Commodity Price Shocks and Financial Turbulence: Implications for Europe Luc Everaert

1. Commodity Price Shocks and Financial Turbulence: Implications for Europe Luc Everaert September 25, 2008 39th CMTEA Conference European Department EU Policies/Regional Studies

2. Outline • Commodity prices: lower growth and high inflation • Growth and real wages need to slow • Core inflation need not increase • Inflation risks depend on labor market flexibility and policy credibility • Financial turbulence: drag on growth with downside risks • Significant impact through various channels, but no systemic breakdown, owing to policy intervention • Impact differs across countries, depending on levels of debt, external imbalances, quality of policy frameworks and policies, degree of financial integration and type of financial system • Real effects manageable, but credit crunch poses downside risk • Economic Outlook and Policy Implications European Department EU Policies/Regional Studies

3. Commodity Price Increases • Developments and outlook • Impact on supply and demand • Impact on inflation • Potential for wage-price spirals: • Advanced economies: • Real wages are adjusting to oil price shock; • But food prices are a concern; • Policy credibility will be key to keep/bring inflation expectations to target • Emerging economies: • Higher inflation risks as shock and pass-through to core are stronger, overheating already present, and track record for credible policies shorter • Policies need to address wage resistance European Department EU Policies/Regional Studies

4. Following their recent sharp increase, commodity prices are likely to stabilize at an elevated level European Department EU Policies/Regional Studies

5. Energy intensity determines supply effects of oil price increases European Department EU Policies/Regional Studies

6. Terms of trade shocks determine impact on demand; the Baltic countries and southeastern Europe are likely to suffer most European Department EU Policies/Regional Studies

7. Food price increases have a sizeable impact, with Eastern Europe more affected European Department EU Policies/Regional Studies

8. The impact of oil prices is smaller, without clear regional bias European Department EU Policies/Regional Studies

9. Advanced economies: oil prices are unlikely to cause second-round effects as wages are not moving up with energy prices European Department EU Policies/Regional Studies

10. But food price increases have recently had a tendency to show up in core inflation European Department EU Policies/Regional Studies

11. Policy credibility is key to keeping inflation expectations in line with targets European Department EU Policies/Regional Studies

12. Emerging economies face more significant inflation pressures European Department EU Policies/Regional Studies

13. As core inflation and inflation expectations have drifted upward European Department EU Policies/Regional Studies

14. Wage resistance and policy attempts to sustain output are likely to aggravate the downturn European Department EU Policies/Regional Studies

15. Financial Turbulence: Channels of Impact • Global risk repricing • Lower equity values • Tighter lending standards European Department EU Policies/Regional Studies

16. Estimating Shifts in the Global Price of Risk(Basis points) Risk has been re-priced European Department EU Policies/Regional Studies

17. iBoxx Euro-Corporate Bond Spread over 10-Year German Bond Rate, January 2007–March 2008(Basis points) Equity prices have declined European Department EU Policies/Regional Studies

18. Lending standards have tightened, and lending to household has slowedbut corporate lending continues in the euro area European Department EU Policies/Regional Studies

19. Money markets remain stressed European Department EU Policies/Regional Studies

20. A direct confidence channel?Headlines in FT of September 22, 2008 Positive tone • Fed action proves positive for ABS Negative tone • Fears emerge over $700 billion rescue • Oil price jumps $25 dollar in a day • Regulators step up curbs on shorting • Lehman bondholders face losses of $110 billion • Money market funds suffer large outflows • Freddie and Fannie bank losses grow • Fed acts to protect Goldman, Morgan Stanley • Pressure builds on Wamu to reach deal • Heavy losses for regional banks amid growing skepticism • Libor rates show that banks are still protecting their cash European Department EU Policies/Regional Studies

21. Financial Turbulence: Factors Affecting Impact Across Countries • Advanced economies: public debt and quality of policies • Emerging economies: external imbalances, credibility of policy frameworks and quality of policies • Financial integration with the U.S. • Mortgage market features • Procyclicality of corporate leverage European Department EU Policies/Regional Studies

22. Advanced economies: spreads depend on levels of debt and the quality of macroeconomic policies European Department EU Policies/Regional Studies

23. Emerging economies: investors differentiate based on external imbalances, credibility of policy frameworks, and quality of policies European Department EU Policies/Regional Studies

24. Financial integration determines size of spillovers from U.S. European Department EU Policies/Regional Studies

25. Mortgage market features define magnitude of house price fluctuations European Department EU Policies/Regional Studies

