Lars Nyberg: Financial disturbances and the real economy
Speech by Mr Lars Nyberg, Deputy Governor of Sveriges Riksbank, to Danske Securities, Stockholm,
11 March 2002.
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I would like to begin by thanking you for the invitation to come here to Danske Securities and speak to
you, who are at the real heart of the financial sector, but also heavily dependent on occurrences in the
real economy. In my speech today I intend to concentrate mainly on the relationship between
developments in the real economy and financial developments, as it has looked in the past and as it
may look in the future.
The Riksbank's two objectives, maintaining price stability and promoting efficiency and stability in the
payment system in a broader context, have both real economy and financial aspects. The objectives
are more closely linked than might be thought initially. Turbulence on the financial markets has
repercussions for economic activity and developments in the real economy and thus great significance
for the shaping of monetary policy. It is difficult, if not impossible, to pursue an effective monetary
policy when the financial markets are functioning inefficiently. At the same time, price stability and
stable, low inflation expectations help to create security and stability in the financial markets.
This far it is quite simple. It is rather more difficult to make an in-depth survey and understand the
relationship between the financial and the real economies. Moreover, developments in the financial
markets are very rapid and there is every reason to believe that the relationship changes over time.
If one looks back at global developments over the past year, the financial markets appear to have
coped with more and greater shocks than many would have thought possible. The IT and telecom
bubble burst, a simultaneous international slowdown in economic activity began, Turkey experienced a
financial crisis, the USA suffered terrorist attacks on 11 September and began a war against
Afghanistan and the American energy company, Enron, collapsed. Finally, Argentina suffered a severe
crisis. The private market operators were not saved by further measures from the IMF, as many had
expected. However, not even all of these events together appear to have had any serious long-term
effects on the global financial markets.
In addition, it now seems as though the repercussions for the real economy were relatively slight,
despite the fact that households and companies, particularly in the USA, were heavily indebted when
the economic upturn began. Does this mean that we can now write down the risk of financial
imbalances and crises delaying the economic upturn most analysts predict to be on its way? Have
economic policy, the financial infrastructure and the behaviour of market operators been adapted to
the globalised, technologically well developed financial markets to the extent that the contagion effects
on the real economy of financial disturbances has declined significantly during the past decade?
These are questions I wish to discuss now, however more with the aim of provoking some interesting
ideas rather than providing any ready-made answers.
Are the markets more robust?
Let me begin with the question of whether the markets have really become more robust, in the sense
that they are now less sensitive to disturbances. There are some arguments in favour of this theory.
One of these is directly linked to monetary policy and inflation. This is namely that an increasing
number of countries have abandoned the ambition of maintaining a fixed exchange rate and chosen
instead to focus their monetary policy directly on an inflation target. Openness and transparency have
increased as a result of this, which in itself has probably improved the functioning of the markets.
Inflation rates and inflation expectations have fallen and become more stable, which has led to
significantly lower nominal rates. Uncertainty with regard to the future has thereby declined and the
conditions for making the right investment and savings decisions have improved. All of this should
have increased the stability of the markets.
However, there are other arguments. Greater awareness of the need for maintaining central
government finances under control has increased budgetary discipline and led to reductions in central
government debts in most countries. It could possibly be claimed that the stricter budgetary discipline
is a rather last-minute conversion, as countries with large deficits are often forced to borrow on the
international markets and there submit to the requirements made, in only to keep down the loan costs.
Large, growing budget deficits also reduce the possibilities for parties other than the central
government to assess the future and increase their costs. Borrowers are forced to pay high and
varying risk premiums to borrow on the bond markets, as financial investors want to be paid for the
uncertainty regarding the inflation rate or exchange rate. In addition, there is always a risk that if the
debt becomes too large the central government will be forced to implement large savings that will in
themselves lead to increased unemployment and poor profitability for domestically oriented
companies.
