Global Financial Crisis – The Road to the Pittsburgh Summit

It may surprise readers to learn that this World Economic Outlook sees global economic risks as having declined since our last issue in September 2006. Certainly this is at odds with many recent newspaper headlines and commentary, which have focused on problems related to U.S. mortgages.

World Economic Outlook, IMF, April 2007

Last April, when the G-20 London Summit took place, the world was on the verge of collapse, and the summit rushed to orchestrate a number of commitments to face the conjunctural issues.

Since that time, the crisis evolved and requires both longer-term measures and a debate on the reform of global cooperation policies and organizations.

The evolution of the crisis is being measured in terms of stock quotes; “not-that-bad”-type results are being welcome, and sporadic minor stock recoveries fuel hopes that the worst stages of the crisis will soon be a thing of the past. On the other hand, output-, trade-, credit-, investment flows-, demand-, and consumption data show no signs of recovery.

The real economy conditions have worsened and the process does not seem to have come to an end, as witnessed by growing unemployment, salary cuts, and household-and small developing country indebtedness.

In the political realm, the situation has also evolved, but the end-result remains uncertain.

The last few months have featured meetings of the G-5, BRIC, ASEAN + 3, Shanghai Cooperation Organization, the UN G-192, etc. The G-8 + G-5 + Egypt meeting heard the Italian Prime Minister Silvio Berlusconi contend the G-8 no longer is an apt structure to set guidelines; the world governance has to evolve, and the world problems cannot be faced without China, Mexico, India, or Brazil participation. President Sarkozy, in turn, advanced his expectations for a G-14 summit in 2011.

Some analysts highlight the modest aspirations of the developing countries: while overburdened by the devastating sequels of a crisis they cannot be blamed for, their sole aspiration is being granted larger participation in the multilateral organizations, However, there are no other fora or mechanisms where policies and measures beneficial to all countries, or able to check harmful policies and measures, can be furthered.

Regional cooperation agreements and “Gs” are the discussion fora where economic and financial policies, regulation and control frameworks, investment sector targets, investment-enticing measures, financial instruments, goods- and services trade rules, international surveillance systems, etc. are agreed on. However, multilateral organizations are the vehicle for such policies to be projected to the rest of the world, and the decisions of such entities are entirely contingent on the voting power of their members.

So far, the voting power has been the factor that furthered all globalization policies, such as capital market liberalization, free circulation of goods and services, capital markets opening to foreign banks, and the financial innovation schemes that ended up becoming dissemination outlets of toxic assets.

The system has not changed, and in spite of G-20 agreements on IMF-, World Bank- and multilateral development banks replenishment and reform, no significant changes are in the offing.

So far, the only countries having provided resources to the Fund are Japan (US$100 billion), Canada (US$10 billion) and Norway (US$4.5 billion). The US Congress has approved an agreement to contribute US$100 billion, whereby the USA will keep its vote –and veto– power, and the European countries are expected to make good their commitments and also keep their vote powers.

Rather than providing resources, the emergent world colossi, Brazil, Russia, India and China, have agreed to buy IMF bonds, but made such decision contingent to the reform of the formula of allocation of voting powers to the emerging economies and mid- and low-income countries, in order that the new order reflects the changes experienced by the global economy.

The industrialized nations, in turn, are still not ready to peacefully accept changes in decision power sharing mechanisms.

Such issues will soon be debated at the Pittsburgh summit, and subsequently at the IMF- and World Bank annual meetings.

A fact that deserves being reminded: the same issues now being discussed were debated in the wake of the Asian crisis: reform of the international financial architecture, IMF rôle in achieving international financial stability and crisis prevention and resolution, and the rôle of the multilateral development banks in fostering sustainable development of people and countries –rather than market and finance development.

Something else to be borne in mind is that the economic boom that followed the Asian crisis gave rise to a “tolerance” stage where change initiatives were cast into oblivion.

The main lesson from the Asian crisis is that the worst scenario is one where nothing is done to check the excesses of the global system.

If the Heads of State –of the large emerging countries and those of the industrialized nations– fail to arrange substantive reforms in the ruling policies and managing institutions of the globalized world, the planet will have to become accustomed to a vicious circle of recurrent crises –an obvious bad omen.

In the road to the Pittsburgh it seems appropriate to consider some principles such policies are based on, and the rôle played by the IMF during the last few months. Such principles, in and of themselves, justify the demand for changes, and the Fund’s positioning requires radical changes if the organization is to have any participation in a future multilateral system.

IMF responsibilities:

Some current media reports seem to indicate the IMF will now monitor financial stability, issue vulnerability warnings, oversee the international financial and monetary system, and help prevent and resolve crises.

