Risks to Global Growth & Recovery

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The International Monetary Fund’s World Economic Outlook (WEO) (April 2012) assesses the prospects for the global economy, which has gradually strengthened after a major setback during 2011.   Global prospects are gradually strengthening again but remain fragile.  Downside risks remain elevated with unemployment still high in many advanced countries.

 

The threat of a sharp global slowdown eased with improved activity in the United States and better policies in the euro area. Weak recovery will likely resume in the major advanced economies, and activity will remain relatively solid in most emerging and developing economies. However, recent improvements are not deeply rooted. Global growth is projected 3.5% for 2012 and 4.1% for 2013.  The breakdown for advanced countries is 1.4% and 2% and emerging/developing countries the outlook is 5.7% and 6%, respectively.

 

Highlights by region

 

In North America, US growth should rise from 2.1% to 2.5% next year reflecting ongoing fiscal consolidation and the continued overhang from housing.  Canada is projected to grow at a 2% pace.

 

Japan, recovering from last year’s earthquake, should see output growth by 2% next year.  In the rest of Asia, weaker external demand has somewhat dimmed the overall outlook.  China, if it can avoid financial spillovers, should be able to maintain growth of a little over 8% driven by domestic demand.  The rest of Asia, including India, should be able to maintain growth of around 6-7%.

 

In Europe, growth is projected to contract in the first half of 2012, but then show signs of recovery in the inner core.  However, growth in peripheral countries will remain anemic, most likely below 1% next year.  A major problem for most European countries is to limit the impact of spillovers from the banking sector to the real economy.  UK prospects remain dim for 2012, but could see a recovery toward 2% in 2013.

 

In other parts of the world, Latin America should grow by 4% a year while other emerging countries could see growth approaching 5%.  Russia could see some moderation of growth towards 4% as exports to Europe are weak and policy tightening is implemented.

 

The most immediate concern to the IMF outlook is still further escalation of the euro area crisis that could trigger a more generalized flight from risk. This scenario might produce a global and euro area output decline over a two-year horizon.

 

Alternatively, geopolitical uncertainty may cause a sharp increase in oil prices: a 50% price increase could lower global output by over 1%. The effects on output could be larger if the tensions were accompanied by financial volatility and a loss in confidence. Furthermore, excessively tight macroeconomic policies could push other of the major economies into sustained deflation or a prolonged period of weak activity.

 

Additionally, latent risks include disruption in global bond and currency markets as a result of high budget deficits and debt in Japan and the United States and rapidly slowing activity in some emerging economies.

 

However, growth could also be better than projected if policies improve further, financial conditions continue to ease, and geopolitical tensions recede.  Policies must be strengthened to solidify the weak recovery and contain the many downside risks. In the short term, this will require more efforts to address the euro area crisis, a temperate approach to fiscal restraint in response to weaker activity, a continuation of very accommodative monetary policies, and ample liquidity to the financial sector.  Policymakers must calibrate policies to support growth in the near term and implement fundamental changes to achieve healthy growth in the medium term.  This challenge will include winding down unconventional monetary policies implemented during the crisis and the need to establish credible deficit reduction programs.

 

The risks to the recovery, while improving, continue to be very fragile.

 

For more on this follow the link: www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm

Balancing Fiscal Risks

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The International Monetary Fund noted in their latest Fiscal Monitor (April 2012) that fiscal risks still remain elevated; although there are signs that in some key respects they are less acute than six months ago. Past efforts with fiscal consolidation are beginning to bear fruit, particularly when buttressed by credible institutional commitments.

 

Policymakers face the dilemma of how best to respond to slackening global activity and continued financial volatility without losing medium-term adjustment needs. The main conclusions of the report include: 1. countries remain vulnerable to unexpected external shocks with limited margin for policy errors, 2. the negative impact of fiscal adjustment remains large and usually unavoidable, 3. gross government debt ratios may overstate short-term problems from the accumulation of assets on central bank balance sheets, and 4. some countries still have short-term flexibility without having it in the long-term and 5. Some countries are implementing fiscal rules.

 

The use of fiscal rules, while not a substitute for specific long-term adjustment plans, can help build confidence and facilitate the establishment of a political consensus on fiscal policy. Second-generation fiscal rules are typically more complex than earlier versions, providing greater flexibility to respond to economic cycles but with more-binding corrections for past deviations.  As such, they also raise significant enforcement and monitoring challenges.  

 

Debt ratios in many advanced economies are at historic levels and rising, borrowing requirements remain large, financial markets are in a state of alert, and downside risks to the global economy predominate.  They are projected to decline by 1% of GDP in 2012 and slightly more in 2013.  

