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“Global Prospects and Policies”
Speech by John Lipsky, First Deputy Managing Director
International Monetary Fund
At the Securities Industries and Financial Markets Association (SIFMA)
New York, October 28, 2008
I would like to thank Tim Ryan and his SIFMA colleagues for inviting me here today.
It is a pleasure and an honor to have the opportunity to address this distinguished
audience, and to share the podium with Secretary Paulson.
In discussing global prospects and policies this morning, I will focus on two key
themes:
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First, to state the obvious, these are very turbulent and uncertain times for the
global economy. The world economy is entering a major slowdown,
accompanied by the worst financial crisis in 75 years. As we all know, the
current challenges are unprecedented in many important ways. As a result,
visibility is unusually imperfect with respect to global economic prospects.
Many plausible voices today are predicting dramatic – and, in some cases, dire
– outcomes. Regardless, developments continue to evolve rapidly, especially
with respect to conditions facing emerging economies. For our part, my IMF
colleagues and I are paying close attention to the latest results, and doing our
best to anticipate future challenges.
•
Second, these very difficult financial and economic circumstances call for
timely, decisive and cooperative action. Given the global and systemic nature
of the current crisis, policy responses need to be scaled commensurately. Our
double mantra is straightforward: Global problems call for global solutions;
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systemic challenges require a systemic response. Increasingly, policymakers
share these basic tenets. Already, many unprecedented measures have been
announced, and need to be implemented quickly. Nonetheless, there is scope
for further action—particularly with respect to guarding emerging economies
from adverse external developments.
I will begin with a very brief overview of the global outlook.
The global economy is in a major slowdown, and there is a risk that it could turn
into an outright downturn. Global growth is slowing sharply. Already in this year’s
first half, growth had slowed to 3½ percent (annualized), down from the 5 percent
annual pace sustained over the four previous years.
a. Advanced economies are contracting at end-2008. Advanced economy
growth slowed to a standstill during this year’s first half. Momentum
subsequently has been falling, with leading indicators already dropping
to levels last seen during 2001-2002. Indeed, the U.S. economy has
slowed sharply and recession risks are looming, while activity in the
euro area and Japan had weakened earlier.
b. Increasingly, emerging and developing economies are feeling the
impact of the global financial crisis, and their growth is decelerating
rapidly. The confluence of a decline in external demand, receding
commodities prices, and a sharp moderation in capital flows is likely to
dampen activity notably in the coming quarters.
In sum, there is ample justification for pessimism: Global prospects remain
highly uncertain and risks of a global recession loom large.
Nonetheless, my IMF colleagues and I are optimistic that a decisive,
comprehensive and coherent policy response will be able to truncate the
downside risks to the global economy. The key is to focus on dealing with the
underlying sources of the weakness, while ameliorating the damage that these
underlying factors are creating.
As is widely recognized, the underlying loci of global economic weakness stems
from asset price deflation – especially in housing and other real estate markets.
Not surprisingly, asset price deflation has been hard on financial markets,
creating concentric circles of crisis that have propagated globally at a pace that
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by and large has taken market participants and policymakers by surprise. How
well macroeconomic and financial policies jointly respond to containing the
disruption will be telling in determining the global economy’s near-term outlook.
There are two key risks to the outlook; One is that asset values – especially housing –
will substantially undershoot reasonable long-term levels. The second is that financial
market dysfunction will produce reinforcing rounds of real economic distress,
especially in emerging economies.
In many countries’ housing markets, the apparent boom-time overshooting in
valuations already has damaged financial markets and the real economy, but an
equally-scaled undershooting would compound the damage.
•
Housing-related conditions are weak -- and weakening -- in the United States
and several other advanced economies. In the United States, housing activity
and prices continue to decline, though the inventory overhang is beginning to
moderate. At the same time, however, foreclosures continue to rise, amid a
weakening labor market. Rather than finding a floor, there is a risk of deeper
and more prolonged housing correction in the United States. In Europe, the
housing correction got underway later and may have some ways to go. Of
course, asset values in many emerging market economies increased in recent
years at a faster pace even than in advanced economies, creating obvious risks.
•
Avoiding damaging undershooting is justification for a strong policy response.
Short-circuiting an adverse feedback loop between housing downturns,
widespread financial deleveraging, and weakening confidence would help
avoid a deeper downturn. This may require policy actions that impact the
underlying markets directly.
The systemic reach of the global crisis underscores the need for global action on
a comprehensive and coherent basis.
In financial markets, notwithstanding bold policy actions announced thus far,
conditions remain exceptionally volatile and uncertain. Modest declines in interbank
spreads, along with sharp falls in bank CDS spreads, suggest some tentative
improvement in market sentiment. Solvency concerns have eased in light of the
commitment to use public funds to recapitalize financial institutions, but money
market funds continue to face large redemptions.
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•
And while liquidity strains have eased somewhat, they remain acute. Spreads
remain at elevated levels, while exceptional volatility and uncertainty is
keeping liquidity preference and risk aversion at elevated levels.
Moreover, the financial crisis has spread rapidly to emerging economies; in
effect, we have moved swiftly from talk about “decoupling” to a situation where
these economies are at substantial risk.
•
As discussed in our latest Global Financial Stability Report, published earlier
this month, emerging markets—as an asset class—are coming under
increasing strains [shown in orange and red in the chart].
•
In particular, intensified financial deleveraging is having a global reach,
including to emerging economies. More intense capital account pressures, in
turn, could seriously harm growth in these economies.
