Risks of a Slower Global Recovery

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The IMF noted in its latest World Economic Outlook (WEO – Oct. 2012) that the global recovery has suffered new setbacks, and uncertainty weighs heavily on the outlook. A key reason is that policies in the major advanced economies have not rebuilt confidence in medium-term prospects. Tail risks, such as those relating to the viability of the euro area or major U.S. fiscal policy mistakes, continue to preoccupy investors.

The WEO forecast sees only a gradual strengthening of activity from the relatively disappointing pace of early 2012. Projected global growth, at 3.3 and 3.6 percent in 2012 and 2013, respectively, is weaker than earlier estimates. Output is expected to remain sluggish in advanced economies but still relatively solid elsewhere. Unemployment is likely to stay elevated.

The forecast rests on two crucial policy assumptions. The first is that European policymakers––will adopt policies that gradually ease financial conditions further in periphery economies. In this regard, the European Central Bank (ECB) has recently done its part. It is now up to national policymakers to move and activate the European Stability Mechanism (ESM), while articulating a credible path and beginning to implement measures to achieve a banking union and greater fiscal integration.

The second assumption in the US is the spending cutbacks (the “fiscal cliff”) implied by existing budget law, raise the U.S. federal debt ceiling in a timely manner, and make good progress toward a comprehensive plan to restore fiscal sustainability.

More generally, downside risks have increased and are considerable.  Failure to act on either issue would make growth prospects far worse. The WEO forecast said that monetary policy was expected to remain supportive. Major central banks have recently launched new programs to buy bonds and keep interest rates low. But the global economy remains fragile and budget austerity, while necessary, has slowed a recovery.

US growth will average 2.2 percent this year and rise to 2.75 percent later in 2013. Weak household balance sheets and confidence, relatively tight financial conditions, and continued fiscal consolidation stand in the way of stronger growth. Continued Fed easing will help.

In Europe, real GDP is projected to decline by 0.4 percent in 2012 overall and return to slightly positive territory in 2013. With lower budget cuts and domestic and euro area–wide policies, should support further improvement in financial conditions later in 2013. The core economies are expected to see low but positive growth, but peripheral countries may remain stagnant until mid-2013.

Elsewhere, Japanese growth is projected at 2.2 percent in 2012. Real GDP is forecast to stagnate in the second half of 2012 and grow by about 1 percent in early 2013. Thereafter, growth is expected to accelerate further.

Fundamentals remain strong in many economies that have not suffered a financial crisis. In these economies, high employment growth and solid consumption should continue to propel demand and, together with macroeconomic policy easing, support healthy investment and growth.  China should be a driver for Asia with growth of 7% or slightly higher driven by public spending on infrastructure.  Russia is expected to grow around 3-4%.  India will experience slower growth in 2012 and moving toward 5% in 2013.  Elsewhere, Latin America should see growth of 3-4% in 2012 and slightly higher in 2013 driven by Brazil. 

Global imbalances, and the associated vulnerabilities, have diminished, but there is still a need for more decisive policy action to address them. Within the euro area, current account imbalances––and the deficits in most periphery economies––need to adjust further. At the global level, the current account positions of the United States, the euro area  as a whole, and Japan are weaker than they would be with more sustainable fiscal policies—and the real effective exchange rates are stronger. In contrast, the current account positions of many Asian economies are undesirably strong and their exchange rates undesirably weak. In part, this reflects distortions that hold back consumption and reflects the effect of accumulation of foreign exchange.

In general, the policies required to lower current account imbalances and related vulnerabilities suit the interests of the economies concerned. More adjustment in external-deficit economies and more internal demand in external-surplus economies would contribute not only to a safer global economy but also to stronger growth for all. Many external-deficit economies need further fiscal adjustment and strengthened financial sector supervision and regulation. These efforts need to be complemented with structural measures, the details of which differ widely across countries.  Otherwise, the global recovery will remain vulnerable to new accidents.

www.imf.org/external/pubs/ft/weo/2012/02

Monetary policy in a downturn: Are financial crises special?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

There is a consensus opinion among central bankers and policymakers that an accommodative monetary policy was instrumental in preventing a deeper recession during the financial crisis.  However, the severity of the crisis required a forceful response by the central banks, especially the need for unconventional monetary policies.  This required both liquidity support and monetary easing to prevent the implosion of the financial system and limit its destructive effect on the real economy.

