Monetary Policy and the Economy Global Market by alicejenny

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									Global Market Disruptions –
Will Global Imbalances Unwind?
    From June 12 to 14, 2008, the Oesterreichische Nationalbank (OeNB) hosted a roundtable            Peter Backé,
    discussion on global imbalances at Weißenbach/Attersee co-organized by the European               Franz Nauschnigg1
    Affairs and International Financial Organizations Division of the OeNB and the Reinventing
    Bretton Woods Committee (RBWC).
        The participants, consisting above all of public sector representatives (especially central
    bankers), market participants and academics, engaged in a lively discussion and a fruitful
    exchange of information.
    JEL classification: F02, F15, F34, F42
    Keywords: global imbalances, capital flows, role of the U.S. dollar, sovereign wealth funds,
    Bretton Woods


Summary of the Roundtable                            the U.S.A. Two other McKinsey sce-
Discussion “Global Market                            narios peg the losses at USD 625 billion
Disruptions – Will Global                            and USD 1,280 billion.
Imbalances Unwind?”                                      As banks have recapitalized by USD
In his opening remarks, Josef Christl                232 billion to date, they still need about
(Executive Director of the OeNB)                     USD 300 billion. Recapitalization is
addressed today’s formidable chal-                   becoming increasingly difficult, how-
lenges: high oil and commodity prices                ever, and will to a considerable extent
and the concomitant high inflation rates             stem from retained earnings in the
and a slowdown in economic growth.                   future. Banks’ remaining recapitaliza-
The financial market turbulence and                  tion needs equal three years of profits.
global imbalances likewise pose daunt-               To weather the crisis, banks will have
ing problems, in particular for central              to clean up their balance sheets. This is
banks. Christl expressed his apprecia-               the only way to restore investor confi-
tion for the high-level participation and            dence and stabilize the liquidity situa-
encouraged all contributors to lead an               tion in the markets, especially in the
open discussion.                                     credit market. To revitalize asset secu-
     Session 1 “The Repricing of Risks:              ritization it will take straightforward
Origins, Remedies and Outcome”                       and transparent financial instruments
centered on the costs and implications               with high-quality underlying assets.
of the financial market turmoil that had                 Christoph Avenarius (Director, Credit
commenced in summer 2007.                            Suisse) noted that the Federal Reserve
     According to Anthony Santomero                  System had assumed the role of ulti-
(Senior Adviser, McKinsey), global                   mate prime broker in combating the
losses attributable to the financial crisis          financial crisis. The turbulence made
have so far run up to around USD 800                 evident the weaknesses of the existing
billion or 5.9% of the U.S. GDP. Banks               framework. Value-at-risk models, for
account for USD 550 billion and other                instance, work only in liquid markets,
financial institutions for USD 250 bil-              and it is problematic that banks all use
lion. These figures are based on a sce-              the same risk models. The Fed stabi-
nario which assumes only a mild and                  lized the U.S. markets at a dangerously
temporary crisis-induced recession in                high price level. Sovereign wealth funds

1
    peter.backe@oenb.at; franz.nauschnigg@oenb.at.




