"Deleveraging in the financial sector is likely to weigh on the pace of credit and economic growth for a considerable period" (photo: Mario Tama/Getty)
GLOBAL FINANCIAL TURMOIL
"The past few weeks included momentous and almost unimaginable financial sector developments. What began more than a year ago with market turmoil surrounding U.S. subprime mortgages, last week became a financial storm of historic proportions—engulfing the largest US insurance company and encompassing the largest U.S. bankruptcy," Lipsky told a conference in California on September 24.
Following their intervention in the two mortgage giants Fannie Mae and Freddie Mac, U.S. officials announced sweeping actions to head off wider market disruptions, including plans to purchase distressed mortgage-related securities on a massive scale, as well as a one-year guarantee of money market mutual funds. On September 21, the two largest stand-alone investment banks announced that they were converting themselves into bank holding companies.
"Thus, before our eyes, financial tectonic plates shifted, wiping away an institutional form—the large, independent investment bank—that as recently as mid-2007 were viewed popularly as financial giants reaping huge profits," Lipsky told an economic forecasting conference at the University of California in Los Angeles. "Other countries also have experienced serious turmoil in their financial systems, albeit not on the scale seen in the U.S."
Crippling losses
Lipsky said the IMF now estimated total losses for the global financial system of $1.3 trillion from the financial crisis that erupted in the United States in August last year. While progress had been made by financial institutions in adjusting their balance sheets, the task of strengthening financial positions had become more challenging. "The downturn in economic activity, falling share prices, rising funding costs, and declining revenues from activities like securitization and leveraged buyouts are making adjustment more difficult," Lipsky said. "Ongoing deleveraging in the financial sector is likely to weigh on the pace of credit and economic growth for a considerable period of time."
Slowing growth
The financial crisis, coupled with high commodity prices and the housing downturn in the United States and some other advanced economies, has resulted in a slowing of growth in major economies, several of which are either close to recession or experiencing growth far below potential." Activity is also slowing in emerging markets and inflation is on the rise.
Nevertheless, Lipsky said a serious downturn in the global economy could be avoided because of four principal factors:
• Oil prices have fallen from record highs
• The U.S. housing market is expected to find a bottom in 2009
• While credit condition have tightened in the United States and Europe, growth can continue
• Relatively resilient domestic demand in emerging economies is likely to support global (and U.S.) growth
The IMF has said that, on balance, it expects a further slowdown of global growth before a gradual recovery next year. But the confluence of shocks has made policymaking more difficult.
Restoring the system
"The key challenges to restoring the financial system to full functionality are to insure adequate liquidity provision, to restore damaged balance sheets, and to rebuild capital where needed," Lipsky said. "An element that makes these policy challenges particularly difficult is that in many markets, the financial sector likely became outsized. Thus, restoring the sector to health will include further consolidation. To put it bluntly, not all institutions can or should be saved."
Monetary and budget policies will be critical in meeting the policy challenges, but it is clear already that these alone will not be adequate to reach the goal of restoring balanced growth. The use of the public sector balance sheet to contain systemic financial risks—a third line of defense—no doubt will continue to be instrumental in addressing the problems.
Deep restructuring
Lipsky said the IMF welcomed the decisive actions taken by the U.S. authorities to shore up the government-sponsored enterprises (GSEs)—Fannie Mae and Freddie Mac—providing crucial support for the U.S. housing market, the banking system, and the broader economy. "Over the longer term, a deep restructuring of the GSEs remains essential to restore market discipline, minimize fiscal costs, and limit systemic risks for the future. Ultimately the conflict of private ownership and public policy objectives within the GSEs' former business model needs to be resolved," Lipsky stated.
"The key," he said, " is to strike the right balance between safeguarding present financial stability and limiting future moral hazard. This task is by no means an easy one, but the consequences—either in the short or longer term—would be severe if the pendulum swings too far in either direction."
"The reality of financial globalization means that policy interventions—including the longer-term issues of regulatory and supervisory reforms—need to be globally coherent and consistent in order to be effective. No doubt, new actions will be needed to cope successfully with the near-term challenges. In addition, the issue will have to be addressed eventually of how to prevent excessive risk-taking in the future, without stifling the powerfully positive potential of effective financial markets."
Comments on this article should be sent to imfsurvey@imf.org
