Speech

Navigating the Financial Storm - The Financial Market Crisis and the Global Economic Outlook-Lessons and Policy Challenges, Remarks by Murilo Portugal, IMF Deputy Managing Director

March 7, 2008

It is a pleasure to address such a distinguished audience that has gathered here for the IIF Spring Meetings, and I wish to thank Charles Dallara for the invitation. What I would like to do this afternoon is to share with you some reflections on three topics: the financial turmoil in advanced economies, the outlook for the global economy which is more uncertain than last year given that we are now facing more downside risks, and thirdly to talk about the key policy challenges going forward and about some of the lessons from the financial turmoil.

I. The Global Setting

The financial market crisis-largest financial shock in decades

The financial market turmoil that erupted last August has developed into one of the largest financial shocks we have experienced since World War II, and its consequences have continued to reverberate.

While the turmoil originated in a relatively small segment of the US financial market-the subprime residential mortgages-, it spread quickly across the Atlantic and across several parts of financial markets in unanticipated ways, inflicting damage on markets and institutions that are at the core of the global financial system. The fallout rapidly spread to curtail liquidity in the interbank money market- which is the heart of the financial system.

Credit market strains have intensified since then, with a broadening range of markets coming under pressure. With rising estimates of bank losses and continuing worries regarding counterparty risk, there were increasing concerns about contagion to other often seemingly unrelated markets.

There has been some success in alleviating pressures, and liquidity strains in interbank markets have moderated. This has reflected the aggressive, coordinated actions by major central banks, including the provision of large-scale liquidity support and forceful policy interest rate cuts by the Fed, the Bank of Canada and the Bank of England. Also, welcome steps have been taken by many commercial banks to quickly recognize losses and to boost capital, including from sovereign wealth funds. It is also important that large monoline insurers in the United States had success in raising additional capital, thus avoiding credit downgrades that would have affected a large stock of insured municipal and corporate debt.

Nonetheless, there is still risk that the financial market turmoil could intensify further. Rising spreads have led to continued mark-to-market losses for banks on their holdings of debt securities. The cost of credit appears to have 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 advanced economies, with financial sector shares hit particularly hard. Banks in the major advanced economies have also tightened lending standards, as they seek to replenish capital in the face of heavy losses and balance sheets that have been expanded by the need to meet underwriting commitments. Some market participants worry that the situation could worsen and that the credit squeeze could become a credit crunch and trigger a severe growth slowdown.

II. Impact of the Financial Market Dislocations and the Global Outlook

Growth performance has "diverged" but not decoupled

The outbreak of the financial crisis has put the global economy on a more uncertain footing. After the best five-year span for global growth in a generation, the world economy this year is facing the unfolding challenges of powerful, but opposing, forces of spreading financial market turmoil in advanced economies against a still vibrant global growth driven by rapidly globalizing emerging economies.

Global growth projections have been marked down, and the IMF's central projection expects global growth to slow from 4.9 percent in 2007 to 4.2 percent in 2008, with risks largely on the downside. In particular, the U.S. economy is expected to slow markedly in 2008 and to grow on average 1.5 percent, with annualized growth in the fourth quarter of this year against fourth quarter of last year at only 0.8 percent, notwithstanding aggressive policy easing by the Fed and timely implementation of a sizeable fiscal stimulus package.

By contrast, the emerging market and developing countries continued to grow robustly last year led by China and India, but with all regions maintaining growth rates well above trend. The growth momentum in these countries has been underpinned by strong productivity gains, improvements in terms of trade reflecting healthy commodity prices, and improved policy frameworks that have helped sustain access to capital. The combination of strong internal growth dynamics, a rising share in the global economy, and more resilient policy frameworks appears to have helped reduce the dependence of growth performance in emerging economies on the advanced economies' business cycle.

In fact the one bright spot in this financial turmoil has been that direct spillovers onto emerging market and developing economies seems to have been largely contained. Fortunately, emerging market and developing countries have had limited direct exposure to the U.S. subprime mortgage market and have been relatively unscathed by the financial turmoil. As a result, while aggregate capital flows to these economies have moderated since August 2007, overall foreign inflows remain still strong, supporting further increases in international reserves.

But while growth performance in emerging economies has diverged it will not "decouple" and emerging economies will be affected by the global slowdown. Spillovers have become smaller from what they were in the past, but they are still important. And part of divergent growth paths results from transmission lags in the global economy. Spreads on debt of emerging market sovereign and corporate borrowers have widened sharply since October, and equity markets among the developing and emerging countries also retreated in early 2008. A number of countries were affected more severely than others, especially those where underlying fundamentals were less sound and that had relied on short-term cross-border borrowing-either lending by foreign banks or offshore borrowing by domestic banks-to finance large current account deficits, such as in eastern emerging Europe. On balance, we expect growth in emerging economies to ease on account of spillovers from advanced economies, but it would still remain robust at 7 percent, largely on the strength of China and India.

