Zeti's Recipe to Save the World from Financial Crisis

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On 7 July 2014 the New Straits Times under its article "Spotting, preventing global financial crisis" revealed that Zeti delivered a speech on 9 June 2014 in Basel, Switzerland at the 2014 Per Jacobsson Foundation Lecture on the subject matter "Managing financial crisis in an interconnected world: Anticipating the mega tidal waves." 

ANK NEGARA MALAYSIA'S Governor, Tan Sri Zeti Akhtar Aziz, tells the world how to manage financial crisis? Wow! I am proud that a fellow Malaysian has the attention of the world. On 7 July 2014 the New Straits Times under its article "Spotting, preventing global financial crisis" revealed that Zeti delivered a speech on 9 June 2014 in Basel, Switzerland at the 2014 Per Jacobsson Foundation Lecture on the subject matter "Managing financial crisis in an interconnected world: Anticipating the mega tidal waves."

Zeti raised concerns on how the economies across the globe are interdependent, so much that an economic downfall in one part of the world is surely to have a ripple effect across. It does not matter whether the fundamentals of the economies are strong. All it needs is a common factor to link them: In this case the global trade and currency exchange between economies. A more forward looking to combat economic recession in a proactive manner is needed more than ever. Zeti laid down these salient points to be considered for which I have reworded in lay men terms:

Phase 1: The Onset of a Financial Crisis - The players in the financial market act as balancers that move money from areas of surplus to deficit. In simple terms, people with money get their funds given to those who needs money (loans) when they deposit money at the banks. When there is unusual quantum or trend of default on loans by borrowers, this function gets disrupted. Why? Well, the banks who suffer losses will have less cash and will lose confidence in their role as balancers. They will increase their risk adversity and are less confident to give out loans. The bank themselves will face the same issue as their financier do the same to them. When this happens, they will start to go after the assets backing those loans, if any - this is entering into Phase 2 below.

Phase 2: The Impairment of the Financial System - Following on from Phase 1, the starting point of the meltdown, the banks will get distressed naturally forcing them to cut losses via deliberate disposal of toxic assets (i.e. liquidating on defaulted loans via foreclosing assets collateralised to the loans) as well as cashing out on their investment assets. The asset markets will fall (price) as the supply increases coupled with lesser active investors. With all these, the banks make less profit (or even losses) and pay lesser interests to those who deposit money with the banks. The depositors then lose confidence and seek alternative and more attractive investments. The spiral (downward) continues. As you can see, what started off as a consumer credit issue has now transformed itself into a depression in investors' activity and finally becomes a banking crisis. The throughput time from the loans defaulting stage to a banking crisis stage were 6 months and 8 months for the 1998 Asian Financial Crisis and the 2008 American Subprime Crisis respectively.

Phase 3: The Onset of the Economic Slowdown - As the banks struggle to cut losses, they will reduce their lending activities. Credit becomes tougher. Even when consumers or businesses are able to get loans, the value of those loans will be low given that the value of assets (that are collateralised) has now fallen. With such reduced level of lending, there will be less businesses to flourish as businesses need loans to grow their operations. Consumers who now have less money will spend lesser. Collectively, this will discourage economic activity. Employment will fall. Income to workers will fall. There will be less money to spend. There will be less goods and services sold and less international trade. The businesses that offer the goods and services will also slow down. Credit depression will also extend itself to dampen the availability of international credit lines. Such depression in international credit lines coupled with the reduced trade transactions will dampen currency exchanges for imports and exports. What do we have then? Currency devaluation. This spiral and cascading effect will depress the entire economy. The 1998 Asian Financial Crisis saw Indonesia experiencing negative Gross Domestic Product (GDP) growth of -13% and the 2008 American Subprime Crisis caused negative GDP growth of -6%.

