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The Global Financial Crisis: Why It Happened, and Options for National and International Policy Change

A comparative overview of the crisis and macro-economic policy responses so far

Western Hemisphere Department International Monetary Fund Barbados January 25, 2011

Trevor Alleyne

The world is recovering from the great recession, but huge challenges remain

• The impact of the crisis
• How did the crisis start
• Why this recession is different
• Policy Responses thus far
• Policies to sustain the recovery
• Lessons from the crisis

2

The Crisis—Impact on Growth

Global growth fell sharply during the crisis everywhere in the world

Emerging and developing economies World Advanced economies

• 10
• 8
• 6
• 4
• 2

2 4 6 8 10 12 14 2006 07 08 09 10 11

IMF Forecasts

3 Source: IMF WEO (October 2010).

Global GDP Growth (percent, quarter-over-quarter, annualized)

The Crisis—Impact on Trade

World trade collapsed…

• 60%
• 50%
• 40%
• 30%
• 20%
• 10%

0% 10% 20% 30% 40% 50% 60% 2007 2008 2009 2010Q1

Source: IMF WEO (October 2010).

World Latin America Other emerging economies Advanced economies Emerging asia

Growth Rate of World Real Imports (percent, quarter-over-quarter seasonally adjusted annual rate)

4

Advanced Economies Emerging and Developing Countries World

4.50 5.00 5.50 6.00 6.50 7.00 7.50 8.00 8.50 2006 2007 2008 2009

Onset of the crisis

5

The Crisis—Impact on Unemployment

Unemployment rose sharply in developed and developing countries

Source: IMF WEO (April 2010).

Global Unemployment Rate (percent)

The Crisis—Impact on the Wealth

6

• Wiped out US$2.7 trillion in U.S. originated assets of

financial institutions (15½ % of GDP)

• Write-downs on global exposures are estimated at

about $4 trillion (7% of GDP)

Caribbean: Real GDP Growth 1/ (annual percentage change)

Source: IMF WEO (October 2010). 1/ Caribbean countries include Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Jamaica, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago.

TTO VCT SUR GUY SUR GRD BLZ BHS ATG ATG

• 15
• 10
• 5

5 10 15 20

• 15
• 10
• 5

5 10 15 20 2006 2007 2008 2009 2010

7

The Crisis—Impact on the Caribbean

Severe recession followed by a slow recovery of growth…

Caribbean: Unemployment Rate 1/ (percent)

Source: IMF WEO (October 2010). 1/ Caribbean countries include Bahamas, Barbados, Belize, Jamaica, Suriname, and Trinidad and Tobago. Data for Guyana and ECCU countries are not available. 2/ Tourism-dependent countries include all Caribbean countries, except for Suriname and Trinidad and Tobago, which are commodity-exporting countries.

SUR BLZ BLZ BHS BHS TTO TTO TTO TTO TTO 5 10 15 20 5 10 15 20 2006 2007 2008 2009 2010

8

The Crisis—Impact on the Caribbean

… higher unemployment…

Tourism-dependent 2/ Caribbean average Commodity-exporting 2/

Caribbean: Public Debt 1/ (percent of GDP)

86.5 80.5 78.2 85.5 90.6

KNA KNA KNA KNA KNA SUR SUR SUR SUR SUR 50 100 150 200 250 50 100 150 200 250 2006 2007 2008 2009 2010

9

The Crisis—Impact on the Caribbean

… and a sharp rise of public debt/GDP ratios

Tourism-dependent 2/ Commodity-exporting 2/ Caribbean average Source: IMF WEO (October 2010). 1/ Caribbean countries include Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Jamaica, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago. 2/ Tourism-dependent countries include all Caribbean countries, except for Suriname and Trinidad and Tobago, which are commodity-exporting countries.

Let’s look at where the crisis began… In U.S. and European banks

10

What caused the crisis? How did it start?

Lots of liquidity sloshing around Asset bubbles

Crisis starts in advanced countries

Banking crises Credit crunch Recession

Weak regulation Excess risk Weak supervision

Advanced economies

11

Failure at the policy and supervisory levels

• Market discipline and regulations failed to keep up

with innovation and leverage build up.

