Speech

John Lipsky, First Deputy Managing Director, IMF
Keynote Speech at the 40th Annual Meeting at the American Association of the Chambers of Commerce in Latin America (AACCLA)
September 17, 2007

As Prepared for Delivery

1. Introduction

Good afternoon, Ladies and Gentlemen.

It is a pleasure and a privilege to address the AACCLA on the occasion of its 40^th annual meeting. Your organization provides important leadership in promoting economic progress and integration in this hemisphere. I am happy to have the opportunity to extend my best wishes and congratulations to the organization on this special occasion.

This meeting comes at a unique moment. Following the best growth performance in over thirty years, and after an exceptionally vibrant period in financial markets, the global economy today is facing financial market turbulence that could undermine what had been viewed as a very favorable outlook.

I will address today three principal aspects of the current situation that I am sure are of interest to this organization: First, what is the source of the current financial volatility, and what initial lessons can be drawn? Second, how have global economic prospects been altered by the financial market turbulence, and what are the implications for Latin America and the Caribbean? And, finally, what can the region do to capitalize more fully on the potential gains from trade and financial openness, while making itself more resilient to global shocks?

My main messages are straightforward: First, while the strains in global financial markets have not played out fully, some moderation in global growth is to be expected in the coming year. Of course, it is not yet possible to reach firm conclusions about exact magnitude. In any case, the IMF will publish the latest World Economic Outlook in only about one month—so we just have until then to refine our forecasts!

However, as the global economy had been performing well, it is reasonable to anticipate that the global expansion will be resilient. Notably, the improved fundamentals evident in many emerging market countries has made them better prepared to weather external challenges—particularly when compared with previous periods of financial stress. There has been some notable recent progress in terms of improved economic fundamentals in Latin America and the Caribbean that should have relevance in the current uncertain environment. Nonetheless, there remains substantial scope for the region to make additional advances.

2. Financial Markets and the Global Outlook

I will begin with a few remarks on the latest developments in global financial markets.

In many ways, the market turbulence in evidence during the past three months represents the first test under strain of innovative financial instruments, markets and institutions that gained importance during the past few years. In particular, many of the new instruments were designed to translate changes in credit quality into prices of new forms of marketable securities. As such, these innovations helped to promote the expansion of private sector finance. To some degree, this period was analogous to the 1980s creation of instruments—such as interest rate derivatives—that translated changes in market risk into securities prices. These instruments—once viewed with suspicion and concern—have become essential elements of modern financial practice.

In part, the recent strains were triggered by heightened uncertainty regarding the strength of underlying economic fundamentals. However, the strains also reflect previously under-recognized weaknesses in certain financial market structures, or in market practices.

As I'm sure you all know well, strains first appeared in the US variable-rate sub-prime mortgage market, where rapidly increasing issuance had been associated—especially in 2006—with a progressive and striking deterioration in prudential standards. This deterioration eventually was reflected in weakening market conditions for collateralized debt obligations (known as CDOs), a new class of instruments that bundled these mortgages into complex—but supposedly liquid—securities.

Until the deterioration in credit quality of the underlying subprime mortgages was recognized, the market for CDOs—like for many credit-linked securities—had reflected such deep investor optimism about the economic and market outlook that some observers had remarked that they were "priced for perfection." I don't need to spell out the details of the current spreading concentric circles of concern about market conditions—at least regarding some specific sectors—and about the potential impact of market developments on the strength of global growth. But it is worth noting that many of the recent market disturbances have come as a surprise, even to experienced market participants and to public authorities.

For example, money markets typically are very tranquil. Nonetheless, some specific segments—in particular the Asset Backed Commercial Paper that has been used in many cases to finance stocks of subprime mortgages—essentially has become illiquid. Thus, commercial paper outstanding in the United States has fallen by over 13% since mid-July. Even short-term interbank lending has become impaired in some markets. Virtually none of this was anticipated clearly, even though the rise in delinquencies in US variable-rate subprime mortgages was first noted clearly over a year ago.

There is a lesson to be drawn here, but it is not a new one: Periods of market discipline typically are uncertain with regard to timing, uneven in their impact, and messy in application. Nonetheless, market discipline tends to be effective. We need to make sure that this is the case this time.

For now, central banks and financial market regulators have been taking action in order to maintain market liquidity. This is essential, as securities markets need to provide continuous pricing in order to function effectively. Moreover, officials have made clear their willingness to take additional action, if needed. However, keeping markets liquid—and combating excessive volatility—is very different from defending market levels, or from protecting specific institutions or investors from their own faulty judgments. Eventually, this period of market disruption will dissipate, and it will be time to draw needed lessons about market structure and practices. It should be remembered that the advantage of securitized markets is that they are intended to provide continuous pricing, avoiding bouts of illiquidity. Moreover, it is crucial to recognize that securitized markets inherently place the primary burden of risk assessment on end-investors, not intermediaries. We will need to make sure that market participants are adequately prepared and that transparency is sufficient for markets to operate effectively.