Emerging equity markets already have absorbed greater losses than mature
markets, reflecting investors’ flight to safety in the face of high uncertainty and
risk aversion. Anticipating a significant growth slowdown, emerging equity markets
are down around 50 percent year-to-date.
•
Moreover, financial flows are moderating. Pressure on banks in advanced
economies—including even those receiving public capital injections and
therefore subject to taxpayer oversight—could curtail lending in foreign
markets; banks and firms in emerging economies that rely on global wholesale
funding markets appear to be facing significant distress and rollover risks;
hedge funds and other institutional investors under pressure to unwind
positions as a result of tighter financing constraints and redemptions are
undermining market liquidity and asset prices more broadly.
Under current strained global financial conditions, the risk of sudden
interruptions (or reversals) in capital flows has risen appreciably.
•
Countries with large external financing needs and highly levered financial
systems face more intense strains in both credit and equity markets. This
underscores their more limited room for maneuver in dealing with spillovers
from financial and economic stress in advanced economies. Especially
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vulnerable in this regard are countries where households have contracted large
foreign currency denominated loans.
•
For the IMF, the current epidemic of spreading financial market strains
reflects a challenge that we have faced many times before in many different
guises. What is novel currently are the scale, scope and complexity of the
current difficulties.
Our earlier experience warns that sudden stops in capital flows potentially can
transform a liquidity shock into a solvency crisis. The needed remedial action –
including helping to minimize the risk of a sudden stop, and/or standing ready to
compensate for one – is a key IMF responsibility.
We all know more or less how we got to this point – even if the recognition was
clear mainly in hindsight. Simply put, the globalizing financial system built up
too much risk and too much leverage.
•
At the IMF, we have drawn two broad lessons from this experience: First, it
seems evident that what we have labeled the “perimeter of regulatory oversight
and risk management“ was drawn too narrowly. Thus, risks remained out of
sight that should have been front and center. The second broad lesson is that
regulation should incorporate macro-prudential considerations. In other words,
regulation and supervision have focused on instruments and institutions, while
remaining more or less oblivious to cyclical and other macroeconomic
considerations
Incorporating both these considerations -- the perimeter of regulation, and macroprudential aspects – will not be either quick or easy. Nonetheless, they will be steps in
the right direction.
The immediate imperative for policies is to restore confidence in the financial
system. IMF experience indicates that successful efforts typically incorporate three
basic aspects: Preserving short-term liquidity, removing damaged assets from bank
balance sheets, and recapitalizing banks.
•
In advanced economies, bold financial measures announced earlier this month
will need to be implemented effectively and quickly.
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o Bank recapitalization should proceed swiftly; central bank liquidity
support should continue to be provided generously; and comprehensive
approaches should be pursued to deal with distressed assets in the
financial sector.
•
More broadly, policies need to decisively contain both financial disruptions
and the possible growth implications, which will include reliance on
traditional macroeconomic tools. With the global slowdown undermining
commodity prices, the scope for monetary policy to support economic activity
has increased, particularly in advanced economies that until recently have been
dealing with containing inflation risks.
o Fiscal measures are being used more comprehensively to address
solvency issues in systemically important financial institutions, to
purchase distressed assets, and to recapitalize the system. At the same
time, further support to aggregate demand may be needed, given the loss
of private sector confidence.
Policy requirements may also require greater multilateral efforts—inclusive of
emerging economies.
•
The policy measures adopted by advanced economies may impart unintended
effects—notably, since financial institutions in emerging economies in general
are not covered under the umbrella of the liquidity operations in advanced
economies. Also, domestic banks in emerging economies do not necessarily
have the same level of protection through deposit guarantees and such
measures as public capital injections. Thus, the may feel pressured to put in
place their own programs, even where the resources needed to create credible
policies of this nature may not be available.
•
In emerging economies, policy actions to deal with sudden interruptions (or
reversals) of capital flows will be needed. Of course, in many cases the
improvement in monetary, fiscal and structural policies in recent years
represents a important protection, as has the build-up in international reserves.
Nonetheless, these may not offer complete protection.
o Liquidity support needs to include the corporate sector in countries
where funding markets are shrinking. Countries with large reserve
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buffers could provide foreign currency liquidity as needed, if acute
dollar shortages of is affecting firms’ ability to operate.
o Emerging economies may also need to consider traditional
macroeconomic policies to deal with a shortfall in financing and growth.
The Fund, for its part, is moving quickly and playing an active role to help
emerging economies battered by the crisis and the sharp slowdown in advanced
economies
• The Fund stands ready to disburse more than $200 billion of loanable funds and
can draw on additional resources through standing borrowing arrangements with
groups of IMF member countries. As you know, we are currently in program
negotiations with several members.
• Since halting economic and financial crises requires timely measures, the Fund is
actively considering the launch of a new short-term liquidity lending facility to
address problems of fundamentally sound countries temporarily exposed to funding
pressures.
Looking past the immediate challenges, a concerted effort will be needed to build
a more resilient and efficient financial system. In addition to the two broad areas I
mentioned already, there is a need to strengthen global early warning systems, in
order to mitigate future risks.
In conclusion, these are very uncertain times and the risks to the global economy are
large. But taking a comprehensive and collaborative approach globally—across the
full range of policy instruments that we have at our disposal, I am confident that the
worst can (and will) be avoided and that a more resilient and sounder financial system
will eventually emerge. But the hard work lies just before us, and all will need to do
their part.