Uncertainty and the economic recovery: knowing how to evaluate risks

Thomas Mirow, President of the European Bank for Reconstruction and Development, Conference de Montreal, 6 June, 2011

Ladies and gentlemen, thank you for inviting me to speak.

The financial crisis of 2007-2009 has been a pivotal event for many of us.

Books will be written about the crisis for many years, but it seems clear that at its origin were loose monetary policies, global macroeconomic imbalances, and weak financial supervision. When credit markets froze up, a local U.S. crisis turned into a global crisis because financial regulatory frameworks had not kept pace with the complexities of the globalisation of finance and financial innovation.

Containing the global recession that followed required an enormous, coordinated policy effort. The focus in the short term was understandably on stimulating demand, by giving a fiscal and monetary boost, while work to address the structural causes of the crisis has been moving more slowly.

The result is that today, the global economy appears to be getting back on track but it continues to face structural vulnerabilities. And there are some serious new dilemmas. The risk I see is that the world economy will again build up macroeconomic tensions and financial sector distortions – but if crisis strikes once more, we will no longer have the necessary fiscal space to deal with it effectively.

What are the dilemmas?

• First, in many countries there has been a very significant increase in public debt. Public sectors are now forced to consolidate, often quickly and severely. Growth can come only from the private sector. The challenge in the Eurozone is even more complex. Eurozone membership turned national debt problems into a test of the European institutions. Fundamentally, there is a need to recognise that monetary union calls for a degree of fiscal union and economic union requires some convergence in competitiveness.
  
• Secondly, stimulus policies have created abundant global liquidity, which is causing problems particularly in emerging markets, including pressure on exchange rates, inflation and renewed credit booms. While this liquidity may be partly cyclical, it shares many features with the constellation that we saw in the period of financial excess between 2005 and 2007. In the context of the G20, ideas have been floated about reforming the international monetary system. But agreement on some parts of this agenda, such as disciplines on exchange rates and on national monetary policies, will be difficult to reach. Others, such as an agreed framework for capital controls and the strengthening of regional financial safety nets may be more realistic objectives.
  
• And thirdly, there is still important unfinished business in fixing those flaws in financial systems that contributed to causing the crisis. Financial lobbies argue that determined regulation, such as the enforcement of new capital standards, could kill the sector’s contribution to recovery. I am not convinced by that argument and I believe that reform is necessary and urgent if we want to avoid a repeat of past mistakes, although of course it has to be well-designed – for example, it needs to take account of the specific circumstances of financial sectors in emerging markets.The past two years have brought some significant achievements in both Europe and the United States. But we still do not know how to wind down systemically important financial institutions when they become insolvent; there is a need for more global consistency in the regulation of capital markets; and there must be more competition in financial systems to deliver better and economically more productive financial services.

It is clear that the crisis is still causing tremendous aftershocks today and will continue to reverberate for many years to come. It is the background to the uneven economic recovery and to an environment of heightened risk.

And while we focus on investors let us remember that daily life is now more risky for ordinary people as well. A survey that we will soon unveil, from the 29 Countries of Operations in the European Bank for Reconstruction and Development’s region, underlines that starkly. The Life in Transition Survey examines the views of people living in those countries which, since the fall of the Berlin Wall in 1989 and the subsequent collapse of communism, have been changing to market economies. They are the countries which the institution that I lead, the EBRD, was set up to help. The survey shows that more than half of all those that we questioned thought the crisis had affected them either a great deal or a fair amount. Many suffered falling wages and seventy per cent tell us that they have reduced spending on staple foods and healthcare. For them, greater risk is part of their everyday existence.

We can’t avoid taking risks, as businesses, banks and individuals. As the Chinese Proverb has it, ‘One cannot refuse to eat just because there is a chance of choking’. But we can and must take risks prudently and temper our search for yield. The expectation of rapid and consistently high returns, which has left its imprint on the collective psyche of investors, is self-defeating in the aggregate and can cause some of the unsustainable patterns that we saw in the lead-up to the crisis.

As part of the EBRD’s special role, we are trying to ease some of the risks faced by investors. We were set up in 1991, exactly two decades ago, to work on the transition of economies from communism to capitalism. We have a track record of prudent risk taking. Many of the projects that we invest in are riskier than those that would be considered by commercial banks. Nevertheless, non-performing loans did not exceed 3 percent of our loan book during the crisis.

When economies turned down, and commercial banks restricted their lending, we stepped up our investments - fulfilling our counter cyclical role. We did so, for instance, by providing equity and mezzanine capital to banks in countries like Latvia, Hungary, Romania and Ukraine, countering systemic risks and a sharp contraction in lending. And by helping to restructure balance sheets in numerous industrial companies when financial markets froze. These were risks but they were containable, and they paid off. Of course you have to do your numbers but the key is to focus on the fundamentals of the business and not the quick buck, to build appropriate governance structures within enterprises, to monitor developments frequently and closely, and to choose business partners for their integrity.

This year, we are again planning to invest around nine billion Euros in our 29 countries of operation, stretching from Poland to Mongolia. And our shareholders are now considering to extend our mandate to the countries of the Arab spring, in order to support their private sectors during the transition to democratic rule and better functioning market economies.

Let me close by returning to the global challenge of tackling uncertainties. The shock of global crisis has triggered a serious search for solutions. In some areas, impressive progress is being made; in others, very little progress has been achieved. The search must continue and may not end anytime soon, if ever. But – and allow me here to paraphrase Confucius – perhaps our willingness to continue searching, and not to forget the lessons from the last or previous crises, will turn out more important for preventing the next one than the most perfect institutional design.

 

Last updated 6 June 2011