Mr. Bäckström discusses the economic situation in Sweden  (Central Bank Articles and Speeches, 10 Oct 98)
Central bank: riksbank | Type: speech | Date: 1998-10-10

Mr.

Bäckstrom discusses the economic situation in Sweden Speech by the Governor of the Bank of Sweden, Mr. Urban Bäckström, at a seminar organised by The Swed Shareholders Association, held in Malmö on 10/10/98.First of all I should like to express my thanks for the invitation to visit discuss the economic situation.

A major phenomenon in the current economic situation is, o the international financial turbulence.

The crisis in the Japanese economy has been d throughout the 1990s and the problems in Asia as a whole are now in their second year.

Th crisis, which is having widespread real economic repercussions in that region, has accentuated the problems in Russia and, to some extent, in Latin America, with ass contagious effects in Western financial markets.

Stock exchanges have fallen around the w some players in the financial markets have incurred losses.This in turn raises a number of questions about the global economic trend. negative may the real economic effects become in the United States and Europe?

What part central banks playing?

The US Federal Reserve has recently lowered its instrumental rate have other central banks.

Will that affect the Riksbank's actions?

Matters to do with world development and what should be done - not just to mitigate the short-run effects but also t systems and institutions so that similar events can be avoided in the future - have been agenda for economic policy discussions in various fora this autumn.

The latest instance i Annual Meeting of the International Monetary Fund in Washington D.C.

earlier this wee connection with that meeting, finance ministers and central bank governors from all over assembled in various groups to discuss the situation.

## Background to the global economic problemsJust a year or so ago, many observers foresaw a golden future for the world ec There was talk in some places of a new economic era, with strong growth and permanentl inflation, at least in the United States.

Today, the discussion has shifted in general to about the risks of a world economic slowdown.

The challenges the global economy is fac present are a combined result of several factors.

One of these factors is, of course, th Japan, where the economic problems, as I just said, have been at work throughout this dec inability to take sufficiently resolute action has led the Japanese economy into a seri Japan has the world's second largest economy and is of primary importance for the outlook as a whole.A crisis in other Asian countries then materialised almost a year ago.

The pr showed up first in Thailand but soon spread to South Korea, Malaysia and Indonesia.

Whi deterioration in these countries was partly a consequence of the economic stagnation i perhaps the main cause of the acute crisis was that a strong capital inflow from the West from the United States, suddenly turned into an outflow.

For various reasons, political economic, assessments of the development potential in the countries in question had been revised.More recently the problems have spread to Russia, where the economic situation in Japan - was already troublesome.

The situation became so precarious that the Russian gov suspended payments on government debt denominated in the domestic currency.

That was a v far-reaching decision.

Since then, capital outflows have also hit Latin America.

For a l seemed that the Asian crisis would not have sizeable repercussions in industrialised count West.

The direct real economic impact was judged to be small and at first it looked as t main effect would be a tendency to keep inflation down, while growth would remain good Russia also encountered increasing problems, however, there was growing concern and theaccordingly began to spread even to financial markets in the West.

During the summer, shar began to fall.

Credit risks rose.

Investors and banks started to become increasingly caut on account of some losses.

When a highly reputable hedge fund, Long-Term Capital Manageme was hit by major setbacks, the international banks became even more wary.Investors have fled to assets that are generally regarded as secure.

Lending ra but the most creditworthy borrowers have therefore risen around the world.

In the last moreover, long bond rates have moved up in many countries, which is a sign that invest increasing the cash component of their portfolios.

Expressions like 'flight to quality' a cash' are common in the course of a development such as that we are now experiencing.

## How great will the repercussions be?Observers throughout the world are now engaged in appraising the global econo effects of the crisis in Southeast Asia, the inability to tackle the problems in the Japa the uncertainty about the situation in Russia and the risk of contagious effects in Latin AThe world economic impact of the problems in the emerging markets can be divi into effects on real economic activity and influences via financial markets.

The latter ar both by falling prices for shares and possibly other assets and by a higher degree of prud part of firms, households and banks.Let me begin with the real economic effects.

In the emerging economies that currently affected, the problems have led to sharply falling demand and output.

Imports fro of the world are therefore declining, too.

At the same time, currency depreciation has im competitiveness of exports.

Thus, a weakening of Western exports to the emerging markets i accompanied by a gradual increase in Western imports from these countries.

For overall gr the OECD area, however, the aggregate real economic effects are probably not all that largeSo what about the effects transmitted by financial markets in the West?

A f stock exchange reduces the value of households' share portfolios, which may influen propensity to consume.

It also increases the cost of capital procurement, which may likew demand via a weaker propensity to invest.

