Global Financial Markets Today and the U.S. ResponseReuben Jeffery III, Under Secretary of Economic, Energy and Agricultural Affairs
Remarks to the British-American Business Council
May 15, 2008
Thank you, it is a pleasure for me to be here today. I want to thank the British-American Business Council for inviting me.
I am particularly pleased to be here in London. I had the privilege of living in London and calling it home for much of the 1990s. Like many of you, I was drawn to this premier international financial center and its innovative and fast-paced financial markets. The City continues to play this vital role.
Accordingly, London is the ideal venue to address some of the key issues posed by recent financial market developments. It is fitting in a historical sense as well: London has played a central role in the development of financial markets.
Even in the early eighteenth century, investors here in London had to deal with a speculative bubble, a recurring problem in all financial markets, including in the U.S. Referring to the South Sea Company bubble, Sir Isaac Newton said, “I can calculate the motions of heavenly bodies, but not the madness of people.”
Today I will share with you some perspectives on recent global financial market conditions. While you follow political and foreign policy developments for signs of political risks to your businesses, at the U.S. Department of State we observe financial market developments for their implications for key foreign policy interests.
The United States, working with our UK and European partners, strongly supports policy initiatives focusing on peace and security, economic development, and democratic institution building. Financial market developments can affect progress toward these objectives.
Ensuring that the economic benefits of globalization are available broadly to all, and in particular to developing economies, is of key strategic interest to us all.
Specifically, I’ll touch on four areas. First, the recent global financial market turbulence; second, the U.S. and international response; third, some perspectives on the impact of financial crises on emerging markets; and finally, our policy agenda to lay the foundation for a growing, healthy world economy in the years ahead.
Recent Market Developments
We meet at a difficult time for major financial centers and the global economy. In recent years, global economic conditions have been quite favorable, with world GDP growth averaging nearly 5% per year. This year, however, is proving to be more difficult, with headwinds coming from adjustments in the U.S. economy; financial market stresses; and higher food, energy and commodity prices.
The U.S. economy, following an eight-year period of exceptional home price appreciation, is undergoing a significant housing correction. The weak housing market, high prices for energy and food, and stress in financial markets are slowing U.S. economic growth.
As of now, the U.S. economic outlook is not without its downside risks. It will take time to work through these challenges. Nevertheless, we are confident in the long-term economic prospects and underlying fundamentals of the United States.
Offsetting the current uncertainties, core inflation is contained. Although the unemployment rate is trending up, at 5.0% it is low by historical standards. Productivity growth, the most important determinant of long-term economic growth, has averaged 2.6% since 2001.
Exports have been strong, and at 11.9 percent of GDP represent a larger fraction of our economy than at any time in history.
Problems in asset-backed securities markets have produced significant volatility. Market participants, reevaluating risks and related rewards, began to question the value of a variety of structured products and the assumptions underlying their valuation models. Liquidity in these products dried up as risk was re-priced.
The U.S. and International Response
U.S. policymakers are responding vigorously. The goals are straightforward: minimize the impact on the real economy; maintain efficient and liquid markets; ensure continued availability of credit; and enhance risk management. We are employing near-term as well as longer-term measures.
As you know, the Federal Reserve quickly adjusted monetary policy to support the overall U.S. economy, as the housing and credit markets adjust. Since August, the Fed has reduced its main policy interest rate 7 times from 5.25 percent to 2 percent.
At the same time, the Fed has opened access to the Fed window to a wider range of participants and has expanded the types and terms of acceptable collateral.
The President and Congress responded with a bipartisan fiscal stimulus package that will put more than $150 billion back into the hands of America’s workers and businesses this year.
The Treasury Department has begun the process of mailing the stimulus checks. Temporary tax incentives for business investment are already in place.
With regard to the housing sector, the Administration has also supported a number of initiatives to help those individuals and families most disadvantaged by the sub-prime fallout.
These steps include both private sector-led and public sector programs designed to increase the availability of affordable mortgage financing, prevent avoidable foreclosures, and minimize the economic disruption of the housing correction.
Since September, the Federal Housing Administration has helped almost 180,000 borrowers refinance under affordable terms. The HOPE NOW Alliance recently announced that, since the middle of last year, nearly 1.2 million homeowners have been helped through workout plans.
U.S. policymakers have initiated a number of medium-term efforts to strengthen market discipline and address regulatory gaps. Treasury Secretary Paulson chairs the President's Working Group on Financial Markets – the PWG – an interagency policy coordination group that includes the Fed, the Securities and Exchange Commission (SEC), and the U.S. Commodity Futures Trading Commission (CFTC), where I previously served as Chairman.
On March 13, the PWG issued a comprehensive review of policy issues related to recent financial market turmoil and recommended measures to reform mortgage origination, strengthen risk management, enhance disclosure and market discipline in the securitization process, and reform the role and use of credit ratings.
The Administration is working on longer-term efforts to maintain competitive capital markets. Treasury Secretary Paulson’s Capital Markets Competitiveness Initiative includes a Blueprint for modernizing our regulatory framework.
