Transcript Global Financial Crisis

MANAGING MACROECONOMIC
AND MONETARY POLICY IN A
HIGHLY UNCERTAIN ENVIORNMENT
ISHRAT HUSAIN
SEACEN, MANILA
July 30, 2012
CONTEXT AND BACKGROUND
• World economy has recorded fastest growth in the
last 50 years ushering in an unprecedented era of
prosperity for the majority of the population. Even
in this decade of slow growth the global economy
will grow to 10 to 20 percent faster than it did a
decade ago, 60 percent faster than it did two
decades ago, and five times as fast as it did three
decades ago.
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CONTEXT AND BACKGROUND
(Continued)
Developing and emerging economies which were
impoverished and faced with poverty, hunger,
illiteracy have been able to make a remarkable turn
around and increased their share of world GDP from
almost negligible proportion to almost 50 percent. In
1980, the number of countries that were growing at
4 percent a year was around 60. by 2007, it had
doubled to 120. even now, after the financial crisis
and recession the number is more than 80. Then
annual average growth rate in the last decade was an
impressive 6.4 percent.
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CONTEXT AND BACKGROUND
(Continued)
• Poverty has been reduced more in the past 50 years
than in the previous 500 years. About one billion
people have been lifted out of poverty since 1980.
The proportion of people living below the poverty
line has dramatically fallen from 52 percent to about
20 percent in this period.
• Between 2005 and 2010 both the poverty rate and
the number of people living in extreme poverty have
fallen in all the six developing countries, the first
time that has happened.
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CONTEXT AND BACKGROUND
(Continued)
• The World Bank projections show that the global
target of the Millennium Development Goals (MDG)
of halving World poverty has been achieved five
years early.
• Rising agriculture production has kept ahead of
population growth. World Food Production Index
rose by 75% in the last 20 years while population
grew by 50 percent in the same period.
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CONTEXT AND BACKGROUND
(Continued)
• Mobility of people, capital, ideas, goods and services
across country border has never been as high as in the
last two decades.
• World Trade growth has consistently outpaced world
output growth; Capital flows in form of portfolio
investment, loans, equity investment, remittances,
official aid have risen sharply.
• Financial innovation and financial engineering based on
complex models gave rise to new products that has
transformed the basic landscape i.e. Derivatives, credit
default swaps, collateralized debt obligations.
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CONTEXT AND BACKGROUND
(Continued)
• Despite these solid achievements, the world
economy has faced many crises during the last three
decades – the most significant being the latest crisis
of 2007-08 which has shaken the foundations of
many theories, beliefs and practices.
• Before we delve into the remedies for the future we
must try to understand as to why these crises took
place.
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SYMPTOMS AND CAUSES OF PAST
FINANCIAL CRISES
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Poor or Ineffective system of banking supervision and regulations.
Lack of adequate disclosure and transparency.
Ineffective systems of corporate governance.
Weak and inflexible exchange rate regimes.
Significant debt and asset price inflation.
Unsustainable short-term capital flows.
Little understood Financial innovation and engineering.
Highly fragmented regulatory oversight and emergence of unregulated
shadow banking system.
• Unwanted credit booms due to monetary easing.
• Vulnerability due to securitization and trading in marketplace
instruments
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APPROPRIATENESS OF INTELLECTUAL
FRAMEWORK
• Modern Macro theory is based upon Efficient Market
Hypothesis, Rational Expectations, McKinnon – Shaw
thesis and Mathematical Models based on past
behavioral relationships.
• Efficient Market Hypothesis (EMH) has been the
predominant theory governing financial markets. The
assumption that market prices are based on rationality
has proved wrong in practice. Individual rationality does
not ensure collective rationality.
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APPROPRIATENESS OF INTELLECTUAL
FRAMEWORK
(Continued)
• Individual does not always behave rationally but in
network economy his/ her behavior depends on what
others are doing. Herd instinct is a common
observable trait.
• Many studies have shown that the McKinnon – Shaw
thesis of financial liberalization, in the short to
medium term, has harmful effect and triggers
financial crises by misdirecting the allocation of
Capital. Competition among banks leads to
indiscriminate and risky credit operations (moral
hazards problem).
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APPROPRIATENESS OF INTELLECTUAL
FRAMEWORK
(Continued)
• Mathematical models and algorithms would
allow financial innovation, ease in manufacturing
and trading in complex derivatives such as credit
default swaps (CDSs) and collateralized Debt
Obligations (CDOs). The models made the
assessment of credit quality of underlying loans
quite difficult and complicated. There were
serious omissions in the specifications of models
such as complete exclusion of high risk events,
systemic risks and non-linearity.
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APPROPRIATENESS OF INTELLECTUAL
FRAMEWORK
(Continued)
• Information asymmetry and Moral hazard have been
studied extensively in economics literature but their
application in designing new financial products was
far from satisfactory.
• We now recognize that these theories have proved
to be inappropriate.
Lags, Asymmetries,
nonlinearities and irreversible have introduced
complexities which are not factored in.
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UNCERTAINITY AND RISKS
• Must differentiate between Uncertainty and
Risks.
Uncertainty
is
unforeseen
and
unanticipated but Risks can be identified
measured, managed and mitigated.
• We should scan the changes likely to taking place
in the next 5, 10, 20 and 30 years. The more
distant is the end point the more hazy is our
picture. But this does not mean we should not
keep refining and refocusing the picture.