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                         (SWFs) might benefit in the medium          imbalances has hitherto been carried
                         term as they could purchase assets at       out in an orderly fashion. It is, however,
                         relatively low prices.                      uncertain whether the required net
                             Tryggvi Herbertsson (President, Askar   capital flows into the U.S.A. are sus-
                         Capital) shed light on developments in      tainable. In 2008, the U.S.A. would
                         Iceland and expressed his doubt about       need gross capital inflows of USD
                         the effectiveness of monetary policy in     1,800 billion to USD 2,700 billion
                         small open economies with large glob-       (current account deficit: USD 627 bil-
                         ally active banking systems. A restric-     lion, capital outflows: USD 1,200 bil-
                         tive monetary policy is immediately         lion to USD 2,000 billion). There is
                         undermined by carry trades, which           substantial risk that foreign investors’
                         moreover increase the vulnerability of      willingness to provide net financing to
                         these economies to the repricing of         the U.S.A. will decline in the medium
                         risk. Under such circumstances, fiscal      term. In this context, Forbes named
                         policy is made to bear the main burden      the following determining factors: (a)
                         of stabilizing the economy with Keynes-     the recent history of low returns for
                         ian demand management. Iceland, how-        foreigners investing in the U.S.A., (b)
                         ever, also has the option of adopting       many countries continue to develop
                         the euro in the medium to long term.        and strengthen their financial markets,
                             In the subsequent discussion, the       (c) the turmoil in U.S. financial mar-
                         insufficiently regulated U.S. mortgage      kets since 2007, (d) hostility to foreign
                         market was identified as one of the         investment in the U.S.A. perceived in
                         causes of the market turmoil. The           some sectors, (e) the danger of exces-
                         rescue plan put forth by U.S. Treasury      sive regulation of U.S. financial mar-
                         Secretary Henry Paulson was viewed          kets in response to the crisis; such a
                         with skepticism. Only a sweeping re-        reregulation might be an overreaction
                         form, which would equal a consider-         and poorly thought out.
                         able political feat, would ensure a truly       Menzie Chinn (Professor, University
                         effective institutional and regulatory      of Wisconsin) talked about prospects
                         framework. It was also pointed out that     for U.S. adjustment and the U.S. dol-
                         the risks to the Fed’s balance sheet        lar. He argued that the decrease in the
                         had increased significantly due to the      U.S. current account deficit over the
                         liquidity support it had provided. More     past few quarters was traceable chiefly
                         than 50% of the assets held by the Fed      to the sluggish U.S. economy. Fore-
                         were in the meantime considered to be       casts from Taylor Rule fundamentals
                         risk laden.                                 indicated that the U.S. dollar would
                             European banks have likewise suf-       continue to depreciate against the euro
                         fered disproportionately high losses        in the adjustment process. It remains to
                         from their U.S. investments. The mag-       be seen whether the U.S. dollar can
                         nitude of these losses depends heavily      retain its hegemony as primary reserve
                         on the U.S. economy, with a severe re-      currency in the medium to long term.
                         cession set to drastically increase the     While a shift from the U.S. dollar to
                         damage.                                     the euro is a low probability event
                             Session 2 was titled “Unwinding of      according to Chinn, it may neverthe-
                         Global Imbalances – Orderly or Disor-       less not be ruled out completely.
                         derly Adjustment?”                              Sophia Drossos (Executive Director,
                             According to Kristin Forbes (Profes-    Morgan Stanley) explained why the
                         sor, MIT), the unwinding of global          framework conditions for an orderly



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                                                          Global Market Disruptions – Will Global Imbalances Unwind?




unwinding of global imbalances had               Michael Dooley (Managing Director,
deteriorated noticeably since the sec-       Cabezon Capital) expressed the opin-
ond half of 2007. Further adjustment         ion that Bretton Woods II (i.e. the U.S.
and the costs involved will be deter-        dollar exchange rate peg of many
mined by capital flows into the U.S.A.       emerging market economies) repre-
by public sector investors (central          sented a stable system in the medium,
banks, sovereign wealth funds). The          perhaps also longer, term. Some of
increase in U.S. asset prices has been       these economies, e.g. Brazil, naturally
driven largely by the vast sums invested     “graduate” from the system at some
in the U.S.A. Furthermore, Drossos           point and switch to more flexible ex-
doubted that Asian economies would           change rate regimes, but then other
be able to continue to grow so dynami-       developing countries are set to join
cally if the advanced industrialized         Bretton Woods II. China and India rep-
countries faced an economic downturn.        resent the core of these countries
The U.S. dollar’s downward slide is          pegged to the U.S. dollar and are bound
bound to end since the ensuing costs to      to remain at the center of the system in
the U.S.A. exceed the benefits, espe-        the foreseeable future because they will
cially as a weak dollar also means that      continue to pursue an export-driven
U.S. assets will become less attractive      growth strategy based on undervalued
to foreign investors.                        exchange rates. In a nutshell, Bretton
    The U.S. dollar’s weakness of the        Woods II remains firmly in place
past months dominated the discussion         according to Dooley and is set to evolve
that followed. It was pointed out that       further.
foreign retail investors’ sinking will-          Arnab Das (Managing Director,
ingness to hold U.S. assets might ex-        Dresdner Kleinwort) contended that
plain part of the depreciation of            the global economy was undergoing a
the U.S. dollar, which, via valuation        disorderly nonadjustment and that the
effects, had led to a decrease in the U.S.   question was how stable this imbalance
net debt. Whether the U.S. dollar will       was. When the rise in asset prices
have to depreciate further against the       had started to abate, investors in U.S.
euro for the U.S. current account defi-      assets turned to commodity markets.
cit to shrink to a sustainable level will    Investors thus amplified the price in-
depend not least on the speed at which       creases of many commodities, which
Asian currencies will appreciate against     resulted in a price bubble. The funda-
the U.S. dollar and the euro in the          mental macroeconomic issue of the past
future.                                      few years – too much liquidity in the
    In the second part of Session 2,         global financial system – still exists and
Miranda Xafa (Alternate Executive            will give rise to other price bubbles.
Director, IMF) showed that the weak-             The subsequent discussion again ze-
ness of the U.S. dollar was attributable     roed in on the U.S. dollar. The U.S.
to domestic factors, referring to devel-     currency was said to come under enor-
opments in the U.S. real estate and          mous pressure should U.S. residents
credit markets as well as the marked         lose their willingness to hold U.S. dol-
decline in U.S. dollar interest rates. As    lars at the given interest and exchange
U.S. households are holding fewer            rates. Global inflationary pressures and
assets and saving more, the U.S. cur-        the monetary policy response were
rent account deficit will contract fur-      another hotly debated issue. It was
ther.                                        criticized that many central banks had



