Speech by John Lipsky, First Deputy Managing Director,
International Monetary Fund
At the Paul H. Nitze School of Advanced International Studies, Johns Hopkins University
November 17, 2008
Introduction
I am grateful to SAIS for the opportunity to address this distinguished audience on such a challenging, critical and timely topic. Over the past few weeks, a consensus has emerged regarding the seriousness of the near-term threats to the global economy, with the advanced economies already close in or near recession. At the same time, there is no sign yet of a fundamental reversal of the financial market dislocation and deleveraging that represents both a sign of and a contributor to the still unfolding global economic strains. To the contrary, the virulent combination of financial stress and shrinking advanced economy demand is impacting emerging economies, with potentially significant negative effect.
The G-20 Summit on Financial Markets and the World Economy that took place here in Washington last weekend was both an unprecedented response to the daunting near-term challenges, and an explicit symbol of the evolving world economic order. The Summit confirmed that the most senior political authorities recognize the urgent need to address credibly the underlying causes of the current crisis, even while acting aggressively to reverse its near-term impact. It is notable that the underlying premise of the Summit—as captured explicitly in the Communiqué—was that success in these efforts will only be possible through international cooperation, and that the scope of that cooperation will have to be broader—both in terms of the policies and the countries involved—than has been the case in the past.
In several important ways, therefore, the coming months will represent both a test and a turning point for the global economy, for international financial markets and for global governance. While the efforts agreed last weekend may fall short of something that could be given as grandiose a label as a new international financial architecture, nonetheless their scope and importance shouldn't be underestimated. The Working Groups that are being formed as a result of the Summit, with a specific deadline for reaching conclusions, together with the Summit participants' explicit commitment to reconvene by next year's second quarter, are intended to impart momentum to the reform efforts.
The Summit also reflected an underlying consensus about the intended nature of the future global system. In particular, the Summit Communiqué states that proposed reforms "will be only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets and efficient, effectively regulated financial systems". Moreover, the level of consensus and political commitment regarding the need to act exhibited at the Summit justify hope and even optimism that the opportunity that is being created by the current crisis for implementing significant structural improvements in the global economy, and in international financial markets, will not be missed. Finally, the G-20 Leaders pledged to initiate a new push to reach agreement on the Doha Round of multilateral trade negotiations before the end of this year, ignoring the widespread skepticism that a deal would or could be reached in the foreseeable future.
The Deepening Challenges
That Government Leaders and Finance Ministers from economies representing about 85 percent of global GDP could agree to assemble in Washington on only a few weeks' advance notice has no precedent. In fact, White House sources indicated that they could find no previous case of so many leaders meeting there for a working session. The motivation of the attendees was clear, however: economic prospects have deteriorated notably during the past two months, and the global financial crisis has taken a sharp turn for the worse. In the advanced economies, consumer and business confidence have dropped to levels not seen in decades, and activity is slowing sharply or even contracting in many economies. Most worrisome has been the sudden—and severe—toll that the crisis has begun to take on emerging economies, where in many cases deleveraging and asset sales have led to capital flow reversals, a sharp widening of spreads on sovereign and corporate debt, and abrupt currency depreciations.
As a result, we now project that the world economy will grow by only 2¼ percent in 2009. This reflects a reduction of three-quarters of a percentage point from the October World Economic Outlook forecast that was finalized only weeks ago. In the new forecast, the advanced economies are expected to contract by ¼ percent on an annual basis in 2009. This would mark the first annual contraction in the postwar period for these countries as a group.
Growth prospects for emerging economies also have been undermined by the latest developments. Still, the new IMF forecast anticipates that activity in emerging economies will expand by 5 percent in 2009, although with considerable regional variation. Thus, it is expected that emerging economies will account for 100 percent of global growth next year. It is also true, however, that even this newly reduced forecast can't be taken for granted, as the downside risks to growth, even for the emerging economies, remain significant. Thus, actions to be taken by emerging economy authorities to bolster confidence in the appropriateness of their policies, as well as efforts by the international community to provide necessary financial support in this moment of crisis, will be critical in order to attain the hoped-for revival of global growth by 2010.
