Likely policy fallout
Wednesday, 22 October 2008
Zahid Hussain
Global stocks have declined in waves on the seemingly growing evidence that the on-going credit crisis will send the global economy into recession. Retail sales in the US decreased by 4.0 per cent in the third quarter of 2008, business inventories are increasing and so are the cumulative job losses. The US and European stock markets have slumped to an extent not seen since the 1930s. The emerging markets have also taken a huge tumble and Asian stocks have tanked. Indonesia halted trading for a second full day in the week of October 7. And what could be a really bad omen: China has started to go down as well. China is used to large swings in its stock markets, but this time it is happening because of extremely unfavourable external circumstances. The question now is how deep the recession is likely to be and how long will it last?
Is this the case of one group or one company or one regulator falling asleep at the wheel? Is this the result of too little oversight, too much greed, or simply not enough information and understanding? Some are blaming free markets and globalization. Others are describing it as failures of government institutions. The government versus market debate has surely got a new lease of life. Does this mean the clock on globalization will be turned back? I doubt it.
The likely fallout for policy depends on how far-reaching the impact will be both in the United States and around the world. The troubles sound familiar. Borrowers are falling behind on their payments. Defaults are mounting. Investors are getting burned. The crisis shows that the world has been unable to combine liberalized capital markets with a reasonable degree of financial stability. Lessons must be learnt. Those lessons must be about how liberalized finance can be made to support the global economy rather than derail it.
Some have laid the blame on global macroeconomic imbalances. This is not exactly right. What causes a controllable macro imbalance to turn into full-fledged crisis is not any net imbalance between saving and investment in the US--or any corresponding current account surplus in Asia. The crisis grew out of the gross amounts of indebtedness involved. The problem in short is too much leverage, not saving-investment imbalance. This in turn is created by finance, not by macroeconomic imbalances or policies.
This is not the first financial crisis the world has endured. The focus on avoiding the next one at the end of each crisis has always been more transparency, more disclosure, and more risk management. This is not an adequate response to systemic crises. The focus of regulation needs to shift, away from sensitivity to the market price of risk and notions of equal treatment for all institutions. There needs to be greater sensitivity to risk capacity and a better recognition that diversity is the key to liquidity. Systemic resilience requires different risks to be held in places where there is a natural capacity for that type of risk. In the name of risk-sensitivity and equal treatment they ended up with institutions who had no liquidity, holding liquidity risk, and those with little capacity to hedge or diversify it, owning credit risk.
Regulatory oversight is likely to get tighter, probably keeping lending restrictions and bond ratings very conservative for the next few years. Irrespective of any lessons learned, be rest assured that Wall Street will continue to seek new ways to price risk and package securities. It therefore remains incumbent upon the investor to see the future through the valuable filters of the past. The triumph of markets over governments that global integration was seen to symbolize is now being questioned. To be sure, the most freewheeling areas of modern finance, such as the US$ 55-62 trillion market for credit derivatives, will be brought into the regulatory ambit. Rules on capital will be reformulated to reduce leverage and enhance the system's sturdiness.
For many countries, including Bangladesh, a more life-threatening shock over the past couple of years has been the sharp increases in commodity, particularly food, prices. The food-price spike in late 2007 and early 2008 caused riots in several countries. The food crisis induced changes in the balance between state and markets in areas other than finance. Governments across the emerging world increased subsidies, fixed prices, banned exports of key commodities and, in India's case, restricted futures trading. Last but not the least, America is losing economic clout. Beyond just shaping the direction of global trade, the emerging economies will increasingly influence the future of finance. That is particularly true of creditor countries such as China.
The international architecture designed to deal with such circumstances has disappointed expectations, putting it rather mildly. Hence the World Bank President's recent call for a New Multilateralism designed to suit our times. This new multilateralism will need to be a flexible network. It needs to build a sense of shared responsibility for the health of the global political economy and must involve those with a major stake in that economy. The world needs this new network so that global problems are not just fire-fought after the fact, but also anticipated. Furthermore, the world must redefine economic multilateralism beyond the traditional focus on finance and trade. Energy, climate change, and stabilizing fragile and post-conflict states are economic issues today. They are already part of the international security and environmental dialogue. They must be the concern of economic multilateralism as well. (The author is Senior Economist at the World Bank Dhaka office. The views expressed in this article are the author's own)
Global stocks have declined in waves on the seemingly growing evidence that the on-going credit crisis will send the global economy into recession. Retail sales in the US decreased by 4.0 per cent in the third quarter of 2008, business inventories are increasing and so are the cumulative job losses. The US and European stock markets have slumped to an extent not seen since the 1930s. The emerging markets have also taken a huge tumble and Asian stocks have tanked. Indonesia halted trading for a second full day in the week of October 7. And what could be a really bad omen: China has started to go down as well. China is used to large swings in its stock markets, but this time it is happening because of extremely unfavourable external circumstances. The question now is how deep the recession is likely to be and how long will it last?
