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The Financial Crisis and Economic Outlook--Lessons for Securing the Benefits of Financial Deepening, Keynote address by Mr. Takatoshi Kato, Deputy Managing Director of the International Monetary Fund
March 26, 2008
March 26, 2008
As Prepared for Delivery
First, I would like to thank Bank Indonesia for hosting this very timely meeting, even in the middle of the national holidays. I will frame my remarks against the backdrop of our latest outlook for the global and Asian economies, and the financial market turmoil that emerged last year. With this as a background, I will then attempt to set the stage for this session by outlining the links between financial deepening, stability, and growth, and highlighting some lessons for policy makers from the ongoing crisis.
1. Financial markets began to seize last August and we are now facing one of the largest financial shocks in many decades. As you know, the crisis originated in a relatively small segment of the U.S. financial market—namely subprime residential mortgages. It quickly spread however, across financial market segments and borders, and now threatens systemically important institutions and markets.
2. Policy makers and financial institutions have taken action in response to these threats. Major central banks took welcome steps to broaden the range of counterparties and collateral, and extend the term for liquidity support, in some cases coordinating the provision of swap lines with other central banks. In addition, policy interest rates have been cut, and fiscal and other measures have been taken to mitigate the downdraft in mortgage markets. Steps have also been taken by some large U.S. and European banks to recognize losses and to boost capital, and some institutions have been recapitalized or taken over. However, with the further deterioration of both the U.S. housing market and overall economic outlook, recent weeks have seen further pressures on liquidity, deleveraging, and an assistance package for the fifth largest U.S. investment bank.
3. Indeed, we are increasingly concerned about the vulnerability of the global financial system to a self-sustaining downward spiral in credit and growth. Rising defaults or margin calls that force asset sales even as the value of collateral deteriorates could produce new rounds of deleveraging and asset price deflation.
4. The immediate priority is to stem these downward pressures and avoid any further erosion of confidence in the stability of the financial system in advanced countries. For public authorities, this will require them to encourage banks and other financial institutions to enhance their disclosure and transparency and to rebuild capital. They will also need to ensure that liquidity is available to solvent institutions, and take prompt and effective action in cases where solvency is in question. There is also likely to be a role for macroeconomic policies to help support demand.
5. The spreading turmoil has already slowed the global expansion (after its best five-year run in a generation); and activity is projected to slow further.
• In our latest update to the World Economic Outlook, in January 2008, overall global growth was projected to decline from 4.9 percent in 2007 to around 4 percent in 2008, and we are in the process of revising that projection downward.
• While we have not finalized our new growth projections for the United States, it is clear that our forecast for this year will be markedly lower than the 1½ percent in our January update, despite aggressive easing by the Fed and timely implementation of a fiscal stimulus package. Growth in the euro area decelerated in the fourth quarter of last year and is now expected to be below the 1.6 percent we had forecast in January.
• Inflation has generally increased across all countries, boosted by commodity prices, and is a growing concern.
6. Emerging market and developing countries are not de-coupled from industrial countries. Altogether, their growth is expected to slow somewhat from the nearly 7 percent we had forecast in January, led by China and India. Thus far, the direct spillovers to these economies have been contained, partly because direct exposure to the U.S. subprime mortgage market has been limited. That said, increased risk aversion is affecting spreads, equity markets, and external financing in emerging markets.
7. Moreover, risks to the outlook for the global economy and emerging markets remain skewed to the downside. Let me briefly mention three key risks I see going forward:
8. First, there is a real risk that the financial market turmoil could intensify, with important implications for the global economy. A number of indicators clearly highlight this concern:
• The U.S. housing market continues to deteriorate and declining property prices mean that the weakness has spread beyond the subprime segment.
• Rising spreads have led to continued mark-to-market losses for banks on their holdings of debt securities. The cost of credit has increased significantly, especially for higher-risk corporates and consumers, as growth prospects have been marked down.
• Similarly, equity markets valuations have come under pressure across both advanced and emerging economies, with financial sector shares being particularly hit hard.
• Banks in the major advanced economies have also tightened lending standards, as they seek to preserve capital in the face of heavy losses and balance sheets that have been expanded by the need to meet underwriting commitments.
9. Indeed, the credit squeeze could become a credit crunch and trigger a more severe growth slowdown. And of course a severe downturn in the United States would have global spillover effects—including on trade and commodity prices—threatening emerging market and developing countries' growth prospects.