Phase 4: The Crisis Runs Its Course - As the saga continues, wrong policies or lack of policies to address the condition will cause the crisis to worsen. Credit will continue to be unavailable. Assets will continue to be liquidated. Asset prices will continue to fall. Investors will retreat further. Businesses and individuals will start to be declared as bankrupts. Unemployment will continue to rise. Consumer spending and trade will be inactive. Currency devaluation will worsen. Credit agencies will then down grade economies and corporations. Capital market will contract as foreign investors leave and domestic investors become dormant. The equity (share) market will collapse. National reserves will deplete. With these, social unrest and political instability emerges. All hell breaks loose.  

Phase 5: The Aftermath of the Financial Crisis - This phase is the hopeful one. Recovery! Banks will regain its courage to leverage on financing again, i.e. the banks themselves starts taking financing arrangements to re-grow their banking business. Asset market will recover as buyers begin to purchase assets in the market resulting in price rise. The banks will reconvene their role as balancer in the equation flowing funds to those in need (loans). Businesses will turnaround to re-grow. More jobs will be available in the market. More monies are spent resulting in an increased level of consumption and trading. Import and export will increase. Currency will appreciate as trading activities grow. Investors will start to pour their money again from both foreign and domestic sources. Whilst all these conveniently give birth to optimism, market confidence remains vulnerable to unexpected setbacks that could undermine the sustainability of the recovery.

For these phases, Zeti offered her thoughts again on what guiding principles are required. They are (as printed in the New Straits Times on 8 July 2014):

Guidance Principle 1: The different stages of financial crisis require different policy interventions with different timing and mix.

Guidance Principle 2: Anticipatory policy actions which recognises the next eventuality as mitigating tool.

Guidance Principle 3: The focus of the policy should reach beyond the distressed financial markets and institutions to have impact on the asset markets and distressed borrowers.

Guidance Principle 4: The recognition of cost escalation if policies are only implemented at later stage rather than up front.

Guidance Principle 5: Entire evolutionary perspective in policies is crucial to avoid partial policy response that does not address all necessary angles.

These Guiding Principles should be incorporated in remedial action stages as follows:

Stage 1: Containing the Onset of the Crisis - 3 objectives are required here - 1. To restore short term money markets and access to liquidity; 2. to stabilise the conditions of the asset markets in which turmoil originated; and, 3. To address the consequent erosion in confidence. Loans will need to be restructured instead of declaring them as default and/or being set for foreclosure. Other forms of incentives will be required to inject liquidity back into the market including attracting capital inflows or reduce outflows. Controls over asset markets pricing will need to be controlled. Currency exchange policy is required to stop further deterioration. During the Asian Financial Crisis in 1998, as part of the International Monetary Funds (IMF) bailout package for Thailand and Indonesia, widespread closures of stressed financial institutions were imposed by the programme - this resulted in further deterioration of asset prices and further sharp depreciations of the domestic currencies. On prices, policies need to be in place to avoid inflationary direction as it will be counter effective to re-start the economic growth.

Stage 2: Repair and Resolution - Policies need to be in place to stop widespread of financial institution failures and distressed businesses and households. This includes debt restructuring arrangements for the business and household debts before they start to get worse. Distressed assets, or Non Performing Loans (NPL), are to be carved out from financial institutions and orderly unwinding of insolvent institutions is required if restructuring is unavoidable. The banks will then need to be recapitalised. The banks will need to take a hair cut for those assets/NPLs carved out. However, if the recovery of those assets/NPLs show an upside, it needs to be shared back with the original financial institution. All these require support from the Government particularly in legislative changes. This was evident in the Malaysian parliamentary act Pengurusan Danaharta Nasional Berhad Act that allowed asset/NPLs carve out, restructuring and subsequent recovery arrangements.