Is this the case of one group or one company or one regulator falling asleep at the wheel? Is this the result of too little oversight, too much greed, or simply not enough information and understanding? Some are blaming free markets and globalization. Others are describing it as failures of government institutions. The government versus market debate has surely got a new lease of life. Does this mean the clock on globalization will be turned back? I doubt it.
The likely fallout for policy depends on how far-reaching the impact will be both in the United States and around the world. The troubles sound familiar. Borrowers are falling behind on their payments. Defaults are mounting. Investors are getting burned. The crisis shows that the world has been unable to combine liberalized capital markets with a reasonable degree of financial stability. Lessons must be learnt. Those lessons must be about how liberalized finance can be made to support the global economy rather than derail it.
Some have laid the blame on global macroeconomic imbalances. This is not exactly right. What causes a controllable macro imbalance to turn into full-fledged crisis is not any net imbalance between saving and investment in the US--or any corresponding current account surplus in Asia. The crisis grew out of the gross amounts of indebtedness involved. The problem in short is too much leverage, not saving-investment imbalance. This in turn is created by finance, not by macroeconomic imbalances or policies.
This is not the first financial crisis the world has endured. The focus on avoiding the next one at the end of each crisis has always been more transparency, more disclosure, and more risk management. This is not an adequate response to systemic crises. The focus of regulation needs to shift, away from sensitivity to the market price of risk and notions of equal treatment for all institutions. There needs to be greater sensitivity to risk capacity and a better recognition that diversity is the key to liquidity. Systemic resilience requires different risks to be held in places where there is a natural capacity for that type of risk. In the name of risk-sensitivity and equal treatment they ended up with institutions who had no liquidity, holding liquidity risk, and those with little capacity to hedge or diversify it, owning credit risk.
Regulatory oversight is likely to get tighter, probably keeping lending restrictions and bond ratings very conservative for the next few years. Irrespective of any lessons learned, be rest assured that Wall Street will continue to seek new ways to price risk and package securities. It therefore remains incumbent upon the investor to see the future through the valuable filters of the past. The triumph of markets over governments that global integration was seen to symbolize is now being questioned. To be sure, the most freewheeling areas of modern finance, such as the US$ 55-62 trillion market for credit derivatives, will be brought into the regulatory ambit. Rules on capital will be reformulated to reduce leverage and enhance the system's sturdiness.
For many countries, including Bangladesh, a more life-threatening shock over the past couple of years has been the sharp increases in commodity, particularly food, prices. The food-price spike in late 2007 and early 2008 caused riots in several countries. The food crisis induced changes in the balance between state and markets in areas other than finance. Governments across the emerging world increased subsidies, fixed prices, banned exports of key commodities and, in India's case, restricted futures trading. Last but not the least, America is losing economic clout. Beyond just shaping the direction of global trade, the emerging economies will increasingly influence the future of finance. That is particularly true of creditor countries such as China.
The international architecture designed to deal with such circumstances has disappointed expectations, putting it rather mildly. Hence the World Bank President's recent call for a New Multilateralism designed to suit our times. This new multilateralism will need to be a flexible network. It needs to build a sense of shared responsibility for the health of the global political economy and must involve those with a major stake in that economy. The world needs this new network so that global problems are not just fire-fought after the fact, but also anticipated. Furthermore, the world must redefine economic multilateralism beyond the traditional focus on finance and trade. Energy, climate change, and stabilizing fragile and post-conflict states are economic issues today. They are already part of the international security and environmental dialogue. They must be the concern of economic multilateralism as well. (The author is Senior Economist at the World Bank Dhaka office. The views expressed in this article are the author's own)