 

This is appropriate, although some countries with fiscal space may slow the pace of adjustment to reduce downside risks or avoid deteriorating economic conditions. IMF policymakers examine the concept of fiscal space, or the scope that policymakers have to calibrate the pace of fiscal adjustment without undermining fiscal sustainability.

 

In this uncertain environment, the challenge for fiscal policy is to find the right balance between exploiting short-term space to support the fragile recovery and rebuilding longer-term space by advancing fiscal consolidation.  Policymakers have to balance the risk of reducing budget deficits, the overhang and potential reduction of central bank balance sheet and the need to return many advanced countries to more sustainable debt levels.

 

For more on this, follow the link: www.imf.org/external/pubs/ft/fm/2012/01/fmindex.htm

Has Systemic Risk Declined?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Yes according to the International Monetary Fund’s Global Financial Stability Report (GSFR) (April 2012). The report notes that financial stability has improved in recent months, although markets still remain fragile, yet policymakers seem committed to long-term reforms to restore confidence. 

 

Recent policy steps have brought some relief to euro area financial markets, but remain under pressure from weak growth and high debt payments. Sovereign spreads have declined, bank funding markets are reopened, and equity prices have recovered. 

 

Nevertheless, European banks remain under pressure from sovereign exposure, weak euro growth, high rollover requirements, and the need for more capital.  EU-based banks are under pressure to deleverage with the IMF estimating that their balance sheets could shrink by euro 2 trillion (7%) by the end of 2013.  They estimate that 25% of the reduction will occur in lending (reduces outstanding credit by l.7%) and the remainder from securities and non-core asset sales.

 

The IMF identified two near-term priorities: limiting the consequences of a large-scale deleveraging through close supervision to avoid damage to asset prices, credit supply, and economic activity, and prevent the outbreak of downside risks by establishing a financial backstop or firewall.  In addition, long-term European policymakers need to establish a euro-wide financial stability framework and pan-European bank supervision and resolution.  The IMF also noted that Europe needs central oversight of fiscal policy and greater fiscal risk-sharing.

 

The recent decision to combine the European Stability Mechanism with the European Financial Stability Facility will strengthen the European crisis mechanism and support the IMF’s global firewall. 

 

Elsewhere, emerging markets need to adopt policies to reduce fallout from Europe particularly from European banks.  The United States and Japan, with their high fiscal deficits, need to establish a political consensus for medium-term deficit reduction, to maintain financial stability.

 

Housing issues need to be addressed in a number of countries.

 

Meanwhile, the global financial regulatory framework is being strengthened, but key agreements still need to be concluded, while the transition to this new setting could add to cyclical challenges facing financial institutions.  Elsewhere, the report noted increased structural risks from lower rated assets used for collateral and the underestimation of longevity risk.

 

The jury is still out on the reduction of systemic risk or has it been kicked down the road?

 

For more information on this, follow the link: www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c1.pdf

Hiring Diversity (Part 4 of 4)

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

We all understand the power of diversity and the evils of groupthink that is caused by a lack of diversity in thought, opinions and ideas.  However have you taken time to look around at the key members of the risk team at your organization?  (By the way, the key members of your risk team may not be a part of the risk team.)  How much diversity is there in your risk management system?  When you closely examine the structure you will see two, perhaps three distinct clusters of individuals – perhaps the wise old experienced ones who hold the institutional knowledge of how things have been done for the last century, and those with advanced degrees of some shape or form that generally are quantitatively based.  No offense, but that is not the most diversified of portfolios.  To rectify the situation I propose at least four new hires for your organization’s risk system.  Unfortunately I expect few will take my advice, but for those that do I strongly believe that there will be unexpected rewards and pleasant surprises.

 

In no particular order …

 

Each risk system should have an ecologist.  An ecologist understands how nature works, and how it works in all of its complex glory.  The biologist Robert May shook up the field of ecology back in the 1970’s by introducing the study of complexity into biology and in particular in natural systems.  Complexity theory is now a major part of ecology and for this reason your risk system needs ecologists.  Business is its own type of natural system, and it is evident (although largely unrecognized) that complexity applies to business just as much as it applies to ant colonies or species population dynamics.  Ecologists can help your organization make this critical leap in thinking.

Hiring Diversity (Part 3 of 4)

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

We all understand the power of diversity and the evils of groupthink that is caused by a lack of diversity in thought, opinions and ideas.  However have you taken time to look around at the key members of the risk team at your organization?  (By the way, the key members of your risk team may not be a part of the risk team.)  How much diversity is there in your risk management system?  When you closely examine the structure you will see two, perhaps three distinct clusters of individuals – perhaps the wise old experienced ones who hold the institutional knowledge of how things have been done for the last century, and those with advanced degrees of some shape or form that generally are quantitatively based.  No offense, but that is not the most diversified of portfolios.  To rectify the situation I propose at least four new hires for your organization’s risk system.  Unfortunately I expect few will take my advice, but for those that do I strongly believe that there will be unexpected rewards and pleasant surprises.