In the remainder of my presentation, I will review the undertakings of last weekend's Summit from the point of view of my IMF colleagues and myself regarding the near-term actions that we view as crucial to restoring growth and financial sector soundness, as well as those measures that we consider to be essential for improving the medium-term performance of the global financial system and for reducing the risk of future crises. Before concluding, I will summarize the role of the IMF envisioned by the Summit Communiqué, and briefly discuss what the IMF is doing to help our members through the crisis.
Sustaining Global Demand
Given the speed with which growth prospects have deteriorated, it is not surprising that there was broad agreement at last weekend's Summit that new monetary and fiscal policy initiatives will be needed to support global demand. For sure, recent policy actions in advanced countries to use the public balance sheet to recapitalize financial institutions, to provide comprehensive government guarantees, and to extend liquidity provision were important and necessary steps. Their swift and effective implementation will be crucial to restoring confidence. However, these measures will not be sufficient by themselves to halt the slide in global output.
With inflation receding, many advanced and emerging economies can further ease monetary policy.
• Many central banks already have taken decisive action in this regard, including aggressive Fed action to reduce policy rates, the recent sizeable cut in interest rates by the Bank of England, and a clear shift toward policy easing by the European Central Bank and other advanced economies, including Australia and Switzerland among others. In many key emerging economies, central banks also have cut interest rates and eased reserve requirements.
• Generally speaking, however, monetary easing is likely to be less effective at stimulating demand while financial conditions remain disrupted. More specifically, survey-based data show that banks have tightened credit standards significantly since the onset of the crisis last year. The impact of such a tightening of lending standards on credit aggregates typically occurs only with a lag. Thus, the negative effects of the current tightening of credit standards likely will be felt for some time to come. Put another way, the deleveraging process is likely to shift from widening risk spreads to actual reduced volumes of credit. In emerging economies that have relied on capital inflows to finance an expansion of bank credit, the effectiveness of monetary policy may also be limited.
It is appropriate, therefore, that fiscal expansion will play a central role in helping to sustain domestic demand. This view was endorsed explicitly by the Summit Communiqué.
• Several countries, including the United States, China and various European economies, already have announced fiscal stimulus plans. In an environment of sagging confidence, the impact of various fiscal measures—both in terms of their timing and their effectiveness at boosting output—requires careful consideration. Any fiscal stimulus should be timely in its impact, as the need to cushion demand is immediate. As a result, innovative measures could be helpful. For example, measures to support low-income households would be particularly helpful in boosting demand, and would be targeted at those most in need. Also, one-off transfers to states in federal systems such as the United States could be helpful in preventing pro-cyclical fiscal tightening at the state level.
• More broadly, our research suggests that global fiscal stimulus on the order of 2 percent of GDP is justified. Moreover, fiscal policy action would be more effective if it were implemented in key trading partner countries more or less simultaneously. That said, fiscal action may not be advisable in countries with greater vulnerabilities, or those where debt sustainability is a major concern. Thus, countries with the strongest fiscal policy frameworks, those best able to finance new fiscal efforts, and those with clearly sustainable debt positions should take the lead.
Preventing a Liquidity Shock from Becoming a Solvency Crisis
While macroeconomic policies are crucial to sustaining demand, emerging economies face an important challenge in ensuring that the unfolding liquidity squeeze does not transform itself into a solvency crisis. Deleveraging is beginning to have an increasingly striking impact on these economies following a period of exceptional growth. Countries with significant vulnerabilities are being hit hard, but even some countries with strong fundamentals are being affected. In particular, some countries with liquid domestic financial markets that previously received large capital inflows have experienced abrupt reversals of external financing flows. Past experience indicates that dealing with these challenges will require efforts by both advanced and emerging economies.