10. The recent rise in inflation complicates the outlook and the ability of policymakers to respond. Rising oil, commodity, and food prices have boosted headline inflation. While the growth slowdown in advanced economies is alleviating demand pressures, there is concern—especially in the euro area—that high headline inflation may feed through into inflation expectations. Inflation risks are also a concern in some emerging markets, where domestic demand is stronger and where food and fuel account for a large share of their consumption.
11. Finally, exchange pressures and still large global imbalances remain a concern. Although the U.S. current account deficit is projected to decline to below 4½ percent in 2008, it remains large, and risks relating its financing persist. The dollar's weakness in recent years is putting increasing pressure on balance sheets and trade competitiveness for many countries, both in Asia and elsewhere. At the same time, the dollar's lack of movement against currencies of key surplus countries, and the ongoing crisis, leaves the system vulnerable to abrupt exchange rate movements.
12. What does all of this mean for Asia? First, Asia has weathered the subprime crisis relatively well so far. The subprime-related exposures of financial institutions in Asia are substantially lower than those in the United States or Europe. Estimates of Asia's exposure (excluding Japan) are in the range $20 to $30 billion. However, this may not be the whole picture. Given the complexity of some of the financial instruments involved, classification of exposures is not straightforward and there has been some concern about the quality and timing of disclosures in Asia. Nevertheless, we do not expect a major direct impact from subprime exposures. The limited exposure in Asia reflects a combination of factors. Structured credit and related derivative products are at a relatively early stage of development; prudential regulations have steered investments towards investment-grade instruments; and profitable domestic activities have limited the "search for yield" elsewhere.
13. Despite the limited direct impact, Asia will be affected by the crisis and accompanying global slowdown. Asian financial markets continue to be broadly guided by global developments, and thus there have been large corrections in equity markets and higher volatility of equity flows to Asia. While growth should remain robust in 2008, downside risks to the outlook have also increased. Let me expand on that point a little:
• We expect growth to moderate by more than 1 percent in 2008, as weaker external demand lowers the region's export growth. Domestic demand, while not independent of external demand, should remain relatively buoyant.
• Intra-regional trade is booming, reflecting the specialization of many of the region's economies as part of sophisticated production chains. However, final demand for Asia's exports still emanates largely from outside the region. Indeed, Asia's exposure to demand elsewhere in the global economy (including the United States and Europe) continues to rise.
14. Thus a larger-than-expected decline in advanced economy growth rates is a key risk. The impact via trade of lower growth in the United States may be relatively modest—our estimates suggest that a 1 percentage point reduction in U.S. growth would reduce growth in Asia by perhaps ½ percentage point on average. But a broader slowdown in advanced countries would have a more substantial impact on Asia. Also, there may well be other channels, such as lower consumer and business confidence or higher borrowing costs, which would adversely affect domestic demand across the region. So far, credit conditions have tightened and credit default swap (CDS) spreads for some Asian banks having been elevated recently, particularly for banks reliant on wholesale and dollar funding. But there are no signs yet of a credit crunch. The impacts from the trade, confidence, and financial channels are likely to be larger in the more open economies or in economies with weaker domestic demand.
15. Inflation, like elsewhere, is another concern in Asia. Given the still robust pace of activity, inflation pressures have risen as food and fuel price increases have begun to generate some second round effects.
16. The current juncture poses difficult choices for policy makers in Asia. Current growth momentum and inflation levels suggest that price stability concerns should take precedence over measures to support growth. However, the level of uncertainty is high, and if growth in the region were to begin to weaken, many Asian economies would have scope to ease monetary or fiscal policies.
17. In terms of financial sector policies to support stability and growth, the current crisis offers some valuable lessons for Asia. I will now turn to these lessons and theme of this meeting—namely, the financial deepening, stability, and growth nexus.
18. It is generally recognized that financial development is supportive of long-term growth, including through the easing of financing constraints of firms and increased efficiency of investment. Stronger financial institutions and greater risk diversification can also strengthen an economy's resilience to adverse shocks. These ideas are very familiar to this audience, as reflected in the financial sector development initiatives in this region. Importantly, improved policies have delivered macroeconomic stability, which is a fundamental basis for credit markets to thrive.
19. Financial innovation can bring great benefits, but as we have seen in the context of the rapidly evolving structured credit and derivative markets, it can also involve substantial risk. These risks stem in part from innovations that add layers of complexity and sophistication, and in part from the evolution of incentives. Indeed the complexity and opacity of structured credit, and proliferation of business models, such as the "originate-to-distribute" approach to lending, are often cited as factors underlying the current turmoil. However, the bigger picture is one in which the macroeconomic environment—with a prolonged period of low interest rates, high liquidity and low volatility—led financial institutions (and others) to underestimate risks. And, as often happens during periods of rapid innovation and benign economic conditions, market practice, regulatory and prudential norms, and supervisory oversight lagged.