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Global Market Disruptions – Will Global Imbalances Unwind?




                         reacted too late to the ongoing rise in     of consolidation efforts, which should
                         inflation. Countries with a U.S. dollar     be supported with stability-oriented
                         peg temporarily tolerated increased         policies. Monetary policy bears the
                         inflation in hopes of reaping the bene-     brunt of the adjustment effort in
                         fits of the peg, namely stability, in the   Romania, but its effectiveness is lim-
                         longer run. Many countries, e.g. the        ited. In addition, the sustained rapid
                         Gulf states, lack an alternative mone-      increase in real wages raises some con-
                         tary anchor in the short to medium          cern at the Romanian central bank.
                         term. The surpluses of the oil export-      Popa expects the economy to slow
                         ing countries (and thus the deficits of     down but does not see a hard landing
                         other countries) are bound to contract      on the horizon. At the current junc-
                         once people realize that the higher oil     ture, Romania plans to introduce the
                         price is here to stay and the oil export-   euro in the year 2014.
                         ing countries step up consumption. As           Mehmet Yörükoglu (Deputy Gover-
                         to Bretton Woods II, it is necessary to     nor of the Turkish central bank,
                         introduce restrictions on capital move-     Türkiye Cumhuriyet Merkez Bankasi),
                         ment in the light of the export-driven      provided an overview of worldwide in-
                         growth strategy Asian countries pursue      flation developments and monetary
                         by maintaining undervalued exchange         policies in emerging market and ad-
                         rates. Such capital controls would          vanced economies. According to
                         become less and less sustainable on the     Yörükoglu, price increases of food,
                         back of a successful catching-up pro-       commodities and energy impact much
                         cess. The euro could play a greater role    more strongly on inflation in the emerg-
                         in this system; after all, with the U.S.    ing economies than in the industrial-
                         dollar and gold, Bretton Woods also         ized countries, as these product groups
                         had had two anchors.                        are more significant in the consumer
                              Session 3 revolved around the issue    price baskets of the former and devel-
                         “The World in the Emerging Market           oping economies. Monetary policy in
                         Mirror: New Suppliers of Financial          the emerging economies will thus
                         Stability,” putting the spotlight on        have to decouple from that of the ad-
                         several country accounts.                   vanced countries. In emerging and
                              The chair of this session, Ousmène     developing economies, this will lead to
                         Mandeng (Head of Public Sector Invest-      tighter monetary policy, exchange rate
                         ment Advisory, Ashmore Group), re-          appreciation and higher inflation tar-
                         marked at the very outset that the          gets.
                         emerging markets, while representing            Paulo Vieira da Cunha (former
                         one-third of the international economy,     Deputy Governor, Banco Central do
                         accounted for half of global economic       Brasil) provided an overview of the re-
                         growth. He thus concluded his state-        markable stabilization and catching-up
                         ment with the recommendation: Sell          process of the Brazilian economy,
                         U.S. dollars and buy emerging market        where a leftist administration applied a
                         currencies.                                 mainstream macro policy and set off a
                              Cristian Popa (Deputy Governor,        virtuous circle. At the same time, he
                                           ˘
                         Banca Nationala a României) briefly
                                     ,                               criticized the shift to big government
                         described the current economic situa-       (transfer economy) and fiscal policy,
                         tion in Romania, where a dynamic            which he called procyclical. It is hard to
                         catching-up process goes hand in hand       dampen the excess demand triggered
                         with great imbalances. There are signs      by booming commodity prices, even



