Question

What were some lessons learned on foreign exchange and derivative markets from the recent financial crisis? What regulations were introduced to prevent future problems? What are some recent developments in domestic and international foreign exchange and derivative markets?

Answer 1

Almost two years ago, the global economy and financial system entered a severe crisis. The incidence and ramifications of the crisis were obscure. Even now, the full dimensions and consequences are not known, but almost certainly this crisis will prove to be the most severe in the extent and severity of its global impact and depth since the end of World War II. Because the crisis is not yet over, among other reasons, we lack the perspective to develop a full catalog of the lessons from the crisis, either in general or for developing countries in particular. However, I thank the Banco de Guatemala for inviting me to share my thoughts on this important and complex subject from the vantage point of June 2009.In these remarks, I first offer my perspective on the causes of this crisis and how this crisis differs from previous global financial crises. This is a necessary precondition to learning the appropriate lessons from the crisis. Otherwise our lessons will be off-target or incomplete. Second, I offer some key relevant lessons under five headings: too good to be true is probably false; be better prepared; the myth of self-insurance; the role of the International Monetary Fund (IMF); and the future of globalization.

In my view the two major causes of the global financial crisis of 2007-09 were failures in macroeconomic policies and in financial supervision and regulation. I would assign principal blame to failures in macroeconomic policies by a small margin. I do not see this as inconsistent with the view that there are structural flaws in national and global financial regulatory and supervisory systems, which had been building for years and should be addressed in the wake of the crisis. It may well be that a crisis of this magnitude was necessary to uncover those flaws. Whether they would have been revealed without the macroeconomic failures is at least a debatable question.

First, the proximate origins of the crisis were in the United States to a greater degree than with other crises. Regardless of the amount of blame for the crisis one places on US macroeconomic policies on the one hand, or US financial regulatory policies on the other, the fact is that the United States led the way into the crisis. Activity in the US residential construction sector peaked in the fourth quarter of 2005. The actions of US financial institutions were central to the unwinding of financial positions that began in the summer of 2007. Activity in the US economy peaked in the fourth quarter of 2007. For the rest of the world, all this meant that the US economic and financial engine eventually went into reverse.

Second, if the largest economy in the world, whose currency and institutions are at the core of the global financial system, stops functioning, the fact that the resulting crisis becomes global should not be surprising. However, many observers and policymakers were surprised. At the beginning of the crisis, "decoupling" was in fashion. In particular, the emerging-market economies in Asia and elsewhere were going to rescue the United States from recession.In fact, globalization has linked all financial systems and economies, but the extent of that linkage was poorly understood prior to the crisis. As a result, comprehensive global solutions have been slow to emerge.

Third, it is not unusual for a crisis to begin in the financial sector, spread to the real economy, cycle back to further weaken the financial sector, and thereby further weaken

the real economy. However, this sequence is debatable if one wants to say the United States was the epicenter of the crisis and trace the trigger of this sequence exclusively to the US financial sector. If the proximate cause of the financial crisis was the US housing boom, housing is a feature of the real economy. Subprime mortgages were a manifestation of financial excess or worse, but they were not the principal cause of the housing boom, which was easy credit and low interest rates. What is real and what is financial? In this case, we really can not say.

Based on the lack of consensus about the causes of the crisis, I suspect that, for the next several decades, scholars and policymakers will be debating the many lessons of this specific crisis and whether the right lessons have been learned. Moreover, the list of possible lessons already has filled hundreds of pages of reports.

First, if something is too good to be true, it probably is not true or eventually will not be true. This lesson for macroeconomic policies also extends to policies for the financial sectors in many economies. Policymakers and the heads of financial institutions extrapolated the good times far into the future, often without qualification. In my view, central bankers around the world, at least in retrospect, did not do their job in 2003-06 as effectively as they should have. Whether or not one agrees with that proposition, one lesson of the crisis is that all good things have to come to an end. If the times are extraordinarily positive, and they continue for an extended period, there is a high probability that the end will be painful.

