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Lessons from the Financial Market Crisis:

Priorities for the World and for the IMF
Speech by Dominique Strauss-Kahn
Managing Director of the International Monetary Fund
to the Indian Council for Research on International Economic
Research (ICRIER)
New Delhi, India February 13, 2008
As Prepared for Delivery
Dominique 1. It has become increasingly clear that the
Strauss-Kahn macroeconomic effects of the financial market crisis will
be serious and that no regions will escape entirely
Speeches unscathed. Today, I would like to explore with you the
prospects for the global economy and emerging markets
like India, and the challenges this outlook poses for
• India and
the IMF
policymakers, both in industrial countries and emerging
• United markets. And I will also discuss the evolving role of the
States and IMF as it carries out its mandate of promoting global
the IMF financial stability. It is a pleasure to be able to talk about
• IMF Quotas these issues at ICRIER, a research institute which has
-- A made a distinguished contribution to the policy debate.
Factsheet 2. Let me begin with a historical perspective on the Fund
• IMF and on the current crisis. The Fund's goal has not
Surveillance changed in essence since its birth more than 60 years
-- A ago. I can sum this up in a single sentence. Our goal is
Factsheet to promote a cooperative approach between nations to
secure economic stability and growth.
What does 3. The challenges that the Fund and its members face,
it mean? however, have changed. In its early years, the crises
• Emergin that our members faced were mostly current account
crises. Large scale capital movements between countries
g were relatively rare, and financial institutions tended to
 Markets be national rather than international. And transmission
• Surveill of problems from the national to the global level was
relatively slow. Obviously that is no longer the case.
ance
4. If we look now at the current financial crisis from this
• Quota perspective we can see that what began as a problem in
More > a single sector in a single economy—the housing market
in the United States—has become a global problem. And
Free Email what was first manifested as a problem for financial
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institutions is now becoming a problem for economies.
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This is obviously the case in the United States. I believe
when we post
that the effects will be felt increasingly in Europe. And I
new items of
interest to you.
do not think the emerging economies are immune from
this crisis.
Subscribe or 5. The lesson I draw from this is that we have to look for
Modify your both the causes and the cures of crises in the interaction
profile of national and global developments and in the
interaction of economic and financial market
developments.
6. Let me be more specific. The present crisis is the
result of a perfect storm: a macroeconomic environment
with a prolonged period of low interest rates, high
liquidity and low volatility, which led financial institutions
to underestimate risks, a breakdown of credit and risk
management practices in many financial institutions, and
shortcomings in financial regulation and supervision.
• This environment both fueled a U.S. housing boom and
encouraged banks and other institutions to take on
excessive leverage to generate high returns.
• Financial institutions weakened their lending standards
and took on excessive risk. The most obvious example is
the US sub-prime mortgage market, but the holders of
these risks were not only in the United States, and
problems may also surface in other kinds of lending—for
example leveraged loans and consumer credit—or other
countries. Nor is the problem confined to industrial
countries. For example loose credit in some emerging
economies may lead to problems down the road.
• Supervisory and regulatory frameworks have also not
been up to the task. This applies to both crisis
prevention frameworks and crisis resolution frameworks.
To give an example relating to crisis prevention, in the
United States, unregulated entities that originated
mortgages were not subject to appropriate disclosure
and consumer protection requirements. But supervisors
and regulators in other countries have to ask whether
their frameworks are adequate, too.
7. The interaction of economic and financial market
developments is also influencing the way the crisis
unfolds.
• The financial problems of banks raise the risks of a
credit crunch. The housing correction is already lowering
growth in the United States. A credit crunch would
worsen the outlook further, and could also affect Europe
and potentially other countries worldwide.
• A bleaker economic outlook would in turn make it more
difficult to get out of the financial crisis, because it
worsens the prospects of businesses and individuals.
This is one reason that equity markets have fallen as the
risks of a U.S. recession and a global downturn have
grown.
8. Just as the origins and development of the financial
crisis lie in the interaction of macroeconomic and
financial market policies, the resolution of the crisis will
require action in both areas. Let me talk first about what
should happen in industrial country economies and
financial markets. I will turn to emerging economies in a
few minutes.
9. With regard to economic policies, I have urged that
monetary policy be the first line of defense. Indeed, it
already is. The major central banks are doing their part
in providing liquidity and monetary easing while
continuing to stabilize inflation expectations. But
governments may also need to deploy fiscal policy.
Unless the situation improves, the fiscal authorities in
countries with low fiscal risks should prepare to exploit
the headroom for timely and targeted fiscal stimulus that
can add to aggregate demand in a way that supports
private consumption. Of course, it has to be temporary—
maintaining a sustainable medium-term fiscal position is
still very important. But in a sense, medium-term fiscal
policy is all about saving for a rainy day. It is now
raining.