For the affected emerging economies, the focus must be dealing with immediate liquidity and exchange rate pressures created by the capital flow reversals. So far, measures taken by policymakers in emerging economies to improve liquidity appear to be having only a limited impact in restoring confidence, even in countries with large reserve buffers.
• In emerging economies with flexible exchange rate regimes, exchange rate adjustment can help to absorb the pressures arising from capital outflows. Of course, countries with pegged exchange rates face a different set of challenges, as they lack this degree of policy freedom.
• At the same time, emerging economies with large reserve buffers may provide foreign currency liquidity as needed by their own economies.
Regardless, emerging economies likely will remain under pressure for some time from global financial deleveraging, even under the most favorable plausible scenarios. As a result, liquidity provision will continue to be critical to emerging economies' ability to weather this storm.
• The IMF Executive Board recently approved a Short-Term Liquidity Facility (SLF) designed to provide substantial liquidity support to emerging countries with good policies and good track records that are experiencing liquidity shortages because of deteriorating external market conditions. This innovative facility is designed to be accessible on very short notice, and carries no ex-post conditionality. If it proves useful, this facility will become a regular part of the Fund's policy toolkit. The Federal Reserve also established swap lines with the central banks of Brazil, Korea, Mexico, and Singapore, in an attempt to ease current dollar funding shortages. These lines will remain open until April 2009.
• Regional initiatives also can be helpful. Efforts aimed at a regional pooling of international reserves, such as in Asia through bilateral swaps, provide a further backup for individual countries facing significant external funding pressures. These arrangements could be broadened, for example by linking them with use of the new SLF.
Improving the Global Financial System
Looking beyond the immediate challenges, the crisis has made clear that new thinking and action are needed in at least three areas related to the global financial architecture. First, the design of financial regulation needs to be improved. Second, a better way of assessing systemic risk must be found. Third, mechanisms for more effective, coordinated actions are needed to reduce the risk of crises and to address them when they occur.
This crisis has shown the limits of the current regulatory and supervisory frameworks at both the domestic and international levels. Open financial markets can provide tremendous benefits by lowering the cost of capital, but more effective regulation is needed to realize this potential. As has been demonstrated all too graphically, financial innovation and integration have increased the speed and extent to which shocks are being transmitted across asset classes and economies. However, regulation and supervision remain geared at individual financial institutions and do not adequately consider the systemic and international implications of domestic institutions' actions. Moreover, macro-prudential tools do not sufficiently take into account business and financial cycles, which has led to an excessive buildup of leverage.
The challenge, therefore, is to design new rules and institutions that reduce systemic risks, improve financial intermediation, and properly adjust the perimeter of regulation and supervision, without imposing unnecessary burdens.
• More effective capital and liquidity requirements would make financial institutions—especially those that are highly interconnected—more resilient to risk. Counter-cyclical macro-prudential rules appear to be a promising way to reduce the buildup of systemic risks. Greater use of centralized clearing houses and organized exchanges would help to improve the robustness of the financial infrastructure to counterparty failures.
• Supervisory and regulatory frameworks should be more globally coordinated to ensure that the perimeter of regulation and supervision is appropriate. The crisis has underscored the tension between globally active financial institutions and nationally bounded regulators and supervisors. The tension exists with regard to both crisis prevention and resolution and is most evident when dealing with the resolution of global banks headquartered in relatively small countries.
• More information—and also better information—would help market participants and authorities improve their assessments of systemic risks. This requires reviewing transparency, disclosure and reporting rules. Information requirements also could cover a much larger set of institutions, including insurance companies and off-balance sheet entities.
This crisis has made clear the enormous costs of not identifying risks early enough. A more effective approach to detecting risks will require close cooperation among key policy makers to bring together the scatter of international and national macro-financial information and expertise.
• The starting point for any early warning system—as it is for better regulation and supervision—must be better information on global financial and economic developments. Better risk assessment will also mean strengthening macro-financial analysis and enhancing work on early warning systems.
