PUBLIC POLICY AND DEVELOPMENT SEMINAR Asian and the Global Crisis Charles Adams Lee Kuan Yew School National University of Singapore Hanoi, May 5, 2009
Introduction and Overview • (1) Big Picture and Context • (2) Perspectives on the Current Crisis • (3) Global Economic and Financial Outlook • (4) Asian Economic and Financial Outlook
Big Picture and Context • The ongoing international economic crisis reflects the disorderly unwinding of a number of large macroeconomic and financial imbalances that emerged during the exceptionally benign conditions in the first part of this decade. • The key macroeconomic imbalances include the large current account deficits of the United States and the corresponding surpluses in the rest of the world, notably in Asia, the Middle East and Russia. • The various financial imbalances included massive increases in leverage and risk taking (parts in shadow banking systems); bubbles in a number of property and equity markets; and a sharp compression of risk spreads across a wide range of financial instruments (risk priced to perfection.) • The macroeconomic and financial imbalances were interrelated.
Big Picture and Context • To a significant degree, the various macroeconomic and financial imbalances were an “accident waiting to happen” but the precise timing and triggers for the inevitable adjustments were not very clear. • Adjustments have been much more severe (seizing up of key financial markets )and very different to what many expected (e.g. no US dollar crash). • With the crisis unfolding, the imbalances are starting to unwind in a disorderly way (not just US current account deficit but other current account deficits as well) as the net private saving rate in the United States rises sharply, massive deleveraging takes place, risks are repriced, some financial systems remain dysfunctional and international credit (and trade credit) markets tighten up.
Big Picture and Context • Contrary perhaps to what was expected by many analysts, there has not thus far been a run on the US dollar as a result of difficulties financing the US current account imbalance. Reflecting safe haven and repatriation effects, the US dollar has generally been strengthening during the crisis rather than losing ground and there has been a US dollar “shortage”. • There is risk, however, that we may get US dollar pressures if confidence in the ability of the U.S. to address its current challenges weakens and confidence in the US fiscal and monetary stimulus packages wanes. • Arguably, the US will require a significant real depreciation as its current account deficit narrows and there is a question about how this will come about if the US dollar remains strong. One possibility would be deflation of US prices.
Big Picture and Context • The disorderly adjustments thus far are being accompanied by significant financial spillovers across countries due to high levels of financial interdependence—including as result of the transfer of risk through complex securitized products—sharp generalized increase in risk aversion, massive deleveraging and heightened counterparty risk. Also, great uncertainty about “who owns the risk”. • More recently, traditional trade linkages are starting to exert themselves as world trade has been slowing dramatically in response to a generalized weakening of demand. Commodity prices have also retreated sharply from their highly elevated levels early last year. • Clearly, the coming year is going to be a difficult one but there are questions about how bad it will get, how the various macroeconomic and other stimulus packages will affect the outcome, and the key risks. • What does it all mean for Asia? Innocent Bystander? Begin with some perspectives on the crisis, the global Outlook and then consider the Asian outlook followed by some financial sector reform issues.
Crisis Perspectives • There are several senses in which every financial crisis is different. The current US crisis has some unique elements related, in particular, to the role of the shadow banking system (conduits, SIVs), the originate-and-transfer model of finance, and the artful slicing and dicing of financial products. In these respects, the crisis is different to other crises, and to the LTCM crisis in 1998 (in which a single unregulated hedge fund was seen to pose risks to systemic financial stability), the crises in the US banking system in the 1930s (in which thousands of US banks went under), the International debt crisis of the 1980s, and the 1980s/1990s Savings and Loan Crisis. But there are also many respects in which financial crises are similar. • The dynamics of the current financial crisis are broadly similar to many other crises.
Crisis Perspectives • First, there is a period during which too much credit is extended, leverage rises to very high levels (in large measure through derivatives and low margins), and people start to believe that things will be different, based on a “story” of a new era (the Greed period). This is the boom or bubble period that precedes the eventual collapse. • Second, there is some event (the “Canary in the coalmine” moment) that triggers a reappraisal of the story and, ultimately, a reversal of the excesses during the boom. The problems in the sub-prime segment of the U.S. real estate market likely served as the wake up call during the current crisis. In this second phase, positions are unwound, leverage is reduced, and financial firms begin to scramble for capital and liquidity in response to losses and writedowns (the Fear period).
