Barbro Wickman-Parak: The financial crisis - where do we stand today
and where are we heading?
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at
Danske Market's Central Bank Seminar, Snekkersten, Denmark, 11 June 2009.
* * *
When I joined the Executive Board of the Riksbank almost exactly two years ago, in May
2007, I expected my new job to be varied and exciting. Though I perhaps wasn't expecting it
to be exciting in the way it turned out to be. Of course we were then already aware of the
problems with subprime loans in the United States. But, like most other people in Sweden
and abroad, I didn't foresee that the worrying signs we saw then would gradually develop into
a global financial crisis of historical proportions. Nor did I anticipate that as a result of this
crisis the Riksbank would lend several hundred billion kronor to the banks. Or that the
Riksbank would cut the repo rate by 4.25 percentage points during the course of just over six
months, to its lowest level ever - the fastest monetary policy easing in the period we have
had an inflation target. And of course I could not anticipate that several other central banks
would by then have reached the lower limit for their policy rates and have begun to resort to
unconventional measures. But nevertheless - this is where we stand now.
Several explanations for the crisis
One usually says that the crisis began in 2007 with problems in the US mortgage market and
that this gradually developed into a global financial crisis, which became acute in autumn
2008 in connection with Lehman Brothers filing for bankruptcy. But the picture is more
complex than this. The origin and course of the crisis will be analysed thoroughly and we
probably will not have a complete history of it until much later.
However, we can already note that there are several explanations as to why the crisis arose
and why it became so widespread. One circumstance that probably played some role is that
growth had long been good in many countries, at the same time as inflation was low - quite
simply, things had gone unusually well for an unusually long period of time. And when things
have gone well for a long period of time it is probably human nature to relax and become
slightly incautious. This is what appears to have happened this time in various ways and
places, not solely in the US mortgage market.
One factor that probably also contributed was that there was a global saving surplus that
meant there were large capital sums to be invested in the financial markets. This surplus
pushed down the interest rate on risk-free assets. The combination of a lot of money to be
invested and low risk-free interest rates contributed to an increase in the demand for assets
that were profitable to invest in and led to an intensified hunt for high yield. This type of
environment often inspires great inventiveness in the financial markets and many new
financial instruments were also created. These were often complex and difficult to valuate
correctly. But in the optimistic climate prevailing then - everything had gone so well for so
long - it was nevertheless easy to sell them. Those who invested in the new instruments
disregarded, or failed to sufficiently understand, the risks that were "inbuilt" in them. The
financial supervisory authorities and regulations also lagged behind this development.
The problems in the international financial markets began to become more apparent as early
as summer 2007. But the Swedish economy and the Swedish financial markets long
appeared able to manage fairly well, despite the fact that the turbulence was having more
and more effects on the world around us. Of course, economic activity in Sweden began to
weaken as international economic activity declined, but this did not initially seem to entail any
very serious downturn. However, when Lehman Brothers filed for bankruptcy in September
2008 the situation worsened dramatically. The confidence that had existed between financial
institutions was shaken to its foundations when no one was certain who might be next in line
to default on their payments. Now the Swedish financial markets were also hard hit and
some sub-markets were practically at a standstill. The earlier expectations that the decline in
economic activity would be fairly mild were replaced by a much more negative view of future
developments, both in Sweden and abroad. The Lehman Brothers crisis was also the
prelude to a series of measures to stabilise the Swedish financial markets. At the same time
the Riksbank took several rapid and resolute steps down the interest ladder to alleviate the
effects of the crisis on economic activity.
Still sensitive but liquidity risk has declined
The first phase of the crisis can be described as a liquidity and confidence crisis. No one
trusted anyone else and very few were willing to lend money and take risks. The price of
loans between the banks, interbank rates, also rose sharply. Since the crisis started the
central banks have lent large amounts to the banks. For example, the Riksbank has offered
loans in Swedish kronor at longer maturities than normal to facilitate the supply of liquidity to
the Swedish banks. We have also lent US dollars to Swedish banks and we have made the
collateral requirements for the loans somewhat more generous. The government has tried to
reduce the banks' liquidity risks through its guarantee programme, which basically involves
banks and other credit institutions being able to sign contracts with the government on
guarantees for some of their borrowing. Without the measures taken by the Riksbank and
other authorities the financial system would have ceased functioning and would still not be
functioning. The same applies of course in many other countries.
As we note in the Financial Stability Report that we published just over one week ago, these
measures have contributed to ensuring that there is no imminent risk of a liquidity shortage
for the banks. Interbank rates have fallen, although it still appears difficult to find funding at
longer maturities. There are also other signs that the conditions on the international credit
markets have eased somewhat and it appears to have become slightly easier to obtain
funding by issuing securities, even when these are not backed by a government guarantee.