The Latin America and Caribbean region is entering this period of turmoil from a position of strength. Over the past four years, the region has benefited from a very favorable global environment, and many countries deserve credit for having adopted sound policy frameworks that made them more resilient to shifts in global conditions. In 2007, economic activity grew at a robust pace of 5½ percent , matching its performance in 2006, and marking the region's best four-year performance since the 1970s.

The region's financial system has weathered the global financial turmoil with signs of only moderate stress. Financial institutions in the region appear to have virtually no direct exposure to subprime mortgages and other distressed structured financial products, thanks to sufficiently high returns on assets in Latin America and strong regulatory frameworks in some countries. The region's banking systems have weathered the turmoil reasonably well, with stable interbank markets and growing deposits and credit. However, banking systems in some countries could still come under some pressure if international banks were to decide to curtail operations in the region. In most countries, equity prices have declined, especially since the fourth quarter of 2007. Spreads have doubled on external corporate bond issues to about 400 basis points, from 200 basis points a year earlier, with the spread on high-yield corporate bonds increasing by almost 300 basis points. Nonetheless, the rise in external borrowing costs has been contained in part by the decline in interest rates in the United States.

Risks to the outlook remain tilted to the downside

There are significant risks around the baseline economic outlook, which are, on balance, tilted to the downside. Let me now elaborate on what I see as being the three key risks going forward.

The protracted financial turmoil poses a key downside risk for the global economy in 2008, especially in the context of rising losses from the U.S. subprime mortgage crisis. The key risk is that a "credit crunch" takes hold in advanced economies. A related risk pertains to a greater-than-projected decline in U.S. domestic demand arising from the possible interaction of adverse financial events, the correction in the housing market, and household balance sheets. A severe downturn in the United States would have spillover effects on other advanced economies, particularly on those that have substantial exposure to structured products linked to U.S. mortgages. Weaker growth in advanced countries would likely lead to a decline in commodity prices, reducing capital flows to many emerging markets, portending greater financial sector vulnerabilities and risks to their growth prospects. In particular, a number of countries that have relied on short-term cross-border borrowing to finance large current account deficits are at greater risk.

It is important to watch closely how banking systems and credit creation both in advanced countries as well as emerging markets are faring in the face of the recent crisis. Thus far, credit to the private sector has held up well, although measures of bank lending standards in some advanced economies indicate a tightening in standards, reflecting partly banks' desire to rebuild capital bases in the wake of subprime-related losses. Although such a tightening of lending standards is already built into the IMF's baseline projections, additional adverse shocks causing losses to multiply to 2-3 times current levels could lead to much greater credit restraint as some major financial institutions at the core of the system could face severe strains. Also, the correction in equity prices in early 2008 and deteriorating labor market conditions are likely to add to pressures on household finances, although their net assets remain high.

Second, inflation risks remain an important concern for policymakers, particularly in view of rising oil, commodity and food prices. Global oil markets remain tight and supply shocks or heightened geopolitical concerns could increase oil prices from their currently high levels. In advanced economies, slowing growth has alleviated pressure on resources somewhat, but there are increasing concerns, particularly in the euro area, that high headline inflation resulting from surging commodity prices might de-anchor inflation expectations and spillover into higher core inflation. This risk complicates the monetary policy response to weakening growth prospects.

Thirdly, large global imbalances remain a worrying downside risk for the global economy. The U.S. current account deficit is projected to decline to 4.8 percent in 2008, but it is projected to remain large through the medium term in the absence of changes in major exchange rate. Unfortunately, the adjustment in exchange rates so far has fallen disproportionately on countries with flexible exchange rate regimes, and may be producing new misalignments or it may fuel damaging protectionist sentiment. At the same time, there is a risk that, the financing of the U.S. current account deficit may become more difficult.

III. Policy Challenges

Let me now turn to some of the policy challenges going forward.

Policymakers in advanced economies are faced with three pressing and difficult tasks of dealing with financial market dislocations, responding to downside risks to growth, while, at the same time, bearing in mind recent high inflation readings and longer-term concerns.