Stage 3: Supporting the Economic Recovery - Both macroeconomic policies and microeconomic policies are required. The former involves fiscal policies in reducing the interest rates necessary to set the platform for an economic recovery and the latter involves improving the conditions of households and businesses, both corporates as well as small and medium enterprises. Fiscal policies alone are insufficient. Prolonged lowering of interest rates will have detrimental effect to the banks as their earnings are impaired. Direct intervention in the factors that contribute to the livelihood of businesses is required. This includes business restructuring and labour market reorganisation. In 1998, Malaysia introduced Corporate Debt Restructuring Committee (CDRC) to look into reshaping selected key corporations that were under distress. Other initiatives include specialised funding schemes and credit guarantee facilities. A more pervasive socialist initiative is also required at household level which includes but not limited to financing ease and funding aids for food, shelter, education, health, entrepreneurship and finally, job market reorganisation. 

Stage 4: Recovering from the Through - It may sound impossible but to make recovery efforts successful, political stability and national consensus in Government policies are crucial. Many countries fail to save themselves (economically) as efforts were disrupted by unwanted political turmoil. One of the main causes of unwanted political turmoil is the scrutinisation of weaknesses (on the Government's side) that are not at all related to the underlying economic turmoil. Instead of focusing on addressing the economic issues, both the Government as well as the citizen will channel efforts to address political matters that seem out of priority at the point where a particular country is experiencing an economic downturn. This was the case when IMF was looking into some of the South East Asian Countries in 1998.    

Stage 5: The Unfinished Business in the Aftermath - At the recovery stage, there are still loads of work to be done. There is the challenge to unwind the extreme measures taken earlier to address the crisis instantly. Premature lifting of life support system may derail the recovery if not done at the appropriate time. Take for example the Malaysian Ringgit that was pegged to the US Dollars (USD1 = RM3.8). It was only lifted when the need has lapsed, which was after 6 years! Both supply and demand side of the economy needs to have continued monitoring. This includes sustaining initiatives such as attracting investors, developing infrastructure and many others until the economy recovers. However, a prolonged implementation may proof to be too costly and may have political backlash. A balancing act is truly required here. Obsolete institution or legislation will need to be replaced with new ones that will uphold the renewed composition of the economy post-restructuring. In a more holistic manner, whatever decision is being made at this stage, it cannot jeopardise the recovery phase. 

As mentioned earlier, Zeti raised concerns on how the economies across the globe are interdependent, so much that an economic downfall in one part of the world is surely to have a ripple effect across. This calls for new features in the design of governance arrangements arising from the increased connectivity in the world call s for the need for greater effective cooperation, collaboration and coordination within a country and across borders. Institutionalised bodies, such as the Bank for International Settlements (BIS) and its various committees, have provided important platforms for the sharing and exchange of information among a larger number of central banks.

Meanwhile, the establishment of the G20 and the Financial Stability Board (FSB) has strengthened and broadened the cooperation among ministers of finance, central banks, regulatory authorities, standard setters and the multilateral agencies. There has also been significant progress in establishing regional governance arrangements in addressing financial stability risks. Drawing on the experiences of the Asian Financial Crisis, the central banks of the East Asian Pacific economies have come together to develop an integrated framework for crisis management and resolution that outlines the cooperative and coordination arrangements to deal with the cross-border effects of financial crises.

On 9 July 2014, as reported by the New Straits Times, Zeti went on telling the central banks of the world 5 important issues that seriously require attention as follows:

 

Issue 1: The need for active interface with other agencies and the Government while avoiding being compromised by the actions that may be taken.

Issue 2: The central banks may be required to do more than they are mandated due to constraints experienced by other authorities.

Issue 3: Potential erosion of the central bank's autonomy as the Government is leading the decision-making process that may be blurred by political motives rather than economic.

Issue 4: The need to speed the actions during crisis is necessary especially when there are legacy red tapes bureaucracy.

Issue 5: Ensuring consistent and effective communication at a time when there is great uncertainty.
 

There you go. I would like to simply take these points as "Zeti's Recipe to Save the World from Financial Crisis"

 

* kopihangtuah




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