The recent global fall in share prices - more or out the increase in the past two years or so - should be seen in the light of the strong that share prices have followed in the 1990s.

In Sweden the OMX Index is still around 300 above the low in the autumn of 1992.

In the United States the Dow Jones Index is about 200 higher than at the beginning of 1991.

This provides a perspective for the impact of fa prices on international growth.

It should also be borne in mind that the US economy sensitive than Europe to a falling stock exchange.When it comes to confidence, it is more difficult both to quantify and to a more definite conclusions about consequences of the crisis.

We do not know to what ext present course of events is affecting how households and firms appraise both their own country's economy.

A good many people and businesses will no doubt become more cautious ab buying a car or making investments for the future, for example.

Here we have a potential effect that must be monitored very carefully.

Some guidance is to be had from various c survey data.

A number of the results point to a fall in consumer confidence.Neither can one draw any precise conclusions about the magnitude of the effec may come from increased prudence in banking around the world.

The global unrest has left i No one foresaw that Malaysia would introduce foreign exchange controls.

Nor did any b believe that Russia would go so far as to suspend payments on debt denominated in roubles.seem to be thinking that if such things could happen in Malaysia and Russia, perhaps happen elsewhere.The problems with the hedge fund Long-Term Capital is another matter that made international bankers more wary.

Although their loans to this fund were secured, t stock of loans from all banks and the total amount of collateral were too large for direc the market; that would have caused prices to fall, leading to losses for the banks. circumstances it is hardly surprising that international banks also review their lending c to other funds.The key question is whether the international banks' review of lending commitm will be extended to include other groups of customers.

Perhaps their lending policies wi generally more restrictive.

One sign of this is that the flow of loans to many countrie regarded as emerging markets has virtually dried up.

The interest rate differential betwe securities issued by such countries and by the US, for instance, has widened dramatic autumn.

In turbulent times, moreover, banks have difficulty in fulfilling their functio highly important in a market system, of distinguishing sound borrowers from others.

The re be that their provision of credit is completely suspended.It is already evident that in their assessments, various players are tending t more fundamental factors.

An example of this is the weakening of the krona.

Despite good ec fundamentals in Sweden, since the summer the krona has weakened sharply and last week tendency accelerated.

In a matter of days the exchange rate with the German mark declined 5 per cent.

In that situation the Riksbank decided to intervene in the foreign exchange ma nowadays is unusual.

We did so to demonstrate that we considered the krona's fall was exce relation to the fundamental state of the economy and that the time had to come to pa reconsider the situation.

Instances of 'follow-the-leader' behaviour occur not just stockmarkets but also in the currency market when many countries with different conditi lumped together in a general assessment.

Market players must assess each country sepa Central bank interventions under certain circumstances are uncommon with a flexible exchan regime but they do occur.

I cannot exclude the possibility of the Riksbank intervening ag were to be called for.Growth in the industrialised countries may thus be affected by the real ec crisis which has hit the emerging markets and resulted in a sharp fall in output there.

Th of such an effect will be highly dependent on confidence - confidence among households an so that they are prone to consume and invest, confidence among banks so that they are provide credit.

## The Riksbank's appraisalIn the Riksbank's most recent Inflation Report we counted on an OECD area grow rate of around 2 per cent in the years ahead.

It should be borne in mind that this figure the latest in a series of downward revisions over the past twelve months.Since the publication of the September Report, our assessment of tendencies rest of the world has not changed.

Considering the mechanisms to which I have just r however, it is not surprising that our Report highlighted the risks associated with t situation.

This situation is unusually difficult to evaluate and has to be followed closelyIn the situation that has arisen, why doesn't the Riksbank lower the repo rat all, other central banks have done so.The answer is that our assessment includes all the factors which have a bear developments in Sweden and future inflation.

To date in 1998, economic development in Sw has been very good.

At present, moreover, it is very difficult to foresee the krona's futu mentioned earlier, the economic fundamentals point to a definite appreciation.

If th sufficiently marked, however, export production will be strongly stimulated.

It is diff whether that in turn would alter inflation prospects for the period of twelve to twentythat is relevant for monetary policy.

That is something to which we will be returning international picture becomes clearer.

It is also a consideration that has to be weighed outlook for the domestic economy.

A repo rate cut is not topical in Sweden at present.

## How did it happen?Why

is it that the unrest in Southeast Asia and Russia, with some tendenc spread to Latin America, is beginning to affect the financial system in the industrialise What has gone wrong in the global financial system?There is no simple answer to these questions.

But let me briefly mention a co factors.

First, however, it is important to underscore the advantages that accrue fro financial system of the type that has been developed in the past decade.

The countri participate in the international capital market tend to have higher per capita growth rat countries.

The globalisation of production and trade calls for new solutions for paym financing.

