- Michael Papaioannou, and Udaibir Das
- Published Date:
- October 2010
© 2010 International Monetary Fund
Cover design: Lai Oy Louie, IMF Multimedia Services Division
Unwinding financial sector interventions : preconditions and practical considerations. – Washington, D.C.: International Monetary Fund, 2010.
p. ; cm.
ISBN 978-1-58906-989-3 (paper)
1. Global Financial Crisis, 2008-2009 – Government policy. I. Das, Udaibir S. II. Papaioannou, Michael G. III. International Monetary Fund.
Disclaimer: This volume contains papers based on presentations at the high-level conference on Unwinding Public Interventions in the Financial Sector held at the IMF headquarters in December 2009. The views expressed in this book are those of the authors and should not be reported as or attributed to the International Monetary Fund, its Executive Board, the governments of any of its members, or the institutions represented at the conference.
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Although at present the global economic recovery is under way, there are significant uncertainties concerning financial stability. This makes the process of exiting from the monetary, financial, and fiscal support provided in the past few years particularly delicate. Thus, it is all the more important to understand the keys to the exit process which, as we have currently seen, is proceeding at difference speeds in different parts of the world.
As the current financial crisis unfolded, governments and central banks rose to the challenge by taking unprecedented steps to avoid the collapse of the global financial system and avert a devastating impact on the global economy. Liquidity support, capital infusions, and public guarantees were provided to banks and other financial institutions; policy interest rates were lowered substantially; and fiscal stimulus packages were introduced. On top of this, international institutions like the IMF enhanced their lending facilities to help emerging markets and developing economies better cope with the threats posed by the crisis. These measures were broadly successful as they were able to avert a 1930s-style Depression.
Depending on the strength of their economic recovery, a number of countries have already started exiting from their monetary and financial support measures while others have maintained much of their support in place. As regards fiscal policy, the situation is also quite different across countries: while some had to move quickly to reduce deficits under market pressure, others will only start to remove their fiscal stimulus in the future.
The ultimate goal of an “exit” process is to converge to a situation of price stability, sustainable public finances, financial stability and the restoration of market discipline in a safer financial sector. This will provide the necessary conditions for strong, sustained and balanced economic growth. In practice, this means several things: removing the degree of monetary accommodation introduced through low interest rates and the credit and quantitative easing policies of central banks; pursuing a policy of fiscal consolidation to bring public debt back to reasonable levels; and withdrawing the measures now in place to support the financial sector, while introducing the necessary reforms to make it safer.
In this policy response, two things are particularly challenging: reducing public deficits and debt levels sufficiently, and achieving a consistent exit process across countries. The weakened state of public finances in the big advanced economies—the United States, Japan, much of Europe—will continue to require vigorous policy action. Population aging meant that the fiscal situation in these countries was already extremely challenging before the crisis, and higher fiscal deficits in response to the crisis have added to the problem. Countries must thus develop and communicate a clear plan for reining in public deficits and public debt, to be implemented over time in a manner which is consistent with their specific economic and financial situations.
A consistent international approach to exit is also essential to contain the risk of destabilizing spillover effects. Especially among those economies whose financial markets are closely linked, withdrawing financial guarantees or tightening regulation in an uncoordinated way could trigger sharp movements in international financial flows that could disrupt the recovery and undermine credibility.
To examine issues related to exit strategies from crisis interventions, the IMF convened in Washington a high-level conference on “Unwinding Public Interventions in the Financial Sector,” on December 3, 2009. This conference was another IMF initiative to help countries prepare the groundwork for a sound exit, following the IMF’s high-level principles for policies during the exit process that were proposed to the G-20 in early November 2009. The main messages and deliberations of the conference fed into a paper on “Unwinding Crisis-Related Intervention Measures: Implementation of Strategies,” that was discussed by the Executive Board of the IMF in early February 2010.
Many people contributed to the successful undertaking of this conference and to the production of this volume: first and foremost, the panelists of the four sections of the conference, who not only made insightful presentations but also generously provided written statements with their comments; as well as John Lipsky, first deputy managing director of the IMF, who provided the opening and closing remarks; Carlo Cottarelli, director of the Fiscal Affairs Department of the IMF; Olivier Blanchard, economic counselor and director of the Research Department; Reza Moghadam, director of the Strategy, Policy, and Review Department, who chaired, along with me, the four sessions of the conference. In addition staff both within and outside the Monetary and Capital Markets Department (MCM) helped with the background material and organization of the conference. Udaibir S. Das, assistant director, Sovereign Asset and Liability Management Division of MCM, and Michael G. Papaioannou, deputy division chief of the same division, edited the manuscript. Sean M. Culhane and his team from the External Relations Department helped with editing and production of this publication. I am grateful to all participants and colleagues.