• Belief in light-touch regulation based on the assumption that

financial market discipline would root out reckless behavior and that financial innovation was spreading, not concentrating risk.

• Macroeconomic policies did not respond to increase

in systemic risk.

• Central banks focused mainly on inflation, not on risks

associated with high asset prices and increased leverage.

• Leadership needed at the international level to detect

and respond to risks.

12

Asset bubbles

Crisis spreads to emerging economies

Banking crises Credit crunch Recession Advanced economies Credit crunch Recession Emerging economies

Trade collapsed - Capital flows stopped

13

14

The Crisis—Contagion to Emerging Economies through Bond Spreads

Bond spreads in emerging economies also increased

Sovereign and Corporate Bond Spreads 1/ (basis points)

1/ The sovereign bond spread series for advanced economies is a composite of the five-year U.S. Treasury rate over the effective federal funds rate and the five-year German Bund over the EONIA rate. 2/ Averages of BB-B US, BB-B Euro, and BBB Japan corporate bond spreads.

• 200

200 400 600 800 1000 1200 1400 EMBI Global Advanced Economies: Corporate 2/ 2007 2008 2009 Sep-10

Jamaica: Spreads and Domestic Interest Rates

15

200 400 600 800 1000 1200 1400 5 10 15 20 25 30 35 40 45 2002 2003 2004 2005 2006 2007 2009 2010 Money Market T-bill Spreads, bps(RHS) Spreads and Domestic Interest Rates 1/

1/ Spread refers to JPMorgan Central American and Caribbean Index (CACI) Jamaican stripped spread, which is calculated as the spread between a portfolio of Jamaican USD denominated bonds and on-the-run US treasury zero-coupon rate.

Asset bubbles

Low-income countries

Banking crises Credit crunch Recession Advanced economies Credit crunch Recession Emerging economies Recession Low-income economies

Trade collapsed - Capital flows stopped

16

17

Why is this recession different?

• Recessions associated with financial crises are severe

and recoveries from such recessions are typically slow. These features become more pronounced if in addition the recession is global.

• Countercyclical policies are helpful in ending recessions

and strengthening recoveries. Their effectiveness depends on the type of recession.

2 4 6 8 Financial crises which are highly synchronized Highly synchronized recessions Financial crises All recessions Output loss (percent from peak) Duration (quarters)

Features of Recessions and Recoveries Depend

• n the Type of Recession…

Recessions Recoveries

2 4 6 8 Financial crises which are highly synchronized Highly synchronized recessions Financial crises All recessions Time until recovery to previous peak (quarters) Output gain after four quarters (percent from trough)

18

Policies Help Shorten Recessions… Fiscal Stimulus is Effective in Financial Crises…

0.0 0.2 0.4 0.6 0.8 1.0 1 2 3 4 5 6 7 8 9 10 Quarters Full sample Financial crises Financial crises with high fiscal response

19

Probability of remaining in a recession beyond a certain number of quarters

Most countries implemented a fiscal stimulus to respond to the crisis

Central Government Fiscal Deficit (percent of fiscal year GDP)

5 10 15 20 Germany Canada United States France Italy Japan United Kingdom Ireland Portugal Spain Greece 2009 2010

Source: IMF WEO (October 2010). 20

21

2 4 6 8 10 12 Australia Canada Denmark Euro Area Germany Iceland Italy Japan New Zealand Norway Sweden United Kingdom United States 2010 Average (2001-2010)

Policy Interest Rates (percent)

Source: Haver Analytics, Inc.

To sustain the recovery, central banks have kept policy rates at historically low levels

22

In the Caribbean, high public debt/GDP ratios have weakened growth and narrowed the fiscal space

BHS BRB DMA DOM GRD HTI JAM KNA LCA VCT TTO

10 40 70 100 130

• 6
• 4
• 2

2 4 6

• 6
• 4
• 2

2 4 6

Average real GDP growth, 2009–10 Public Debt, 2008 (percent of GDP)

Public Debt Burden and Real GDP Growth

Growth has been weaker in countries with higher debt levels...

