Sunday, March 1, 2015

BIS Speech - Former Italian Minister of Finance - The International Monetary System Strikes Back

The Bank for International Settlements publishes speeches relevant to the monetary system on its web site from time to time. This one is a dinner speech given by a former Minister of Finance from Italy, Fabrizio Saccomanni. In the concluding remarks to this speech, he laments that world leaders often use the phrase "global challenges require global solutions", but do not actually implement global solutions. This speech touches on many issues we have covered here on the blog that relate to the monetary system. 

Below are several quotes from the speech. The speech is fairly long so I can only use some excerpts for this blog post. To get full context, please read the whole speechJust below each quote, I will add a comment in bold type to try and clarify the point to be made.


"I am grateful to Jaime Caruana and Claudio Borio for having invited me to this important meeting. After my brief experience as Minister of Finance in Italy, it is nice to be back in the more stable world of central banking where I have spent most of my professional life."

This speech is from a Central Bank lifer to more Central Bank lifers.

"In my remarks today, I will review the three aspects of the current policy debate that I have mentioned. These will be examined separately, but they are components of the same global economic problem and I will make frequent cross-references to highlight the interconnections among them."

1-Monetary spillovers

"In its 84th Annual Report last year, the BIS forcefully made the point that international financial markets have been “under the spell of monetary policy”, showing a keen sensitivity to the impact of monetary policies, actual or expected. It used not to be that way. There were indeed many episodes in the past in which markets were taken by surprise, most famously in 1994, when the unexpected increase in the policy interest rate by the Federal Reserve led to the collapse of the market for government and corporate bonds world-wide, paving the way for the “Tequila crisis” in Mexico. The current spell originates from the conventional and unconventional monetary policies adopted by the major advanced economies since 2008. Policy rates have remained at very low levels for an unprecedentedly long time; long-term interest rates have fallen to historical lows; credit spreads have been compressed across asset classes, including emerging market economies’ (EMEs’) debt securities and high-yield corporate bonds. This has led to a dramatic increase in global liquidity and, in the context of uncertain growth prospects for advanced economies, to large capital inflows to EMEs. The composition of these flows has seen a decline in bank lending and an increase in portfolio flows, which tend to be more volatile. Especially for countries with relatively underdeveloped and shallow financial markets, large capital inflows may feed credit and asset price bubbles. Moreover, by causing the exchange rate to appreciate, inflows may create external imbalances. Contrasting the impact of such inflows may be costly and not necessarily effective. However, these trends can be quickly reversed if markets become convinced that a change in the monetary policy stance of major countries is imminent."

In his first area of discussion, he is simply pointing out that since the 2008 financial crisis world financial markets have become addicted to monetary policies (low interest rates, QE, etc). Just the expectation of a monetary policy announcement now moves markets regularly. He says "It used not to be that way."  He notes that large flows of capital around the world, especially into emerging market nations, "may feed credit and asset price bubbles." He goes on to say in this section that the risks from monetary spillovers still exist and could lead to abrupt market corrections. 

2-Financial cycles (i.e. boom & bust)

"These developments in the research on the functioning of global financial markets confirm that procyclicality is a fundamental feature of their behaviour. But what is the main cause of procyclicality? As I have argued in the past (Saccomanni 2008), although global financial intermediaries operate in a highly competitive environment, they have uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. Thus, competition and uniformity of strategies combine, in periods of financial euphoria, when the search for yield is the dominant factor, to generate underpricing of risk, overestimation of market liquidity, information asymmetries and herd  behaviour; in periods of financial panic, when the search for safe assets is predominant, they combine to produce generalised risk aversion, overestimation of counterparty risk and, again, information asymmetries and herd behaviour."

In this second area of discussion he talks about market cycles (boom & bust) and asks: What is the main cause for them? He suggests that that investment managers tend to run in a herd mentality and use similar models to project markets and risks. He says when times are good, they get overconfident and use models that are too rosy. When panic sets in, they use models that overreact and become too risk averse. He says this behavior then amplifies the normal business cycle. He also notes that these days the addiction to monetary policies of central banks can help trigger these cycles.

3-Currency wars

"Monetary policy changes in a key country have an obvious impact on the exchange rate of its currency vis-à-vis other currencies. At the same time, exchange rate movements can have an impact on investors’ strategies and contribute to amplifying the impact of monetary spillovers and to triggering a financial cycle."

In this section he just notes that monetary policies of various countries impact currency exchange rates that can lead to what are now commonly called currency wars. He says this can also amplify the impact of market movements. So he ties all three of these concepts together to say that the stability of the world financial system overall is heavily impacted by these three areas.

"The monetary-financial-exchange rate interactions that I have tried to describe are in fact the manifestations of the shortcomings of the current IMS (International Monetary System). And indeed some sort of a debate on reforming the system, restoring international monetary order, or promoting international monetary coordination has begun, involving both central bankers and academic economists. . . . The overall impression, however, is that there is a deep divergence of views and that little progress is being made towards any form of consensus on what should be done to fix the system."

Now that he has established the "global challenges" to financial stability, he goes on to say that we need "global solutions" to these problems. He says the current international monetary system (IMS) has broken down and needs better coordination from the IMF and the BIS. But he says the overall feeling these days is "that little progress is being make towards any form of consensus on what should be done to fix the system."