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UNCERTAINITY AND RISKS
(Continued)
• Keep focused on the main Global Drivers of Change
that can be source of uncertainty if not properly
understood and prepared for. They provide both
threats and opportunities. We cannot fully protect
against or eliminate every potential risk factor but we
need to develop a strong immune system before the
disease hits us so that the damage to the economy is
limited.
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MAIN GLOBAL DRIVERS OF CHANGE
Realignment of economic activity:
- Top 20 economies in 2050 half of them expected
to be countries that are currently described as
‘Emerging and Developing’ (EDEs).
- Manufacturing relocating in EDEs because of
lower wages for similar skills, Economies of scale,
closer to points of consumption.
- Knowledge intensity of industries up on the rise
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MAIN GLOBAL DRIVERS OF CHANGE
(Continued)
Growing pressure on public expenditures for:
– Healthcare
– Medical insurance
– Pensions
– Higher education
– Research & Development
– Unemployment benefits
– And other social safety nets
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MAIN GLOBAL DRIVERS OF CHANGE
(Continued)
Demographic Dividends or Disaster:
– 1.2 billion people in Emerging and Developing
countries are aged between 12 and 24.
– Investments in skills and training of these young
people in EDEs
– International migration flows to labor scarce
countries – will this be allowed?
– If EDEs fail to find jobs for the youth the likelihood
of social upheaval will be high
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MAIN GLOBAL DRIVERS OF CHANGE
(Continued)
Technological Connectivity
– Geographical boundaries have become irrelevant in
transmission and dissemination of information
– Information explosion at exponential speed needs to
be sifted and screened
– Technological revolution in form of Internet, mobile
phones, cable and satellite TV, networking, have made
communication and connectivity easy and physical
distances shrink. Cell phones today have more
computing power the Apollo Space Capsule.
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MAIN GLOBAL DRIVERS OF CHANGE
(Continued)
New Industry Structure
– Interlinked systems of suppliers, producers and
customers breaking national barriers have emerged.
– Components are manufactured at different locations
which are cost competitive and then shipped for final
assembly to a country that exports it
– High skill intensive services industry will dominate
the scene in the Advanced Economies while
fabrication and manufacturing will take place in EDEs
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MAIN GLOBAL DRIVERS OF CHANGE
(Continued)
Greater Complexity
– Public policy makers have to acquire new
resources, skills and techniques and adapt to the
rapidly changing environment .
– The increased mobility of factors and integration
of markets would have consequences – both
positive as well as negative.
– Response capacity to tackle these complexities
will require agility.
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CHALLENGES IN MANAGING UNDER
UNCERTAINITY
• Volatility of capital flows (FDI, FPI, Loans & grants,
Remittances etc.) with effects on:
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Monetary policy
Exchange rate
Competitiveness
Reserves
• Global supply chain
– Demand fluctuations in final assembly country
– Excess capacity
– Unemployed resources
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CHALLENGES IN MANAGING UNDER
UNCERTAINITY
(Continued)
• Financial Sector Stability
– Contagion and spillover effects
• Swings in Commodity prices
– Oil and Gas
– Food
• Tools and Instruments for effecting changes
– Public policies
– Regulatory Frameworks
– Market Institutions and Discipline
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MACROECONOMIC MANAGEMENT
UNDER UNCERTAINITY
• Construct and Develop a strong Immune System. The main
components of the system would be
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Fiscal policy stance
Financial sector soundness
External robustness
Monetary policy credibility
Quality of Governance
Export Diversity
Private Sector Debt
Government effectiveness
International Reserves
Exchange Rate flexibility
• The stronger is the immune system the better will be the
capacity for resilience and bounce back.
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MACROECONOMIC MANAGEMENT
UNDER UNCERTAINITY
(Continued)
• Response capacity of the Immune System would
depend upon:
RESOURCE ENDOWMENTS
• Commodity Dependence
• Diversification of Economy
NATURE, INTENSITY AND SPEED OF EXOGENOUS SHOCKS
EXPOSURE TO INTERNATIONAL MARKETS CONTAGION
EFFECT
• Interconnectedness
RESPONSE OF OTHER PLAYERS SUCH AS INTERNATIONAL
FINANCIAL COMMUNITY
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MONETARY POLICY MANGEMENT UNDER
UNCERTAINITY
• Transmission mechanisms break down under uncertainty.
• Ingenuity, agility and thinking on the feet would be
required at these times.
• Timely and substantive public sector intervention required
when the private markets fail to clear
• Too much resilience on the post stable behavioral
relationships would be inadvisable
• Asset prices should be kept under vigilance and so the
credit booms for corrective action.
• Resolution Authority, Lender of Last Resort function and
Insurance mechanism should be in place and lubricated
from time to time.
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MONETARY POLICY MANGEMENT UNDER
UNCERTAINITY
(Continued)
• Resolution Authority, Lender of Last Resort function
and Insurance mechanism should be in place and
lubricated from time to time.
• Greater coordination between monetary and fiscal
policies all the time
• Capital buffers leverage ratios and liquidity benchmarks
for the big financial institutions should be prescribed
and enforced
• Exchange rate should remain realistic and flexible
• Macro prudential regulations should be invoked
selectively in support of monetary policy objectives
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