 

In no particular order …

 

Each risk system should have an artist.  An artist does not see things as they are, but as they might be.  An artist sees things in new ways that are creative, novel and not bound to tradition.  A good artist creates paradigm shifts.  An artist helps an organization visualize.  A good artist is not committed to just one style or medium.  An artist helps an organization capitalize on Nason’s First Law of Risk Management.  (You say you forgot Nason’s First Law of Risk Management?  I will refresh your memory:  the mere act of visualizing a risk automatically increases the probability and magnitude of it occurring if it is a good risk, while decreasing the probability and severity of it occurring if it is a bad risk.)

 

 

Systemic Risk, Shadow Banking and Governance

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The costs from the recent financial crisis in terms of asset write-downs by financial institutions, wealth destruction and the lost output and job creation have refocused regulators attention on the role of hedge funds in the management of systemic risk.

 

Andrew Patton, Tarun Ramadorai and Michael Streatfield note in a recent VOXEU communique (9th April) Are Voluntary Hedge Fund Disclosures Reliable? Discuss some of these issues. In the wake of the financial crisis, the Securities and Exchange Commission (SEC) proposed a rule requiring US-based hedge funds to provide regular reports on their performance, trading positions, and significant counterparties.  

 

Currently, hedge funds are part of the unregulated shadow banking system that perform financial intermediation (estimated at 50% of total intermediation process) and account for a significant portion of trading volume (over 50%) in different asset classes.  Before the policy is implemented, Patton et al argue that such a move will benefit both regulators and investors.

 

Recent policy debates on the pros and cons of imposing stricter reporting requirements on hedge funds have raised various arguments. The benefits of disclosures include market regulators having a better view on systemic risks in financial markets, a better understanding of asset price dislocations, and investors and regulators being able to better determine the true, risk-adjusted performance of funds. Costs include the administrative burden of preparing such reports, and the risk of leakage of valuable proprietary information on trading strategies that may be derived from portfolio holdings.  

 

The authors’ analysis suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC last year and due to be implemented in 2012 would be beneficial to regulators.  They also suggest considering whether these reporting guidelines could also apply to disclosures to prospective and current investors.  Currently they only apply to the funds' disclosures to regulators...  They conclude that such information would help hedge fund and other investors make more informed investment decisions.

 

The IMF estimated that global financial institutions wrote down over $2 trillion in the value of assets on their balance sheet from the financial crisis from 2007 to 2010.  If you add the loss of potential economic output and job creation the cost of the crisis makes it very expensive.  The implementation of governance in the management of systemic risk is much less costly than the alternative.

 

For more on this follow the link: www.voxeu.org/index.php?q=node/7858

 

Hiring Diversity (Part 2 of 4)

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

We all understand the power of diversity and the evils of groupthink that is caused by a lack of diversity in thought, opinions and ideas.  However have you taken time to look around at the key members of the risk team at your organization?  (By the way, the key members of your risk team may not be a part of the risk team.)  How much diversity is there in your risk management system?  When you closely examine the structure you will see two, perhaps three distinct clusters of individuals – perhaps the wise old experienced ones who hold the institutional knowledge of how things have been done for the last century, and those with advanced degrees of some shape or form that generally are quantitatively based.  No offense, but that is not the most diversified of portfolios.  To rectify the situation I propose at least four new hires for your organization’s risk system.  Unfortunately I expect few will take my advice, but for those that do I strongly believe that there will be unexpected rewards and pleasant surprises.

 

In no particular order …

 

Each risk system should have a sociologist.  I know that I have blogged and spoken on this several times before, but the point needs repeating.  A sociologist studies how groups of people behave.  The emphasis here is on groups.  Understanding how individuals behave is important, but how individuals behave is not the whole story.  In fact there is a lot of evidence that individuals behave very differently in the presence of a group.  We know this.  Yet what do we do about it?  Answer – nothing.  Organizations are groups of people.  An industry is composed of groups of people.  The economy is composed of groups of people.  Yet we focus on the individual and assume that things scale.  Things do not scale when it comes to people.  People are complex, and groups are complex adaptive systems.  Groups are not the sum of the individuals – and for that matter there is never an “average” individual.  A sociologist helps the organization understand this in new and novel ways that the old embedded employees cannot see and ways that the math wizards can never imagine.  A sociologist is a valuable risk team necessity.