somewhat puzzling. Indeed, apparent inconsistencies can be perceived in the current financial market environment, and they require reflection.

First, low long-term yields, especially when there is an inverted rate curve, usually point toward expectations of a growth slowdown, while rising equity and narrow credit spreads usually signal the reverse. Second, very low market volatility contrasts with a number of uncertainties, including that related to the path of central bank interest rate policies into 2007. Finally, it seems that, notwithstanding the improvements in macroeconomic management and in the related debt structures, narrowing sovereign credit spreads across a number of emerging countries cannot be fully explained by the improvements in their fundamentals. In addition, global economic financing patterns show that it is the emerging countries (oil exporters: +$335 billion and China: +$160 billion) and Japan (+$167 billion) that are financing the U.S. current account deficit (-$800 billion).

Some of these above-mentioned developments can be explained in part by factors such as the ample liquidity that currently exists in global markets and the "search for profitability" in a low-interest rate environment. However, to explain all this, we need to analyze a whole series of structural changes taking place in the global economy and in global financial markets. These changes may be grouped into three categories.

One category of structural change is the growing integration and new role of emerging market countries, particularly China and India, in the global economy. The rapid growth of China and India may also be contributing to expectations of low global inflation, and hence reduced long-term risks in financial markets, because of their abundant labor. This effect, however, may be counteracted by upward pressure on commodity prices resulting from the rapidly rising demand for primary commodities and energy in these countries.

Emerging market economies, especially Asian countries with high saving rates, along with Middle Eastern economies, have also helped forge new patterns of global financial flows, in terms of both direct investment and the recycling of funds through reserve accumulation. At a recent conference on capital flows held in Washington, it was determined that reserve accumulation by central banks of oil-producing and other emerging countries had a major influence on the behavior of U.S. bond rates (and may have contributed to a reduction of about 90 basis points in those rates), even though it was emphasized that the principal variable explaining the behavior of bonds was the increased credibility of central bank policies.

I would like to stress here that one of the major causes of most of the saving and investment patterns occurring globally and leading to this particular pattern of capital flows is the difference in levels of financial system development. Accordingly, the improvement of financial systems, to make them sounder and more resilient, is becoming one of the most important structural reform policies.

Another group of structural trends is the growing sophistication of financial markets and risk management. The rapid growth of credit risk transfer instruments, such as credit derivatives, has enabled banks to manage their credit risk more actively and to distribute risk to a diverse range of investors. In parallel, hedge funds have grown rapidly also, fuelling the development of risk transfer markets by providing liquidity. The wider dispersion of credit risk has increased the ability of the financial system as a whole to absorb potential shocks, which may have enhanced financial stability.

However, as I stated earlier, the stability impact of risk transfer markets has not yet been tested during intense phases of economic slowdown and major disruptions on the markets. Furthermore, these markets introduce other kinds of risk into the financial system, such as counterparty risk and operational risk resulting from insufficient capacity to handle the rapid increase in trading.

The final category of structural trends I wish to note here is population aging. Population growth is a major issue in some parts of the world, particularly in developing countries. At the same time, population aging is a challenge in many other countries, particularly industrial ones. Population aging increases the needs for household saving because of longer life expectancy and higher health care costs associated with aging. At the same time it exposes households to increased longevity risk, that is, the risk of outliving one's resources.

To enable households to meet these challenges, a variety of financial instruments is required to help raise long-term saving and investment and manage longevity risk. These instruments include, for example, very long-term (such as 50-year) bonds and annuities. However, many of these instruments and their associated financial markets remain underdeveloped or will need to be created, even in mature economies. Meeting the challenges of population aging will therefore require further financial market innovation and development. The demand for long-term investment products is another of the special factors bringing pressure to bear on the rate structure and helping to explain its paradoxical behavior.

In addition, population aging may have important influences on asset prices, financial structure, and financial stability through changes in the pattern of saving and investment and in the risk preferences of households and asset managers.

Understanding Better the Integration of Financial and Macroeconomic Issues

I have just shown how developments in the financial sector closely interact with those in the broader economy. As I have said, these interactions are not fully understood. Let me now discuss and point to a few more areas where further research can be illuminating. This issue is of central relevance to the Fund and to policy makers, and we at the Fund are giving increasing priority to research in these areas.

A major difficulty is that the role of financial institutions and markets in economic activity is often not an integral element of standard macroeconomic models. Factors such as financial stability, balance sheet effects, and the credibility of policies are difficult to incorporate into standard macroeconomic equations. There is no unified body of economic theory that explains and models the relationship between the financial sector and the overall macroeconomy. Indeed, there is no widely accepted framework for assessing financial sector stability. The necessity to use a variety of approaches rather than one standard economic model that is generally applicable complicates our task. This is certainly an area where much research remains to be done.