Such, however, in addition to those of lender of last resort, are the inherent functions of the IMF; almost its raison d’être.

As stated in the Fund’s website:

“The IMF is responsible for promoting the stability of the international monetary and financial system. Its job is to promote economic stability, help prevent crises, and help resolve them when they occur, thereby promoting growth and alleviating poverty.”

IMF concepts on globalization and recurrent crises

“We must also acknowledge that globalization benefits people unevenly. It produces losers as well as winners.

This is not new: history is full of examples of technological developments and rapid economic changes that benefited society as a whole while hurting some individuals or groups.”

Flemming Larsen, Director of the IMF’s Office in Europe

Finance & Development / March 2001

“It produces losers as well as winners”: the concept is simply callous. People who have lost their jobs or suffered extreme hunger would appreciate a not-so-quick pace in world evolution –a scenario where their ills be not exacerbated, even though no benefits derive.

“Crises are inevitable. As long as there are financial markets, there will be boom and bust cycles.”

Bijan B. Aghevli, former Deputy Director of the IMF’s Asia and Pacific Department – Finance & Development / June 1999

A sample of IMF documents on securitization (structured financial papers)

The IMF and WB’s opinions on such instruments are worth considering, particularly in respect to the standards used by the risk-assessment entities to contend that a firm may continue to generate receivables even when it is in financial default –the so-called “going concern” criteria developed by Fitch IBCA, and Standard and Poor’s “survival” assessment, for instance– and the final recommendation: educating national authorities and potential issuers in promoting this type of assets.

“Securitization of Future Flow Receivables: A Useful Tool for Developing Countries
“During financial crises, developing countries cannot obtain low-cost, long-term loans. Securitization of future flow receivables can help investment-grade public and private sector entities in these countries obtain credit ratings higher than those of their governments and raise funds in international capital markets.

Risk mitigation: Securitization is a fairly recent financial innovation. The first securitized transactions occurred in the United States in the 1970s and involved the pooling and repackaging of home mortgages for resale as tradable securities by lenders. Since then, securitized markets have grown in sophistication to cover a wide range of assets….

Rating agencies have come to accept the argument that an entity may continue to generate receivables even when it is in financial default. Thus, based on such recently developed criteria as Fitch IBCA’s “going concern” and Standard and Poor’s “survival” assessment, certain entities such as banks may receive higher ratings for asset-backed transactions than for domestic-currency debt. …

Educating policymakers and potential issuers would also help promote this asset class.”

Dilip Ratha, Senior Economist, World Bank, and Suhas Ketkar, principal of International Research and Strategy Associates LLC and a consultant to The Royal Bank of Scotland – Finance & Development / March 2001

IMF & the current crisis

April, 2007 – Notice (1) the first crisis signs became apparent in mid-2006, (2) things had worsened week after week, and (3) the IMF and its hundreds of specialized technicians are experts in the area – moreover, unless the multilateral system is reformed, they are the very individuals who will continue to “oversee” risks and vulnerabilities and advise the world on how to address them.

IMF report: World Economic Outlook / April 2007

Spillovers and Cycles in the Global Economy

“It may surprise readers to learn that this World Economic Outlook sees global economic risks as having declined since our last issue in September 2006. Certainly this is at odds with many recent newspaper headlines and commentary, which have focused on problems related to U.S. mortgages, the potential for “disorderly” unwinding of global imbalances, and worries about rising protectionist pressures..

Nevertheless, … looking at the big picture, we actually see the continuation of strong global growth as the most likely scenario. The most immediate concern is bad news from the U.S. housing market, and an associated slowing of U.S. growth. However, these developments have been evident for some months and are largely reflected in market assessments of credit quality. These assessments remain positive for most types of credit. …

We should be careful not to underestimate the potential spillovers from the specific problems with high-risk mortgages in the United States but, compared with six months ago and based on the information available today, there is less reason to worry about the global economy. …

The chapter finds that rising trade and financial integration of the global economy does increase the potential impact of spillovers across economies, but even if the U.S. economy were to slow further, the scale of such spillovers should be manageable, especially recognizing the strengthening of macroeconomic policy management around the world over the past 20 years….”

July, 2007 – In July, 2007 several U.S. financial institutions filed for Chapter 11 bankruptcy; in August, the collapse took place and the central banks started to rescue financial entities on both sides of the Atlantic.

IMF report: World Economic Outlook Update – An update of the key WEO projections / July 2007 – The global economy continues to grow strongly

“The strong global expansion is continuing, and projections for global growth in both 2007 and 2008 have been revised up to 5.2 percent from 4.9 percent at the time of the April 2007 World Economic Outlook. Risks to this favorable outlook remain modestly tilted to the downside.