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                                                           Global Market Disruptions – Will Global Imbalances Unwind?




though inflationary developments and          that there was no international mone-
the current account deficit call for a        tary system, but rather a non-system.
tighter macro policy.                         Owing to capital account liberalization,
    Lawrence Brainard (Chief Economist,       low transaction costs and new players,
Trusted Sources) stressed the difficul-       such as hedge funds, capital flows have
ties faced by China: more than USD            increased substantially, by far exceed-
1,700 billion in international reserves,      ing trade flows.
inflows of speculative capital to the              The number of financial crises has
tune of USD 46 billion per month. As          likewise risen, and so have the effi-
an interest rate raise would only rein-       ciency of capital allocation and the
force capital inflows, China cannot           options for financing current account
avail itself of this option for cooling the   imbalances and the possibility of paral-
overheated economy. For this reason, it       lel financial market development. This
will attempt to combat inflation by           deepening of international financial
means of administrative measures and a        integration promotes the development
currency revaluation. China’s transi-         of national financial markets.
tion to post-Bretton Woods II will                 The hegemony of the U.S. dollar in
likely prove disorderly and entail insta-     the international monetary system is
bility.                                       increasingly being eroded. It remains
    The consensus in the discussion that      to be seen whether the ascent of the
followed was that the current state of        euro will lead to greater instability
the global economy provides a litmus          (hegemonic stability theory). Before
test for the inflation targeting strate-      1914, the pound sterling did not play as
gies pursued in some emerging econo-          dominant a role as the U.S. dollar after
mies. Opinions differed as to whether         World War II, given its rivalry with the
today’s inflationary pressures call for       French franc and the Deutsche mark.
an upward revision of the – in some                The weakness of the IMF, which
cases quite ambitious – inflation tar-        has yet to reinvent itself, and the lack of
gets. The argument was put forth that         both a lender of last resort and an inter-
repeated breaches of the targets could        national bankruptcy court have taken
impede the credibility of central banks;      their toll on the international monetary
yet, central banks would risk losing          system. Furthermore, there is room
face by (prematurely) changing infla-         for improvement in how the large cen-
tion targets in the first place. Perhaps      tral banks, i.e. the Federal Reserve
inflation targeting strategies will suffer    Board, the Eurosystem and the Bank of
the same fate as monetary targeting           England, cooperate; as liquidity pools
strategies. Inflationary developments         are international, suboptimal coopera-
in China were deemed to be precarious         tion proves problematic.
since under the current conditions                 According to Alexander Swoboda
the government and the central bank           (Professor, University of Geneva), the
lacked instruments to curb inflation.         economic developments of the past few
    Session 4 was dedicated to the “Pros-     years, i.e. a sound macro background
pects for the International Financial         (Goldilocks economy and the Great
Architecture: Merits and Demerits of          Moderation), unexplainably low bond
the Current International Monetary            yields (“Greenspan conundrum”), a flat
System.”                                      yield curve, quasi-reliable interest rate
    Richard Portes (Professor, London         cuts in times of stock market down-
Business School and CEPR) claimed             turns (“Greenspan put”), global imbal-



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Global Market Disruptions – Will Global Imbalances Unwind?