This effort, which began well before the recent financial market turmoil, has kicked off a much needed debate on steps the U.S. can take to improve financial regulation. The U.S. Department of the Treasury is consulting with market participants and regulators worldwide, including counterparts here in the United Kingdom.
In taking these steps, U.S. policymakers and regulators are sensitive to the danger of contributing to market uncertainty through excessive government involvement, which would threaten the capital market innovation that is vital to U.S. and global growth.
As Federal Reserve Governor Kevin Warsh explains it, central banks are currently providing “public liquidity,” but this cannot replace “private liquidity.”
On the international front, the Federal Reserve and other central banks have taken focused, and sometimes coordinated, actions to protect the financial system from severe disruption by ensuring that markets have access to financing.
Many financial institutions, with the support of their national regulators, have written down assets, disclosed losses, and raised new capital. Subprime-related financial sector write downs and losses total over $300 billion, with U.S. financial institutions accounting for about half; Europeans, over a third; and Asians, Canadians, and others, the remainder.
Replenishing the capital dissipated by these losses, global financial institutions are raising over $200 billion in capital, with sovereign wealth funds (SWFs) playing a significant role initially. It is important that financial institutions act promptly to recognize the losses, replenish their capital, and ensure credit availability for consumers and businesses.
We are working closely through the G-7 and the Financial Stability Forum (FSF) to address weaknesses that produced the current market problems.
At the April G-7 Finance Ministers meeting, the FSF recommended action in five areas: strengthened prudential oversight of capital, liquidity and risk management; enhancing transparency and valuation; changes in the role and uses of credit ratings; strengthening the authorities’ responsiveness to risks; and robust arrangements for dealing with financial system stress. The G-7 strongly endorsed these recommendations.
The U.S. is doing its part to implement these recommendations and to foster international regulatory cooperation. The Federal Reserve is working with its counterparts to raise Basel II capital requirements on specific exposures that have been troublesome, such as off-balance sheet commitments, and to require better disclosure of such commitments and valuations of complex structured products.
The U.S. Securities and Exchange Commission (SEC) has undertaken a systematic review and examination of credit rating firms, including their handling of conflicts of interest and maintenance of the integrity of their ratings. The SEC will review the results of those examinations to inform its consideration of whether additional rules are required regarding those firms.
The SEC is also working with its counterparts in the International Organization of Securities Commissions (IOSCO) in analyzing the role credit rating agencies play in the structured finance market, with a view to strengthening the IOSCO Credit Rating Agency (CRA) Code of Conduct in areas where recent events have highlighted weaknesses.
In December 2007, the SEC adopted rule changes that allowed foreign issuers to file their financial statements in the U.S. without reconciling to U.S. Generally Accepted Accounting Principles (GAAP) if those financial statements use International Financial Reporting Standards (IFRS) as promulgated by the International Accounting Standards Board (IASB). The SEC is also generally considering the additional step of allowing U.S. issuers of securities to report relevant financial details using either International IFRS or GAAP.
The SEC recently also adopted rules making it easier for foreign private issuers of securities to de-register in the U.S., which makes U.S. capital markets more attractive by making exit easier.
Mutual recognition is an approach by which the SEC would allow foreign exchanges or broker-dealers to participate more freely in U.S. markets, provided that they are subject to a comparable foreign regulatory regime.
This approach would also foster cooperation and reduce regulatory burdens. On February 1, SEC Chairman Christopher Cox and European Commissioner for the Internal Market and Services Charlie McCreevy agreed on the goals of a future mutual recognition arrangement. In late March, the SEC announced a series of actions it intends to take to implement further the concept of mutual recognition for high-quality regulatory regimes in other countries. This is a promising area where our regulators are making real progress in creating more open and resilient financial markets.
While no silver bullet exists to prevent the recurrence of past excesses, by reforming our domestic regulatory frameworks and encouraging greater communication and cooperation across borders, we can strengthen market discipline, enhance risk management, and improve the efficiency and stability of our capital markets.
Next, I would like to discuss emerging markets. At the U.S. State Department, we focus on the fact that many emerging market countries are key U.S. and European allies. We have an obligation to help these countries help themselves stay on positive trajectories of economic growth.
Unlike previous crises in the 1980s and 1990s, today’s economic turmoil is mostly affecting developed countries and as of now has not caused serious financial problems for emerging economies. To date, there has been little sign that emerging market institutions have significant exposure to U.S.-derived asset-backed securities. Investor risk appetite remains relatively high, and capital continues to flow to emerging markets in pursuit of portfolio diversification and higher yields stemming from strong growth prospects.
Compared to only five or six years ago, many emerging markets have substantially improved fundamentals, having used periods of high global liquidity to grow their economies, reduce debt ratios, undertake reforms, and amass large quantities of foreign exchange reserves. These reforms have been instrumental in attracting inflows when times are good and resisting the worst impact when international liquidity is withdrawn.
There has been a dramatic, and rarely mentioned, improvement in many African countries, with GDP growth averaging 6% in sub-Saharan Africa, and 5.4% in non-oil exporting African countries.
