jose de gregorio : the international financial crisis and its impact on the chilean economy speech by mr jose de gregorio, governor of the central bank of chile, presented before the honorable senate of the republic, santiago de chile, 8 october 2008. * * * mr. president of the senate, in response to your invitation to participate in this special session of the honorable senate, i would like to share with this audience our vision on the severe financial crisis the world economy is enduring, as well as its implications on our country. the world financial crisis and international growth the financial crisis being experienced by developed countries is the outcome of a period of stability, with abundant liquidity, fast economic growth and an asset price bubble. this combination of aggregate factors yields, as it frequently happens, to a cycle of high credit growth. the problem is that this occurred during an extremely accelerated process of financial innovation in market segments that were poorly or ambiguously regulated – mainly in the us. low interest rates prompted an intense search for higher returns. individuals with little or no ability to repay were lent for housing and, to reduce risks, credits were securitized and often taken out of the banks ’ balance sheets ( i. e. structured investment vehicles and conduits ). money was lent on the assumption that housing prices would continue on the rise, so the mortgage was all that was needed to relax lending standards. also, the real - estate bubble encouraged the demand for homes to be used as financial assets. these credits were sold to agencies that did not do a diligent risk assessment, and that triggered contamination not only throughout the us financial system at large, but also to other developed economies. risk - rating agencies were unable to give the proper ratings to complex instruments. in addition, there was a severe conflict of interests in the risk - rating system. the executive compensation structure also encouraged the search for returns with little attention to the risks involved. that it is costly to lend to bad debtors that will not repay goes without question, but this can hardly spark off a crisis of the proportions we are seeing today. the problem worsened because of the way banks decided to get rid of these loans, the way they were rated, and the financial instruments that were devised to reduce risks and make it appear as they had vanished when they had only shifted. there are also doubts whether the operations of derivatives markets have been as transparent as they should have been or if they have been manipulated. the paradox here is that in the banking

system, whose purposes must be credit intermediation and risk hedging, it seems that risks were covered up rather than covered against, in an intricate web of derivatives ( and acronyms ) favored by regulations that did not measure up to the challenges. chile suffered a major banking crisis in the early 1980s, part of which can be blamed on poor regulation, which cost the country, only in gdp terms, a drop of 16 % between 1982 and 1983. the lessons learned the hard way have provided the basis for strict banking regulation, where banking business supervision and limits to risk exposure prevent episodes like the ones we are now seeing abroad from being replicated in our economy. regarding the external scenario we face, consensus projections and information at hand show that the international economy continues to grow and, surprisingly, there is a decoupling between developed economies and the rest of the world. as can be expected in such a situation, and from the reactions we have seen at the global level, the world will see a deceleration, but from varied levels. while the developed world will probably go through a recession, emerging economies will moderate growth. this may be helped by the current - account surplus accumulation of emerging markets, favored by high commodity prices and more responsible economic policies than in the past. for example, the substantial hoarding of international reserves in many countries, chile included, allows the financing of deficits for several years to weather the turbulences via domestic growth. overall, more severe effects on emerging economies ’ growth from a prolonged period of weakness in developed countries cannot be ruled out. the reserve accumulation program and liquidity provision confronted with the uncertain outcome of the financial crisis in developed countries, where difficulties in funding for emerging economies could not be ruled out, and at a time when the chilean peso had appreciated significantly, the central bank of chile deemed appropriate to strengthen its international liquidity position. to that end, in april it began an international reserve accumulation program. in recent weeks, particularly after the downfall of lehmann brothers in september, signs of more severely constrained international financial markets and tight foreign currency liquidity conditions began to surface. chile was no exception. accordingly, on september 29, the board of the central bank of chile decided to terminate the reserve accumulation program. during its application, 5. 75 billion dollars were acquired, amounting to 70 % of the initially announced plan, which is the equivalent to an increase of 30 % in international liquidity over the level of end of march 2008. in