Tough Political Decisions Needed to Fix the Financial System

   By José Viñals

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It was fitting that I should present our latest assessment of global financial stability in Sao Paulo, the financial center of one of the leading emerging economies. In common with many of its peers in Latin America, Brazil is recovering strongly from the crisis. But new financial stability challenges are emerging in this, and other fast-growing regions.

Let me start with three key messages:

  •  First, financial risks have increased since April.
  • Second, as a result, policymakers in both advanced and emerging economies need to step up their efforts to preserve financial stability and safeguard the recovery.
  • And third, we have entered into a new phase of the crisis – a political phase- when tough political decisions will need to be made, because the window for substantial policy action is closing. Time is of the essence. 

Let me delve into the details of the increased financial stability risks, which have kept policymakers and investors, on the edge of their seats.

First, a string of negative surprises in recent economic data is prompting investors to reassess the sustainability of the economic recovery. While a global recovery remains the most likely scenario, downside risks to this forecast have increased. Any weakening in the economic outlook will threaten to stall—and possibly reverse—improvements in the balance sheets of banks and households.

 Second, there are increasing concerns about the political resolve to support the adjustment efforts in Europe. The lack of a comprehensive solution to this problem has led to increased financial market pressures on some European governments, and has rekindled worries about potential contagion within and beyond Europe.

In the United States, there are increased financial market concerns, due to the continuing political stalemate over the debt ceiling and the longer-tern fiscal path. And Japan’s medium-term fiscal adjustment targets may have become even more challenging because of the impact of the recent earthquake and tsunami.

And third, we are concerned about the effects of a prolonged period of low interest rates. Accommodative monetary policies remain necessary in advanced economies, partly because of the limited progress in resolving structural problems. But a prolonged period of low interest rates may lead investors to underestimate risk in their search for yield. This could promote the buildup of financial imbalances.  We have noticed two trends

  • The declining cost of debt is prompting some companies and investors to rediscover their appetite for financial leverage. There is evidence of such re-leveraging in the market for corporate high-yield bonds and leveraged loans
  • Investors’ search for yield has also spurred strong capital inflows into some key emerging markets, although such flows have recently eased. For example, buoyant foreign demand has led to a recent surge in international corporate bond issuance, notably from Latin America, and a decline in corporate bond yields.

Policy priorities

Given these risks, policymakers need to increase their efforts to tackle longstanding financial challenges once and for all.

In Europe, there is a need to finally cut the Gordian knot of mutually reinforcing financial exposures between banks and governments, which has fuelled worries about potential contagion.

To reduce the contagion risk, policymakers need to follow a two-pronged approach—(i) push for a comprehensive plan to repair the financial system and (ii) reduce sovereign risk through credible medium-term fiscal consolidation.

  1. Financial System. So far, there has been insufficient progress in strengthening bank funding and capital positions in some European Union countries. The forthcoming stress tests by the European Banking Authority will be a decisive opportunity to enhance transparency and address the weak tail of undercapitalized banks.
  2. Governments. Political resolve is required to address medium-term fiscal adjustment needs in several advanced countries, including the United States and Japan, which have yet to take decisive action in this area.

In short, when it comes to financial systems and governments, advanced economies need an orderly de-leveraging, which means they would cut back on the amount they borrow.

By contrast, emerging economies need to focus on orderly re-leveraging.

  • They should do so by guarding against overheating and the buildup of financial imbalances—with strong credit growth, rising inflation, and surging capital inflows.
  • Corporate leverage is also rising, and weaker firms are now accessing international capital markets. This could make corporate balance sheets more vulnerable to external shocks.
  • With strong domestic demand pressures—especially in emerging Asia and Latin America—macroeconomic measures are needed to avoid overheating, accumulating financial risks, and undermining policy credibility.
  • Macroprudential tools, such as higher reserve requirements, and, in some cases, a limited use of capital controls, can play a supportive role in managing capital flows and their effects. However, they cannot substitute for appropriate macroeconomic policies.

Policymakers continue to face potentially large future shocks to the financial system, at a time when its resilience is not yet assured.

And there is less room for maneuver to counter these shocks through traditional fiscal and monetary policies. Moreover, in increasingly gridlocked political systems, policymakers may find it progressively harder to take substantial policy action to address sovereign and financial risks.

We are now in a new phase of the crisis – the political phase – and tough political decisions need to be made.  Time is of the essence.

5 Responses

  1. [...] quickly, it can result in a sharp increase in bad loans and jeopardise financial stability. The IMF expressed this concern in June: “Brazil is recovering strongly from the crisis. But new financial stability [...]

  2. I believe the author outlines some basic fundamental behaviors to apply in the current financial system but fails to address the target problem. Increasing capital reserves on a balance sheet that is entirely out of synch with the true value of the underlying assets is window dressing, not a solution. De-leveraging emerging markets is another piece of window dressing because the de-leverage is against incoming currency that has an intrinsic value of 0 and relative value projected to be much lower than current purchase price of the assets.