10. With regard to the financial markets, the first priority
is to restore confidence. Many things are needed to
make this happen.
• Central banks will need to continue to provide liquidity
to ensure smooth functioning of interbank money
markets. They should also take this opportunity to seek
more convergence on what kind of institutions they
provide liquidity to, what collateral they will accept and
what maturity they provide liquidity on. For their part,
auditors and supervisors need to encourage consistency
across financial institutions on how assets are valued
and how writedowns are determined.
• Financial institutions must also act. They need to
restore confidence through full disclosure of exposures to
sub prime and related securities, both on and off their
balance sheets. It is also critical that large systemic
institutions that have experienced significant writedowns
raise capital and restore liquidity cushions to reassure
investors about their financial soundness.
11. Let me now turn to the effects of the crisis on
emerging economies. I believe that these effects will be
felt, and probably sooner rather than later. Some may
say that emerging economies have now decoupled from
industrial economies. They would argue that growth in
major emerging economies like China and India is now
such a powerful engine that it can continue to move
forward without the large industrial countries. I don't
think so—at least, not yet. The industrial and emerging
economies are more like two horses yoked together. If
one is tired, the other can take up more of the strain for
a while. But if one stops in its tracks neither is going to
get very far. Let me explain why I think this is so.
• Sustained strong growth in the emerging economies
has been based in part on stronger policy frameworks.
But it has also been based on gains from trade and
financial integration in the global economy. This is true of
India as well as other emerging economies.
• As growth slows in the U.S. and Europe, emerging
economies' exports to them will slow. In the past, a 1
percent decline in U.S. growth has led to a decline in
growth in emerging economies by 0.5 to 1 percent,
depending on trade and financial links with the United
States.
• It is true that intra-regional trade has diminished, as
regional trade has grown. But it is also true that many
emerging economies export intermediate products to
other emerging economies, which are in turn exported to
the United States or Europe. So I think that the trade
links that bind emerging and industrial economies
together are still tight—and perhaps are tighter than
they seem from a casual examination of trade figures.
• There are also complex financial linkages and
spillovers. India has experienced very large capital
inflows since the sub-prime crisis. This reflects both
market judgments about India's good economic
prospects and interest rate differentials between India
and other countries. There could also be a reversal of
inflows, if there is a general retreat from risk by global
investors. The authorities are well aware of the risks of
volatility in capital flows in the period ahead.
12. This leads me to policy advice. Obviously, the major
emerging economies are not yet in a downturn. But I
think they should be prepared.
• In economic policy, emerging economies could consider
how they would respond to a downturn: how much scope
there is for monetary easing in some countries; how
much scope there is for a fiscal stimulus in others. And
bearing in mind that fiscal stimulus should be timely,
temporary, and targeted to those who will spend it—
which often means low-income people—some emerging
economies could already begin thinking about the design
of a fiscal package. The appropriateness of both
monetary easing and fiscal stimulus will vary country by
country. I do not mean to suggest that every country
should be loosening fiscal policy. For example, India
already has very high growth and a still high public debt,
and medium-term fiscal consolidation remains a priority.
• There is also a broader role that some emerging
economies can play to help support global growth—
through policies to strengthen their domestic demand as
a growth engine, including greater exchange rate
flexibility. These are also policies that will help to bring
about an orderly unwinding of global economic
imbalances.
• In financial market policies, emerging economies can
learn from the risk-management and regulatory failures
of industrial economies. All emerging markets should
build regulatory capacities to safeguard against
the risks associated with non-transparent
instruments and excesses in lending. I would also
advise central banks and regulatory authorities to make
sure that they have the capacity to react rapidly to
changes. For example, some may need to change their
frameworks for liquidity management and collateral. In
addition, the much smaller subset of countries whose
domestic banks have borrowed excessively from foreign
banks to support domestic credit should prepare for
sudden changes in market sentiment that could occur if
financing conditions in global markets tighten
significantly.
13. Let me now turn to the lessons the Fund itself can
learn from the financial market crisis.
14. Before I came to the Fund three months ago, I
traveled to many of the Fund's member countries. I
came here, to India. I went to Latin America—to
Argentina, Bolivia, Brazil, Chile and Mexico. I went to
Russia, and to Saudi Arabia and South Africa. And all
around the world I heard the same thing: that our
members value the analysis and advice we give them for
the challenges they face. And they support our efforts to
keep step with change by refocusing our activities to
meet the challenges of tomorrow.