However, views differ on how long monetary policy should remain accommodative.  These are some of the issues considered by Morten Bech, Leonardo Gambacorta & Enisse Kharroubi in a recent BIS WP 388 (September 2012) called Monetary policy in a downturn: Are financial crises special?

At the heart of this debate is the notion that a protracted period of policy accommodation may delay the necessary balance sheet adjustments and create a base for potential distortions such as a new credit bubble.  The impact of the expanded central bank balance sheet adds to the uncertainty.

Some would argue that any distortions will be limited in extent and that further monetary stimuli should bolster the recovery. Others fear that prolonged easing may delay much-needed balance sheet adjustments, thus entrenching weak economic performance.

The authors, in their analysis, find that monetary policy is less effective in a financial crisis, when impairments in the monetary transmission mechanism may occur, as in a balance sheet recession. In particular, the results show that the benefits of accommodative monetary policy during a downturn for the subsequent recovery are more elusive when the downturn is associated with a financial crisis and non-traditional monetary measures are used.

The authors confirm that when using traditional monetary policy easing during the downturn does lead to a stronger recovery in the case of normal downturns. However, in downturns associated with a financial crisis and non-traditional policy, this result is not clear.

Secondly, deleveraging (measured by changes in the private debt-to-GDP ratio or by the real growth of private debt) during a downturn associated with a financial crisis has a positive effect on the subsequent recovery: a 10% reduction in the debt-to-GDP ratio during the downturn leads to a 0.6 percentage point increase in the average output growth during the recovery.

The results add further confirmation of the limits to traditional monetary policy tools during a financial crisis.  However, the application of unconventional monetary policy for a prolonged period can create economic distortions and sow the seeds for next financial disaster – and create a new risk problem!

www.bis.org/publ/work388.htm

Financial Innovation & Risk

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Since the start of the financial crisis, the debate about financial innovation has increased among economists and investors that warned that financial innovation has a dark side.  A number of new financial products have dramatically increased in complexity, but were poorly understood in terms of their risk characteristics.

A recent VOXEU communique by Thorsten Beck et al called Financial Innovation: the good and bad (T. Beck, T. Chen, C. Li &, F. Song, VOXEU, 2nd Oct.) looks at cross-country data on financial innovation and its positive and negative impact.  Their research on financial innovation provides evidence that financial innovation can lead to more volatility, more fragility, and more severe losses. But it also finds evidence of improved growth opportunities, better financing alternatives and increased R&D expenditure.

The traditional innovation-growth view posits that financial innovations help reduce agency costs, facilitate risk sharing, complete the market, and ultimately improve allocative efficiency and stimulates economic growth. The innovation-fragility view, on the other hand, focuses on the ‘dark’ side and has identified financial innovations as the root cause of the recent Global Crisis that resulted in a misallocation of resources, leading to an unprecedented credit expansion and a housing price bubble.  Financial institutions, by engineering securities perceived to be safe, exposed investors to excessive risks and misallocation of capital in financial markets.

The authors look at the impact of financial innovation on the real economy, specifically growth and volatility, as well as on the financial sector, through banks’ risk-taking and fragility.  The study uses a cross-country indicator of financial innovation and is applied to an array of real and financial sector outcomes.

The study produced the following positive results: countries where financial institutions spend more on financial innovation saw increased per capita GDP growth, and industries that rely external finance and R&D activity grow faster in countries where institutions implement financial innovation.

However, it also produced negative results: industries that rely external finance and R&D activity also experience more volatile growth in countries with high financial innovation, these countries are more fragile possibly due to a higher share of non-traditional intermediation activities and may experience higher bank profit volatility of banks with higher innovation. These results provide evidence for both the innovation-growth and innovation-fragility hypotheses.

It is important to note that the study’s indicator of financial innovation is focused on the process rather than on specific outputs of financial innovation, which can take many forms, such as new securities or products, new screening, monitoring and risk management tools or new types of institutions and markets.

Financial innovation can be associated with higher levels of economic growth and suggest that it is not so much the level of financial development, but rather innovative activity of financial intermediaries, that may help countries grow faster at high levels of income.  The results provide a direct link to the recent boom and bust experience in the early 21st century. The findings show that financial innovation provides significant benefits for the real economy but also contains risks that have to be managed carefully.

The lesson for the risk manager is they have to understand how financial innovation is measured, how the process works and not just look at the final product.

www.voxeu.org/article/financial-innovation-good-and-bad