Now it is unfortunately not the case that the problems are over - we are not yet on solid
ground with regard to financial stability. There is still a lack of confidence between financial
institutions and the international credit markets are fairly far from functioning as they did
before the crisis. The situation is still sensitive and there is still a risk of a surprisingly
negative shock giving the crisis new energy and once again making it more difficult for the
banks to obtain funding. The Riksbank will of course follow developments very closely. We
will continue to supply the banks with liquidity and we are prepared to do so as long as
necessary. But to summarise briefly, the situation does look somewhat brighter with regard to
liquidity risk.
Greater focus on credit risks
Now that liquidity risks are less prominent, there is instead a greater focus on credit risks, as
economic activity has weakened and growth prospects have deteriorated. The very large
policy rate cuts made by central banks around the world and the fiscal policy stimulation from
governments have not been able to prevent a severe weakening in economic activity. Our
most recent forecast published in April points to GDP in the world falling by a good 1 per cent
in 2009. This is a something quite unique: since 1970 GDP in the world has increased by on
average 3.6 per cent a year and growth has not been negative even for a single year. The
export-dependent Swedish economy is hard hit by the international downturn. In our April
Monetary Policy Update we forecast a fall in GDP of more than 4 per cent in 2009.
When economic activity weakens and the demand for goods and services declines it
becomes more difficult for the banks' borrowers to meet their payments. Bankruptcies
increase and the banks suffer loan losses. The loan losses in their turn make the banks even
less willing to lend money and the economy risks ending up in a spiral where falling activity
and stricter credit terms reinforce one another.
The banks can cope with loan losses
The main scenario in the Riksbank's forecasts does not involve Sweden ending up in a
serious downward spiral. But in the recently published Financial Stability Report we are
nevertheless assuming, even in the main scenario, that the Swedish banks will face fairly
substantial loan losses in 2009 and 2010. A large share of the losses, approximately 40 per
cent, is expected to arise from operations in the Baltic countries and the rest of eastern
Europe. But in the Report we also note that all of the major Swedish banks have sufficient
capital to cope with the losses that will arise if the Riksbank's forecasts are correct. We also
observe that the Swedish banks are well-capitalised in an international perspective.
One cannot disregard the fact that there is great uncertainty over future developments in
economic activity. When one has the task of safeguarding financial stability, it is natural
preparing for situations where things go very badly. And when assessing the resilience of the
financial system it is also of greater interest to study a more negative development than the
one forecast. We have therefore investigated in our Financial Stability Report how the banks
would cope with a scenario of a much weaker development than that considered most likely
today. There we assume, for instance, that GDP in Sweden will fall twice as much as
predicted in our main scenario forecasts for 2009 and 2010 in the Monetary Policy Update
published in April. It is assumed in the really negative scenario of the Financial Stability
Report that developments in the Baltic countries and the rest of eastern Europe will be much
weaker, although that is far from the only reason behind the poor development. Here, too,
approximately 40 per cent of the loan losses are expected to come from operations in these
regions.
In this scenario all of the banks meet the statutory requirement of Tier 1 capital adequacy of
at least four per cent. However, it may be necessary to have higher capital adequacy to
avoid negative consequences such as funding problems and downgraded credit ratings. In
the unlikely event that this very negative scenario were to occur, several banks might
therefore be forced to act to strengthen their capital bases. If this could not be achieved
solely through private capital injections, there is a possibility for the government to inject
capital by virtue of the Government Support to Credit Institutions Act of last autumn. The
Riksbank's assessment is that we, together with other Swedish authorities, are also well
prepared to be able to manage the problems that could arise if the situation were to
deteriorate to the level of the stress test described in the Financial Stability Report.
Let me just clarify that the Financial Stability Report's test of the financial system's resilience
cannot be compared with the alternative scenarios of a "more probable" nature that are
usually presented in the Monetary Policy Reports. The latter normally describe the
consequences for monetary policy of developments being better or worse than the situation
described in the main scenario, but where the alternatives are not normally too far from the
main forecasts. In the Financial Stability the scenario is rather more exaggerated.
So where do we stand now and where are we heading?
Let me briefly summarise where we stand now in terms of risk focus; the liquidity problems
have been dampened, while credit risks and feared loan losses are increasingly in the
limelight as economic prospects have deteriorated. Credit risks and the size of loan losses
are of course closely interlinked with economic activity. So I shall now, not least for this
reason, move on to talk about economic activity - the assessments made by the Riksbank at
the most recent monetary policy meeting in April and the nuances in the views of future
economic developments that I put forward at the meeting.
Things could be better or worse
It is natural in times like these to paint a gloomy picture and focus on downside risks. And I
am probably the last person to deny that such risks exist. It is also natural that the focus of
the monetary policy discussion should be on what a central bank can do when the policy rate
approaches zero and further stimulation may be necessary as this is to some extent
"uncharted territory" for us.
