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ODE Di nner John Carrol I University AprÌl 28, 1988 Concerns Facing I. the Federal Reserve Introduction A. -- Job of a central banker is to have nightmares. 0R The definition of a central banker is a person who is afraid that Joke someone, somewhere might be happy. B. I am now a central banker I will focus on the concerns see facing the Federal Reserve over the next year or so. Because l. Inflationary Risks 2. Risks facing the financial industry 3. Difficulties with developing country II. Inflationary Ri sks An inflation-free environment should be the Federal Reserve's primary objective because it is the only way we have to achieve maximum sustainable growth and other important goals. B. Today t,re see some . 2. 3. C. III. debt A. I I lnflationary rlsks. Import pri ces have ri sen. Demands on productive capacity can be strained. Economy remains strong. Federal Reserve should specify a path for reducing inflatìon, starting at about four percent for 1988 and going to zero in reasonable time period -- three to five years. some Financlal reform at a crossroad. A. In debating and deciding on the steps to deregulate the financial industry, the fundamental goal should be to reinvigorate market incentives and tests of performance in banking and other financial markets. -2B. lntent of bank regulatlons may have been to insure safety. regulatlons undoubtedly have worked in that direction, but there have been other consequences as well -- some have worked in the opposite direction. The Some l. Have encouraged the entry of non-regulated supplÍers of and drlven business outside of flnancial services long-establ i shed channel s. 2, In some cases, risk-taking itself. a. has been encouraged in banking Overnight financlng by large banks in the federal funds and the repo markets has mushroomed, adding fragility to banki ng and money markets c. D. b. Banks, seeklng to compete with new entrants, have taken business off balance sheets with devices such as standby commitments and guarantees adding nev/ elements of risk. c. Deposlt insurance has also encouraged risk-taking. Deposìt Ínsurance reform is necessary. t. Adopt risk-based deposit insurance system. 2. Place more person. 3. Enforce current stringent llmits on insurance such as $100,000 per I I mi ts . we restructure the fi nanci al servi ce i ndustry, of capltalism should be our guide. As t. 2. basi c pri nci pl es Market forces should determine the outcome including the blend of financial and nonflnanclal products offered by a firm, well as the rlsk profìle of firms. as risk evaluatlon must lnclude possibllitles for gain and the risk of loss and ultimately Market incentlves and fai I ure. IV. Dlfficulties wlth developing country debt. A. Since the onset of the developing country debt problem in late 1982, the heavily indebted countrles have undertaken a series of painful economìc adjustments that many had hoped would enable debtors to fully service their internatlonal debts. l. Despite these adJustments, the burden of debt for many developing countries has continued to grow ln absolute terms and relative to the debtors' capaclty to service the debt. -32. B. The abllity undertake and wìllingness of many debtor countries to economic adJustments has begun to erode. further The Debt Buildup -- the 1970s witnessed a rapid growth external indebtedness of developing countries. . 2. I in the 0i I prì ce shocks Financing growth -- increasing proportion of the inflow of capital in the 1970s represented debt, rather than equity capita'l and growing share was in the form of commercial bank loans, rather than official loans or bond issues. 3. Changing vrorld economy world-wide recesslon. 4. Internal policfes -savings available c. Belief in Full for -- risÍng real interest rates and a large budget deficits reduced domestic domestic investment. Repayment l. The initial step following the unfolding of the developing-country debt problem in 1982 was to reschedule loan repayments and to maintain debt service through both official channels and commercial banks. 2. The second step was 4. Creditors to institute economic adjustment programs in the debtor country, usually under the auspices of the IMF. 3. The Baker Pl an, i ni ti al ly offered i n the I ate I 985, essenti al ly took thi s approach. seemed to view the debt situation as a liquìdity which would be solved by time, economic growth in creditor countries, and resource adjustment in debtor countri es. crisis, D. Debt Repayment Probìems -- Debt repayment problems occur when external or internal events push debtor countries off their expected growth paths, leaving debtors with obligations to service debts that exceed their ability to make the necessary real resource transfers. E. Outlook l. for Resolution l,,lorldwide economic conditions will be important -- a number of projections suggest that growth by the major ìndustrial countries of approximately 2.5 to 3.0 percent annually wou'ld be necessary to absorb debtor country exports. -42. Economic conditions have worsened in many debtor countries has resulted in increased flnanclal market tensfons surrounding the international debt situation. and a. Despi te economi c austeri ty programs, reschedul i ng, and additional fundîng, the total external debt of heavily indebted countries rose to an estimated $485 billion in I 987 from $350 bi I I ion I n I 981 . b. Debt burdens remain well above the capacity of heavily i ndebted countr i es abi I i ty to serv i ce them compl ete I y. c. The ratio of outstanding public and public'ly guaranteed debt to exports rose from $10.l.5 percent in l98l to 267.9 percent in .l986. F. The secondary market reflects concerns -- outstanding debt traded at 77 percent of book value in January ì986, the index has fallen to 47 percent. G. Major U.S. creditors began to take actìons in 1987 that reflected lack of progress in debtors countries' resource adJustments. l. 2. The U.S. banking system has reduced its exposure -- by June 1987, the exposure of U.S. banks to the l5 heavily indebted countrles had fal len to $84.4 bi I I ion from $90.2 b1 I I ion in I 982. to capital -- exposure as a of capital declined from 136 to 68 percent. Banks have made large additions percent 3. In December many large reglonal banks made further substantial additions to reserves -- in many cases raising reserves beyond 50 percent 4. H. of exposure. Markets have rewarded banks thel r exposure. that have taken steps to reduce As recent developments suggest, a more market-oriented approach seems to offer us greater hope of attaining that goal. Solutions are unlikeìy to programs. l. 2. 3. come Resource adjustments must now from bold new government financing involve both creditors and debtors. Creditors must provide debtor countries with increased access to their goods markets. Debtors must continue to pursue regulatory and structural changes in their economies that wlll attract foreign investments and that will encourage expert-oriented growth.