Large international efforts have been made and are being made to create new regulations and
standards that will reduce the risk of financial instability in a deregulated environment. The Basel
Committee's new capital adequacy rules are an example of this. Financial supervisory authorities in
most countries have been strengthened considerably, although the complexity of the markets always
threatens to increase more rapidly than the competence to supervise them.
Quantitative deregulation of the financial markets is largely complete and the adaptations have been
made. Increased experience of acting in a deregulated environment should in itself have reduced the
risk of financial crises. The banks, which are particularly important because of the role they play in the
payment system, are better capitalised than they were a decade ago. Credit risk management has
also improved considerably. This applies in particular to the Swedish banks, which are now much
better equipped to manage risks than they were prior to the bank crisis at the beginning of the 1990s.
Central banks and financial supervisory authorities have also become better at assessing risks.
Looking back, the really devastating bank crises have stemmed from a combination of soaring
property prices and rapid growth in bank lending, and they have often taken place in countries with a
fixed exchange rate. A growing number of central banks now closely follow macroeconomic factors
that could lead to a build-up of imbalances in the financial system and publish their conclusions in
special stability reports. The Riksbank is one of the forerunners in this field, based on the experiences
gained from the Swedish bank crisis.
For some years now, the IMF has carried out assessments of the functioning and safety of the entire
financial sector in both developing countries and industrial nations. Sweden was subject to one of
these FSAPs (Financial Sector Assessment Programs) last year and this year it will be the turn of
Japan and the United Kingdom. These assessment programs compare the entire financial systems of
the countries; banks, clearing houses, payment systems, legislation, supervisory authorities, central
banks, etc. with the "best practice" in the world and any shortcomings are pointed out. Each country
can then choose whether or not to publish the results of the assessment. A summary of the
assessment is included in the IMF's annual assessment of member countries' economies.
Dependence and complexity are increasing
While the markets have thus (hopefully, I should perhaps add) become more robust, our use of them
has grown. Households and companies have become operators on the financial markets, mainly
because these offer better and cheaper services than those traditionally offered via the banks. An
increasing percentage of the investments made are financed on the market through shares and bonds
in other countries than the USA. This has become possible because households' savings are to an
increasing degree channelled into shares and mutual funds. We use the financial markets much more
than we did just ten years ago. This means that we have good reason to be concerned over their
functioning. It has also meant that questions regarding financial stability have acquired greater
importance on the international political agenda.
At the same time as use of the markets has grown, new instruments are being traded that are
increasingly complicated in structure and their risk content has become more difficult to assess.
Various forms of derivative have been developed, for instance, to spread risks more efficiently. This in
itself creates conditions for reducing the vulnerability of the banks as well as the financing costs of the
investments. Essentially, this development benefits long-term growth. In recent years, the use of credit
risk derivatives and securitisation has increased, for instance. However, there is a risk that the
complexity of these instruments will increase the difficulty of seeing to which credit risks companies
and banks are actually exposed.
The complexity of the financial instruments and the fact that they are often found, in various forms, on
both the asset side and the liability side of companies' balance sheets as well as "off balance sheet",
makes it difficult to detect the financial risks within banks and companies. This is particularly serious
as an increasing number of households have their savings in these companies' shares, but nor is it
easy for professional analysts and portfolio managers to see.
The collapse of the American company Enron can serve as an example of the problems connected
with the development of complicated financial instruments. A lack of understanding of the instruments
used and a lack of transparency in the company's accounting meant that directly after the collapse
there was considerable concern over possible contagion effects. Here I do not mean the evident
breach of the regulations in force, where auditors burn documents and senior managers sell shares in
the company prior to publishing negative information. Enron raises a number of other, in the long term
more fundamental, issues. Today, I shall limit myself to discussing three of these.
