Global Financial Crisis -International Monetary Fund Perspective - Case Study Example

International Monetary Fund (IMF) Position Paper on Global Financial Crisis Submitted By: Anand Kumar Srivastava M.Sc. Development Finance Frankfurt School of Finance and Management Sonnemannstraße 9-11, 60314 Frankfurt am Main, Germany www.frankfurt-school.de Global Financial Crisis: IMF Perspective The Financial crisis has affected the economies around the world very seriously at various fronts. On one hand, the advanced economies experienced an unprecedented 7½ percent decline in real GDP during the fourth quarter of 2008, and output is estimated to have continued to fall almost as fast during the first quarter of 2009. Although the U.S. economy may have suffered most from intensified financial strains and the continued fall in the housing sector, Western Europe and advanced Asia have been hit hard by the collapse in global trade, as well as by rising financial problems of their own. In the context of emerging economies, they too are suffering badly and contracted 4% in the fourth quarter in the aggregate. This damage in the global system is created by both financial and trade channels, particularly to East Asian countries that rely heavily on manufacturing exports and the emerging European and Commonwealth of Independent States (CIS) economies. Simultaneously with the rapid cooling of global activity, inflation pressures have subsided quickly. Commodity prices fell sharply from midyear highs, causing an especially large loss of income for the Middle Eastern and CIS economies but also for many other commodity exporters in Latin America and Africa. At the same time, rising economic slack has contained wage increases and eroded profit margins. As a result, 12-month headline inflation in the advanced economies fell below 1 percent in February 2009, although core inflation remained in the 1½–2 percent range, with the notable exception of Japan. As mentioned above, there are many reasons to be considered for this problem. Continuous de-leveraging by the financial sector and serious declines in consumer as well as business confidence has started a sharp deceleration in domestic demand across the globe. The decline in commodity prices is providing some support to commodity importers, but is affecting the growth of commodity exporters severely. Global growth is also a very important point to consider because activities are expected to decelerate from 3½ percent in 2008 to ½ percent in 2009 before embarking on a gradual recovery in 20101. The developed economies are facing their sharpest post-war reduction. The euro area and Japan have been hard hit by the decline in external demand. Activity in these countries is now expected to contract by 2 percent in 2009, followed by a modest rebound in 2010. On the other hand, LICs are exposed to the current global downturn more than in previous episodes because they are now very much integrated than before with the world economy through trade, FDI, and remittances. The crisis significantly impacts these countries because of the reduced demand for their exports. Many LICs are also hit by lower remittances and foreign direct investment (FDI) while aid flows are under threat. Growth of remittances was flat in the second half of 2008, and is expected to be negative in 2009. A sharp slowdown in FDI is expected in about half of all LIC2s. Prospects for higher aid to offset these effects are particularly uncertain, given budgetary pressures faced by many donor countries. LICs’ financial systems have so far not been strongly affected by the global crisis. Their banks have little, if any, exposure to complex financial instruments. However, those LICs that had begun to access international financial markets have seen this access come virtually to an end. Foreign lenders may become more reluctant or unable to roll over sovereign and private debt falling due. There will a second round effect and domestic banks may be hit by this effects, as the economic downturn increases the number of borrowers unable to repay their loans. The global financial crisis will worsen the budgetary position of many LIC governments. Government revenues are expected to suffer as economic activity slows and commodity prices fall. Potential declines in donor support and tighter financing conditions will likely impose further pressures on LICs’ budgets. At the same time, many countries will need to increase spending to protect the poor, and additional spending pressures may arise from currency depreciation and rising interest rates, which could raise debt service costs. This Financial Crisis has deepened to the point where governments need to take bolder steps and not shrink from capital injection even in the form of common shares, even if it means taking majority, or even complete control of institutions. A very stronger coordination is needed among economic and financial sector policymakers around the world during the global recession and the International Monetary Fund (IMF) is well placed to help bring countries together to tackle their joint problems. The problem of financial crisis is very complex and the IMF is working hard on several fronts to help its members combat the worldwide economic and financial crisis. The Fund is closely tracking economic and financial developments worldwide so that it can help policymakers with the latest forecasts and analysis of developments in financial markets. It is giving policy advice to countries and regions, and money to assist emerging market and low-income economies that have been hit by the crisis and it is assisting the Group of 20 (G20) industrialized and emerging economies with recommendations to reshape the system of international regulation and governance. IMF would like to mention that this phase of global financial crisis is and will be a difficult transition for the financial system and we request the policymakers to take actions "with a long-term vision of a healthy, efficient, and dynamic financial system.” In the context of Global Financial Crisis, IMF urges for specific steps which are very much required to bring the global economy on track. Few important measures are – I. Stimulus: As global growth is coming down sharply, the IMF is advising the countries to stimulate their economies. IMF growth projections are indicating that global activity is slowing down quickly. An estimate says that world output is expected to expand by 2.2 percent in 2009, down by 0.75% point of GDP (relative to the projections in the October WEO). In advanced economies, output is forecast to contract on a full-year basis in 2009, the first such fall in the postwar period. Initiatives to strengthen the system include public capital injections and a wide range of liquidity facilities, monetary easing, and fiscal stimulus packages. Governments and central banks have responded to the problems of financial institutions by introducing a number of substantive and innovative measures to deal with both liquidity and solvency problems. In addition, central banks have reduced interest rates to unprecedented levels to offset the increase in private sector risk premium and to strengthen aggregate demand. In spite of these efforts, credit conditions remain very tight and aggregate demand and employment in many countries are going down very rapidly. With limited scope for further stimulus through monetary policy, attention is now towards fiscal policy. In this context questions are being asked about how effective government fiscal policy actions would be in lessening the depth and duration of the slowdown in the major industrialized economies and the emerging economies, and what the preferred mix of fiscal policy actions would be. It is not a very easy task and IMF is exploring the best possible answers to these questions. An estimates says that write-downs on U.S.