    If you want truly tough political decisions to “fix” the financial system do the following:

    1. Make illegal all speculation on raw materials and foodstuffs. No more options and futures. If you cannot make this illegal, tax the profits like there is no tomorrow by writing a specific tax code that does not allow write-offs on these deals. This would release capital into the “productive” markets and lead to price stabilization for the underlying assets thereby improving the future of the asset producing nations that tend to be “emerging”.
    2. Make millisecond algorithmic trading illegal. Banks and governments cannot measure the risks associated with these trades and they do not serve the fundamental role of markets which is to allocate capital to ventures with the goal of increasing productivity, wealth and ultimately social contribution. Sure, the millisecond trading platforms re-distribute investments to optimize market positions, but only in a speculative sense which has no intrinsic value to the economy. Once again, if you cannot make these illegal, tax them out of business.
    3. Make CDS vehicles and markets illegal. Oblige banks and institutions to have strong in-house risk management capabilities and do not allow them to get out of this obligation. We have seen what happens when markets are created to address the lax governance and methods of both banks and insurers. The balance sheets 3 years later are still not cleaned and this goes for banks, governments and the federal reserve. This is a travesty.
    4. Re-introduce duty and tariffs based upon “social net” frameworks of trading nations. If one lives in a nation that on principle has education, healthcare, etc, etc, then align duty and tariffs from partner nations where those with similar social nets would have little if any duties, and those without any social nets would have significantly higher import duties. Yes this would increase inflation for many goods and it is a protectionist measure; however, it is necessary, as we have seen, to maintain the “developed” worlds social fabric without which, the broader populations will revolt.

  3. Yes, the world is now approaching entry into a large crisis. Most countries have been taking the old and traditional measures like fiscal and monetary policy adjustment. However,inflation has been growing rapidly where ther is no control over financial markets, especialy exchange rate devaluation. Under this situation, fiscal and monetary adjustment will worsen the living condition of the majority of the people, giving rise to an emergency in world consumerism, and create hidden blocks to trade trade relationships. The situation will have double the impact in developing countries where traders, investers and private companies exploite the labour of the poor, charge whatever price that market never create, but poor monetary policy(devaluation).

    Therefore, it is the peak time for international policymakers to urgently come up with solutions for unregulated, unbalanced financial markets in the framework of globalization.

  4. What a load of bull: Why are so many people within the IMF/ECB and EU so set against burning the bond holders? If the bond holders are required to take a hit, then do it. Stop all this bull. It’s time the i.m.f / e.c.b / e.u wake up to the fact that the banks are in control and all three main parties need to get off their butts and set up an international body to carry out a full investigation into all banks, once and for all regardless of who they are. For far to long these banks have being doing what ever they like, what is needed now is an international body to ‘oversee’ all aspects of these banks, and i am not just talking about the main Irish banks. It’s time the IMF/ECB and teh EU wake up to the fact that the banks are in control, And i don’t care of what anyone has to say ‘Someone ‘Somewhere’ within the I.m.f / E.c.b and / or the E.U have a vested interest in what is now happening. The major banks ‘Here in Ireland’ are required to sell off their assets. Sure these banks will sell these assets ‘BUT’ they will do it in their own time. As long as the I.m.f / E.c.b and the E.u continue to give bailout after bailout, these banks will do as the like and will take their time. As with everything in life ‘If you are getting something for nothing’ would you rush going back to work ‘etc’ These Banks are not interested in what anyone has to say. Why should they, with all the monies given so far? Where has it gone? Sure, we all know part of it went to repay the international markets. But what happened to the remainder? It was used to pay big bonuses to the Fat-Cats in these banks. It was used to give interest free loans to these Fat-Cats within these banks and it was used to pay their Shareholders.
    Time the I.m.f / E.c.b wake up to the fact that banks are in control, and as long as the i.m.f ‘etc’ continue to bailout these banks, the more these banks will remain in control. Stop with all this bull–sort out the banks once and for all.

    Member of E.e.a.g [ire]
    Philip j Carroll
    Dublin

  5. Thanks for sharing this lucidly comprehensive assessment with iMFdirect bloggers. I would like to focus on your third theme: “And third, we have entered into a new phase of the crisis – a political phase- when tough political decisions will need to be made, because the window for substantial policy action is closing. Time is of the essence.”

    Regarding “tough” political measures. May I suggest that “balanced” political measures would be a more useful and inspiring word to employ in this context? “Tough” may be the process of making the choices necessary — for all concerned. Yet, is the outstanding feature of the guy who performed, and undid, the astounding feat of balancing recorded in the video whose URL appears below pre-eminent for his tough minded style or for his uncompromisiing dedication to gently executed balance?

    http://www.youtube.com/watch_popup?v=jJrzIdDUfT4&=vq=medium

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