A second lesson is that there was essentially no decoupling. The reduction in growth has not been limited to the advanced economies. The decline from the actual growth rate for 2007 to the growth rate now projected for 2009 is essentially identical for all four groups of countries: 6.5 percentage points for the world on average, the same for the advanced economies, 6.7 percentage points for the emerging and developing economies, and 7.2 percentage points for those in the Western Hemisphere. The expected cumulative shortfall from actual 2007 growth rates for the years 2008-10 is 11 percent for the advanced countries and 12.8 percent for the emerging and developing countries in general, as well as for those in the Western Hemisphere (table 1).

The broader lesson of this crisis is that globalization of trade (in both goods and services, such as tourism), finance (in both the availability and cost of credit), and labor (in terms of the direct and indirect demand for labor and the flow of remittances) had tied countries together to a much greater extent than they had been for about a century, since the early 1900s. This reality was underappreciated. The consequence is that in today's world any crisis that affects a major country or group of countries in the global economy or financial system will have some, largely adverse, effects on all other countries. It follows that the citizens and authorities of all countries, large and small, have a common interest in the quality of the economic and financial policies in other countries, in particular in the systemically important countries.

It should be noted that not all countries were equally prepared for the global financial crisis. The policies and circumstances of some countries not only made them

vulnerable to contagion, but they also had little or no room to cushion the effects of the slowdown in the global economy, the deleveraging of the global financial system, and the increase in risk aversion. Thus, for example, a number of countries in Eastern Europe and elsewhere have found it necessary to turn to the IMF for assistance designed to support strong programs of economic policy reform that in most cases would have been needed eventually in the absence of this crisis. In some cases, these countries probably would have had their own crises without the contribution of the global meltdown.

However, these developments were insufficient to protect the Korean economy from a sharp growth slowdown in 2008 to an IMF-estimated 2.0 percent, a recession in 2009 of minus 4.0 percent, and the prospect of little growth in 2010-a cumulative shortfall from 2007 growth of 15.6 percent. From the start of the global financial crisis in August 2008 through February of this year, the Korean won depreciated on a real effective basis by 36 percent, according to the BIS data. (The depreciation was 24 percent from July 2007.) Although the won has since recovered by about 10 percent, the central lesson is that Korea's massive build-up of foreign exchange holdings did not self-insure that country against severe economic and financial strains as a consequence of the global financial crisis.

The lesson is that in today's global economy and financial system, financial crises are inevitable. We can hope that efforts to improve the global adjustment process and to implement financial reforms at the national and international level will be successful in limiting the virulence of future financial crises, but that is the most we can expect. Meanwhile, the IMF must have adequate resources to assist its members when crises occur. Many of the lessons that I have outlined in these remarks, if I am correct and if those lessons are learned, would be consistent with a continuation of the globalization trends of recent decades albeit with the application of a substantial amount of mid-course correction. However, there is no assurance that these lessons will be learned.

Highlights from recent trends in OTC derivatives markets after the financial crisis by

using OTCD statistics, with the following points in mind: (1) increases in USD IR and FX derivatives due to Japanese investor's activity; greater use of CCPs for centrally cleared transactions, mainly in IR derivatives after implementation of the clearing obligation; (3) increases in compression activity to reduce OTC derivative positions; and (4) decreases in CDS, which require a higher capital charge. After the financial crisis, considerable progress has been made in OTC derivatives markets, and there are prospects for further changes in OTC markets. For example, in Japan and other key markets, margin requirements, which oblige dealers that engage with non-centrally cleared derivatives to exchange margins with the counterparty, began to be passed in September 2016 and to be fully implemented in order. The OTC derivatives markets, although not in an expansionary phase like before the financial crisis, will continue to be essential to today’s financial activity, and it is therefore still important to capture the impacts of a series of OTC derivatives regulatory reforms. The BOJ will continue to contribute to reliable compilation and publication of OTCD statistics with cooperation of reporting financial institutions in Japan. We will continue to endeavor to compile and disseminate informative statistics, so that the OTCD statistics in Japan will be used by a wider range of economists, policymakers, and other users.