Testing the Financial Waters, A Commentary by Rodrigo de Rato, Managing Director, IMF

September 3, 2007

By Rodrigo de Rato, Managing Director, IMF
Published in ABC
September 3, 2007

The recent turbulence in credit markets-stemming from problems in the U.S. subprime mortgage market-has reverberated across global capital markets in recent weeks, and raised worries about implications for the real economy. Everything seems to indicate that the impact on the risk pricing of some financial assets will be felt in the medium term.

The view of the IMF is that global growth is likely to be somewhat affected by these market disruptions but should still remain strong. Although prospects for the United States have been a source of concern, the United States is not the only engine of global growth. Economic fundamentals remain strong in other large industrial countries, as well as in most emerging market economies-with many having current account surpluses and lower public debt levels. A combination of strong economic fundamentals, and appropriate and timely action by central banks and other authorities, should help to calm financial waters and keep the economy on course. Nevertheless, the downside risks to the outlook have undoubtedly increased when compared with a few months ago, and these risks bear close watching. Even if calm returns and economic growth stays strong, the adjustment process for financial markets is likely to be protracted.

The principal risk is of an even deeper disruption of financial markets, or that declining asset prices (of real estate or shares), tightening financial conditions, and weaker confidence could have a more severe impact on both consumption and investment. Encouragingly, however, financial conditions seem to be normalizing, corporate balance sheet positions appear robust, and household finances continue to be sustained by solid employment growth in most countries.

Although recent developments have highlighted some of the risks that come with innovations in financial instruments, it is worth recalling their positive role. Markets play a critical role in mobilizing savings and in allocating them to productive investment, and innovations often make important contributions that help sustain rapid growth and enhance welfare in both advanced and emerging market economies. Innovation in structured credit products have enabled market participants to better diversify risk and lower the cost of credit world-wide, providing an important boost to global growth.

This said, recent developments have provided a stark illustration that some participants have under-estimated the risks related to new complex instruments. With increasing financial globalization, these problems have also spread more widely, and the resulting loss of confidence that this has engendered has contributed to a serious liquidity crisis in money markets. The liquidity support provided by central banks and other monetary authorities in the United States, Europe, and Asia has been an appropriate response, and we are seeing signs that liquidity conditions are returning to normal.

This episode, however, has reminded us that increasingly interdependent financial markets are most likely to deliver on the promise of growth and stability if they are transparent and well regulated. This is an area where the IMF has been active for some time. For example, for the past decade, the Fund has taken a leading role in promoting statistical transparency regarding both economic and financial information. The special data dissemination standards (SDDS) initiative spearheaded by the Fund has provided a mechanism for countries to enhance their data transparency. The Fund is also actively engaged with regulatory bodies and in international fora to help determine appropriate levels and types of transparency. The international community, through the IMF, must address the consequences of market regulation and transparency for investors and consumers and a good time to do so is at the upcoming IMF meetings in October.

The current financial market turbulence is a manifestation of risks that many observers-including the IMF-had warned about in recent months. Increased transparency, tempered over-confidence, and correct risk valuation are some of the areas where action is needed. The current crisis represents the first real test of several categories of innovative financial instruments, especially those that are used to securitize private credit risk. Market players have responded with a re-appraisal of the risk involved. This is a natural response, particularly following an extended period of low volatility and high liquidity in credit markets, during which incentives structures may have contributed to the relaxation of credit standards. While certainly costly for some market participants, the turbulence provides an opportunity to learn what can be done to set the stage for a more resilient global financial system going forward.


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