Current and emerging issues in finance

CURRENT AND EMERGING ISSUES IN FINANCE

Traditional Policy Coordination

The literature on international policy coordination became very active in the late 1980s (see Bryant 1995 for a summary of what was argued), and actual policy coordination peaked at the time of the Louvre agreement of 1987. The idea of the policy coordination of the period was to have the seven major powers, which thought of themselves as a closed system, agree on demand management and exchange rate policies, so as to produce a set of consistent and mutually satisfactory outcomes. The objectives were internal and external balance, and the fear was that in the absence of policy coordination the countries with active exchange rate policies would choose exchange rates that would

deprive the residual country (the United States) of the ability to secure a satisfactory

(sufficiently strong) payments position.

The main ground for opposing policy coordination at that time was a conviction that countries would never change their policies for the benefit of other countries. Such changes may well have been unrealistic, but they were not advocated by the more sophisticated supporters of coordination. What was envisaged was that each country would commit itself to abiding by a set of rules that it would expect to find advantageous in the long run. It might be that such a rulebook would require occasional sacrifice of short-run gains, but this is something that countries would be far more likely to find acceptable than sacrificing their perceived interests to those of others in a one-off agreement.

The idea of policy coordination went out of fashion as it was argued that the floating exchange rate system that had come into being meant that the exchange rate was not a policy instrument. Each country pursued internal balance as best it could, and passively accepted the exchange rate and balance of payments that was generated by the system. So far the world has stuck with this “system”, though the results of it have at

times been close to the limit of what countries have been willing to accept. If there is ever a real crisis that is clearly the result of these arrangements there will almost certainly be the desire to build something better, though the adoption of an alternative will surely depend upon the availability of a model perceived to be better.

While policy coordination was abandoned, the idea of surveillance persisted.

Even if countries should not be expected to change their policies in the light of the wishes of others, it remained accepted that countries had a duty to bear in mind the interest of the global community in making their choices. Surveillance came in two forms, bilateral and multilateral. Bilateral surveillance involves the IMF raising questions with the authorities of individual countries about whether their policies are consistent with a satisfactory global outcome. A revision of the terms of reference for bilateral surveillance introduced last year requires the Fund to take into account the implications of each member’s

policies for the functioning of the system. However, since successful adjustment generally requires mutually supporting actions by several countries, one would expect

multilateral surveillance to be of greater relevance. The Fund’s initiative in this regard

involved the convening of talks among the five major players (the US, Euroland, China, Japan, and Saudi Arabia) with a view to their agreeing a set of policies that each would pursue and that would in due course achieve the desired aim. In the end the outcome of these talks proved disappointing, since each of the participants merely promised to persist with its existing policies and the IMF sanctified their inaction by publishing their G7-like promises.

It would be necessary to do better than this in order to achieve real policy coordination. In the first place, one might expect this to involve an attempt to plan where countries are going. There is not much scope to plan where output is going, since that is largely determined by the maintenance of internal balance, though there may be scope to marginally vary the investment ratio and other growth-input variables in the interest of spurring growth. There is more scope for choice over current account outcomes, which steers the evolution of external wealth. Second, this presupposes a determination to use all available policy instruments to pursue those targets. The main way in which this differs from current arrangements is that it would involve an attempt to influence the exchange rate. It should be taken as read that influencing the exchange rate is not the same thing as determining it, and that the latter is infeasible in the world as it is today. But influence is less ambitious and may be possible. It would presumably start with official announcement of a set of consistent target exchange rates. Given that it is now accepted that intervention is more likely to be effective when it is internationally coordinated (Sarno and Taylor 2001), which fact is most obviously explained by a willingness to be swayed by official actions when the official world shows itself to be agreed, one would expect such an official announcement to carry more credibility than the isolated announcements of recent years (e.g., “we believe in a strong dollar”).

Would a system that was based on these principles have helped head off the three sources of financial problems now threatening the world? I cannot see that it would have been of any relevance in preventing the financial turbulence. This has resulted from imprudent financial practices within countries, practices that ideally might have been diagnosed by FSAPs, although I am not aware of actual FSAPs having been concerned with these issues. On the other hand, it could have helped avoid the buildup of the global

imbalances to their present threatening level, assuming that countries would have been called on to manage their demand and to influence their exchange rates in a way that would have curbed the current account imbalances of recent years. Similarly, it would surely have called on (or maybe prohibited) Japanese intervention in support of a gross undervaluation of the yen, and would thus have given exactly the signal that it was argued above was needed to limit the yen carry trade. This would have given the IMF a central role in the process of avoiding traditional crises. For it to gain an equivalent role in the prevention of future episodes of financial turbulence, as appears to be envisaged (see the remarks of John Lipsky 2008), it would need to use future FSAPs in order to

investigate the extent to which financial actors in the IMF’s developed member countries were taking imprudent positions.