                         ances and overspending by U.S. con-        properties for recessions. Today’s slow-
                         sumers, have led to a situation of abun-   down in U.S. economic growth corre-
                         dant liquidity in the financial markets,   sponds to the pattern of previous reces-
                         bubbles and excessive leverage. The        sions, but U.S. monetary policy has
                         current financial crisis will make macro   responded more quickly and more ag-
                         developments more volatile and put a       gressively than in earlier periods of
                         stop to the Great Moderation. A decou-     recession.
                         pling of these developments is not in          Harold James (Professor, Princeton
                         the offing.                                University) stated that financial institu-
                              Financial markets are procyclical     tions tended to act procyclically in
                         and prudential regulation amplifies this   financial crises. However, in the past
                         procyclicality, which is a problem when    there has always been the odd big finan-
                         dealing with general macroeconomic         cial market player that acted in an anti-
                         shocks. Here, it is necessary to inte-     cyclical fashion and thus defused crises.
                         grate buffers. Monetary policymakers       Cases in point and thus quasi-forerun-
                         are faced with the problem that they       ners of the IMF were the Rothschilds in
                         have multiple mandates and only a lim-     the 19th century and JP Morgan in the
                         ited number of instruments at their        1907 crisis.
                         disposal. Hence, one can either reduce         In the current crisis, the sovereign
                         the number of targets (the Eurosystem      wealth funds could assume this anti-
                         solution) or increase the number of        cyclical role. Were he still alive, Lenin
                         (short- and long-term) instruments. As     would describe the SWFs as the highest
                         for central bank cooperation, Swoboda      form of capitalism.
                         sees three and a half players, namely          The IMF, whose influence has been
                         the Federal Reserve, the Eurosystem,       decreasing over the past few years,
                         the Bank of England and the Swiss          might take on a new role and invest
                         National Bank as half a player.            SWF reserve assets. This would, on the
                              Banks that are too big to rescue      up side, depoliticize SWF investments
                         rather than too big to fail, such as UBS   (guaranteeing no problems with the
                         in Switzerland, pose another problem,      host countries of investments) and effi-
                         especially for smaller countries with      ciently ward off speculative attacks.
                         large banking systems.                         Naturally, IMF governance would
                              Stijn Claessens (Division Chief,      have to be adapted accordingly.
                         Research Department of the IMF) pre-           Servaas Deroose (Director, European
                         sented results of IMF analyses showing     Commission) affirmed that the euro
                         that 21 OECD countries experienced         had established itself as the second most
                         122 recessions between 1960 and            important international currency after
                         early 2007. Furthermore, there were        the U.S. dollar. It is particularly popu-
                         114 cases of falling real estate prices,   lar in countries geographically close to
                         233 occurrences of declining stock         the euro area. Some 40 countries use
                         prices and 105 cases of a credit crunch.   the euro as an anchor or reference cur-
                         Most macro and financial variables         rency; reserves have been diversified
                         respond procyclically to a recession. A    away from the U.S. dollar to the euro.
                         credit crunch amplifies a recession;       Despite warning calls predating its
                         recessions that go hand in hand with       introduction, the euro has on balance
                         falling real estate prices last longer.    successfully promoted stability.
                         Real estate investment and credit              The euro and the U.S. dollar domi-
                         growth have the best forecasting           nate the global monetary system (bi-



118                                                                   MONETARY POLICY & THE ECONOMY Q3/08
                                                        Global Market Disruptions – Will Global Imbalances Unwind?




polar system), and some, e.g. Chinn,        currency had been underestimated,
believe that the euro could overtake        recalling former Federal Reserve Chair-
the U.S. dollar in the coming decades.      man Greenspan’s statement that it
Deroose, by contrast, sees a tripolar       would take the euro 100 years to be-
monetary system on the horizon. To          come a challenge to the U.S. dollar.
strengthen the international role of the    Some warned of impending instabilities
euro, the euro area has to remain eco-      in the battle for predominance between
nomically sound and to deepen finan-        the euro and the U.S. dollar (citing the
cial integration. Furthermore, a con-       interwar years when the U.S. dollar
solidated representation would raise        replaced the pound sterling), while
the profile and increase the bargaining     others found a stable system with
power of the euro area in the inter-        several reserve currencies conceivable,
national arena. In other words, the euro    giving the pre-World War I period as
area has to speak with a single voice in    an example.
international fora such as the IMF, the         SWFs rather got a vote of confi-
G-7 and the G-20.                           dence as they were seen to help stabi-
    In the discussion, some called for      lize financial markets by buying under-
tightening financial market regulation –    valued companies and by injecting
variable minimum capital requirements       additional capital into banks. The IMF
for banks, preventing excessive lever-      as a reserve manager was regarded
age, special regulations for major banks,   with skepticism because SWFs are
strengthening oversight in the EU un-       unlikely to shell out capital to the IMF
der the auspices of the Eurosystem.         and the IMF would have to compete
    U.S. participants stressed that the     with private reserve managers and the
euro’s role as an international reserve     BIS.




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