Fortunately, as I have noted already, the global economy entered into this period of financial turbulence in relatively good shape. During the first half of this year, global growth was more than 5% at an annual rate. Moreover, emerging market countries accounted for more than half of this growth. The unusual strength of these economies should help to sustain the global expansion despite the current challenges. Thus, moderation of growth in the coming year would still imply a solid pace of expansion.

3. The Latin America and the Caribbean (LAC) Region

Turning briefly to Latin America and the Caribbean, the regional economy has been growing at the most vigorous pace since the 1970s. Last year, growth accelerated to 5%, with this growth relatively well distributed in the region. We had been expecting the region to grow at 5% this year, and around 4½ % next year. Obviously this forecast remains contingent—at least to some degree—on developments elsewhere, and it will be updated in the upcoming World Economic Outlook forecast.

The region's strong recent performance reflects both "good fundamentals" and "good luck." With external conditions less supportive, this is the time to underscore the importance of "good fundamentals," and to build on the gains that have been achieved. In the time that I have left, I would like to touch on three areas where much can be accomplished: (1) Investment and Productivity; (2) Fiscal Policy; and (3) Financial Market development.

The region's recent growth—while strong relative to its own history—still lags other developing regions. Moreover, faster growth is a necessary condition in order to make more meaningful reductions in poverty. By necessity, this will have to be achieved through a combination of increased investment and faster productivity growth. But additional progress is possible: The region's productivity growth from 1990-2006 was some 2 percentage points per year slower than that of emerging Asia over the same period. Investment ratios also are substantially lower than the developing country average—in fact, by some 6 percentage points of GDP.

There are reasons for optimism, as it is recognized widely in the region that the investment climate must be improved. Nonetheless, it is noteworthy that of the top 50 economies ranked for the overall ease of doing business by the World Bank's Doing Business survey, only two countries—Mexico and Chile—are from Latin America. I am sure that you will continue to take a leadership role in supporting new improvements in this crucial area.

It is equally important to consider other drivers of prosperity—specifically, openness and diversification. The vital role these factors plays was demonstrated in a study conducted by our Research Department that looked at the predictors of sustained income growth—defined as per capita GDP growth of at least 3.5 percent per annum, maintained for at least seven years. According to this work, an increasing variety and share of manufacturing exports is one of the most striking features common to cases of rapid, sustained growth. Complementary work has been completed recently by the Commission on Growth and Development. The Commission's studies show that without exception, cases of sustained growth have been driven by an increasing GDP share of merchandise and services exports.

There have been encouraging recent developments in the LAC region, in terms of increasing and diversifying trade. Here again, I know that you are providing needed leadership.

Regional fiscal policy improvements have been notable recently, including increased primary surpluses. However, higher commodity prices accounted for more than half of the average increase last year of 1.5 percentage points of GDP in the region's primary fiscal surplus. More needs to be done to reduce the dependence of public revenues on commodities, however. Current spending also seems to be taking a precedence over public investment in Latin America. Public investment outlays have remained largely flat in relation to output. Public debt in Latin America, while greatly reduced to some 50% of GDP (from 65% of GDP in 2002) is still high, and comparable to where it stood in 1999. Thus, new efforts will be needed to make sure that fiscal policy makes room for the investment spending necessary to boost growth and reduce poverty.

Finally—and notwithstanding the current financial market difficulties—I would like to stress the importance for growth of strengthening local financial markets. The development of local markets is essential to mobilizing saving for productive investment, for providing governments a stable source of financing, for providing needed credit to consumers and businesses, and thus for spurring higher rates of growth. A recent study carried out by our Research Department shows that countries with stronger financial sectors are better placed to reap the benefits of increased cross-border capital flows, while coping better with periods of market volatility.

This is an area where much remains to be accomplished, but I am sure that you all are familiar with the essential building blocks of strengthened financial markets. These include the development of a well-specified legal, regulatory and supervisory framework, and the availability of accurate and timely information. The main point here is that the recent market turmoil outside the region should not impede progress in developing deeper and more sophisticated financial markets. The potential for improved economic performance from strengthened markets is significant.

Let me conclude by summarizing my main points: The still on-going turbulence in financial markets represents a significant test, but one that should not undermine the global economy's positive momentum. Nonetheless, the change in external conditions underscores the need for the region to remain focused on making fundamental improvements that will generate the faster growth that will be necessary for meaningful poverty reduction, enhanced stability and increased resilience. This audience—and your colleagues around the region—will have a crucial leadership role in making this happen.

Thank you for your attention. I would be happy to take your questions.