The contribution of Policy Coordination

If it is agreed that policy coordination of the traditional type could help address the problems of global imbalances and the yen carry trade, then any proposals for a reformed system could benefit by incorporating such provisions. But the fact that they would have missed completely the financial turbulence implies that it will be necessary to add something less traditional. What?

Let us go back and reconsider the turbulence and what caused it. It seems to me clear that the problems emerged from the sort of issue that regulators are expected to be aware of and take action to prevent. One might have hoped that regulators would have realized that unscrupulous salesmen were foisting unsuitable mortgages on borrowers

who were likely to default when the going got rough, as it was bound to do. (The problem may arise from the fact that, at least in the United States, mortgage lending is unregulated.) Regulators should have prevented the resulting mortgages being securitized and distributed to a thousand lenders who had no idea what risk they were bearing, but thought they were buying a risk-free asset because it had been awarded an AAA-credit rating. They should have prevented banks setting up SIVs to avoid the need to hold

capital against risks that had not really disappeared. There is also a question as to whether regulation that is undertaken by national governments is still adequate in the age of

globalization.

The fact is that the regulators did none of these things, in some cases for the compelling reason that the activities were unregulated. Accordingly, this crisis appears to me to be principally attributable to failures in supervision. I am not saying that one

cannot criticize central bankers for keeping the punch bowl available too long, but that failing seems to me to have been exaggerated compared to the failures of the regulators.

That conclusion may point to the irrelevance of the traditional form of policy coordination in generating this particular crisis, but it certainly does not point to the conclusion that international coordination is an irrelevance. To begin with, as pointed out above, different types of crisis are conceivable, and in some of them the traditional form of policy coordination is still highly relevant. But even the avoidance of this type of crisis is dependent on international coordination of regulatory principles. One reason for the easy regulation of recent years has presumably been the fear of driving financial business (and its profits, and its employment) abroad, perhaps to less well regulated markets. Even if this fear was not uppermost in their minds, it is a danger that needs constantly to be safeguarded against. The worst of all worlds would be if the financial firms took all their value-added abroad, but the fear of a financial crisis still drove the Fed to bail out a financial firm because of the consequences its failure would have for domestic activity.

It was not a fear of driving financial firms abroad that was directly responsible for the failures of regulation that caused this crisis, but in this day and age regulation can

only hope to be effective if it cannot be evaded by a simple shift of location. Any regulation needs to apply to all the principal financial centers. The world has in fact created a mechanism to secure this type of consistency in regulation, which operates through the Financial Stability Forum located at the Bank for International Settlements in Basel. This was set up in response to the Asian crisis of 1997. It has established a Working Group on Market and Institutional Resilience that has been preparing a Report (to be completed by April this year) to the G7 Finance Ministers and Central Bank Governors. This has already issued Preliminary and Interim Reports (FSF 2007, 2008) on the subject of how to strengthen the system in response to the financial turbulence.

These two reports make it clear that the authorities are contemplating tinkering

rather than fundamental changes. They take it for granted that securitization and the

originate-to-distribute model are here to stay2. International comparisons may suggest that this should not be taken for granted. In a recent speech, Anoop Singh (2008) of the IMF is reported to have said:

It has helped that in many countries, including here in Brazil, regulatory frameworks have made it difficult for banks to either buy the kind of structured products that have been at the center of events in the United States or accumulate significant off-balance sheet exposures.

The Reports of the FSF are not as complacent in applauding the practice of parking assets off-balance sheet in SIVs as they are in endorsing securitization, arguing rather that the implementation of Basel II will in any event reduce the regulatory arbitrage that generated large off-balance-sheet risk exposures. But there is no discussion of potential additional sources of vulnerability: for example, many of those who have taken one side of the market in credit default swaps (like Bear Sterns) might not be able to afford to honor the liabilities they have incurred if many of them came into the money.