As noted, financial systems vary greatly in their degree of sophistication. In developing the conceptual frameworks, it would be important to know whether these differences in financial structure are relevant for economic policy. There may be a need to tailor conceptual frameworks to the financial conditions existing in individual countries.

In this regard, there is evidence that differences in financial structure do matter. For example, financial systems dominated by arm's-length transactions (markets with less bank density and greater disintermediation) have been found to better accommodate resource re-allocations from declining to expanding sectors than systems dominated by relationship-based transactions. As arm's-length transactions tend to be more characteristic of capital markets than of banks, this would suggest that economies with more developed capital markets may be more flexible and dynamic, and therefore more likely to experience higher productivity and growth, than those with bank-based financial systems. Could this be a factor explaining the higher productivity and growth in the United States compared to European economies? I will leave you with this question to ponder.

I want to focus, in particular, on the connection between financial development and macroeconomic stability. Observers have noted that the frequency and amplitude of business cycles appear to be on a declining trend across advanced economies, a development that some have attributed in part to the growing relative importance of financial markets. There are several possible ways in which financial development can produce such an outcome.

First, through financial stability. I have already explained that the development of credit risk transfer markets may have increased the stability and resilience of the international financial system. Could it be that as financial markets develop, the degree of pro-cyclicality between the financial system and the real economy diminishes? This subject is worth investigating further.

Second, through more effective and credible monetary policy. The development of money markets enables central banks to use market-based instruments of monetary policy and to target monetary variables more effectively. This strengthens monetary control and improves the effectiveness of monetary policy. In modern central banks, better institutional frameworks, their clarity as regards objectives and strategies, and the greater attention paid to transparency and communications are playing a central role in enhancing the credibility and effectiveness of policy. This may well have set the stage for less volatility in financial markets and more stable economic activity. This issue should be explored further.

Third, through smoothing of consumption over the business cycle. By this, I mean the ability of individuals to sustain their consumption in times of falling income, and to increase their saving in times of rising income. Financial development provides the means for individuals to do this. Research shows that in more market-based financial systems, households are able to access a larger amount of financing and seem better able to smooth consumption in the face of temporary changes in their income. Of course, counteracting this effect is evidence that corporations' access to credit in an economic downturn is more secure in relationship-based banking systems, which would argue in favor of bank-based financial systems. This issue needs to be explored further.

Fourth, through capital market development. Capital market development enables countries to reduce their reliance on foreign borrowing. This is particularly important in emerging market countries. As is well known, external debt is a major source of vulnerability in such countries, and capital market development could therefore potentially exercise a stabilizing influence.

I think that Spain provides a good illustration of all these mechanisms that link the soundness and efficiency of the financial sector with the dynamism of the economy. The financial sector in this country has been able to provide opportunities for investment to the savers and efficiently finance the rapid development of the economy. It has contributed to a more efficient distribution of risks and more generally, to better governance of enterprises and stronger institutional development.

Global Policy Challenges and the Finance-Macroeconomics Nexus

I come now to my last subject-the challenges that policymakers face because of the integration of the financial and real sectors. I have already discussed one major challenge: the need to understand better the interaction between the financial sector and the broader economy. There are, however, other challenges, both for macroeconomic policy and for financial regulation and supervision.

At the macroeconomic level, a major challenge is to strengthen financial sector surveillance and integrate it into overall macroeconomic surveillance. Financial sector vulnerabilities may initiate or amplify macroeconomic shocks, and impede policy responses. Early identification of such vulnerabilities will therefore be crucial to prevent macroeconomic crises. This will require the development and use of the appropriate analytical tools, including balance sheet analysis and early warning systems, and the compilation of timely and high-quality statistical data.

Monetary policy will have to adapt continually to the evolving financial system in order to maintain macroeconomic stability. The monetary transmission mechanism will evolve over time. The impact of interest rate changes on asset prices, and via asset prices on consumption and residential investment, will become increasingly important. In addition, to the extent that structural changes in the economy exert a stabilizing effect on the financial system, and possibly the overall economy, this will have implications for the conduct of monetary policy that central banks will need to understand properly.

Abrupt corrections of asset prices, including exchange rates, may have an adverse impact on key macroeconomic variables. More broadly, asset prices have become increasingly important in the transmission of domestic and global business cycles, and will likely assume greater importance in the assessment of demand conditions and in macroeconomic policy decisions. As such, we need to understand better the linkages between asset price movements and the macroeconomy.