Crisis Perspectives • Finally, following a series of ad hoc interventions involving lender of last resort and life-boat rescues, the official sector steps in with bold measure such as guarantees and the purchase of substantial chunks of the financial system and/or distressed assets • For those with at least some familiarity with financial crises, the time signature of every crisis is uncannily similar. In the ending to many financial crises, the economy enters a deep and protracted downturn and public debt levels soar to high levels as the official sector bails out the private sector. • The current crisis fits this mould. As the crisis is far from over, however, one should be careful in speculating about the end point.
Crisis Perspectives • The key differences this time around are that the crisis blew up in the core rather than the periphery of the system (recall the large number of recent crises that occurred in emerging markets at the periphery of the system); has been affecting multiple markets, instruments, and institutions (commercial banks, investment banks, insurance companies); has spilled over across countries as financial risks were unbundled and sold around the world; and is both a banking and capital market crisis. • Intriguingly, new financial players such as Sovereign Wealth Funds are starting to play a role as sources of new capital while hedge funds, at least thus far, have been in the back seat. • As in other crises, the current episode has involved a breakdown of the multiple lines of defence set up to deal with periods of excessive exuberance
Crisis Perspectives • The first line of defence is the risk management of financial firms. Arguably, risk management across a range of firms has again been subject to massive failures, and their oversight Boards have not performed as intended. • The second line of defence includes all the various market and official analysts-- as well as credit rating agencies--that monitored the US financial sector and failed to spot impending problems until too late. A conflict of interest on the part of rating agencies that advised on, and then rated, complex financial products likely played a role here, and will need (somehow) to be addressed. But it is also staggering how many other private and official observers did not predict problems, and did not call for action that could have avoided the excesses.
Crisis Perspectives • Finally, in the third line of defence, the very fragmented US supervisory regulatory bodies did not play their proper role and were arguably “asleep at the wheel” as the shadow banking system bloomed. • Clearly, any one of these lines of defence could have prevented the crisis but each broke down, with serious consequences. • What about the macroeconomic backdrop to the current crisis? As is usual, a list of the “usual suspects” can be drawn up. • Three possible factors can be identified, even while noting that the fundamental responsibility for the crisis must lie with the financial firms that made massive errors in risk management.
Crisis Perspectives • The macroeconomic “suspects” would clearly be: • (1) The very accommodating monetary policy followed for an extended period by the US Federal Reserve in the wake of the bursting of the dot-com bubble earlier in the decade (less so monetary policy in other major countries); • (2) The global net savings glut along with the massive recycling of funds that have been part of the global current account imbalances and; • (3) The very benign conditions in the global economy in recent years which may have created the illusion that things will remain “as good as they get”. • Needless to say, these factors may be related but it is useful to consider them in turn.
Crisis Perspectives • (1) The key question is whether very accommodating monetary policy was the main cause of the boom, and here the arguments seem less than compelling. To be sure, globalization and the growing integration of China and India into the global economy may have helped temporarily to hold down inflation in circumstances where monetary policy may have been too loose. As implied by much analysis, however, the size of these effects is generally not large enough to offset the implications of an excessively loose monetary policy for inflation. Also the story does not fit all countries • Most importantly, even were there to be some temporary effects from monetary policy, it is not clear that it would be feasible or desirable to assign financial stability objectives to monetary policy along side its primary focus on medium-term price stability
Crisis Perspectives • (2) The net savings glut of recent years along with the recycling of savings from the periphery to the core through current account imbalances and reserve accumulation is a possible contributor to the crisis. Even though the causal mechanisms are not always clear, the argument seems to be that excessive saving in Asia and the Middle East helped keep US interest rates low which in turn led to an aggressive search for yield, a failure of long-term interest rates to rise during the cyclical upswing and a sharp compression of risk spreads (Greenspan’s conundrums). The argument does not seem very convincing. • (3) Finally, the last potential factor is the benign economic conditions of recent years as reflected in broad and strong economic growth, low and stable inflation, and very low levels of financial volatility. Arguably, these favourable “Goldilocks” conditions may have led to an increase in risk appetite and helped encourage the boom.
Crisis Perspectives • Even though such explanations are by their nature difficult to test, the benign conditions may have played a role with their dynamics carried forward by the many pro-cyclical elements in financial systems. • If this explanation is, at least, partially correct it has the unfortunate corollary that the crisis may have been the result of the strong macroeconomic polices of recent years that supported the benign economic conditions that were experienced before the crisis rather than a result of “bad” policies. • As in the case with the many other “suspects”, however, it is difficult to reach definitive conclusions
Global Economic Outlook and Risks • Consider IMF’s latest (official) assessment of the global economic outlook. • IMF is projecting a very sharp and synchronized global slowdown and continues to see the short-term risks to growth as being very skewed to the downside. • Increasingly, the IMF is also talking about a protracted as well as deep growth slowdown (i.e. it is starting to question its own story of a second half of 2009 rebound ).