But let me now change perspective and adopt a slightly more positive tone. In the
discussions at the two most recent monetary policy meetings I have pointed out that there is
some possibility that the recovery both in Sweden and abroad could come more quickly than
most people are assuming. One could perhaps say that I have acted as the devil's advocate,
if one can use this expression for arguing that there is some chance that things will be better
than is generally believed.
A more general reason as to why an upturn might come more quickly than expected, once it
starts, is that the crisis can to a large extent be described as a massive confidence crisis that
has made a lasting impression on the real economy. Households hesitate over consumption
and companies hesitate over investment. But confidence is in many ways an on-off variable
- either you have it or you don't. All countries have been affected more or less at the same
time and world trade has declined dramatically. Once confidence and faith in the future
return, it may well be the case that the upturn is rapid and forceful as more and more
countries come on board.
My views at the April monetary policy meeting did not primarily concern 2009. I think
everyone is agreed that this year will unfortunately be a really poor growth year. In Sweden,
as in many other countries, growth plummeted in the fourth quarter of last year. Recently
published preliminary GDP figures for the first quarter also show that growth continued to fall,
although the rate of the fall slowed down. My main emphasis was on what lies ahead of us -
the economic cycle further on this year and into 2010. I shall not repeat everything I said at
our two most recent monetary policy meetings; anyone who is interested can read the
minutes of the meetings. But I would like to take the opportunity to bring up some of the
views I expressed then.
One view that I wished to highlight concerned the housing market in the United States, which
is in many ways the origin of the problems. Some signs of stabilisation are now visible there,
although some quarters of adjustment still remain before the stocks of unsold houses have
been reduced and house prices stop falling. Falling housing investment has provided large
negative contributions to growth in recent years. Very little housing has been built for several
years now in relation to the increase in the number of households. When the turnaround
comes, housing investment should provide a good contribution to growth.
I also mentioned that stocks in the United States have been phased out rapidly and they will
sooner or later be down to levels where the demand flow, even if it is declining, will need to
be met with increased production. However, here one must bear in mind that this "cyclical"
upturn will be temporary if final demand does not catch on further ahead. I could also see
signs of stabilisation in important forward-looking indicators, particularly orders in the
purchasing managers' index. However, the picture is not clear-cut and never is when
economic activity is in the balance. But, as I mentioned at the meeting, if the signs of
stabilisation become clearer they may affect the mood more permanently, not least on the
stock market. This can in its turn have a positive effect on households' undermined wealth
and help increase consumption. Further ahead it may be possible to reinforce a positive
cycle and for investment to pick up. I also mentioned that a large part of the economic policy
stimulation, particularly investments in the US infrastructure, would have its greatest effect in
2010.
Having said this, I would like to point out, as I did in the discussion at our most recent
monetary policy meeting, that it might very well be the case that the signs of stabilisation I
mentioned then were delusive. And it is definitely not the case that I fail to see the
seriousness of the economic downturn we are in. Nevertheless, the recovery could as I have
said be quicker or slower than expected.
Inflation outlook may change quickly
Falling resource utilisation and inflationary pressures have meant that we could conduct a
strong, expansionary monetary policy to alleviate the effects of the economic downturn and
at the same time ensure that inflation does not undershoot the target very far. We will see a
negative inflation rate this year if we measure inflation by the consumer price index, the CPI.
But this is largely due to our own interest rate cuts. The low inflation rate is temporary and
should not trigger expectations of future deflation. Inflation expectations according to, for
instance, Prospera's survey, are anchored in a slightly longer perspective around the target
of 2 per cent.
My view at the April meeting was that we should begin to see signs next summer or autumn
that the extremely low interest rate needs to be raised. I said then that it was not merely a
question of an upturn possibly being on the way; I also pointed out that monetary policy is
forward-looking and its effects come after a time lag. It is therefore more guided by
developments in 2012 and 2013 the closer we come to this period. I also emphasised that
although inflationary pressures were not a problem at that point, or in the near future, the
situation could look very different in a year or two. For example, commodity prices could
have begun to rise more than we had predicted, or the expansionary monetary policy and
fiscal policy conducted in large countries could have pushed up international inflation with a
risk of increased imported inflation. I also mentioned that we could not be certain that the
krona would strengthen in the way we had assumed, or that productivity would recover as we
had predicted.
We know from experience that the inflation outlook can change rapidly. During the late spring
and summer of last year we were concerned over inflation being too high, even though this
was mainly due to rising oil and food prices. Rising unit labour costs were also taken into
consideration. Fears that high inflation expectations would become entrenched also formed
part of the picture. We then raised the interest rate despite beginning to see signs of weaker
economic activity in the future. The assessment was that this was necessary to attain the
inflation target a couple of years ahead. When developments turned out differently, we had to
quickly change our course. We are of course always prepared for situations like that. We are
ready to act as quickly and as forcefully as is necessary, both to attain the inflation target and
to carry out our financial stability responsibilities.