Of course, some emerging markets bear close monitoring, especially those with underdeveloped financial systems that have large current account deficits or large fiscal deficits. Moreover, inflation is a growing concern in emerging and developed economies alike.
There are other risks as well. Although many emerging markets have exhibited greater resiliency than in the past to a slowdown in growth in developed economies, emerging markets have not fully decoupled.
We are already seeing slower growth in many export-oriented emerging market economies. A downward shift in commodity prices will slow commodity exporters' growth. At the same time, high food prices pose risks to vulnerable populations in developing countries, and to policymakers trying to implement market reforms and maintain prudent fiscal policies. Accordingly, ongoing vigilance in this regard is essential.
Looking to the Future
To address current challenges and lay the foundation for future global growth, including in developing countries, it is vital that we push ahead in multiple arenas. I’ll discuss five areas in particular: addressing the current food crisis; completing the Doha Round; strengthening transatlantic economic ties; continuing financial sector reforms; and finally, establishing policies aimed at maintaining a transparent, open investment environment, including for sovereign wealth funds (SWFs).
First, with regard to the immediate food crisis in poor countries, President Bush has announced nearly $1 billion in additional food aid, bringing projected U.S. spending to fight global hunger to a total of $5 billion for 2008 and 2009.
President Bush has also called on Congress to support a proposal to purchase up to 25 percent of PL 480 Title II food assistance directly from farmers in the developing world, in order to help build up local agriculture.
U.S. action complements efforts by the international community and our partners in the UK and Europe. As you know, Prime Minister Brown recently hosted a “Food Price Summit” at which the UK announced a $910 million package to address rising food prices, including $60 million for the World Food Program, $800 million over five years for agricultural research, and $50 million this year to boost the incomes of the poorest people in Ethiopia. We salute these very valuable contributions.
Second, we need to continue to push forward with the Doha Round and efforts to open markets and bring economic opportunities to both our developed economies and low-income countries in Africa and elsewhere. Successful conclusion of the Doha Round will reduce the cost of food by eliminating tariffs and other barriers to agricultural trade and remove distortions in agricultural production that prevent a prompt response to price signals.
Third, we need to work to preserve and enhance ties between Europe and America. One way we are doing that is through the Transatlantic Economic Council (TEC). The U.S. economy and the collective economies of the EU are integrated to a degree that is truly remarkable. Preliminary numbers from 2007 indicate that U.S.-EU trade in goods and services is approximately $800 billion. Likewise, our reciprocal investment is huge. The most recent available information shows that the stock of direct investment from the EU into the U.S. and from the U.S. into the EU is, in each case, approximately $1.1 trillion.
The Council just met in Brussels for a day of discussions on how to accommodate our different regulatory policies to facilitate greater trade and investment, and how to find solutions when businesses struggle with burdensome and, at times, conflicting rules. The breadth of our economic ties, and the fact that the U.S. and the EU value open economies based on transparency and the rule of law, provides us an influential platform from which to work.
Fourth, ongoing structural, financial sector, and other reforms worldwide are also essential. As the Financial Stability Forum’s work highlights, the key message that everyone should take away from periods of turmoil, past and present, is that the most effective way to minimize damage from market turmoil is to set in place a world-class financial sector and responsible corporate governance. Transparent markets, robust legal institutions, and healthy banking systems are key shock absorbers. Open financial systems allocate capital efficiently and provide the capital needed to fund economic growth.
Finally, let me talk briefly about sovereign wealth funds. The growth of SWFs clearly has implications for the international financial system. As long-term investors, SWFs have demonstrated that they can have a stabilizing influence on markets and can provide capital at times of global financial stress.
Yet, SWFs also raise financial market and investment policy issues that are important to consider. Sovereign wealth funds represent large, concentrated, and often non-transparent positions.
Through inefficient allocation of capital, perceived unfair competition with private firms, or the pursuit of broader strategic rather than strictly economic return-oriented investments, sovereign wealth funds could potentially distort markets. Fortunately, to date we have seen scant evidence of such behavior.
While maintaining our open investment policy, the U.S. encourages SWFs to base investment decisions on commercial rather than political criteria; maintain transparent investment policies; compete fairly with the private sector; and respect host-country rules.
We also encourage recipient countries to maintain predictable investment frameworks, avoid discrimination among investors, and exercise national security restrictions that are proportional to genuine risks.
A multilateral approach to SWFs that maintains openness is in the best interest of countries that have these funds and the countries in which they invest. The United States supports efforts at the IMF and the OECD to develop best practices on these issues.
In conclusion, the current economic environment presents us with opportunities to address some of the weaknesses that have been exposed in our financial system and to lay a more sound foundation for future growth.
As Samuel Johnson said over two centuries ago, “adversity leads us to think properly of our state, and so is most beneficial to us.” In this spirit, as a former banker turned financial market regulator turned foreign policy official, I have shared some perspectives on how the United States, Europe, and our international partners are addressing the challenges posed by today’s global economic uncertainties.
Thank you, again, for your invitation to speak before this distinguished audience, and I look forward to hearing your views.
Released on May 19, 2008