## Scanning the Horizon: Monitoring and Managing Financial Market Risks — Speech overview

_IMF News, June 19, 2007_

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## Bibliographic details
- Published: June 19, 2007

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### 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.*

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## References

- [Canada and the IMF](http://www.imf.org/external/country/CAN/index.htm)
- [Japan and the IMF](http://www.imf.org/external/country/JPN/index.htm)
- [United States and the IMF](http://www.imf.org/external/country/USA/index.htm)
- [Speeches](https://www.imf.org/en/news/searchnews)
- [Rodrigo de Rato y Figaredo](https://www.imf.org/external/np/omd/bios/rrf.htm)
- [PRESS CENTER](http://presscenter.imf.org/)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp061907_