Mohamed A. EI-Erian
FINANCIAL markets are generally seen as providing the best unbiased insights into future economic developments. But in recent months, many market segments have appeared to be sending competing, if not confusing, signals, such as the following:
• Many national equity markets finished 2006 at or near all-time highs, prompting analysts to see them as signaling confidence that robust global growth and subdued inflation will continue—what has become known as the “global Goldilocks” scenario (“not too hot, not too cold”). Yet bond markets—especially in the United States but also increasingly elsewhere—were suggesting a more cautious outlook.
• There has been an unusual degree of disagreement among major Wall Street analysts (the “Fed watchers”) as to the direction of U.S. policy rates in 2007. With the Fed Fund’s rate at 5¼ percent, some have predicted a move down to 4 percent by December of this year, others, a move up to 6 percent. Moreover, measures of market volatility have been unusually muted across virtually all major markets (including foreign exchange, equities, and fixed income) notwithstanding the lack of market conviction about U.S. policy rates.
It is tempting to dismiss these competing signals as “noise”—that is, market movements devoid of serious information content. But that would be inadvisable. These apparently inconsistent signals carry important information about the changing global circumstances facing national policymakers, multilateral institutions, and market participants—circumstances that call for changes in the way these participants in international finance react.
Big changes afoot
At the root of these seemingly competing signals are three major structural changes that have been influencing the global economy simultaneously. The most visible of these changes comes from the positive productivity shock associated with the growing integration of large segments of the labor force residing in developing economies. The immediate result has been to broaden the sources of global economic growth. Indeed, developing countries account for a significant and growing portion of total global expansion. In addition, the increasing integration of their labor forces has reduced overall input costs for a range of products, allowing companies in industrial countries to better contain spending and enhance profits.
The second structural change speaks to the repricing of commodities. This is a direct consequence of the broadening of global growth—a process that is seeing rising demand for commodities from an expanding list of countries, but only a limited supply response so far. The resulting increase in commodity prices has helped a larger group of emerging economies run sizable current account surpluses, with a concurrent rapid increase in their holdings of international reserves. For some economies, this transition is nothing short of a dramatic regime shift: from international debtor status to international creditor status. Indeed, this combination of higher commodity prices and productivity advances, together with the manner in which the surpluses have been deployed, has transformed the emerging markets as a group into a major source of low-cost funding for the rest of the world (and the United States in particular).
The third structural change is more technical. It pertains to a significant and far-reaching bout of financial innovation triggered by the proliferation of derivative-based instruments. The overall impact has been to dramatically reduce the barriers to entry to a host of markets. And the lowered entry barriers are turbocharging important asset allocation adjustments among institutional and retail investors.
Together, these three factors have fundamentally altered the marginal determinants of global growth, trade, price formation, and (internal and cross-border) capital flows. In the process, we are seeing some notable changes to the determinants of market valuation, volatility, leverage, velocity, and liquidity.
No wonder traditional models have become less effective in both explaining developments and predicting the future. No wonder policy reaction functions have become more tentative. It is also not surprising that markets have adopted a hesitant and bumpy path to pricing the new global realities, some of which are still developing robust anchors.
Temporary or here to stay?
As recognition of these structural changes grows, participants in international finance are playing serious catch-up. Analytical approaches are being recalibrated, traditional policy wisdom is being revisited, business models are being reassessed, and new market instruments are being created. There is also growing recognition of the changing nature of cross-border linkages, with implications for multilateral institutions (particularly their activities, effectiveness, resource requirements, governance, and funding).
The catch-up process, although increasingly obvious to many, is also inherently complex in terms of design and implementation. Moreover, the dynamics of the process itself are prone to overreactions. At a minimum, the process encourages a temporary but notable dispersion in views—not an entirely surprising outcome in view of the profound structural changes in play, and the delicate balance that needs to be struck between transitory and longer-run considerations.
Perhaps the best way to vividly illustrate the complexities in play is to refer to some of the extreme differences of views that have emerged in the secular-versus-cyclical debate. The best place to start is with the loudest of all current global discussions—that is, the one pertaining to payments imbalances, particularly the persistently large U.S. current account deficit and the large surpluses in Asia and oil-exporting economies.
In discussing the implications of the global payments imbalances, proponents of the secular view see the unprecedented U.S. current account deficit as an efficient accommodation of the regime shift being experienced by several emerging economies. Specifically, by running a large deficit, the United States is absorbing what U.S. Federal Reserve Board Chairman Ben Bernanke has labeled “the savings glut” emanating from emerging economies. Some go further and argue that, responding to limitations in their domestic financial systems, emerging economies have also outsourced the financial intermediation function to the more efficient U.S. capital markets. All of this is seen as consistent with the maintenance of high global growth and financial stability.
“When faced with such fluidity, participants have a natural tendency to wish to remain on the sideline awaiting greater clarity. But this would be inadvisable.”
Proponents of the cyclical view see things very differently. For them, the large U.S. deficit is nothing more than the result of domestic overconsumption—a reversible phenomenon that has played out in many other countries in the past, and historically has often assumed disorderly characteristics. It is affecting the largest economy in the world, which, for now, has been able to “sustain the unsustainable” because of its special economic attributes (such as the dollar being a reserve currency) and the depth of its financial markets.