It seems to me that the recommendations of the FSF are unlikely to suffice to prevent further crises. One needs to ask whether securitization and the originate-to- distribute (OTD) model are worth preserving. If the answer is no, they could be

eliminated by (joint) regulatory action. It is common to read assertions that there are great benefits from securitization (which would not be possible without OTD, so the two go together), but what are these? Presumably the main advantage is that borrowing is somewhat cheaper. This is not an inconsequential advantage, but if it is bought at the cost of a greater vulnerability of the financial system to crisis one needs to ask where the balance of advantage lies. The increased vulnerability to crisis is due to lenders holding less transparent instruments, the blunting of their incentive to restructure when times turn difficult, and the incentive of the loan originators to maximize volume even if this is at

the cost of issuing shaky loans. The fact that securitization occurs implies that there are net private benefits to the financial sector, but if these rely on being bailed out of any difficulties by the official sector, the spread of securitization is hardly definitive evidence of net beneficial social effects.

The market for credit default swaps has not yet experienced a crisis, but the newspapers have referred to the possibility that if many of the credits that have been covered turn bad, then those who took that side of the market will be bankrupted and unable to honor the outstanding instruments. This would in turn mean that many of those currently holding credits that are guaranteed via credit default swaps would be obliged either to hold distinctly more risky instruments or else that they will be forced to sell. The possibilities of further intensification of the crisis are apparent. It is not obvious that one can do much to ameliorate this situation during the crisis, but in future one would wish to see supervisors ensuring that credits are guaranteed only by those who have the net worth to honor all the guarantees that they have made. The practice of treating this as a cheap way to earn fee income needs to be ended.

The authorities welcomed the process of financial intermediation, rather than recognizing its dangers and imposing rules that would have provided a counterweight to the greed that drives the private financial sector. Securitization and its corollary, the originate-to- distribute model, do have their advantages, but these need to be weighed against the dangers they inherently bring of an increased susceptibility of the financial system to crisis. There is no sign that any such appraisal is under way; the committee that is currently considering how to reform the system is instead proposing only modest changes. While it does betray recognition of the desirability of reining in SIVs, there is no similar recognition of the dangers posed by credit default swaps.

It is desirable that any changes be introduced essentially simultaneously in all the major financial markets, for otherwise there is an acute danger of the benefits of reform being lost due to regulatory arbitrage. If that is classified as policy coordination, then coordination is central to achieving a more robust system. The more traditional form of coordination, in which the authorities of the leading countries commit themselves to pursuing a mutually consistent set of macroeconomic policies, remains of some importance, although its benefits lie in reducing the danger of a sort of crisis that has not yet occurred. The yen carry trade is one of the factors that contribute to the danger that this system will end up in crisis, and it would be addressed as well as seems feasible by a system of traditional-style policy coordination.

As long as this remains overwhelmingly a financial crisis and does not lead to a severe economic slowdown, the widespread adoption of prudent macroeconomic policies by emerging markets in the past few years should enable them to ride the crisis out. It is only if the financial weaknesses led to an important slowdown in the world real economy that one has to fear a major impact on emerging markets and developing countries. To date there is not evidence of such a major slowdown. Most indicators of the real economy remain rather strong. This is less true in the United States than elsewhere, but one of the thrusts of US policy has been expansionary actions on both the fiscal and monetary fronts, and it is only if these—and the improvement in the foreign balance as a result of the dollar depreciation—are overwhelmed by further financial problems that emerging markets would be likely to suffer. In Europe there has been a slowdown, which happened because of the financial turbulence rather than because of higher interest rates, but it is doubtful if there was much net increase in slowdown as compared to what otherwise would have occurred. In Asia there is still little sign of a slowdown at all. The chances of avoiding a major slowdown appear quite good.

What can emerging markets and developing countries do if, despite the current outlook, a major slowdown occurs? They could do rather more than in the past, because of their stronger current position. Many of them should be able to avoid taking deflationary actions and thus actually reinforcing deflation, as they have often been obliged to do by past collapses of confidence. Some have actually built up reserves and shown sufficient fiscal prudence that they would be able to adopt expansionary policies. Few need fear a big deprecation of their dollar exchange rate, which has in the past imposed severe deflationary pressures, at least in the short run. The outlook this time around appears much less gloomy than in the past.

