The world has left the worst of the financial crisis behind, but memories of the meltdown have barely faded. But what made the world's economy so vulnerable, and what kinds of lessons can we draw from it? Yi Gang, Deputy Governor of the People's Bank of China and Administrator of the State Administration of Foreign Exchange, discussed these issues in a speech at the Lujiazui Forum 2010 held in Shanghai on June 25-26. Edited excerpts follow:
Two years after the overwhelming international financial contagion broke out, the world economy is still standing on wobbly legs. The crisis in the financial system quickly forced many banks and institutions to their knees. But what rubbed salt in the wounds was a protracted ripple effect that sent a chill throughout the real economy. From this painful experience there are several lessons we can learn.
Inadequate government policies sowed the seeds of the crisis. The United States held onto very low interest rates for too long, inflating asset bubbles in the real estate market. This eventually led to the sub-prime mortgage crunch, which ultimately sparked the crisis. In addition, many countries, especially those in Europe, entered the economic downturn in an already weakened fiscal position. Their fiscal deficits and debt-to-GDP ratio had reached unsustainable levels. So when the crisis hit these economies, it was difficult for policymakers to drag them out.
Meanwhile, weak regulation before the crisis allowed the situation to become more ominous. When banks issued a mountain of sub-prime debts, the regulators did almost nothing to stem the dangerous tide. Meanwhile, investors easily trusted credit rating agencies, snapping up the souring debt. When the hidden problems came to light, panic overcame the capital markets.
When financial institutions that do not take deposits were backed into a corner, there was no legal basis for a government bailout. When Lehman Brothers became buried under an avalanche of bad debt, the government could not come to its rescue. The bank's demise shook the ailing financial system and marked the beginning of a turbulent course for the world economy.
A full recovery of the global economy now falters because of the European sovereign debt crisis. As the financial fallout settled, capital markets went through drastic deleveraging. In other words, governments and central banks absorbed massive debt from private sectors to rework the distressed assets. This has effectively helped the financial markets sail through the storm, but it also made a dent in the financial health of governments. With solvency risks growing, the sovereign debt prices dropped. This meant tighter liquidity for the big debt holders—the banks.
So what can we do to steer the economies on a sustainable path of growth? There are several solutions.
First, it is necessary to put in place adequate and flexible monetary and fiscal policies to ensure economic health.
Second, there is the growing need for enhanced financial regulation, and China should help push for the reform of international financial institutions.
Third, we need to seriously consider building an early-warning system of some sort to fend off financial risks.
Fourth, efforts will be required to fight trade protectionism and ensure global economic liberalization.