It is also a great advantage to have a financial system that is capable of savings to those parts of the world that need them most for investment.However, participation in the international capital market presupposes that a has an adequate banking system with accounting regulations and other institutions, such as supervision that ensures sound banking practices.

This has evidently not been the case in of the countries that are now affected by the crisis.

Nor should we forget that the bankin Sweden was not fully prepared at the time when our credit market was deregulated.If loans from the international capital market are channelled to a country w banking system and other financial institutions are not ready to function in this community may thus be loan losses.

But, as you know, it takes two to tango.

It may well be asked why the industrialised countries have arranged loans to countries that evidently were not yet sound borrowers.

Capital has been flowing to emerging markets in a broad stream in recent has been channelled directly through the banks as well as indirectly, for instance via hed good many such funds have obtained large loans from banks in the industrialised countries pursuit of favourable yields, invested the money in emerging markets.

This indirect lendi likened to the Swedish banks' earlier lending to finance companies.This brings us to the nature of banking in a more profound sense.

Traditional involves accepting deposits from the non-bank public and lending these funds to various bo Moreover, the equity capital on which banking is based is small, which implies high leve low solvency.If all the banks' capital had consisted instead of equity, incurred losses c been handled more or less painlessly.

With a large proportion of borrowed capital, howev are liable to be chain reactions that successively spread through the banking system.

It this that necessitates comprehensive, efficient supervision and a functional set of regulat to avoid unnecessary losses.

That is also why central banks around the world have been ass function of safeguarding the financial system's general stability.

## What can be done?The current problems in the global financial system need solutions for both th and the longer run.

In the short run it is a question of resolving the acute crises.

Work run must focus on the creation of an international rule system that prevents crises of th occurring.

In the work that has begun on a new architecture for the financial system, me three kinds have been singled out as particularly important:

more transparent accoun financial institutions as well as for governments and central banks; a greater involvement investors in crisis management; and a reinforcement of the financial system.For work on the third category, there are in principle two different approac combination of these.

One involves tightening up the supervision of banks and the ot introduction of higher capital standards to raise the proportion of equity capital in the My guess is that the future work to create a more functional banking system will be conduc both these approaches.In the prevailing situation it is important that the international banks do n unduly cautious.

Banks should take risks but their risk-taking should be properly managed. be unfortunate if more countries were to start imposing restrictions on capital exports. exacerbate the present state of affairs.

Similarly, it would be directly counterproductive some type of turnover tax, as proposed earlier by Professor James Tobin.

That was trie Sweden in the late 1980s and simply resulted in trading being transferred to other countri agreements were to be reached between many countries, there would always be countries refrained from joining the arrangement.

Moreover, the poorer liquidity that would acc turnover taxes might actually impair the workings of some financial markets.

New regulati simply do more harm in the present situation.

But the players in international financial need to review their systems for evaluating risks.

Risk assessments based on historically correlations between different assets may be inadequate when earlier patterns are broken supply of liquidity changes.In the short run the problems in the global economy must be solved at their o Via the International Monetary Fund, in certain situations the international commun contribute liquidity if the countries in question are prepared to take measures.

It i enigma that the world's second biggest economy, Japan, has not managed, year after year, t the problems in its banking system.

Economic development in Japan is highly important, n for other countries in the region.

All observers are agreed that the problems in the ban must be rectified.

Fiscal measures are also called for.

Nor would I rule out the introduc of a stability programme, of a numerical inflation target that might help to modify th expectations.

It is my hope that the current signals about future measures will be fulfilleThe US Federal Reserve is also strongly focused on the problems in the gl economy.

In Europe the action of central banks will be determined by the extent to which E affected by what is now happening.

To date, however, it looks as though Europe is moving right direction.The Riksbank, too, is keeping a close watch on the financial system's stabi times of financial unrest, such as recently, the Riksbank steps up its oversight as a matt above all as regards financial enterprises.

If problems were to arise with bank liquidity, they would create difficulties not only for monetary policy, in that the interbank mar function less well, but also for other parts of Sweden's economy.

The Riksbank therefore the potential effects that financial unrest could have on the financial sector's solvencyThe analysis of the situation is supplemented with an ongoing exchange of information w competent authorities in this field.

Stockmarket unrest of this kind also leads to surveillance of the flow of payments in the Riksbank's payment system, RIX.Judging from the available statistics, the Swedish banks are in a better posi many of the international banks, with lower direct exposures to the countries involved in Perhaps one could say that Sweden's bank crisis did at least result in Swedish banks becomi more efficient at risk management.Central banks throughout the world have accordingly become more watchful.

No o can remain passive if world economic growth continues to slacken as a consequence of fi problems.