JAM BHS BRB ECCU DOM TTO

• 20
• 15
• 10
• 5

5 10

• 4
• 3
• 2
• 1

1 2 Change in primary deficit (percent of GDP)¹ Real primary expenditure growth minus potential GDP growth (percent, right scale)

Change in Primary Deficit and Primary Expenditure Growth, 2010

... where fiscal space remains constrained.

23

Policy Response in the Caribbean

• Some central banks followed an accommodative monetary policy

and lowered the policy rate as U.S. rates declined.

• Financial sector legislative and supervisory frameworks were

strengthened:

• Intensified monitoring of financial institutions (FIs).
• Broadening the regulatory perimeter to include nonbank FIs.
• Liquidity facilities provided to avoid the contagion from CLICO.
• Short-term fiscal stimulus (constrained by scant fiscal space):
• Temporary decrease of hotel/payroll taxes and/or lower cost of

electricity and energy contingent on maintaining employment.

• Aggressive tourism marketing efforts.
• Temporary employment and training programs, and extension
• f unemployment benefits.
• IMF programs.

Two–speed recovery is underway

As before the crisis, EMEs are growing much faster than advanced economies

Emerging and developing economies World Advanced economies

• 10
• 8
• 6
• 4
• 2

2 4 6 8 10 12 14 2006 07 08 09 10 11

IMF Forecasts

24 Source: IMF WEO (October 2010).

Global GDP Growth (percent, quarter-over-quarter, annualized)

25

Two-Speed Recovery

• EMEs buoyed by an accommodative policy stance and plentiful

inflows of foreign capital. Instead of worrying about unemployment, risks relate to possible overheating.

• In advanced countries, growth remains too weak to bring down
• unemployment. Large output gaps and weak balance sheets in

households and banks are holding back credit growth and private demand.

• In Caribbean, growth projected to turn positive but subdued.

Tourism grew in 2010 and expected to continue in 2011.

• Downside risks: (1) financial stresses and fiscal sustainability―in

the Euro area in particular; (2) lack of progress on credible m-t fiscal consolidation plans in advanced economies; (3) high commodity and food prices.

26

What can be done to foster the recovery?: A consistent policy framework

• Accommodative monetary policy and continued

support for banks to support credit and demand.

• Repair and reform financial systems.
• Medium-term fiscal consolidation plans, including to

build credibility and new room for policy maneuver.

• Structural reforms and exchange rate flexibility to

boost domestic demand in key EM.

• Employment promotion and protect the most

vulnerable.

27

Financial sector repair and reform need to accelerate

• Recapitalize/resolve banks.
• Repair markets for securitized assets.
• Re-establish market discipline.
• Implement regulatory reform with a broader and more

global view (broaden the regulatory perimeter and foster cross-border coordination among regulators).

28

Over the medium-term, fiscal plans are urgently needed

Projected Change in Cyclically Adjusted Primary Balances (percent of potential GDP)

Source: FAD staff estimates. 1/ In percent of GDP; distance from blue bar reflects required additional fiscal adjustment relative to 2010-13; adjustment to be sustained between 2020–30 to reduce public debt to prudent levels. 2/ Structural primary balance. 3/ Excluding financial sector support recorded above the line.

• 5

5 10 15 20 Germany Canada United States 2/ France Italy Japan 3/ United Kingdom Ireland Portugal Spain Greece Change 2013-2011 Change 2011-2010 Change 2010-2009 Additional adjustment between 2013-2020 1/

Expansionary policies in advanced countries pose policy challenges for EMEs: Soaring capital flows

29

30

Dealing with inflow surges: Exchange rate flexibility and capital controls

• Fiscal and monetary stimulus policies are leading to capital

inflow surges in emerging economies.

• Macro and prudential policies can help deal with the

downsides of inflow surges (appreciation and inflation).

• Macro policy space (especially exchange rate) must be

exhausted before imposing capital controls.