Financial Counsellor and Director
Monetary and Capital Markets Department
American International Group, Inc.APS
Asset Protection Scheme, UKBCBS
Basel Committee on Banking SupervisionBIS
Bank for International SettlementsCB
Credit default swapECB
European Central BankECOFIN
Economic and Financial Council of the European UnionEME
Emerging market economyFDIC
Federal Deposit Insurance CorporationFOMC
Federal Open Market CommitteeFRNs
Floating rate notesFSB
Financial Stability BoardG-20
Group of Twenty Finance Ministers and Central Bank GovernorsG-7
Group of Seven Industrialized CountriesIMFC
International Monetary Fund CommitteeIMF
International Monetary FundIOR
Interest on reservesIPAB
Instituto para la Protección al Ahorro Bancario, MexicoIPO of EdF
Initial public offering of Electricité de FranceIRR
Internal rate of returnLIBOR-OIS
Libor—Overnight Indexed SwapM&A
Mergers and acquisitionsMBS
Mortgage backed securitiesMCM
Monetary and Capital Markets DepartmentNPLs
Organisation for Economic Co-operation and DevelopmentQE
Residential mortgage backed securities, UKSFEF
Société de Financement de l’Économie FrancaiseSIVS
Structured investment vehiclesSMEs
Small and medium-sized enterprisesSPVs
Special purpose vehiclesTAF
Term Auction Facility, Federal ReserveTARP
Troubled Asset Relief Program U.S.
The IMF’s Monetary and Capital Markets Department moderated a conference of senior policymakers, academics, and senior representatives of the private sector on unwinding public interventions initiated during the crisis. Participants agreed that an exit strategy is vital. Its main goal would be to secure safe, stable, and sustainable economic and financial conditions, including a new financial environment. They emphasized that the strategy will need to be cohesive, consistent, comprehensive, and well explained to anchor public expectations.
Relevant economic and financing indicators should be used to guide the exit process. It was stressed that there were risks linked both to unwinding too quickly and too slowly. Political pressures could make exit from fiscal measures challenging, while problems with assessing output gaps could complicate decisions to reverse monetary measures. Participants’ views varied on both the timing and sequencing of the exit strategy. They welcomed the role of the IMF in addressing issues related to the exit process, noting in particular its continued work on establishing sound principles to guide the process.
Discussions distinguished areas in which a broad consensus appears to be emerging from those in which views remain disparate; and they addressed possible challenges that policymakers are about to face.
Consensus on the importance and goal of the exit strategy
Participants were in broad agreement that an exit strategy from monetary, fiscal, and financial sector interventions is essential. The pivotal goal of the exit process would be to arrive at a condition of price stability, fiscal sustainability, and financial stability, including a new financial landscape that would be much safer than currently exists. Those conditions will provide the necessary underpinnings for stable, strong, and sustainable growth. The strategy will need to be clear, cohesive, consistent, and comprehensive in addressing the debt and asset management issues generated by the intervention measures. That said, tailoring the strategy will likely be more an art than a science because of the uncertainties and the need to have firm assurances that it will not undermine recovery. Such strategies will need to be flexibly implemented and reflect changes in the economic, financial, and political environment.
Different perspectives on the timing and sequencing of the exit process
Presenters were of different minds regarding the timing and sequencing of the exit process. Some argued that it was better to exit soon because of possible fiscal policy lags or potential new asset bubbles, while others maintained that it was too early to exit given the highly uncertain global economic prospects. Further, some participants felt that credible programs for returning to fiscal sustainability in key countries should be announced first to ensure a more orderly exit from extraordinary monetary accommodation. Others argued this may not be feasible because the political process of unwinding fiscal interventions would likely be long and complicated, and, hence, monetary policy should be unwound first. IMF staff members expressed the view that the risk from exiting too early is higher than from exiting too late and that fiscal policy should start adjusting first.
Some principles for an exit strategy
Conference participants agreed that exit strategies need to be consistent at three levels: across monetary, fiscal, and financial policies in each country; across different financial sector interventions; and internationally, to avoid spillover effects, including from advanced to emerging markets economies. They also stressed that the measures to be unwound first are those that impose known distortions. Further, discussions emphasized that economic and financial indicators should provide a basis for guiding the exit strategy. These indicators should include quantity as well as price signals, in particular regarding developments in aggregate and sectoral credit.
Main challenges ahead
Views regarding the major challenges were fairly uniform. The most difficult task will be the fiscal exit. Credible fiscal rules and institutions are needed to reverse debt trends; debt ratios should be reduced; and contingent liabilities should be better accounted for in the fiscal accounts to clarify the fiscal risks.