A number of other risks, however, look more balanced. In particular, while the correction in the housing sector is continuing, overall downside risks related to U.S. domestic demand have diminished somewhat.“

September, 2007 By then, no one was challenging the fact “financial innovations” were at the root of the crisis

Testing the Financial Waters, By Rodrigo de Rato, Managing Director, IMF – Published in ABC / September 3, 2007

“Although recent developments have highlighted some of the risks that come with innovations in financial instruments, it is worth recalling their positive role. Markets play a critical role in mobilizing savings and in allocating them to productive investment, and innovations often make important contributions that help sustain rapid growth and enhance welfare in both advanced and emerging market economies. Innovation in structured credit products have enabled market participants to better diversify risk and lower the cost of credit world-wide, providing an important boost to global growth.”

 January, 2008 – At this stage, transactions with structured financial instruments were perceived as complex, obscure, hard to value, and even harder to monitor. Nonetheless, right in the middle of the crisis, the IMF made public it, along with the World Bank were escalating their efforts to persuade the emerging countries to use such instruments.

IMF Survey Magazine / January 2008 – Helping Build Local Bond Markets

“In a world of large-scale capital flows, the development of a local bond market has become a priority for many emerging market countries. Well-functioning local bond markets make a vital contribution to the efficiency and stability of financial intermediation and to economic growth.

Many emerging market countries have liberalized their capital accounts, improved their macroeconomic environ­ment, and made advances in financial innovation-steps that have increased capital inflows to these countries. The IMF and the World Bank are stepping up their active engagement in these countries to help them develop local bond markets. …

 Securitization. Asset-backed securi­ties markets can help improve access to long-term funding for housing and infra­structure investment while also providing pension funds and insurance companies with the long-term instruments they need to match their liabilities. Although the recent subprime crisis demonstrates that risk dispersion can amplify volatility, securitization has fos­tered the development of financial mar­kets, and its merits cannot be discounted.”

January, 2008 – By January, the crisis was already being depicted as “the worst ever in the globalized world.” However, the IMF First Deputy Managing Director forecast increased employment and economic prosperity, rather than a recession.

IMF Survey Magazine / January 2008 – John Lipsky Interview, the IMF’s First Deputy Managing Director, Global Economy Likely to Slow More

“IMF Survey Magazine: U.S. polls indicate that a growing number of people think that the recession is around the corner. What do you think?

Lipsky: Never say never, but the latest indicators do not justify such a con­clusion. Keep in mind that consumer spending is the largest single compo­nent of any economy, and the principal determinant of consumer spending is household income. Over the past year or so, employment growth and wage increases have decelerated, but they both continue to grow. As long as U.S. household income continues to expand, it’s reasonable to expect consumption expenditures to increase.

IMF Survey Magazine: What’s the bottom line?

Lipsky: I’m cautiously optimis­tic. As long as corporate profits remain solid, businesses will continue to expand, jobs will continue to grow, income will grow, and the economy should remain in positive territory. This outcome cannot be taken for granted, however, and monetary policy flexibility is required.”

April, 2008 – At this stage the Fund finally realized use of such instruments did entail some “costs.”

IMF report: Global Financial Stability Report, GFSR / April 2008

“Conclusions and Policy Initiatives

Although the growth and prosperity of recent years gave ample illustration of the benefits of financial innovation, the events of the past eight months have also shown that there are costs. Credit risk transfer products –innovations that were meant to disperse risk broadly– were not always used to move risk to those best able to bear it.”

December, 2008 ­– IMF report: Finance & Development / December 2008

The international dimension and the IMF’s potential role

Olivier Blanchard, Economic Counsellor and Chief Economist of the IMF

“The crisis has made clear that the financial system is a global system, with strong interconnections across countries. What was initially a U.S. crisis is now affecting the entire world. National policymakers cannot do the job alone: what happens to them depends not only on their own regulatory structure, but also on the regulatory structure of other countries; not only on systemic risk at the national level, but also on the buildup of systemic risk elsewhere. Monitoring systemic risk at the global level is essential. The IMF seems best equipped to do the job, in collaboration with central banks and other international organizations.”

As apparent from the above, by December, 2008, when nobody had failed to realize the crisis had caught the Fund by surprise just as the most ill-advised individual was, the institution was an obvious failure as a financial system watchdog, and its risk evaluations were unanimously mistaken, the organization’s Economic Counsellor claimed “The IMF seems best equipped to do the job” from then on.


Raúl de Sagastizabal
International consultant
Montevideo, September 2009


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