20. The current crisis should not overshadow the case for financial market development, innovation, and integration. Recent research at the IMF confirms that countries with more developed financial sectors, stronger institutions, sound macroeconomic policies, and more open trade systems are better placed to benefit from financial globalization and are considerably less likely to suffer the instability that greater openness to global capital flows could entail.1 But this begs the question of how best to develop the financial sector and minimize risks?
21. Asia is in the advantageous position of being able to learn from the risk-management and regulatory failures elsewhere. Perhaps the most fundamental lesson for oversight is that it should strive to give market participants incentive to internalize the systemic consequences of their decisions. In particular, financial market decision makers and market participants are often are rewarded for short-term performance and have little reason to appropriately cost the sort of infrequent but very damaging "tail events" that we are now experiencing. Let me give some specifics:
• In recent years, banks shifted a large share of loans to off-balance sheet entities with wide maturity mismatches, in part to avoid regulatory capital charges. However, the opacity of these off-balance sheet transactions has severely undermined the ability of banks to gauge counterparty risk and impaired the smooth working of money markets.
• The increasing distance between the originating bank and the ultimate holder of credit risk, including through the use of structured debt instruments, significantly lowered credit discipline and underwriting standards.
• And the increased investment by banks in ABS CDOs, including in their off-balance sheet conduits, exposed them to much greater market and liquidity risk.
22. Therefore, there is an urgent need for a broadening of the perimeter of supervision. The introduction of Basel II in several Asian countries will help in this regard, given the increased risk sensitivity of capital charges and supervision. But there will still be a need for rigorous consolidated supervision, to ensure the necessary upgrading of supervisory capacity, and to avoid undue declines in regulatory capital.
23. Let me mention some other preliminary lessons for policies over the medium and longer term that we might draw from the ongoing crisis:
• Risk management practices of many financial institutions were deficient. Both managers and supervisors will need to play a more active role in scrutinizing these practices, especially with regard to off balance sheet entities and structured products, particularly in "good times," when risks are least obvious.
• Some of the financial engineering of recent years may have been spurred partly by the premium that regulators and investors had placed on high ratings. This suggests the need to adopt a differential ratings system for structured instruments, taking better account of their different risk profile, and to review how prudential norms would then need to be modified for these instruments.
• Weaknesses in the application of accounting standards and gaps associated with the valuation and the disclosure of complex structured products contributed to the depth and the duration of the current crisis. National authorities need to collaborate with international standard setters to achieve better cross-border convergence of accounting and disclosure practices.
• Central banks should be careful to ensure that the range of collateral and counterparties that they can deal with is sufficiently broad and—given the growing importance of cross-border finance—work to avoid significant differences in practice.
• Crisis management frameworks, including deposit insurance, have in some cases proved inadequate and need to be strengthened.
24. Let me end with some of the more immediate issues facing policy makers and market participants in Asia—particularly, policies for mitigating the danger of an even more disorderly deleveraging and its effects:
• I would advise central banks and regulatory authorities to make sure that they have the capacity to react rapidly, which may require changes to operational frameworks that take into account financial sector innovation and development.
• Special effort is needed to ensure timely and consistent reporting of exposures by financial institutions, particularly for structured credit products and other illiquid assets. Institutions need to write down assets as losses arise and develop and disseminate plans on how capital positions will be boosted.
• Early action is needed to resolve troubled institutions, and supervisors must be proactive in addressing weaknesses, acting promptly to require remedial action and to intervene—but doing so based on well designed triggers, to avoid the use of public funds for indemnifying shareholders or managers.
• Countries whose domestic banks have borrowed extensively from external sources to support domestic credit should prepare for sudden changes in market sentiment as financing conditions in global markets have tightened significantly.
25. In closing, let me summarize some of my main points. The world economy has entered a particularly difficult phase, with the financial turmoil spreading, across borders, across sectors, and to the real economy. Asia was spared the direct impact but will not be immune from indirect consequences as it is increasingly integrated with the rest of the world. Asia now has the opportunity of learning from developments elsewhere how to best leverage the benefits from financial development while minimizing the risks. Indeed, one of the key lessons has been the importance of international policy cooperation and coordination. Such a collaborative approach offers the best hope for ensuring the stability of the global economy.
Thank you very much.1 See the Discussion Paper prepared by the IMF Research Department "Reaping the Benefits of Financial Globalization", June 2007 (http://www.imf.org/external/np/res/docs/2007/0607.htm ).
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