Timing and sequencing the unwinding of monetary ease will be challenging, mainly because of uncertainties related to the correct estimation of potential output and size of output gaps in a postcrisis environment.
It will be relatively easy to unwind financial interventions that have sunset clauses or have penal rates, as they become unattractive when market conditions normalize. The challenge regarding financial interventions is rather how to offload risky assets from central bank balance sheets, which threaten central bank autonomy, and how to unwind debt guarantees and blanket deposit insurance.
Introductory Remarks by John Lipsky
As the crisis abates, governments are being confronted with new challenges. One of the most important will be to balance the withdrawal of fiscal and monetary support for the financial sector with the reestablishment of sustainable growth, price stability, and sound public finances while creating a more stable and resilient financial system.
Recognizing the importance of the impending challenges, the IMF Board’s International Monetary and Financial Committee and its Executive Board asked the IMF staff to provide concrete views on exiting from the crisis-related financial intervention measures. The request was one of the motivations for holding this conference. It has been organized to provide a forum for discussion of some of the key issues regarding the unwinding, including management of the public finance aspects. The topics covered include strategies governments could follow to normalize their involvement in the financial sector, key principles for timing and sequencing these strategies, and areas for domestic and cross-border coordination.
I will note here some of the implications of the crisis for sovereign balance sheets and outline some broad considerations for unwinding the unprecedented public interventions. The interventions greatly increased the size of sovereign balance sheets through the acquisition of financial system assets and through the buildup of debt, including the accumulation of contingent claims.
As a result, the balance sheets of the central banks in 6 advanced countries and that of the ECB increased by an average of more than 8 percentage points of GDP between June 2007 and June 2009. At the same time, the government balance sheets of 16 advanced countries increased on average by about 5.5 percentage points of GDP. As we all know, this ballooning of balance sheets poses significant management challenges, as the downsizing of these balance sheets will require substantial and sustained policy efforts.
In particular, the unwinding of monetary and fiscal policies will need to place government debt on a sustainable path while accommodating growing private credit demand and supporting the economic recovery. Low interest rates have so far muted the impact of the dramatic growth in government debt, but a significant increase in interest rates would bring the underlying vulnerabilities more clearly into focus. Unconventional monetary policy measures eventually will be unwound, and private sector credit demand will pick up. At that time, the growth of government debt and the corresponding financing needs will raise the possibility of crowding out.
Moreover, adverse implications for sovereign balance sheet risks—arising from the accumulation of weak sovereign assets, greater contingent liabilities, and still-increasing government debt—will need to be managed. So will strategies for asset disposal and the withdrawal of public guarantees. Government refinancing risk has been manifested in increasing sovereign debt issuance and a drift toward shorter debt maturities, developments that signal a worrisome trend in debt management strategies and in sovereign liability management more generally.
These broad concerns suggest a few considerations regarding the unwinding of public interventions.
Of course, the evolution of financial market conditions—including trends in sovereign credit spreads—will influence both the prospects for a systematic unwinding of public sector support and the balance of risks to financial stability during the unwinding.
At the same time, clarifying fiscal accounts could help to manage fiscal policy during the unwinding process. For example, quasi-fiscal activities, which were a prominent feature of the response to the crisis, would be more transparent if they were transferred to the budget. Likewise, guarantees and other contingent liabilities require appropriate management.
Unwinding public sector interventions in the form of capital injections, as well as the purchase of assets and the assumption of liabilities, also will give rise to sequencing issues. A key consideration in disengaging from these types of interventions should be their impact on asset prices. In some cases, this task may be carried out more successfully if assigned to a specialized asset management company. In other cases, a decentralized approach may work best to take advantage of market incentives.
Ideally, the most distortion-inducing and redundant measures will be discontinued first. Careful evaluation of the implications of the intervention measures for financial sector competition, along with the role of the financial regulatory structure at the time of the unwinding, therefore will provide important guides to policy action.
Another important general consideration is the need to maintain the coherence of unwinding strategies across countries, as coordination issues could influence capital flows and financial intermediation and could give rise to regulatory arbitrage.
Although it is not the subject of the sessions today, you probably are aware that the IMF has been asked by the G-20 leaders to provide an options study regarding possible financial sector taxation to compensate for the costs of risk mitigation for potential financial sector crises.
Rather, the four sessions today will focus on (1) the prospects for unwinding public interventions in the financial sector, (2) the public finance aspects of unwinding, (3) indicators for guiding liquidity support and financial sector guarantees, and (4) restoring private control of crisis-related assets. I hope that the presentations and exchange of views at this conference will prove challenging and helpful.