Global Financial Stability is in the ICU

This is a joint note with Prof. Charan Singh, IIM B

The vital signs have emerged but if care is not taken then risks may reappear and global financial crisis could morph deeper into a coma or a more chronic phase, warned the IMF in its latest Global Financial Stability Report released on April 17 at Washington DC. Though the Report opens with the statement that the global financial stability has improved in the last six months, the reading of Chapter 1 gives the perception that vital organs are still infected.

The Report mentions some persistent and old risks which are a legacy of the crisis. These are in the Euro area and mainly in the periphery – small and medium companies are suffering on account of inadequate flow of credit and the corporate sector is facing a large debt overhang. The Report assesses the effects of high corporate leverage on debt servicing and debt repayment capacity over the medium term and concludes that it needs continued vigilance by supervisors. Five years after the start of the crisis, banking systems are still in different stages of balance sheet repair with the Euro area requiring significant adjustments where banks remain weak with low buffers, deteriorating asset quality and poor profitability. The medium term prospects seem bleak. The new risks,  mainly in the US and euro area, are associated with weakening of the underwriting standards of corporate debt; further risk taking by pension funds and insurance companies, in view of ultra-low interest rates; increased borrowings by emerging market corporates in international markets exposing them to foreign currency risks; and finally, eventual unwinding of prolonged monetary easing by the US.  

The emerging markets have been performing well but some deterioration in asset quality has begun to appear in countries like Brazil, India and Mexico. Asset restructuring by the financial institutions in China and India also needs to be carefully assessed, according to the IMF. The emerging markets have also been advised to stay alert to the risks stemming from increased cross-border capital flows. In view of the low interest rates and high risk appetite in advanced countries, there is a possibility that too much money chasing too few emerging market assets, says the IMF. Alas, the recognition of the fact, long advocated by India at the IMF board, that easy monetary policy in advanced countries spills over to the emerging countries and causes asset appreciation is finally being recognized by the IMF. Another related aspect which has been so elegantly articulated in the Report was the need for some emerging countries, in the face of the appreciation pressure from increased inflows, to opt for looser monetary policy than they would otherwise have done for fear of becoming major carry trade destination.

In any war, since the times of Mahabharata, a good army general plans an exit before launching an attack. Well, better late than never, the focus of Chapter 3 titled Do Central Bank Policies since the Crisis carry risks to Financial Stability is mainly on exit policies that central banks need to consider. The chapter, sort of an extension of Chapter 1, discusses the unconventional monetary policies, called MP-plus in the chapter, followed by four major central banks – Fed Reserve, European Central Bank, Bank of Japan and Bank of England. It identifies possible risks to domestic financial stability and to the financial health of banks. The MP-plus has been useful in the short run but has had some side-effects. The Report recognizes that longer the MP-plus remains in place, a number of future risks are likely to increase, including heightened credit risks for banks, delays in balance sheet repairs, difficulties in restarting private interbank funding markets and challenges in exiting from markets in which central banks have intervened.  MP-plus refers to policy measures like prolonged periods of very low interest rates, quantitative easing involving direct purchases of government bonds, indirect credit easing providing long term liquidity to banks and direct credit easing whereby central banks directly intervene in credit markets. These operations have changed the size and composition of the balance sheet of the central banks. The risks in the exit strategy, associated with rising interest rates and sale of assets in the balance sheet of central banks would impact banks, financial institutions, and markets. Hence, the IMF provides advice to policy makers to use macro-prudential toolkit to mitigate risks and strengthen supervision of the financial sector during the exit phase.

The remedial prescriptions in the GFSR would seem familiar to Indians, who firmly believe that precaution is better than cure. While the world is busy in getting rid of the malady, cautious approach of the policy makers in India, including that of the RBI, needs to be recognized. It would have been interesting if the measures initiated during this time by a central bank on the other side of the spectrum, illustratively an emerging market like India, would also have been analysed in GFSR.

