Yedlin: Carney sees major challenges to global economic recovery

 

 

BY DEBORAH YEDLIN, CALGARY HERALD SEPTEMBER 10, 2010

 

 

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Bank of Canada Governor Mark Carney speaks on Friday September 10 2010 at Spruce Meadows Round Table in Calgary.

Photograph by: Dean Bicknell, Calgary Herald

The tone of the speech delivered by Bank of Canada Governor Mark Carney at Friday's Round Table at Spruce Meadows wasn't exactly optimistic about the global economic recovery. In fact, one could say it was as upbeat as diehard Edmonton Eskimo fans are about their team making the playoffs.

In other words, not very. But the message was clear - a lot of change needs to happen for things to get back on the right track, and stay there; it won't be easy, and as Carney pointed out, there is no magic bullet.

One of the critical pieces that must fall into place, said Carney in an interview, is the need to re-establish confidence in the international monetary system.

"By re-establishing confidence in the monetary system you create the conditions for growth," he said.

Getting there means the G-20 countries following through with the framework outlined at the G-20 summit earlier this year, which also sets out the key elements for financial reforms that will arguably safeguard against another financial meltdown.

"We are addressing issues on the financial sector side and the macro policy side that contributed to the financial crisis but both need to be finished. We have also made significant progress on the bank capital standards," said Carney.

His comments in this area were particularly pointed on Friday, as he spoke to a room full of Canada's business elite.

Indeed, on Sunday central bankers from around the globe, Carney included, will be meeting in Switzerland to approve the new bank capital standards that will set the stage for improving the stability of the international financial system - not to mention shape the financial infrastructure for years to come.

The success of the new bank capital standards - which are expected to mandate higher levels of top-quality, Tier I capital - not only lies in the establishing a robust regulatory framework that ensures the shadow banking system cannot circumvent the new regulations nor allow for the exploitation of regulatory differences between countries. It should be pointed out, too, that the new capital standards will tread a fine line between capital standards that, if deemed to be too high, could choke off lending, while anything perceived as too low could precipitate another financial crisis.

Without financial reform, warned Carney, history will repeat itself.

In a printed text of the governor's remarks reflected "cause for concern that the current system will repeat the failures of its predecessors."

But financial reform is not the only item on the 'to do' list for central bankers.

Equally important is the establishment of a mechanism that allows for the orderly failure of a financial institution that doesn't come at the expense of the taxpayer.

To that end, Canada has been at the forefront of developing a solution - from the bank capital perspective - that appears to address this challenge.

It's called the contingent capital mechanism and as Carney explains it, it means that preferred shares or subordinated debt convert into common shares should a bank reach the precipice of insolvency. This immediately shores up the bank's capital base.

Obviously, that's not the only change that needs to be made. Carney, using the failure of Lehman Brothers that took place nearly two years ago, was as optimistic as an economist/central banker can be, about the progress being made on the macro policy side. He cites examples such as moving the trading of derivatives to centrally cleared platforms, establishing limits on margins and how transactions are collateralized.

Certainly, there was much criticism levelled at regulators in the aftermath of the financial crisis that they had failed to keep up with the pace of financial innovation.

There's also the issue of pegged exchange rates - which Carney contends cannot cope effectively with "major structural shocks" because the adjustment mechanism is not symmetric.

In a speech given to the Foreign Policy Association in New York last year, Carney stated that flexible exchange rates allow for "less costly and more symmetric adjustment" because wages and prices can adjust much faster because it happens through the exchange rate mechanism. Even more important, noted Carney in that speech, is that floating exchange rates coupled with a liquid foreign exchange market minimize the need for huge currency reserve holdings.

"One of the reasons we have countries holding big reserves is because of the anxiety surrounding the financial system," he said, characterizing the current system as "troubled."

Managing all the competing forces requires an updated tool kit, something Carney says is recognized by policy-makers and is on the agenda.

"It's up to us to innovate and develop tools and use them as appropriate."

Carney's remarks come at a time of renewed economic uncertainty and an increased questioning over the future role of the International Monetary Fund. In the printed text of his speech delivered on Friday, he effectively raises the question of whether the IMF should be the lender of last resort and points out there is moral hazard in extending credit to countries with huge foreign exchange reserves they choose not to utilize.

Ultimately, he points out, the combination of "sound monetary policy, sustainable fiscal policy and robust supervision and regulation are the best defences against crises and contagion."

That's true - but the trick is getting countries to buy into the reforms on the table courtesy of the G-20 framework and the Basel Capital Standards. For all this to work, and for confidence to be restored, the playing field has to be level; there can be no exceptions. Given the current economic uncertainty, and because confidence in financial markets is a key ingredient for sustainable economic growth, the work that is currently underway must be completed. And soon. The global economy is depending on it.

Deborah Yedlin is a business columnist at the Calgary Herald.

dyedlin@theherald.canwest.com

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