Global Imbalances

The current imbalances involve a concentration of the major current account deficit in the United States and the corresponding surpluses in parts of East Asia and the oil-exporting countries. The latter reflect the recent increases in the oil price, and the IMF has argued that the oil exporters tend to eliminate most of their surpluses in due course. If that is right, it implies that the adjustment problem is essentially between the United States and certain East Asian countries. China inevitably comes to mind, but Hong Kong, Malaysia,

Singapore, and Taiwan also have highly-managed exchange rates and have been building up reserves, and are therefore natural candidates for adjustment. Japan is more debatable, since it also has a large current account surplus but allows its exchange rates to float. This floating has been reasonably free for the past several years, so it is sometimes argued that Japan does not need to adjust, but ought to be allowed to remain with the large surplus

that reflects the savings preferences of its citizens.

How did the imbalances grow so large? In my view this was a joint result of the oil price, the East Asian crisis, a macroeconomic policy that reflected a determination not to have any prolonged excess supply in the United States, and the policy of a fixed dollar exchange rate by some of the East Asian economies. This led to chronic and prolonged undervaluation of several of the East Asian exchange rates.

Are the imbalances dangerous? There is a school of thought (e.g. Cooper 2007) that argues that since the imbalances have (at least up to now) been easily financeable they must be seen as in the mutual interest of deficit and surplus countries, and therefore they cannot be dangerous. At some stage the surplus countries will choose to consume or invest a larger part of their income, and at that time adjustment will be triggered, without any need to fuss about matters at this stage. The contrary view is that time consistency is not one of the abiding virtues of financial markets, so that what is accepted today may prove unacceptable if it is prolonged too long. One has to extrapolate into the future, and while it is conceivable that the markets may accept deficits that cumulate into massive debts, it is unwise to rely on this. The larger the debts become, the greater the likelihood of a crisis developing. At the same time, the arguments against initiating adjustment advanced by the “do-nothing” school are not convincing. There is, for example, the contention that adjustment would be paralyzed by the acute conflict of national interests that would be ignited. The main exhibit here is the export-led growth of China, which do- nothing advocates argue to be indispensable to rapid growth in China (e.g. Dooley, Folkerts-Landau, and Garber 2003). This is wrong, because it ignores the possibility of expanding domestic demand to fill the gap that would result from lower external demand. In fact, since non-tradables are more labor-intensive, one expects such a policy switch to lead to a faster fall in unemployment (including disguised unemployment in the countryside), which would be very much in the national interest of China.

What sort of crisis is it that is envisaged by those who are anxious to head off its likelihood? It is not so much that the Fed will be forced to raise interest rates in order to check the inflation following a dollar decline (a traditional interpretation), but that the US economy will suffer a crisis of confidence (e.g. Williamson 2008). This would involve an exogenous decline in investment (like in East Asia in 1997). It means that the US economy is not completely forecast by the traditional models. The dollar collapse would in due course bring expenditure switching to the rescue of the United States, but in therest of the world expenditure switching would reinforce expenditure reduction in a deflationary spiral.

The gratifying fact is that the financial turbulence has not to this point ignited this particular type of crisis. Even though the financial turbulence was initiated by some of

the securities into which funds flowed proving much less solid than investors had been led to believe, the investors mainly sought alternative dollar assets rather than switching out of the dollar altogether. Of course the dollar has fallen, and such a fall is a part of most of the doomsday scenarios, but this has not been associated with a loss of confidence that brings a major fall in investment.

REFERENCE

Galati, Gabriele, Alexandra Heath, and Patrick McGuire. (2007). Evidence of Carry Trade activity. Bank for International Settlements Quarterly Review, Sep.

Lipsky, John. (2008). Dealing with Financial Turmoil: Tail Risks, Policy Challenges, and the Role of the IMF. Speech at the Peterson Institute, March 12. Available on https://www.petersoninstitute.org/events/event_detail.cfm?EventID=63.

Sarno, Lucio, and Mark P. Taylor. (2001). Official Intervention in the Foreign Exchange Market: Is it Effective and, If so, How Does it Work? Journal of Economic Literature, 3. Sep., pp. 839-68.

Singh, Anoop. (2008). The Financial Market Crisis and Risks for Latin America. Speech to a conference on “The Euro: Global Implications and Relevance for Latin America” in

São Paulo, 17 March.

Williamson, John. (2008). Are Global Imbalances a Problem? Paper presented to a conference on “Currency and Competitiveness” organized by the Austrian National Bank in Vienna, 19-20 November.