Firstly, Enron was basically an energy company, which in time came to pursue financial operations on
a large scale, but without coming under the supervision to which financial companies are normally
subjected. The lack of supervision also applied to Long Term Capital Management, LTCM, some
years earlier. One might wonder whether function rather than company type might not be a better base
for supervision. There is otherwise a risk that functions essential to society and thus needing
protection will be transferred to companies not subject to supervision. At the same time, the public
sector is in practice forced to intervene if the failure comprises a threat to the system, regardless of
whether it has been able to exercise supervision. To what extent Enron was involved with functions
that can be assessed as worth protecting is a question for discussion, but it is an important question of
principle. We cannot and should not regulate all companies involved with financial operations, e.g. in
managing their own funds.
Secondly, it appears obvious that accounting regulations, at least those in the US, have not developed
at the same rate as the instruments and forms for capital acquisition on the financial markets. Is it
really reasonable in the long term for an increasing number of companies' risks to be reported off
balance sheets? In the case of Enron, it also appears that there were risks that did not need to be
reported at all, according to the regulations in force, such as liquidity risks that were triggered by a
down-rating.
Thirdly, it is educational (and frightening) to see exactly how the shortage of liquidity brought about
Enron's downfall when questions were raised regarding the quality of the balance sheet and the
market lost confidence in the company. Enron's balance sheet had some similarities with that of a
bank, in that the liabilities side consisted of borrowing that proved to be rather short term, while the
asset side was difficult to value and had much poorer liquidity. A bank that found itself in an equivalent
situation could face a run, with customers withdrawing their deposits, and this was really what
happened to Enron. This makes some form of liquidation necessary, even if there later proved to be
some value left in the balance sheet.
The experiences of the Enron case led to investors temporarily fleeing companies with complicated
constructions and ownership or companies suspected of being rather too creative in their accounting.
However, this seems to be just a temporary phenomenon. Companies' credit spreads have not been
affected as much as was feared and the stock market shook a little, but has begun to recover again.
The effect appears rather to have been that accounting methods and procedures have been
voluntarily revised, a development welcomed by both market operators and authorities alike.
Perhaps the Enron case can become a further indication that the markets have actually become more
robust. However, the Enron collapse also illustrates clearly some of the risks that might arise when the
markets grow in both significance and complexity. These risks and their effects on the real economy
should not be underestimated. The markets' increasing dependence on one another both within and
between countries could lead to considerable contagion effects when there is a disturbance in one
part of the system.
To summarise; the risks of large financial imbalances building up in economies have probably declined
over the past decade as a result of more predictable economic policy. Regulations and risk
management systems have also improved. At the same time, the complexity of the financial
instruments and the opportunities for extensive positions off the balance sheets have increased the
difficulty in assessing future profits and risks in companies. Meanwhile, increased saving and financing
in market-listed instruments have made households and companies more dependent on the safe and
efficient functioning of the financial markets. This could mean that the effects of disturbances from the
financial system on the real economy could increase in the long term if regulatory frameworks and
supervision are not adapted sufficiently rapidly.
Can we live with large imbalances?
When share prices plummeted almost two years ago and when uncertainty increased following the
terrorist attack in September last year, there were fears that expectations for the future would be
revised down so strongly that households' willingness to consume and companies willingness to invest
would decline drastically. The fears concerned the US economy in particular, but the uncertainty was
also expected to affect the rest of the world. The high level of indebtedness built up during the
economic upturn in many countries significantly increased this risk. Positive expectations of the future
had increased companies' financing needs for investment. At the same time, a bright picture painted of
the future and an increase in wealth had stimulated households' consumption and increased their
investment in housing.
It was easy to imagine a risk scenario where household sector demand declined so rapidly that heavily
indebted companies went bankrupt, where unemployment rose drastically and where banks an other
lenders suffered extensive loan losses. This negative spiral could continue with further falls in share
prices and household wealth and rising credit risk premiums would make lending more expensive. If
this negative sequence of events were not broken, high loan losses could eventually lead to bank
crises and credit crunches, which would contribute further to the downward spiral.