15. My guiding principle as I consider reform of the Fund
is that we should focus on areas and issues where it has
a comparative advantage. To expand on this, there are
many international and national organizations that
produce economic analysis, give economic advice and
provide technical and financial assistance and training,
but there are issues within the Fund's mandate on which
it is uniquely qualified to help its members. It is on these
issues that we should concentrate.
16. Let me give an example on how we could apply this
principle to the Fund's work on the current financial
crises. The Fund did warn our members and warn the
world about the crisis. In fact the Fund gave repeated
warnings, most fully in the Global Financial Stability
Report that we issued last April, and we also gave more
warnings on how the crisis might unfold in another
report last October. But perhaps we did not warn
forcefully enough. And we, like many others, did not
foresee just how the turmoil would spread and what
would be the key interlinkages that I have talked about
today.
17. The lesson that I draw from this is that we need to
pay more attention to the links between changes in
the real economy and changes in financial markets
—links which go both ways. And we need to pay more
attention to the links between national economic policies
and international macroeconomic and financial
developments—links which again go both ways. The
Fund has a clear comparative advantage in
understanding these linkages and assessing their
implications. With our involvement in the real economy
and the financial sector, we stand at the corner of Main
Street and Wall Street.
18. The recent market turmoil has made it very clear
that we need to pay greater attention to the links
between real and financial sector developments. There is
a hunger around the world, and especially in emerging
markets, for greater understanding and insight on these
links. The Fund is the institution with the greatest
capacity to provide such insight. Only the Fund has the
global membership—and the legitimacy that comes from
that—and the breadth of experience to cover both
economic and financial market developments. Therefore,
we have to do more to meet the world's need for
understanding on these issues. We also have to be
prepared to act on that understanding, both through
advice and, if countries experience difficulties, through
financial support. This is why we are working hard to
make sure that both our advice and our instruments for
supporting member countries financially are the right
ones.
19. We also need to sharpen our focus on the
interlinkages between national economies and the global
economy. This surveillance activity is our bread and
butter, and it is essential that we give our members what
they need. To do so, we will focus our surveillance and
consultations with individual members on those issues in
our mandate that matter most. And we are putting
greater emphasis on cross-country and regional work
and pay more attention to key links between bilateral
and multilateral surveillance. We have been moving in
the right direction. To give you an example, the recent
staff report on India contained useful cross-country
comparisons of exchange rate developments, capital
flows and macroeconomic policies in India with those of
Brazil, China and Russia. And we will be doing even more
of this in the future
20. I said earlier that the Fund gained legitimacy from
having a global membership. But that legitimacy needs
to be protected and enhanced. At the moment, emerging
and developing countries do not feel sufficient ownership
of the Fund. In reforming the Fund we need to reflect
not only the changed role of the Fund in the world but
also the changed role of many of our members. Many
Asian economies, including India, are now economic
powerhouses. In order to strengthen the legitimacy of
the Fund, the emerging economies as a group must be
given a greater representation and a greater voice. Part
of the story is reform of the quotas on which voting
power in the Fund is largely based, and I am committed
to pursue the reforms of quota and voice started by my
predecessor, Rodrigo de Rato, and bring them to a
conclusion soon.
21. There is another aspect of legitimacy, which relates
to the Fund's own financial position. We cannot be
legitimate in giving advice to our members on financial
issues if our own finances are not in order. This is why
we need a more sustainable income model for the Fund.
And we cannot be legitimate if we do not ourselves
practice the expenditure restraint that we have often
urged on other countries. This is why we must cut the
Fund's administrative expenses at the same time as we
take steps to increase our income. I will over the next
two months bring to the Executive Board proposals to do
 both of these things.
22. These measures—refocusing the Fund's activities,
realigning quotas and enhancing the voice of emerging
and developing countries, and setting the Fund's
finances in order through income increases and
expenditure reduction—are at the heart of my strategy
for reform of the Fund. I believe that the principle of
comparative advantage which guides my proposed
approach to surveillance can also be applied to other
areas of the Fund's activities, including technical
assistance and our work on program and near-program
countries, especially low-income countries, and this is a
theme that I will develop over the coming months.
23. In closing, let me return to my main theme. The
world economy has entered a difficult phase, with the
financial crisis spreading to the real economy. This has
become a global problem that requires a global solution.
Emerging markets need to join industrial countries in the
macroeconomic and regulatory policy response. Such a
collaborative approach offers the best hope for ensuring
the stability of the global economy.
Thank you very much.

IMF EXTERNAL RELATIONS DEPARTMENT

Public Affairs Media Relations
Phone:202-623-7300 Phone:202-623-7100
Fax: 202-623-6278 Fax: 202-623-6772

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