-originated assets by all financial institutions over 2007–10 will be $2.7 trillion, up from the estimate of $2.2 trillion in January 2009, largely as a result of the worsening prospects for economic growth. Total expected write-downs on global exposures are estimated at about $4 trillion, of which two-thirds will fall on banks and the remainder on insurance companies, pension funds, hedge funds, and other intermediaries. Across the world, banks are limiting access to credit (and will continue to do so) as the overhang of bad assets and uncertainty about which institutions will remain solvent keep private capital on the sidelines. Funding strains have spread well beyond short-term bank funding markets in advanced economies. Many non-financial corporations also are unable to obtain working capital, and some are having difficulty raising longer-term debt. The broad retrenchment of foreign investors and banks from emerging economies and the resulting buildup in funding pressures are particularly worrisome. New securities issues have come to a virtual stop, bank-related flows have been curtailed, bond spreads have soared, equity prices have dropped, and exchange markets have come under heavy pressure. Beyond a general rise in risk aversion, this reflects a range of adverse factors, including the damage done to advanced economy banks and hedge funds, the desire to move funds under the “umbrella” provided by the increasing provision of guarantees in mature markets, and rising concerns about the economic prospects and vulnerabilities of emerging economies. An important side effect of the financial crisis has been a flight to safety and return of home bias, which have had an impact on the world’s major currencies. Since September 2008, the U.S. dollar, euro, and yen have all strengthened in real effective terms. The Chinese renminbi and currencies pegged to the dollar (including those in the Middle East) have also appreciated. Most other emerging economy currencies have weakened sharply, despite the use of international reserves for support. Observing all these dimensions, IMF believes that a global stimulus package is very necessary to trigger the growth and thus advocating the stimulus package. II. Reduced Inflationary Pressure: The forecasts are indicating that a combination of stabilizing commodity prices and increasing economic slack will help to control inflation pressures. As per the projection, inflation should decline below 1½ percent by the end of 2009 in the advanced economies. In emerging economies, inflation is also expected to be moderate. However, in a number of these countries, inflation risks are still apparent, as higher commodity prices and continued pressure on local supply conditions have affected wage demands and inflation expectations. III. Cross – Border Consistency and Global Supervision: IMF believes that policy coordination should be across borders. "Most crucial, there must be better cross-border consistency of policies,” A key task will be to develop cooperative arrangements for the resolution of large cross-border institutions where none currently exist, keeping in mind the limitations of individual country frameworks. However, the extension of financial support and guarantees must consider potential cross-border effects, including for emerging economies. The crucial aspect which we all should keep in mind is the exit strategies for the public sector from financial system ownership and that needs to be developed as soon as possible." In the past, we have experienced the lack of political will power from various parts of the world towards stabilizing financial markets. This is the time for the international community to take strong steps towards stable global financial system because of the integrated characteristics of the structure. All the economies, whether developed or developing, will be affected by any change in any market of the world. We have the historical experiences to learn from and we have a future which we have to protect from all the shocks and fluctuations. At this point, in the context of Global Financial Architecture stability, IMF would like to emphasis on few points which is very crucial: A). Surveillance of systemic risk: In the global financial system vulnerabilities may arise from various which includes unexpected events, bad policies, exchange rate risks, credit-fueled asset booms, external imbalances, or data deficiencies that obscure trends. To gain a complete control over all this, surveillance needs to be reoriented to ensure warnings are clear, to successfully connect the dots, and to provide practical advice to policy makers. B). International coordination of macro-prudential responses to systemic risk: This cuts to the arrangements that govern collective policy decisions, involving forums such as the International Monetary and Financial Committee, the Financial Stability Forum, and the various “Gs” (in particular, the G7 and G20). Systemic concerns about the international economy should be reported directly to policy makers with the ability and mandate to take action. C). Cross-border arrangements for financial regulation: At International institution level, best practices have been developed to help avoid regulatory arbitrage and assist in burden sharing across borders by international financial conglomerates, with understandings on regulation, supervision, and resolution. These ground rules need to be strengthened and made more automatic to avoid a repetition of the “go-it-alone” responses seen in this crisis. D). Funding for liquidity support or external adjustment: It is very clearly evident that public funds are available from the Fund and others to help countries weather short-term liquidity strains, or to smooth necessary adjustments from unsustainable external trajectories. Given the size of international transactions, these resources should be amplified, and processes for providing short-term liquidity better defined. IV. Reforms & Restructuring at IMF: This IMF-supported programs can succeed only if country owns them. “We have to be seen as doctors, not as cops” Read More