• Monetary policy should be the first line of defense. But policymakers in many countries face a delicate balancing act between mitigating the downside risks to growth while guarding against a build-up in inflation.
• Fiscal policy in advanced economies can play a useful countercyclical role in the event of a downturn in economic activity. But care will be needed to ensure that fiscal stimulus measures do not jeopardize longer-term sustainability, which is an increasing concern given population aging. While in most countries there is scope for allowing automatic stabilizers to operate fully, additional discretionary fiscal stimulus may be appropriate only in cases where the downside risks to output are severe and where debt sustainability is relatively assured.

In the Latin America and Caribbean region, many countries continue to face challenges from inflationary pressures and some countries face the challenges associated with strong foreign exchange inflows.

• Achieving low inflation has been one of the region's most important economic accomplishments of the past decade, and has helped support the recent growth in investment and economic activity. Monetary policy needs to stay focused on keeping inflation under control, recognizing that even if higher headline inflation may be driven initially by rising food and energy prices, this could quickly spill into broader price and wage pressures in the context of a rapidly growing economy. That is why it is important to fight the second round effects of higher energy and food prices.
• The global financial turmoil appears to have slowed foreign exchange inflows to the region as a whole, at least for a while. But foreign exchange inflows and pressures for currency appreciation seem to have returned in several countries, including Brazil, Chile, Colombia, and Peru. Flexible exchange rates will help countries absorb the effect of these shifts in international financial conditions, and currency appreciation will ease the burden on monetary policy. Countries with exchange rates that are heavily managed vis-à-vis the U.S. dollar, however, have less room to respond as raising interest rates may encourage heavier capital inflows.
• As for fiscal policy, public debt, while on a declining trend, still remains high at close to 50 percent of GDP, on average, and sustained fiscal consolidation would provide the basis for further strengthening public sector balance sheets. In particular, it would be important to restrain the real growth in primary spending, which has been particularly rapid in a number of countries.
• At the same time, policymakers in the region, as well as in other emerging economies should be prepared if a more negative external environment would emerge in the months ahead, possibly with weaker commodity prices, slower export growth and a reduction in capital inflows. If that scenario materializes, countries with credible policy frameworks and sound public balance sheets may have some limited scope for counter-cyclical demand policies, especially if inflation is below target.

With respect to financial sector policies, advanced countries should aim to resolve the current market turmoil, while not losing sight of the longer-term issues that will need to be addressed to prevent a recurrence.

Regulators in the advanced economies are discussing reforms to address the current turmoil by rebuilding counterparty confidence, ensuring the financial soundness of institutions, and easing liquidity strains. While many reforms are under consideration, let me highlight the areas that deserve the greatest emphasis:

• Improve transparency. Loss of confidence in valuations has been at the core of market turmoil. Promoting greater transparency of exposures to a variety of complex assets, both direct exposures and indirect exposure through off-balance sheet entities, and improving the valuations of these exposures are critical to reducing the level of uncertainty about potential losses across financial institutions and for restoring investor confidence.
• Encourage banks to raise capital as needed. Especially the systemically important institutions should be strongly encouraged to rebuild capital cushions-preferably by inviting new equity investment and by cutting dividends, in order to help bolster confidence and their capacity to support the role as financial intermediaries.
• Continue to provide liquidity. Central banks should continue to provide liquidity as needed to assure the smooth functioning of markets, while taking care to avoid taking on credit risk themselves or sending confusing messages about the broader stance of monetary policy. The recent episode has illustrated, however, the need for central banks to review the operational characteristics of their liquidity facilities to make sure that they are sufficiently flexible and adapted to the needs of markets. There is also a need to coordinate the design of these facilities amongst central banks.
• Broaden supervision and strengthen underwriting. The experience of the last 12 months has demonstrated that supervisors need to do more to ensure that off-balance sheet exposures of banks are properly accounted for, and that banks themselves need to do a better job in managing the risks posed by off-balance sheet liabilities. And it is especially critical that supervisors and rating agencies take greater care in assuring that underwriting standards are maintained.

Let me conclude with what perhaps may be the most important lesson of the recent financial turmoil, which is the need for more multilateral approaches. In an increasingly multi-polar and integrated world, economic problems will become ever more international than before. We see this in trade, where multilateralism has become key. We see it in climate change, where international collective action has become essential. And we are seeing it in financial regulation. Joint efforts to deal with global challenges have become indispensable. It is crucial to strengthen the framework of supervisory cooperation among countries, since the very rapid pace of financial innovation has increased the availability of complex financial assets that can be traded internationally and be a source of contagion. We are also seeing that this recent financial turmoil has come on top of the protracted global imbalances, underscoring the importance of a coordinated multilateral pattern of adjustment to right the balance. In both of these areas, the IMF can play an important role, working with the Financial Stability Forum, as well as through the process of multilateral consultations.

Thank you very much.