Scanning the Horizon: Monitoring and Managing Financial Market Risks — Speech overview
IMF News, June 19, 2007
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- Published: June 19, 2007
Global economic outlook and macroeconomic context
- The world economy is experiencing an extended expansion described as "the best season of growth and stability since the 1960s" and "seems likely to continue."
- United States:
- U.S. economic prospects judged "good."
- Expectation that the U.S. economy will "regain momentum gradually" as the drag from the housing correction and business-sector softness dissipates.
- Recent data indicate a recovery in manufacturing in the first quarter of this year.
- Sub-prime mortgage risk premia have experienced "a striking fall" in recent months; effects on general financial market conditions "seem to be limited so far."
- China and India growth projections:
- China: growth "likely to be around 10 percent in 2007 and 2008."
- India: growth "likely to be around 8 percent."
- Both imply continuation of "the very strong growth of 2006."
- Role of macro policy frameworks:
- Fiscal consolidation cited as a foundation of global success.
- Canada reduced public debt by 30 percentage points of GDP over the past decade.
- Central bank independence and inflation targeting (New Zealand and Canada cited) have reduced inflation risk premia and supported lower real interest rates and higher growth.
- Recent monetary policy moves: European Central Bank raised policy rates; Bank of Canada signaled concern about increased inflation risks and potential near-term rate increases.
- Emphasis on the need for pre-emptive action to contain inflation risks.
Canada-specific analysis and recommendations
- Canada characterized as a "highly successful participant in the global economy" with decade-long growth exceeding that of the United States, the euro area and Japan, founded on openness to trade and investment.
- Investment and financial sector development:
- Investment in the financial sector identified as important over the next few years.
- Canada's banks described as "sound and well capitalized."
- Recommendations to deepen markets for high-yield bonds and venture capital to strengthen the financial sector as an engine for growth.
- Suggested policy actions:
- Make the banking system more open to foreign investment and mergers to improve competition.
- Strengthen investment framework and supporting legislation.
- Update regulation of securities; note that "Canada is currently the only G-7 country without a common securities regulator."
- Establishment of a common securities regulator recommended to improve investor protection and enable mutual recognition with other countries, including the United States.
- Sensitivity to U.S. growth:
- A 1 percent change in U.S. output affects Canada's GDP by "somewhere between 0.3 and 0.7 percent of GDP"; the Fund believes "the true figure is at the higher end of that range."
Financial globalization: scale, benefits, and vulnerabilities
- Financial globalization measured by the sum of gross external assets and liabilities as a share of GDP has "increased threefold since the mid-1970s," with acceleration since the mid-1990s and the most dramatic increases in high-income countries.
- Fund calculations (as of 2004):
- Average sum of external assets and liabilities was "more than 100 percent of GDP in low-income countries."
- "More than 1½ times GDP in middle-income countries."
- "More than 5½ times GDP in high-income countries."
- Benefits listed:
- Wider pool of investments for global savers.
- Broader market for borrowers lowering cost of capital.
- Encouragement of local capital market and financial sector development.
- Foreign direct investment fostering technology transfer, improved productivity, and employment.
- Risks highlighted:
- Large capital inflows into emerging and developing countries can reverse abruptly, exposing recipients to shocks.
- Fund study finding: recipient countries best positioned to benefit from foreign inflows if they have stronger financial infrastructures, stronger institutions, sound macroeconomic policies, and more open trade systems.
Financial market developments and systemic risk concerns
- General observation: greater willingness to take risks in financial markets driven by search for yield and greater ease of transferring risk.
- Specific areas of concern:
- Sub-prime and Alt-A U.S. mortgage markets:
- Many borrowers appeared to assume continued house-price appreciation and ignored downturn consequences.
- Lenders sometimes "cynically encouraged" such behavior while passing most risks to other investors.
- Growth in risk-transfer markets:
- Global issuance of loan securities expanded from "around $0.5 trillion in 2000 to $2.75 trillion in 2006" and became more geographically widespread.
- Banks' lending behavior increasingly driven by the price at which loans can be sold in securities markets.
- Risk-transfer markets can enhance stability by spreading exposures, but often lack transparency about ultimate risk holders and their capacity to manage risks.
- Two systemic unknowns specified as unanswered:
- How well liquidity in credit risk transfer or securitized loan markets will hold if defaults rise sharply.
- The aggregate effects of increasingly sophisticated hedging strategies combined with high leverage on the system's ability to dynamically hedge risks.
- Hedge funds:
- Assets under management estimated "to be over US$1.4 trillion by the end of 2006," more than three times the level in 2000.
- Estimated "more than 9,500 hedge funds—fourteen times more than in 1990."
- Rapid proliferation raises concerns about the quality of late entrants and potential systemic significance of individual failures.
- Large private equity buyouts:
- Dramatic growth in large buyouts financed by a rising proportion of debt.
- Potential risks:
- Banks underwriting deals could be exposed if deals fail before completion.
- Failures could trigger a reappraisal of risk, curtail market access more broadly, and adversely affect investment and growth.
- Call for investors to exercise due diligence and for regulators to remain vigilant regarding systemic implications.
Policy recommendations and institutional responses
- Strengthen transparency and oversight:
- Increase transparency of hedge fund operations to enable counterparties to exercise market discipline and help regulators monitor cross-border spillovers.
- Complement counterparty monitoring with measures that improve visibility into hedge fund activities.
- International monitoring and cooperation:
- Adequate international monitoring and cooperation urged to identify and address potential cross-border spillovers quickly.
- The Fund is deepening work on financial globalization and integrating financial market/sector analysis with macroeconomic policy analysis.
- The Fund's role as a forum for multilateral discussion of common problems emphasized.
- For emerging and developing countries receiving large inflows:
- Strengthen financial infrastructures and institutional frameworks quickly.
- Interim macroeconomic policy mix recommended: "a combination of reserve accumulation, nominal currency appreciation, lower interest rates, and, in some cases, fiscal tightening."
- For Canada specifically:
- Move to a common securities regulator to improve investor protection and enable mutual recognition.
- Encourage openness to foreign investment and mergers in the banking sector, and strengthen investment frameworks and supporting legislation.
- For market participants and regulators more broadly:
- Preserve risk diversification and innovation (including hedge funds) while ensuring precautions against systemic problems.
- Exercise due diligence on leveraged private equity activity and monitor potential systemic exposures.
Source: Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund, Economic Club of Toronto, June 19, 2007.