A comparison of the G7 and the Asian approaches highlights the crucial dilemma confronting policy-makers when dealing with financial cycles, which Rey (2013) described as follows: “independent monetary policies are possible if, and only if, the capital account is managed, directly or indirectly, regardless of the exchange rate regime”. If international monetary policy coordination is precluded by political considerations and/or the domestic orientation of central bank mandates, then the issue is how to devise an efficient and effective strategy to manage the capital account. It is obvious, at least to me, that this goes beyond the regulatory measures to strengthen the capital base and the liquidity position of banks and financial intermediaries. This process is well underway within the Basel and FSB fora, and it is being implemented in both advanced and emerging economies. But, as Governor Zeti Akhtar Aziz eloquently put it: “Our efforts will not be sufficient to prevent the next mega tidal wave (Aziz 2014), because, incidentally, shadow banking activity continues to grow unabated

This section is more difficult to follow for us non bankers. But basically he seems to be saying that while there is some global effort underway to prepare for the next financial crisis, the efforts are not sufficient "to prevent the next mega tidal wave." Note his reference to "shadow banking" which we covered here earlier. He is preparing us for his argument that more global coordination and cooperation will be required in the next crisis. Next he suggests that these inadequate efforts underway now (which allow each nation to try and solve its own problems) will have to be replaced with a global approach. Here is where he talks about that.

"Is this what the world economy really needs? To roll back financial integration and to promote financial fragmentation? And what for? To preserve temporarily the independence of national policies until the next crisis, when all countries will be forced to cooperate under the pressure of events? It seems to be a very shortsighted approach, and it might hamper the growth prospects of the world economy. Rather, I do not see why it should not be possible to improve our ability to prevent and mitigate financial crises by combining the necessary but insufficient house-in-order approach with a realistic reform that would strengthen the instruments and the procedures for managing international financial instability within the institutions that have been created over the years for that very purpose."

The institutions he is talking about are the IMF and the BIS. He says reforms to strengthen them are what is needed. He then offers four reforms to move towards that goal listed just below.

1- A first priority would be to implement the reforms of IMF governance and quotas agreed by the IMFC but still awaiting formal ratification by the US Congress. As this is not considered possible at the present political juncture in the US, the IMF should find alternative ways to achieve the rebalancing of votes and voices in favour of EMEs.

2- Another important step in the same direction would be the inclusion of the Chinese renminbi in the SDR in the context of the basket review scheduled for 2015.  It should be possible to reach a consensus on this reform, which would also enhance the credibility of the SDR by making it more representative of the changed conditions in world currency markets. Whether this step would lead to a new reserve currency regime, as advocated by the Governor of the People’s Bank of China (Zhou 2009), remains to be seen. But I see no harm in trying.

3- A reform of a more general significance would entail the expansion of the global safety nets to an extent sufficient to discourage an excessive accumulation of reserves, which can have a negative impact on economic activity and foreign trade.

4- However, the most necessary and yet more difficult reform is in the area of international policy cooperationHere again, an important body of background information and analysis has been assembled since the outbreak of the crisis by the G20, the IMF, the World Bank, the BIS and the OECD. But, with a few exceptions, results of these efforts have been modest so far, to say the least . . . .   Sometimes the communication from international cooperation fora tends to broadcast, perhaps not intentionally, a message of the opposite sign, like “it’s every man for himself now”This is not acceptable, and I fully share the view of the BIS that in a highly integrated global economy “the need for collective action - cooperation - is inescapable

Here he makes his call to end the days of "every man for himself" and defer national interests to "the need for collective action-cooperation". In other words, "global challenges call for global solutions" and those solutions should be coming from the IMF and the BIS. He adds that this is actually a political problem:

"The question therefore seems to be more political than technical and, to quote from a perceptive lecture by a former Governor of the Reserve Bank of India, Y.V. Reddy, the real problem is that “short-term motivations at the national level seem to run counter to the longer-term interests of the global economy."

Concluding comments:

This is obviously a longer article than usual for this blog. However, it ties together many points we have made here that relate directly to coming monetary system change. Here is the bullet point list:

- the current system is unstable and at risk from asset bubbles created in response to various central bank policies around the world 

- these various central bank policies are shaped by the desire to achieve short term results for the various nations and are causing harm to the overall global monetary system. They lead to an "every man" (nation) for himself mentality

- the IMF and BIS have studied all this and have tried to start global solutions by requiring higher capital buffers (Basel regulations) for the worlds banks and investment houses, but their efforts are too meager to prevent the next financial crisis (mega tidal wave)

-when the next crisis comes, nations will be "forced to cooperate under the pressure of events" because the current system is inadequate and too uncoordinated

-only strengthening the existing global institutions (IMF in the lead) will make it possible to coordinate a global solution to the problem. He lists four ways to strengthen global institutions right now

-nations will have to give up the idea that their individual needs are more important than the stability of the overall global monetary system and will have no choice because the global system is so interconnected now

There you have in one speech almost everything we have covered and talked about here for over a year. This is how the world's central bankers are thinking about what needs to happen in the future. Notice how all this ties in very closely to what Jim Rickards has predicted will happen. That is, a new bigger global financial crisis that leads to the IMF stepping in to solve the problem. The IMF using the SDR as a new global reserve currency in some way. This speech lays out that whole idea as possible.

It should be clear now why we are covering all this here on the blog. The world's central bankers are anticipating the potential for another crisis. They expect it to lead to essentially what Jim Rickards has predicted. If that happens, the US dollar will be replaced as sole global reserve currency and everyone who uses the US dollar will be heavily impacted. That's the bottom line for readers here.

Interestingly, this speech expresses a lot of frustration at how none of this is moving forward right now. So, we really don't what may happen if we get another major crisis. But we do know very clearly what a possible plan is. Whether the world will accept it is the unknown.

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