Preparing For The Next Recession
Friday, Jul 08, 2022

Preparing For The Next Recession

The panel discussed how high inflation, supply chain disruptions, the ongoing pandemic and geopolitical conflicts could trigger the next global recession and what financial authorities could do to mitigate the impacts. Read their bios here. Read the transcript here

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Carmen Reinhart

Senior Vice President and World Bank Group Chief Economist, Development Economics


Ceyla Pazarbasioglu 

Director, Strategy, Policy, and Review Department, International Monetary Fund (IMF)


Kuben Naidoo 

Deputy Governor of the South African Reserve Bank




Babak Abbaszadeh

President and CEO, Toronto Centre




July 5, 2022



Opening automation:            

You're listening to a Toronto Centre Podcast. Welcome. The goal of TC Podcasts is to spread the knowledge and accumulated experience of global leaders, experts, and world-renowned specialists in financial supervision and regulation. In each episode, we'll delve into some of today's most pressing issues as it relates to financial supervision and regulation, the financial crisis, climate change, financial inclusion, FinTech, and much more. Enjoy this episode.

Babak Abbaszadeh:

Hello, everyone. Welcome. I'm Babak Abbaszadeh, CEO of Toronto Centre. We are delighted to be joined with 770 registrants today from 84 countries representing about 130 agencies from around the world. Our conversation about recession is taking place against the backdrop of the devastating war in Ukraine, which erupted when the world was still grappling with the economic, social, and political disruptions of COVID 19. These uncertainties are not only affecting advanced countries, but also impacting vulnerable populations, including women and children in developing countries who are particularly exposed to price swings of essential commodities.

Recently, I had the owner of interviewing the governor of the National Bank of Ukraine who provided insights into the heroic resilience of the Ukrainian people and this central bank's important role in these extreme times. Please visit the National Bank of Ukraine's website to read Governor Kyrylo Shevchenko's moving responses. Toronto Centre also has ongoing training programs with the National Bank.

According to the Financial Times, the war is a multiplier of disruption in an already disrupted world. Countries are struggling to pay for energy, food, and fertilizers. Rising inflation, disruption of trade and financial instability are all fueling a debt crisis and potential global recession. There are concerns that gains in financial stability, financial inclusion, and even climate resiliency, which are critical to ending poverty, are at risk.

Since our establishment in 1998, Toronto Centre has trained more than 17,000 financial supervisors from 190 jurisdictions to become change agents for building more stable and inclusive financial systems. Our mission is sponsored by Global Affairs Canada, Swedish CETA, and the IMF. And we are very grateful for the World Bank has been one of our early founders.

Today our distinguished speakers will reflect on these challenges and what can be done to mitigate the impact. They are considered superstars in our world. They are Dr. Carmen Reinhart, Senior VP and World Bank Chief Economist, Dr. Ceyla Pazarbasioglu, Director of the Strategy, Policy, and Review Department of IMF and a former member of Toronto Centre's board of directors. Ceyla, we miss you. And Kuben Naidoo, Deputy Governor South African Reserve Bank. And as you know, you've already seen their bios, but please join me in giving them a big, welcome. Welcome to all of you.

Carmen Reinhart:

Thank you.

Babak Abbaszadeh:

Please type in your questions in the Q&A section in English, French or Spanish. So, let's begin. Carmen, I would like to, first of all, good to see you. And I would like to pose the first question to you. We hear from commentators daily that high inflation and supply chain disruptions, the ongoing pandemic and geopolitical conflicts could trigger the next global recession. The US Federal Reserve's jacking up of interest rates has been called the sharpest tightening since 1994. Wells Fargo puts the odds of a major recession as 50%. As a world-renowned economist, we want to hear from you firsthand, where are you on the prospects of a recession and whether it will be a soft landing or hard landing? Also, I can't resist because of your book, will this time be different? Thanks, Carmen.

Carmen Reinhart:

Well, I think the one thing, starting backwards, the thing that is the same is the view that somehow, we can engineer things better. That's the common thread that policy makers usually convey the message that this time will be different because they have things under control. And often that turns out to be wishful thinking, which again, working backwards brings me to the other part of your question on the soft landing versus the hard landing scenario. By way of background, you mentioned in your opening remarks that this is the largest set of rate hikes we've seen since '94. And if you look back, I've worked on Fed history with Ken Rogoff also. And if you look back to 1994, 1994 was indeed of soft landing, but it was the only one historically. And that's an important... I would note that in 1994, the inflation being surmounted was in the ballpark of 3%, not eight and a half.

So initial conditions were much more favorable to a soft landing. And I reiterate the important point that except for that episode, fed tightening’s have had in varying degrees, recessionary impacts on the US. So am I in the soft landing camp? No, I don't think so. I don't think that's likely. We have a lot of headwinds. Now, that's the US. How about the rest of the world? Well, one of the things that I've been remarking on recurringly is the unevenness of this economic recovery from COVID in which the advanced economies, as a group, because of more aggressive and ability to deliver more stimulus during the pandemic, among other things have done better.