Global Economic Outlook and Risks • (a) Very weak end 2008 and beginning 2009 data; • (b) Protracted financial sector difficulties; • (c) Much larger than expected spillovers across markets and countries; and • (d) Recent commodity price weakening • IMF projections appear in its regular World Economic Outlook Publications and are on its website ( www.imf.org )
Global Economic Outlook and Risks • End 2008 and early 2009 data has generally been very weak (falling off a cliff?) • But, government polices are responding in a major way in advanced countries and elsewhere: financial sector interventions; liquidity support; monetary easing, fiscal packages. • Will these avoid annus horribilis or will the Greens Shoots bloom? • Consider some recent data which follows or exceeds the slowdowns in the charts.
Global Economic Outlook and Risks • What are the key Short-term Risks in the global economy? Are the Green Shoots overdone? • (1) Macroeconomic Stimulus measures have limited effectiveness—monetary policy hits liquidity and other traps and fiscal multipliers prove to be very low. • (2) Financial System problems not fully addressed and systems come under renewed pressure even though . The “W” path? • (3) Emerging Markets face severe protracted pressures. • (4) US Dollar Dumping and Crash scenarios • (5) Trade and financial protectionism and pullback from globalization
Asian Economic and Financial Outlook • What about the outlook for Asia based on the global outlook? • When the crisis first erupted in 2007, there was an expectation of relatively modest spillovers to Asia based on three key considerations: • (a) The region’s continued heavy dependence on bank rather than capital markets based financing and its limited exposure to relatively complex capital markets products such as sub-prime securities. Even though a number of banks in China, Japan, Korea, Taiwan and Singapore, in particular, held some sub-prime and related products, the exposures were generally very small in relation to bank capital.
Asian Economic and Financial Outlook • (b) External Current Account, International Reserves and bank balance sheets across much of the region were relatively strong. • ( c ) The growing importance of intra-regional trade and the belief in the decoupling of regional growth from the major advanced economies. Decoupling, however, was greatly exaggerated. Much of the region’s intra-regional trade consists of intermediate goods that are part of global production networks and over 60 percent of the region’s exports still ultimately depend on final demand outside the region • The financial and real spillovers from the international crisis to the region have recently been increasing sharply as conditions in the global economy continue to deteriorate.
Asian Economic and Financial Outlook • Various linkages: goods and services trade, remittances, capital flows, financial markets (equity and debt), confidence, trade credit, commodity prices • Reflecting its close integration with the global economy and strong export orientation, Asia is being affected very adversely by the unwinding of the imbalances. • Growth in the region has started to slow as its exports to the major advanced countries have been contracting sharply and a number of countries in the region have been moving into recessionary conditions. • Countries in the region have been adopting macroeconomic and other stimulus measures (swap lines, guarantees, liquidity support etc) to help cushion the effects of the slowdown, limit its adverse spillovers and maintain financial stability. • During this year, in particular, managing sharp growth slowdowns is likely to dominate the macroeconomic policy agenda in the region
Asian Economic and Financial Outlook • Notwithstanding considerable heterogeneity in region, some common short-term challenges. • (1) Need to cushion the effects of global slowdown via monetary and fiscal stimulus where there is room and start re-balancing demand away from exports. Fiscal and monetary space varies across countries, however. • (2) Need to deal in some countries with foreign currency liquidity pressures (Korea, Indonesia, Philippines, Vietnam, India (?)) • (3) Need to be prepared for any domestic liquidity or solvency issues that arise in local banking systems if the slowdown is very sharp and protracted. Absorb equity market declines
Asian Economic and Financial Outlook • Key short and medium term challenge associated with global current account imbalance unwinding (Adams and Park). • What is rebalancing and how does the region rebalance?
Asian Economic and Financial Outlook • How is Vietnam being affected by the Crisis? • Current slowdown reflects both lagged response to 2008 tightening measures and the effects of the global slowdown. • What are the short-term risks for Vietnam? • Are macroeconomic policies overreacting to the short-term slowdown? • Is Vietnam positioned well to take advantage of the eventual pickup?