1. MANAGING MACROECONOMIC AND MONETARY POLICY IN A HIGHLY UNCERTAIN ENVIORNMENT ISHRAT HUSAIN SEACEN, MANILA July 30, 2012

2. CONTEXT AND BACKGROUND World economy has recorded fastest growth in the last 50 years ushering in an unprecedented era of prosperity for the majority of the population. Even in this decade of slow growth the global economy will grow to 10 to 20 percent faster than it did a decade ago, 60 percent faster than it did two decades ago, and five times as fast as it did three decades ago. 2

3. CONTEXT AND BACKGROUND (Continued) 3 Developing and emerging economies which were impoverished and faced with poverty, hunger, illiteracy have been able to make a remarkable turn around and increased their share of world GDP from almost negligible proportion to almost 50 percent. In 1980, the number of countries that were growing at 4 percent a year was around 60. by 2007, it had doubled to 120. even now, after the financial crisis and recession the number is more than 80. Then annual average growth rate in the last decade was an impressive 6.4 percent.

4. CONTEXT AND BACKGROUND (Continued) Poverty has been reduced more in the past 50 years than in the previous 500 years. About one billion people have been lifted out of poverty since 1980. The proportion of people living below the poverty line has dramatically fallen from 52 percent to about 20 percent in this period. Between 2005 and 2010 both the poverty rate and the number of people living in extreme poverty have fallen in all the six developing countries, the first time that has happened. 4

5. CONTEXT AND BACKGROUND (Continued) The World Bank projections show that the global target of the Millennium Development Goals (MDG) of halving World poverty has been achieved five years early. Rising agriculture production has kept ahead of population growth. World Food Production Index rose by 75% in the last 20 years while population grew by 50 percent in the same period. 5

6. CONTEXT AND BACKGROUND (Continued) Mobility of people, capital, ideas, goods and services across country border has never been as high as in the last two decades. World Trade growth has consistently outpaced world output growth; Capital flows in form of portfolio investment, loans, equity investment, remittances, official aid have risen sharply. Financial innovation and financial engineering based on complex models gave rise to new products that has transformed the basic landscape i.e. Derivatives, credit default swaps, collateralized debt obligations. 6

7. CONTEXT AND BACKGROUND (Continued) Despite these solid achievements, the world economy has faced many crises during the last three decades – the most significant being the latest crisis of 2007-08 which has shaken the foundations of many theories, beliefs and practices. Before we delve into the remedies for the future we must try to understand as to why these crises took place. 7

8. SYMPTOMS AND CAUSES OF PAST FINANCIAL CRISES Poor or Ineffective system of banking supervision and regulations. Lack of adequate disclosure and transparency. Ineffective systems of corporate governance. Weak and inflexible exchange rate regimes. Significant debt and asset price inflation. Unsustainable short-term capital flows. Little understood Financial innovation and engineering. Highly fragmented regulatory oversight and emergence of unregulated shadow banking system. Unwanted credit booms due to monetary easing. Vulnerability due to securitization and trading in marketplace instruments 8

9. APPROPRIATENESS OF INTELLECTUAL FRAMEWORK Modern Macro theory is based upon Efficient Market Hypothesis, Rational Expectations, McKinnon – Shaw thesis and Mathematical Models based on past behavioral relationships. Efficient Market Hypothesis (EMH) has been the predominant theory governing financial markets. The assumption that market prices are based on rationality has proved wrong in practice. Individual rationality does not ensure collective rationality. 9

10. APPROPRIATENESS OF INTELLECTUAL FRAMEWORK (Continued) Individual does not always behave rationally but in network economy his/ her behavior depends on what others are doing. Herd instinct is a common observable trait. Many studies have shown that the McKinnon – Shaw thesis of financial liberalization, in the short to medium term, has harmful effect and triggers financial crises by misdirecting the allocation of Capital. Competition among banks leads to indiscriminate and risky credit operations (moral hazards problem). 10

11. APPROPRIATENESS OF INTELLECTUAL FRAMEWORK (Continued) Mathematical models and algorithms would allow financial innovation, ease in manufacturing and trading in complex derivatives such as credit default swaps (CDSs) and collateralized Debt Obligations (CDOs). The models made the assessment of credit quality of underlying loans quite difficult and complicated. There were serious omissions in the specifications of models such as complete exclusion of high risk events, systemic risks and non-linearity. 11

12. Information asymmetry and Moral hazard have been studied extensively in economics literature but their application in designing new financial products was far from satisfactory. We now recognize that these theories have proved to be inappropriate. Lags, Asymmetries, nonlinearities and irreversible have introduced complexities which are not factored in. 12 APPROPRIATENESS OF INTELLECTUAL FRAMEWORK (Continued)

13. UNCERTAINITY AND RISKS Must differentiate between Uncertainty and Risks. Uncertainty is unforeseen and unanticipated but Risks can be identified measured, managed and mitigated. We should scan the changes likely to taking place in the next 5, 10, 20 and 30 years. The more distant is the end point the more hazy is our picture. But this does not mean we should not keep refining and refocusing the picture. 13