ECB Liquidity support for Euro Banks, Italy and Spain

In my blog of October 27th. I had stated (point 4)that only the ECB had to act like a normal central bank for the Euro area (i.e. provide unlimited liquidity in times of financial crisis) if basically solvent Euro countries were to be saved from becoming insolvent.  The best way would be to change the ECB constitution to allow it to do so (in parallell with changes to impose tough fiscal rules on Euro-countries).  This may however take too long to stave of a crises in the next 12 months.  One possibility that has been suggested is the issue of Euro Bonds.  However, it is unclear whether this has any greater feasibility till the fiscal rules have been changed by treaty.  There is however, an alternative that may be worth considering.
     National Banks within the Euro area, such as the German Bundesbank still exist, but do not have the authority to undertake monetary policy (interest rates) or to create money (Euros). This authority has been ceded to the European Central Bank (ECB).  They do, however, still have the capacity to issue euro bond to raise hard cash and their debts are still implicitly or explicitly guaranteed by their National governments. Thus these would have triple A rating in countries with a similar rating.  To the best of my knowledge, there is nothing barring the ECB from buying such bonds as part of any effort to increase liquidity in the Euro zone. The money raised in this way could in turn be used by the National Banks to create bilateral funding arrangements in the IMF.  Given the triple A rating of the IMF, this would preserve the triple A chain.  The funds could then be used to provide liquidity support to fundamentally solvent (even if currently stressed) Euro governments, under a fund program that ensures that these governments undertake the policy reforms that ensure debt sustainability (point 1 of Oct 27 blog).  Non-Euro area countries with a current account and trade surplus, such as China could also contribute to the bilateral fund in the IMF if they choose to do so.

How can the World help the Euro Group Save itself

    In my blog of October 27th I outlined the four critical steps for saving the Euro and the possible role of the IMF. In this note I focus on what the rest of the World can do to help, possibly through the IMF.  The IMF, given its expertise in enforcing fiscal and monetary discipline for restoring Balance of payment sustainability, has already been involved in helping the Euro-area governments enforce policy reforms (conditionalities) on Greece and Portugal for the support they are recieving from the Euro area (2/3rd) and the IMF (1/3rd).  This has however invloved the IMF providing unprecedented level of funds (100s and 1000s of times thier normal entitlement) and extrodinary fiscal support to soveregns that markets consider insolvent.  In principle the genuine and valuable role of the IMF in enforcing conditionalities on delinquent sovereigns can be provided with much lower levels of financial support, as was done historically in Latin America, Asia and other continents!

   From a global perspective the question is, what should the Rest of the World do to ensure that the Euro crisis is contained and any potential contagion to countries outside the Euro area minimised?  To answer this question it is essential to recognise that the World is currently suffering from a severe shortage of effective demand.  Thus there are two types of countries which are playing or should play different roles in diffusing the global crisis.  On one side are the current account and trade (goods and services) deficit countries who are making a net contribution to the global demand from the rest of the world, including the countries in crises.  Without thier continuing contribution there, it is impossible for the crises and near crises countries to reduce or eliminate thier current account deficits in the next few years. 

   On the other side are the current account and trade (G&S) surplus countries who are earning foreign income and accumulating foreign assets/ reserves.  These countries have the international resources to reallocate thier foreign earnings/assets into alternative channels, including to international financial institutions, to build a loan fund/buffer for ensuring that "innocent bystanders" hit by contagion from any euro-crises are provided adequate liquidity support.  It is thier obligation and duty to do so as long as they remain in surplus. One way of doing this is to contribute to a Bilateral loan fund in the IMF.  This would be fair and evenhanded contribution by all non-euro countries to help save the rest of the World from the negative contagion effects of the Euro crises and a potential melt-down of the Euro.  To the extent that some of these contributors are middle income countries, it would be legitimate to ask non-contributing rich countries to underwrite part of the risk. The precise nature of the contribution and the manner in which it should be used would ofcourse be need to be worked out in co-operation with the potential donors to this fund.

   In between these two types of countries, are an ambiguous type, which can contribute either through an increase in thier net purchase of goods and services from the rest of the World or through bilateral provision of funds to IFIs/IMF or a combination of the two, depending on thier thier income levels and reserve currency standing.

     Another source of funds for providing global liquidity could be fresh SDR allocations.  The conversion of SDRs into hard currencies by those in need of liquidity would have to be carefully circumscribed as long as the Euro crises lasts.  This is because a Euro-meltdown will result in a credit squeeze by European banks that is likely to lead to a sudden stop/capial outflow from emerging market economies.  Thus emerging economies with Current account and trade deficits who are dependent on foreign capital will become vulnerable even if they have substantial foreign exchange reserves.  Minimisation of contagion thus requires that these countries be shielded from demads for SDR conversions into free foreign exchange.  Any substantial new issue of SDRs should ensure this risk mitigation feature!