Financial Crisis and Sovereign Risk: Implications for Financial Stability — Opening Remarks By Dominique Strauss-Kahn, Managing Director, International Monetary Fund

IMF News, March 18, 2011

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Financial Crisis and Sovereign Risk: Implications for Financial Stability — Opening Remarks By Dominique Strauss-Kahn, Managing Director, International Monetary Fund

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Bibliographic details

• Authors: Dominique Strauss-Kahn
• Published: March 18, 2011

Introduction

• Event: IMF High–Level Roundtable: Financial Crisis and Sovereign Risk—Implications for Financial Stability.
• Location and date: Washington DC, March 18, 2011.
• Core premise:
  • The 2008 crisis left a legacy of high public debt and sharply elevated sovereign risk.
  • In the European context, these legacies have come close to undermining financial stability and recovery prospects.
  • A wider definition of sovereign risk is warranted: core fiscal variables and the macroeconomic context should be complemented with elements reflecting broader balance sheet developments, debt portfolio structure, investor base, cross-border linkages, and financial assets of a country.
• Purpose of the Roundtable: explore the multifaceted nature of sovereign risk and set out policy and operational challenges stemming from it.

Key findings on sovereign risk dynamics

• Markets and measurement:
  • Traditional fiscal variables and rating agency measures have not been able to adequately explain crisis-related developments and their broader ramifications.
  • High levels of debt and related vulnerabilities are being priced into market assessments of sovereign risk.
  • Observed market outcomes include major sovereign credit downgrades, increased volatility in sovereign debt markets, and questioning of government debt as a risk free asset.
• Transformation of sovereign risk since the crisis:
  • Public interventions to support financial institutions blurred distinctions between sovereign and non-sovereign/private liabilities and increased public exposure to private risks.
  • Contagion channels among weaker mature market sovereigns were revealed.
  • Sovereign credit risk concerns have spread to countries perceived to have similar fiscal vulnerabilities, raising sovereign funding costs and inducing market volatility and short-term financing strains.

Spillovers between sovereign risk and financial stability

• Analytical work:
  • IMF has embarked upon “spillover reports” for five systemic economies—China, the Euro Area, Japan, the United Kingdom, and the United States—to assess policy impacts on the rest of the world and the transmission channels.
  • Spillover analysis underscores the importance of financial linkages, as opposed to trade links, as the main transmission channel for shocks from major economies.
• Policy questions posed:
  • What policy responses are required to mitigate spillovers from the banking sector to the sovereign balance sheet and vice versa?
  • What role do recovery-oriented policies in advanced economies play for financial stability in emerging markets?
  • What policies are needed to restore market discipline and corporate governance?
  • Under what conditions should further sovereign support for bank balance sheets be provided?
  • Could stress tests be used in managing sovereign risk as well as banking supervisory risks?

Sovereign risk and capital markets

• Observations:
  • Crisis responses highlighted benefits of policy coordination nationally and internationally.
  • Reassuring markets is critical to preserving recovery and containing volatility in sovereign debt markets.
  • Poorly composed and structured debt profiles could intensify debt management risks and raise sovereign risks.
  • The Global Financial Stability Report, published by the Fund in October 2010, details sovereign balance sheet vulnerabilities and debt management challenges.
• Policy and structural questions:
  • How should debt issuers position portfolios to mitigate sovereign risk?
  • Would maturity extension and additional cash cushions provide sufficient insurance against another large financing shock?
  • In an environment of growing inflationary concerns, is there a role for increased issuance of inflation-linked bonds, and could these credibly reduce incentives to “inflate away” the real size of debt?
  • In an environment of strong deleveraging, how serious are crowding-out concerns for corporate issuers?
  • Will sovereign credit differentiation ease over the medium term, and will most sovereigns regain access to markets on terms comparable with the recent past?

Regulatory changes and implications for sovereign risk

• Diagnosis:
  • The crisis was linked to insufficient financial regulation and supervision; regulatory “gaps” allowed vulnerabilities to grow.
  • Regulators and supervisors were often less attentive than required amid fast-moving market developments and a prevailing deregulatory mindset.
• Reform direction:
  • Basel III on banking regulation is identified as a major step expected to deliver qualitative and quantitative improvements in bank capital.
  • Proposed regulatory changes are expected to carry major financial stability benefits, but may have short-term contractionary effects as banks adjust.
  • Preliminary IMF research suggests macroeconomic costs of raising capital and liquidity requirements are likely to be quite moderate, though more work is underway.
• Sovereign risk specific questions:
  • Will changes to banks’ business models affect their role as market makers for public debt?
  • What is the impact of requirements to hold high-quality liquid assets on demand for sovereign debt and liquidity in secondary debt markets?
  • Would macroeconomic impacts differ if tighter requirements were implemented over a period of time?
  • Have ratings significantly affected the price dynamics of government bonds and credit default swaps?

Conclusion and policy implications

• The crisis revealed underappreciated vulnerabilities in financial and sovereign spheres.
• Reducing sovereign vulnerabilities has become a key policy priority to avoid undermining recovery and global financial stability.
• The Roundtable aims to develop a common understanding of sovereign risk challenges and elicit specific suggestions on the IMF’s possible role.
• Final outlook: unprecedented international cooperation helped avoid a second Great Depression, but substantial work remains to secure a brighter future.

Opening Remarks by Dominique Strauss-Kahn, Managing Director, International Monetary Fund at the IMF High–Level Roundtable, Washington DC, March 18, 2011

References

• United Kingdom and the IMF
• United States and the IMF
• Speeches
• Dominique Strauss-Kahn
• IMF High–Level Roundtable: Financial Crisis and Sovereign Risk—Implications for Financial Stability
• Press Release: Definition and Measurement of Sovereign Risk Need to be Broadened, IMF Roundtable Concludes
• PRESS CENTER
• https://www.imf.org/en/home