The unprecedented increase in cross-border capital flows in the context of growing integration of global capital markets also have implications for both domestic monetary policy and international policy coordination. These capital flows have enhanced global growth, but they also expose the host economies to substantial vulnerabilities because a stoppage or reversal of such flows could have major ramifications for macroeconomic stability and growth.

At the national level, cross-border flows may impose severe constraints on policy choices. For example, domestic credit booms may be initiated or exacerbated by foreign capital inflows, and monetary policy choices in curbing such booms may be limited by the vulnerability to capital flow reversals. In the case of debt-related inflows, concerns about currency and interest rate mismatches in balance sheets may limit countries' ability to adjust exchange rates and/or interest rates in response to external shocks.

At the international level, as you all know, global capital flows have been of paramount importance in sustaining global macroeconomic stability. The large global imbalances that exist today have been able to persist only because they are supported by global capital flows. The orderly adjustment of such imbalances is a major challenge of international policy coordination. There is consensus that adjustment of these imbalances will involve efforts to rebalance global saving, investment, and consumption. The question is, how much and how fast will this adjustment be. Global asset allocation preferences are crucial in the debate. Gradual adjustment will depend in part on continued demand by foreigners for U.S. assets while corrective action is taken on a global scale. The risk, otherwise, is a sudden re-direction of capital flows away from the U.S. that would be quite disruptive to the global economy.

From a growth perspective, countries will need to tackle the structural weaknesses in the financial sector that impede saving, investment, and efficient resource allocation. These include legal and institutional weaknesses that hinder credit assessment, use of collateral, contract enforcement, and creditors' rights, all of which may limit potential borrowers' access to credit and constrain investment.

The close inter-relationships between the financial sector and the rest of the economy also have important implications for the soundness of financial institutions, and therefore need to be taken into account by bank regulators and supervisors. These relationships have attracted increased attention in recent years, and several regulatory issues have been highlighted. I will mention briefly just one of these issues.

This issue is the need to strengthen macroprudential regulation and supervision further. Bank regulation and supervision are often directed at limiting distress in individual banks, in part to protect the savings of depositors. While this microprudential approach is important, regulators should think increasingly also of limiting the probability that financial stress at the systemic level will adversely affect the macroeconomy-or vice-versa, that developments in the macroeconomy will create stress in the financial system. The macroprudential approach, in other words, focuses on the relationship between the financial system and the economy as a whole. Its ultimate goal is to prevent output costs from financial distress.

Macroprudential analysis closely complements and reinforces early warning signals and other analytical tools to monitor vulnerabilities and prevent financial crises. A crucial requirement of such analysis is the availability of a set of indicators of the soundness of the financial system. The IMF has been at the forefront of efforts to apply macroprudential analysis and to develop financial soundness indicators in member countries, in the context of its Financial Sector Assessment Program (FSAP). I would strongly urge countries to give priority to the development of financial soundness indicators-at a minimum, it would be desirable to have a set of core indicators for the banking system.

Concluding Thoughts

To conclude, further work on financial sector issues is urgently needed to inform macroeconomic policy choices. The increasing importance of financial markets in achieving macroeconomic objectives is a major feature of financial development and globalization. Given the absence of a unified theoretical model to integrate financial and macroeconomic analysis, a pragmatic approach will be needed. Such an approach should emphasize, among other things, modern supervisory and regulatory frameworks, the use of selected analytical tools as appropriate, closer interaction with market participants, and the exercise of sound judgment.

Although I have insisted on the need for further understanding to encourage some of you in this line of research, many institutions are devoting substantial resources to this, and much has already been done. As I have noted, this work is a major priority in the Fund. We have been strengthening our efforts to work with countries to better integrate the financial sector into macroeconomic surveillance work. Financial sector surveillance has become a core area of Fund surveillance, focusing on both stability and efficiency issues. In a world of integrated financial markets and large-scale capital flows, the Fund can only monitor the international monetary system and the global economy effectively if such surveillance is underpinned by a solid analysis of macro-financial linkages and cross-country spillovers.

The centrality of the financial sector has been officially incorporated into the Fund's Medium-Term Strategy, which provides added focus on helping members meet the challenges of globalization.

Specific actions have been taken on a broad and complex range of issues, such as multilateral consultations with systemically important members or groups of members to contribute to the analysis and correction of global imbalances, vulnerability assessments to prevent financial crises, and collaboration with countries to build their institutional capacity and manage to create more resilient, integrated financial markets that can contribute to stability and growth. Banking supervision and regulation are often geared toward limiting problems that may arise for the banks, in part to protect the savings of depositors. I encourage economists like you, in academia and in policy-making institutions, to join us in this work. The stakes are high. If we succeed, prospects are good for a more stable and productive global economy.


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