A credit boom, large increases in asset prices and a high rate of growth in investment, often
concentrated on a particular sector, have been the factors preceding serious financial crises around
the world. However, it is important to remember that neither a credit boom nor a large deficit on the
current account need be interpreted as an accumulation of financial imbalances. If savings and
investment decisions are based on realistic expectations of future growth and banks and financial
investors have been able to make realistic assessments of the credit risks connected with investment
projects and consumption loans, then this development is more a sign that the international capital
markets are functioning efficiently. The task of the capital markets is to channel capital to investment
projects with a high return. If financial investors assess the return on investments in a particular
country to be higher than in other countries, there is reason for the exchange rate to strengthen. One
cannot rule out the possibility that this is exactly what happened in the USA.
Whether the level of indebtedness, the deficit on the current account and the strong USD exchange
rate comprise a significant risk of large fluctuations in growth and a threat to global financial stability in
the near future depends to a great extent on whether the long-term growth in the US economy will
develop much more weakly than was expected when decisions on loans and investment were made.
And, as I mentioned earlier, the shaping of economic policy and improvements in regulatory
frameworks and risk management systems should have reduced the uncertainty in investment and
savings decisions and thereby also the risk of a build-up of large financial imbalances. However, it
remains to be seen whether globalisation, IT and telecommunications technology and perhaps also
more efficient financial markets have really created the potential for higher growth that lay behind the
expectations that pushed up economic activity. So far, the economies have reacted fairly moderately
to the shocks they have faced over the past year. The risk of financial imbalances being built up as a
result of over-optimism still remains, but is now assessed to comprise less of a threat to the recovery
of the economy than was previously thought.
Monetary policy considerations
Developments over the past months also indicate that the risks of a profound and prolonged
international economic slowdown have declined considerably. There are a number of signs that the
lowest point has now been reached. One condition for an upturn in international economic activity is
that growth in the US economy picks up. Productivity has continued to develop very positively relative
to the economic situation, which is a good sign. The fact that American households' demand for
consumption has improved since the autumn also indicates that the lowest point has been reached
and a turnaround is on the way.
The unease that has existed, and which was accentuated after the terrorist attack on 11 September,
over the possibility that rapid and perhaps exaggerated adjustments of financial imbalances in the
American households' and companies' balance sheets might cause a deeper decline appears, at least
so far, to have been quite unfounded. Better functioning financial markets as a result of the changes in
economic policy and the improvements in regulatory frameworks and supervision that I mentioned
earlier may have contributed to this. If so, the level of indebtedness in the corporate and household
sectors should not comprise such a great threat to economic activity in the coming years as many
have feared, including the Riksbank in a number of Inflation Reports.
In Sweden, the decline in economic activity has not affected capacity utilisation and unemployment to
the same extent as in previous cases in the economy. This means that the upward turn will be from a
relatively high level of resource utilisation in the economy. Low interest rates, a weak krona and a very
expansive fiscal policy have been contributing factors here. One consequence of the high level of
resource utilisation could be the unexpectedly high inflation rate registered recently. Earlier price
increases on certain product groups are assumed to be temporary, which would mean that inflation
should fall this year. However, price rises in the services sector, for instance, probably reflect higher
labour costs. A number of my colleagues have expressed concern over future inflation and I must say
that I share their concern.
The fact that the international upturn in economic activity is taking place after a very brief and
moderate decline means that the economic upturn is not expected to be as strong as earlier upturns.
For Sweden, this means that exports are increasing, but that growth is primarily expected to come
from domestic demand, in particular in the services sector. In my opinion, this increases the risk that
domestically-oriented companies with pressurised profit margins will continue to compensate
themselves for cost increases by raising prices.
This is roughly how the picture looks as the Executive Board of the Riksbank gathers on Monday 18
March to discuss the economic situation and monetary policy. We will also have as a basis for our
decision a completely fresh Inflation Report, which will be published on the following day.