This discussion has also tended to spill over to what is already quite a heated discussion about the unusual pricing of virtually any risk premium—a phenomenon that is visible in many markets in both emerging and industrial countries. For some, the virtual disappearance of risk premiums is the result of global economic convergence and the ability of markets to better tailor risk management instruments and techniques—that is, secular factors that are deemed permanent and consequential. Proponents of this view also cite the “great moderation” of inflationary pressures and the enhanced transparency of macro policy around the world (and in the United States in particular).
Others argue that risk premiums are bound to reappear as temporary investor euphoria gives way to a repricing that is more consistent with underlying economic fundamentals. For them, the cyclical compression in risk spreads is both temporary and reversible. They go on to argue that, as this repricing takes hold, the “risk-mitigation” characteristics of many of the new derivative-based instruments will assume destabilizing dynamics, bringing to the fore the “weapons of financial mass destruction” that investor Warren Buffet warned about a few years ago when he commented on the derivative phenomenon.
The secular-versus-cyclical debate is also at the root of some major disagreements about the potential role of multilateral institutions, including the IMF. One view sees the IMF as having lost relevance, leading some to question its existence and others to advocate major changes in the institution (including expertise, governance, and representation). At a minimum, the institution must develop new sources of revenue generation, given the decline in income now that few emerging economies borrow from the IMF. The cyclical view warns against such “overreaction,” noting that it is simply a matter of time before the IMF is again thrust center stage in its traditional roles of crisis management and crisis prevention.
Market participants are also being forced to express a view about the secular-versus-cyclical balance. If nothing else, the structural changes noted above are eroding the traditional sources of investment returns. Here, the secular camp argues for fundamental changes in the approach to asset allocation, the management of investment return expectations, and the specification of correlations among instruments. On the other hand, the cyclical camp cautions against reacting to an overshoot in markets. Instead, it argues for biding one’s time. It notes that forgone investment returns in the short run are a small price to pay to limit exposure to potential capital loss.
Thoughts on coping strategies
So how should the various participants in international finance design their strategies to cope with this fluid financial landscape? It is best to start with what participants should avoid at all costs: they should not allow the complexity of the issues to paralyze deliberations and appropriate actions. Indeed, it is critical, whether they operate in the public or the private sector, to be explicit about the set of (often implicit) secular-versus-cyclical assumptions that underpin their current approaches, relate these to the current fluidity of the global system, and enunciate both the upside and the downside associated with alternative approaches. In the process, there will be an identification of the costs and benefits associated with possible changes to operating models, business strategies, and risk management approaches.
For national authorities in industrial countries, the challenges include how best to react to the reduction in policy-related insights emanating from traditional market measures (such as the shape of the yield curve and the level of various risk premiums). They also need to incorporate explicitly in their modeling the impact of the more rapid internationalization of national labor forces, as well as the notable change in cross-border capital flows (particularly the growing importance of emerging economies as holders of industrial country government and corporate bonds).
For several emerging economies, the challenges include adjusting to the dramatic change in their external payments situation. At a minimum, this involves their adopting more sophisticated approaches to managing their outstanding liabilities (including how best to buy back and/or re-profile debt) and to enhancing the management of their growing financial assets. In some cases, they will need to adapt their institutions to improve operational transparency and accountability, as well as change the guidelines governing investments and liability management. There is also the difficult question of whether certain countries should use the bout of economic and financial strengthening to implement greater flexibility in some key policy areas, such as exchange rate determination and domestic consumption.
For institutional investors, the challenges go well beyond how best to react to unusual valuation and volatility measures. They also face some fundamental questions about how best to adjust their asset allocation and portfolio construction to take into account the ongoing structural changes. Given that such adjustments inevitably involve a migration to a more internationalized investment positioning, they need to enhance their risk management techniques so that they can better navigate embedded risks.
For multilateral institutions, the challenge is to remain credible and effective as trusted providers of policy advice that incorporates the right balance between national and international considerations. In the IMF’s case, many of the issues have already been identified in the Managing Director’s medium-term strategy documents issued in September 2005 and April 2006. And, in the words of the Managing Director, “the imperative is [for the Fund] to stay relevant in a changing world.” Measures are thus needed to address a host of challenges, such as enhancing the Fund’s ability to inform national policies, including improving its ability to be an effective cross-border conveyor of best practices and imparting a multilateral dimension to national policy dialogues; better integrating financial sector analysis in national and international economic assessments; updating its outmoded approach to governance and representation; modernizing the institution’s skill set and expertise; and shifting to a more robust model for generating income internally.
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In sum, this is an unusual time for the global economy and markets. Both are being affected by structural changes that are consequential not only in themselves but also in the way they interact. As a result, participants in international finance face many moving pieces, some of which appear contradictory.
When faced with such fluidity, participants have a natural tendency to wish to remain on the sideline awaiting greater clarity. But this would be inadvisable. The longer they put off reacting, the greater the risks associated with existing—and increasingly outmoded—approaches. Instead, participants would be well advised to test and retest the robustness of their operating models to the world’s changing realities. And, in going back to first principles, they need to be able and willing to consider necessary adaptations should their approaches prove less effective.
Mohamed A. El-Erian is President and Chief Executive Officer of Harvard Management Company, Deputy Treasurer of Harvard University, and a faculty member of the Harvard Business School. He served on the IMF staff from August 1983 to December 1997.