26. Procyclical leverage boosts the volatility of investment European Department EU Policies/Regional Studies

27. Financial Turbulence: Real Effects • Significant reduction in growth: • relatively more important for advanced economies • and stronger in cases where a negative feedback loop with housing prices exist; • Further downside potential: • if bank capital is impaired and/or deleveraging is needed; • if a mutually reinforcing deterioration of financial and economic conditions develops European Department EU Policies/Regional Studies

28. Higher borrowing cost and falling asset prices take a toll on growth European Department EU Policies/Regional Studies

29. Markets are concerned about the viability of financial institutions European Department EU Policies/Regional Studies

30. Deleveraging to repair balance sheets could cut growth further >Bank capital is being impaired by losses on subprime assets and rising delinquencies associated with economic slowdown Example: euro area. Bank losses on subprime assets of U$50 billion are equivalent to 2 percent of bank capital; at constant leverage leading to a credit contraction of 2 percent, with an estimated negative impact on GDP 0.2 percent. However, banks have raised capital to offset the losses, though not fully. >Markets are pressuring banks to delever; i.e. increase the capital to non-weighted assets ratio This ratio is less than 3 percent in continental Europe (more than 5 percent in U.S.). Projections suggests an increase to 3 and ¾ percent, leading to a sharp and protracted slowdown in credit growth European Department EU Policies/Regional Studies

31. Economic Outlook and Policy Implications • Slower growth with gradual recovery and varying inflation • Growth below potential, with sharp slowdown in some emerging economies • Advanced economies stagnating before gradual recovery • Inflation likely to recede in advanced economies but remain high in most emerging economies • Risks tilted unfavorably • Output: downside from financial turmoil • Inflation: upside from wage-price spiral (especially in emerging economies) • Policy response: monetary, fiscal, and financial sector polices • Adjusted to country specific circumstances, balancing output and inflation risks • Contingency plans needed for financial turmoil related risks European Department EU Policies/Regional Studies

32. Growth likely to be well below potential European Department EU Policies/Regional Studies

33. Advanced economies: stagnation followed by a gradual recovery European Department EU Policies/Regional Studies

34. Inflation is likely to recede in advanced economies, but remain high in emerging economies European Department EU Policies/Regional Studies

35. Risks are unfavorably tilted While a majority of models predicts euro area inflation to fall to target, the average of all forecasts is still slightly higher Though growth forecast is balanced, financial risk imparts a tilt to the downside European Department EU Policies/Regional Studies

36. What should policymakers do? • Advanced economies: • Monetary policy: on hold to deal with inflation risks, but easing soon as disinflationary forces take hold; • Fiscal: automatic stabilizers but within limits afforded by fiscal rules and need for sustainability • Financial sector: provide liquidity as needed, have contingency plans operational to address financial system instability • Emerging economies: • Monetary policy: tighten, except where inflation falling and inflation expectations are within target • Fiscal policy: tighten to address structural deficits and let automatic stabilizers operate; contingency plans for hard landing • Financial sector: ensure crisis resolution frameworks are operational, including cross-border dimension European Department EU Policies/Regional Studies

37. Thank you! European Department EU Policies/Regional Studies

38. IMF advice on turmoil • Policy recommendations through bilateral and multilateral venues to deal with turmoil and prevent recurrence: • Restore confidence in markets: • provide liquidity • improve transparency • raise bank capital • Reinforce soundness of financial institutions: • increased supervisory oversight of liquidity management • build capital buffers • monitor leverage • manage liquidity risk • regulate off-balance sheet entities • Improve financial system architecture: • crisis resolution frameworks (e.g. UK) • cross-border supervisory cooperation European Department EU Policies/Regional Studies

39. Effect on bank capital and leverage will be crucial First round effects of exposure: European Department EU Policies/Regional Studies

40. Caveats • Losses may be higher: • US recognized losses are now at US$160 billion, and estimated losses US$220-260 billion (compared to US$95 and US$144 billion, respectively at end March 2008). • European banks may post further write-downs (e.g., UBS likely Q2 $4.8 billion) • Monoline insurers are under pressure: reduction in rating would require banks to make further write offs; • Banks may be hit by other shocks related to economic slowdown and other financial institutions are not covered by the analysis • Real impact may be lower: • Bank recapitalization may continue: e.g. US banks have raised US$125 billion and Citi just announced it would seek another US$40 billion European Department EU Policies/Regional Studies

41. Financial Conditions: Role of Credit European Department EU Policies/Regional Studies