• Early warning and surveillance work will also require finding the right incentive balance between countries voluntarily engaging in vulnerability assessments and making assessments mandatory. In doing so, decisions will need to be made about the usefulness of models relying on "name and shame", "comply or explain", and binding commitments to act.
• The private sector clearly needs to improve its risk management systems, as the real world has proved to be even riskier than reflected in conventional models. But accomplishing this may require the creation of new business forms, and not just new systems. The reformed regulatory framework should create the correct incentives to encourage this to take place.
The G-20's Action Plan
In fact, the Summit addressed all these issues in a concrete fashion. Looking beyond the short-term need to support global demand, the Summit participants adopted a sweeping Action Plan to Implement Principles for Reform. Working Groups will be formed to pursue policy reforms in five broad areas: Strengthening Transparency and Accountability; Enhancing Sound Regulation; Promoting Integrity in Financial Markets; Reinforcing International Cooperation; and Reforming International Financial Institutions.
In each of these areas, the Summit participants agreed on a set of short-term issues, with specific reform proposals expected to be ready for consideration by the end of March 2009. They also agreed on a set of medium-term actions to be pursued by the Working Groups. The Plan comprises some 50 concrete steps to be taken by G-20 members and various international entities, of which over half are to be delivered by the end of next year's first quarter.
The Summit's Action Plan responds directly to the key challenges. Specifically, the Summit Communique's Action Plan calls for new agreement on the valuation of complex securities, a review of the role of credit rating agencies, and an improvement of the infrastructure for the credit default swap market and other over-the-counter derivative markets. Additionally, the Action Plan calls for a review of standards for risk management practices and improved standards for managing liquidity risk.
The Action Plan also calls for the IMF, working together with an expanded Financial Stability Forum (FSF) and with standard-setting bodies to develop recommendations for mitigating the current system's apparent pro-cyclicality, as well as to help improve the scope of existing regulations. Moreover, the IMF is tasked with helping to improve the cross-border consistency of regulations and to enhance international regulatory cooperation. To this end, supervisors are instructed to establish supervisory "colleges" for all major cross-border financial institutions. The Summit Communiqué also commits G-20 members to undertake a Financial Sector Assessment Program (FSAP) report, conducted jointly with by the IMF and the World Bank.To date, all but two of the countries that attended the Summit have either already had FSAPs or have initiated them.
Of course, the exact outcomes of the G-20 efforts cannot be taken for granted. Among other things, it goes without saying that the near-term deadline will fall due after a new US Administration takes office. But it is notable that the most significant specific challenges have been identified, and a clear politically-endorsed mandate has been established with a defined deadline for concrete proposals. Rather than dismissing this effort as just a collection of good intentions, international stake-holders in this area hopefully will keep up the pressure for decisive action along the lines specified in the Action Plan.
The Role of the Fund
Before concluding, I would like to address the role of the IMF in these very challenging times.
• First, the Fund continues to conduct its regular multilateral and bilateral surveillance and to provide policy advice and technical assistance to members.
• Second, the Fund has moved quickly to help emerging economies battered by the crisis and the sharp slowdown in advanced economies. As the crisis deepens and spreads, the Fund can disburse more than $200 billion in liquid resources to support member countries facing financing shortfalls. Indeed, several countries already have sought financial support from the Fund in recent weeks, including Hungary, Iceland, and Ukraine, and more arrangements are under negotiation.
• Third, as it became clear that innovative policy tools were needed, the Fund responded by acting to deploy its resources in new ways. Recently, the Exogenous Shock Facility has been made easier for low income members to access, while the new SLF I mentioned earlier provides those members with strong macroeconomic positions and records of consistent policy implementation large upfront access to Fund resources to help address short-term, self-correcting external liquidity pressures that give rise to balance of payments needs.