• Capital controls and prudential measures should target

specific risks.

• Prudential measures when flows intermediated

through the regulated financial institutions.

• Capital controls when flows by-pass regulated

financial institutions.

31

Foster employment and protect the most vulnerable

ILO/IMF collaboration (Oslo Conference 9/2010)

• The crisis will not be over until unemployment falls.
• Growth is essential for employment, but it is not enough.
• Job creation must be a priority.
• Specific policies are needed to protect the poor and the

vulnerable (social protection floor).

• Programs to subsidize short-term work and on-the-job training.
• Unemployment benefits.
• Job subsidies.
• Focus on policies for employment-creating growth

32

What are the main lessons for policy makers on the macroeconomic level?

• Monetary policy should respond to the buildup of

systemic risk (focus on macro-financial stability).

• Fiscal policy should be put on a stronger footing in good

times (to open up fiscal space for countercyclical fiscal stimulus in bad times).

• While international capital flows are on the whole

beneficial, global imbalances have to be addressed.

As the Caribbean recovers from the global crisis, it faces significant challenges going forward

Promoting growth

• Energy and infrastructure
• Human capital development
• Competitiveness
• Diversification

Fiscal sustainability

• Reducing debt-to-GDP ratios
• Creating fiscal space to allow for

countercyclical policy

Financial sector

• Strengthening regulations, particularly for

nonbank FI

• Resolving CLICO

Climate change

33

34 Source: IMF WEO (October 2010). 1/ Caribbean countries include Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Jamaica, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago. 2/ Tourism-dependent countries include all Caribbean countries, except for Suriname and Trinidad and Tobago, which are commodity-exporting countries.

Caribbean: Real GDP Growth 1/ 2/ (annual percentage change)

Reforms to boost growth are needed: In absence of reforms, growth is projected to be lower than in the past

3.1 3.2

• 1.2

3.0 3.2 2.7

• 1.6

2.7 2.3 6.1 1.1 4.3

• 4
• 2

2 4 6 8 1990-99 avg. 2000-08 avg. 2009-10 avg. 2011-15 avg. Caribbean Tourism-dependent Commodity-Exporting

35

Medium-term fiscal plans are urgently needed

Caribbean: Projected Change in Cyclically Adjusted Primary Balances (percent of potential GDP)

Source: WHD staff estimates. 1/ Numbers next to the country names refer to 2009 public sector/central government debt as a percent of GDP.

118.3 45.0 110.7 80.2 83.1 122.3 60.5 126.1 184.7 73.9 59.8 18.5 32.4

• 20
• 15
• 10
• 5

5 10 15 20 Antigua & Barb. Bahamas Barbados Belize Dominica Grenada Guyana Jamaica

• St. Kitts & Nevis
• St. Lucia
• St. Vincent & the

Grenadines Suriname Trinidad & Tobago Change 2013-2012 Change 2011-2010 Change 2010-2009

36

If no additional measures are taken, debt-to-GDP ratios will continue to rise

Antigua & Barbuda Source: Staff reports. 1/ Shaded area corresponds to IMF projections. Bahamas Barbados Jamaica

• St. Kitts and Nevis

Public Sector Debt 1/ (percent of GDP)

20 40 60 80 100 120 140 2005 2007 2009 2011 2013 2015 20 40 60 80 2005 2007 2009 2011 2013 2015 20 40 60 80 100 120 140 160 2005 2007 2009 2011 2013 2015 40 80 120 160 200 2005 2007 2009 2011 2013 2015 50 100 150 200 250 300 2005 2007 2009 2011 2013 2015

37

Financial Sector

• Strengthening the financial sector requires:
• Upgrading the legislative and supervisory framework for:
• Commercial banks.
• Nonbank financial institutions.
• Intensifying monitoring and on-site inspections, and more

frequent reporting.

• Consolidated supervision of conglomerates.
• Agreements and closer collaboration for cross-border

supervision.

• Urgent resolution of CLICO.
• A transparent resolution process.
• Minimize fiscal costs and contingent liabilities.

Thank You