Unconventional measures
There have been many discussions on what the Riksbank could be expected to do if
developments turn out weaker than we are now assuming. And our toolbox is not empty
because the repo rate is so close to its lower limit.
Put simply, the way the repo rate tool works is that the banks either borrow or buy Riksbank
Certificates with a maturity of one week from the Riksbank at the price of the repo rate. In
addition, there are what is known as daily fine-tuning operations between the Riksbank and
the banks at an interest rate very close to the repo rate. The current level of the repo rate
and expectations of what it will be in the future in turn affect other interest rates with longer
maturities and, of course, activity in the economy. As I mentioned earlier, the Riksbank has
implemented a number of measures that work through the banks in order to improve the
functioning of the financial markets. This includes loans at maturities of 3 and 6 months to
Swedish banks, against collateral and at a variable interest rate. These measures were
recently supplemented with the possibility to borrow at a 12-month horizon. The primary aim
of the lending has been to manage financial stability. But the measures also have monetary
policy side-effects in that the Riksbank is active further out on the yield curve than normal.
The liquidity premiums decline, which in turn should lead to lower interest rates.
If a central bank wants to affect interest rates more directly at slightly longer maturities there
are various measures at its disposal. Central banks such as the US Federal Reserve and the
Bank of England are for example buying government bonds with long maturities to influence
long-term interest rates in the economy, thereby trying to attain monetary policy easing.
However, the effects of such a strategy are uncertain. As yet our experience of that kind of
action is rather limited. Moreover, government bond rates are affected by many other factors
than the central banks' possible purchases of these securities.
The Riksbank has not taken any such measures. The Executive Board decided at its meeting
in April that the time was not yet ripe for this. But nor could we exclude the possibility that this
might be possible further ahead, if the economic situation were to deteriorate more than we
were assuming.
During our discussion of this type of unconventional measure at our most recent monetary
policy meeting I pointed out that the Riksbank is already implementing extensive measures
through its lending to the banks. These measures will continue as long as is necessary. I
also considered that it was not necessarily the case that we would need to take the same
measures as, for instance, the Federal Reserve and the Bank of England. There are several
different reasons for this. The companies in these countries are more dependent on market
funding, while in Sweden the banks are the most important source of funding. I also said that
we had not yet seen the full effect of the radical interest rate cuts we had made, which
contributes to an even greater uncertainty in the question of whether further stimulation
through unconventional measures is needed.
When we meet in July we will present our forecasts for the economy and the repo rate over
the coming three years and discuss once again whether there is a need to carry out other
measures than those we have already carried out. We must always maintain the best
possible level of preparedness to deal with various situations that might arise. But this is not
the same thing as needing to put those plans into action.
Concluding thoughts
I would like to carefully emphasise that what I have taken up regarding economic activity and
monetary policy should not be interpreted to mean that in a sudden outburst of uncontrolled
optimism I have a much brighter view of the coming period than most others. And my
message today does not contain anything new in relation to what I said at the most recent
monetary policy meeting. I can assure you that I am aware of the seriousness of the ongoing
downturn. And it is not a question of my being hawkishly "trigger-happy" and wanting to raise
the interest rate again as soon as we see the slightest sign of a recovery. I believe, like my
colleagues, that we need to maintain a low interest rate for a relatively long period of time.
What I want to say is rather this: I believe it is easy to become a hostage to the situation
when all of the figures are falling and to put a large emphasis - possibly too large - on the
downside risks. And, of course, one cannot rule out the possibility that the crisis and the
economic downturn will be more protracted and more profound than we are now assuming.
But there is also a risk that one may thus give too little weight to the possibility that things
could actually go better than we believe and thus we may receive a surprise from a different
direction.
I have worked with forecasting for many years, and there are two things in particular that I
have noted, and for which I also believe there is scientific evidence: that it is difficult to
predict turning points in the economy, and, once they have happened, it is easy to
underestimate the strength of the development that follows. This applies to both downturns
and upturns. There is perhaps no reason today to assume that a rapid recovery will be the
most likely alternative. But it is definitely something that it is worth being prepared for in the
slightly longer perspective.
A central bank must have good long-term planning. Even if we are busy trying to alleviate the
effects of a collapse in economic activity we must ensure that we bear in mind the
mediumterm perspective. This may seem self-evident, but I believe it may be important to point it out.
Not merely emphasising the short-term perspective is important for maintaining confidence in
the inflation target in the long term. There must be a preparedness to act in a situation which
could differ from the expected by being both better and worse. We currently have an
extremely low interest rate and we are in a crisis that to some extent stems from having had
a low interest rate for a long time. We must be aware of the imbalances that may build up
and neither be "deflation nutters" nor "inflation nutters".