• Fourth, while the Fund can draw on additional resources through standing borrowing arrangements with members, there remains a serious question as to whether the cumulative pool of resources will be sufficient to meet the needs of members as the crisis continues to spread. A more systematic approach to international liquidity provision should be a high priority—be it through the co-financing of IMF-supported programs (as was done in the case of Hungary) or increasing the Fund's loanable resources. In the first instance, it would seem prudent to aim for a doubling of the resources available for Fund lending, even if the resources appear adequate in the current situation.
With respect to improving the financial architecture, the Fund already is taking several steps. Consistent with the core mandate of the Fund to promote global financial stability, we already have begun strengthening our early warning capabilities. However, better understanding is needed regarding the linkages between financial sector developments and macroeconomic performance (for instance, on the relationship between monetary policy and risk taking). In response, we are taking the lead in research in this area. New and better operational tools also need to be developed for macro-financial surveillance. We at the IMF therefore are eager to strengthen our collaboration with others involved in this area.
Of course, the role of the Fund was an important topic for last weekend's Summit. During the Summit sessions, in bilateral discussions, and in the Summit Declaration, G-20 leaders made it clear that they look to the Fund to play a critical role in the period ahead in crisis management, in drawing lessons from the crisis, in strengthening surveillance, and in rebuilding the international architecture. Specifically, they:
• Strongly supported the Fund's role in crisis management and response, including its new Short-Term Liquidity Facility, while also calling for continued review and adaptation of its lending instruments.
• Agreed to insure that the Fund's resources are sufficient to play its role. In that regard, the Japanese authorities announced their commitment to provide an additional $100 billion to augment the Fund's loanable resources, and called on others to help to double the Fund existing liquid reserves.
• Asked the Fund to conduct vigorous and even-handed surveillance of all its members, with greater attention to their financial sectors and stronger macro-financial policy advice; as part of this, they committed all G-20 members to undertake an FSAP.
• Asked the Fund, in collaboration with an expanded FSF, to better integrate regulatory and supervisory responses into our macro-prudential analysis and to develop our early warning capability.
• Asked the Fund to take a lead role in drawing lessons from the current crisis; and more generally to strengthen collaboration with the FSF, along the lines of last week's agreement between the Heads of the two institutions.
• Called for the Fund to be involved in the development of recommendations to mitigate pro-cyclicality of the financial system.
• Called on the Fund to provide capacity-building for the formulation and implementation of new regulations, consistent with international standards.
The leaders also emphasized that they want to see reform of the Bretton Woods institutions themselves. In particular, they emphasized the need to insure that emerging and developing economies have greater voice and representation in the institutions, and in the international system as a whole.
Conclusion
The broad picture that I have sought to develop here today is one where it has been recognized at the highest level of political authority that action across a range of areas is needed urgently to help the global economy and the financial system regain their footing. There is no need to make exaggerated claims about requiring a new system. Already, an impressive consensus has emerged about the reforms required to correct the flaws of the existing system, and they are substantial. Macroeconomic policy action—especially fiscal policy—is becoming increasingly relevant and necessary for a broad swath of countries. Financial sector policy reforms also must continue to be implemented and fine tuned as needed. And collectively, we must work together to strengthen the global financial architecture in a way that reduces future risks by re-examining regulatory weaknesses, forging ahead with new tools for detecting and warning about vulnerabilities, and recognizing the importance of financial integration and cross-border financing in designing regulations and new mechanisms for crisis prevention and resolution.
The G-20 Summit on Financial Markets and the World Economy represented an unprecedented political messaging of the increasingly powerful agreement in favor of broad action in order to confront the daunting and in many ways unprecedented challenges of the current crisis. By any standards, the Summit laid out an ambitious agenda. My Fund colleagues and I stand ready to assist the G-20 leaders as they develop a detailed implementation plan to turn today's concerns and challenges into specific actions. First and foremost, the IMF stands ready to use its financial resources and expertise to help pave the way toward a more resilient post-crisis global economy.
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