14. UNCERTAINITY AND RISKS (Continued) Keep focused on the main Global Drivers of Change that can be source of uncertainty if not properly understood and prepared for. They provide both threats and opportunities. We cannot fully protect against or eliminate every potential risk factor but we need to develop a strong immune system before the disease hits us so that the damage to the economy is limited. 14

15. MAIN GLOBAL DRIVERS OF CHANGE Realignment of economic activity: -Top 20 economies in 2050 half of them expected to be countries that are currently described as ‘Emerging and Developing’ (EDEs). -Manufacturing relocating in EDEs because of lower wages for similar skills, Economies of scale, closer to points of consumption. -Knowledge intensity of industries up on the rise 15

16. MAIN GLOBAL DRIVERS OF CHANGE (Continued) Growing pressure on public expenditures for: – Healthcare – Medical insurance – Pensions – Higher education – Research & Development – Unemployment benefits – And other social safety nets 16

17. MAIN GLOBAL DRIVERS OF CHANGE (Continued) Demographic Dividends or Disaster: – 1.2 billion people in Emerging and Developing countries are aged between 12 and 24. – Investments in skills and training of these young people in EDEs – International migration flows to labor scarce countries – will this be allowed? – If EDEs fail to find jobs for the youth the likelihood of social upheaval will be high 17

18. MAIN GLOBAL DRIVERS OF CHANGE (Continued) Technological Connectivity – Geographical boundaries have become irrelevant in transmission and dissemination of information – Information explosion at exponential speed needs to be sifted and screened – Technological revolution in form of Internet, mobile phones, cable and satellite TV, networking, have made communication and connectivity easy and physical distances shrink. Cell phones today have more computing power the Apollo Space Capsule. 18

19. MAIN GLOBAL DRIVERS OF CHANGE (Continued) New Industry Structure – Interlinked systems of suppliers, producers and customers breaking national barriers have emerged. – Components are manufactured at different locations which are cost competitive and then shipped for final assembly to a country that exports it – High skill intensive services industry will dominate the scene in the Advanced Economies while fabrication and manufacturing will take place in EDEs 19

20. MAIN GLOBAL DRIVERS OF CHANGE (Continued) Greater Complexity – Public policy makers have to acquire new resources, skills and techniques and adapt to the rapidly changing environment. – The increased mobility of factors and integration of markets would have consequences – both positive as well as negative. – Response capacity to tackle these complexities will require agility. 20

21. CHALLENGES IN MANAGING UNDER UNCERTAINITY Volatility of capital flows (FDI, FPI, Loans & grants, Remittances etc.) with effects on: – Monetary policy – Exchange rate – Competitiveness – Reserves Global supply chain – Demand fluctuations in final assembly country – Excess capacity – Unemployed resources 21

22. CHALLENGES IN MANAGING UNDER UNCERTAINITY (Continued) Financial Sector Stability – Contagion and spillover effects Swings in Commodity prices – Oil and Gas – Food Tools and Instruments for effecting changes – Public policies – Regulatory Frameworks – Market Institutions and Discipline 22

23. MACROECONOMIC MANAGEMENT UNDER UNCERTAINITY Construct and Develop a strong Immune System. The main components of the system would be – Fiscal policy stance – Financial sector soundness – External robustness – Monetary policy credibility – Quality of Governance – Export Diversity – Private Sector Debt – Government effectiveness – International Reserves – Exchange Rate flexibility The stronger is the immune system the better will be the capacity for resilience and bounce back. 23

24. MACROECONOMIC MANAGEMENT UNDER UNCERTAINITY (Continued) Response capacity of the Immune System would depend upon: RESOURCE ENDOWMENTS Commodity Dependence Diversification of Economy NATURE, INTENSITY AND SPEED OF EXOGENOUS SHOCKS EXPOSURE TO INTERNATIONAL MARKETS CONTAGION EFFECT Interconnectedness RESPONSE OF OTHER PLAYERS SUCH AS INTERNATIONAL FINANCIAL COMMUNITY 24

25. MONETARY POLICY MANGEMENT UNDER UNCERTAINITY Transmission mechanisms break down under uncertainty. Ingenuity, agility and thinking on the feet would be required at these times. Timely and substantive public sector intervention required when the private markets fail to clear Too much resilience on the post stable behavioral relationships would be inadvisable Asset prices should be kept under vigilance and so the credit booms for corrective action. Resolution Authority, Lender of Last Resort function and Insurance mechanism should be in place and lubricated from time to time. 25

26. MONETARY POLICY MANGEMENT UNDER UNCERTAINITY (Continued) Resolution Authority, Lender of Last Resort function and Insurance mechanism should be in place and lubricated from time to time. Greater coordination between monetary and fiscal policies all the time Capital buffers leverage ratios and liquidity benchmarks for the big financial institutions should be prescribed and enforced Exchange rate should remain realistic and flexible Macro prudential regulations should be invoked selectively in support of monetary policy objectives 26