So, for many countries, many emerging and developing countries, they have not fully recovered to previous per capita income. Per capita GDP remains well below prior peaks. And the real risk is that many are already in stagflation mode, which is the word... and I'll end here, the word that's been revived from our old glossary.

Babak Abbaszadeh:

Thank you very much. Carmen, as you were speaking, I was reflecting on the fact when you said uneven manifestations, what a shame, what a pity that all this happening at a time when the global architecture some would argue is coming sort of apart. I mean, other than NATO, that is really coming together, looks like all the cohesion that was built up is at the risk of getting disrupted. Of course, that's the topic of another session, but that made me think.

Ceyla, as I said, welcome back. So, let's look at the perspective across the street from the fund, according to the IMF's recent global assessment, financial stability risks have risen as the war tests resilience of the financial system. So financial system, Ceyla, got a really bad rap in the 2008, but despite unbelievable challenges this time around, since COVID, in fact, it held up very well and became part of the solution. But now we might be facing a different set of challenges with persistence of inflation and the war. So let me pose that question to you. How vulnerable is the global financial system to the challenges of the recession, and is this a question that keeps you up at night? Thank you.

Ceyla Pazarbasioglu:

Thank you. Thank you, Babak, and great pleasure to be with you and back at the Toronto Centre in this event and great to be in the same panel as Kuben and Carmen. The overall theme, preparing for the next recession, is a very important one. We should certainly be ready for adverse shocks, and we need to do best we can to calibrate policies in a timely manner to actually avert a global recession. I agree with Carmen, the headwinds are very strong and the pandemic, the war, the looming climate crisis, all of this is coming together, if you like, almost like a perfect storm.

So, it is clear countries' circumstances, of course, differ. We will hear from Kuben as well, but it is clear that central banks need to tighten monetary policy. And this has been happening already. This is really critical to prevent the anchoring of inflationary expectations. And I will come to the key point I want to make, and you ask what keeps me up at night, and this is the need for central banks to remain independent, operationally independent.

This is critical for them to be able to do their job. Adequate fiscal policies, of course, needs to be in place to rein in inflation and address distribution of implications from this, what we see as this global wide inflationary development. But it is very important that the central bank independence is preserved. We've spent many, many years to actually put this in place and I see evidence that this is actually at risk. So, I am worried about it.

And it's relevant regarding the question you ask. Financial systems to remain resilient, central banks need to do their job. They need to stay operationally independent, and they need to take the necessary steps given what the development. So, to some extent, we do have a more resilient financial sector. It remained resilient during the pandemic, during the recent shocks, the war, and its aftermath. And to some extent, this does reflect the regulatory reforms and you know this very well. There were a lot of discussions at the time that were implemented after the global financial crisis.

And there were of course measures that were taken during the pandemic, which was instrumental in facilitating the flow of credit to the real economy. But all that means is that we are now at a difficult place because we did have, however we call it, loosening of regulatory standards, a lot of non-transparent practices in terms of non-performing loans, asset quality and so on and so forth.

So, I think these are going to be difficult issues going forward and what needs to be done to make sure that we don't end up with a systemic crisis or a global systemic financial event, which we have so far been able to prevent. One is, as I said, and I will repeat it, allow central banks to do their job, that they need to take the measures to make sure that the inflationary expectations are not detached. Second, we need to make sure that we deal with pockets of vulnerabilities. The GFSR, as you mentioned, shows that the financial system in the globally systemic important banks are strong, but there is a tail of risky institutions. And that depends on country to country how fat that tail is.

But I would caution that we need to be careful because there is a lack of transparency in terms of asset quality. And I will end with that. To me, a third very important action going forward, which we were late to take this during the global financial crisis is asset quality reviews. Taking early action, being prepared, stress test and the necessary measures to deal with any emerging stress in the financial sector. Thank you.

Babak Abbaszadeh:

Thank you. And I counted, you talked about the independence of central bank, I think three times in your comments. And that's very apropos. In fact, according to the chair of the board of directors of Toronto Centre, Governor Stefan Ingves, the governor of the Central Bank of Sweden. I mean, he has a lot of info experiences globally. He always reminds us that countries that interfere in their central banks are the ones who end up paying severe economic consequences. And we are also seeing globally today, central bank independence is coming under attack through the extreme politics of populism politics around the world. I'm not going to mention any specific countries, but that we are beginning to see some of that. Thank you, Ceyla, that was very well put.

Kuben, we wanted to have a central banker and you are our number one, number two, and number three choice. So, I'm glad you accepted our invitation. It's always great to have you. South Africa is not just a pivotal country in Africa, it is also a major G20 nation. Yet economists are concerned about South Africa's economy because of the country's major macroeconomic problems, such as lackluster economic growth, growing inflation, and very high unemployment that have been exacerbated by a series of major disruptions, such as the pandemic, massive regional floods, and now food shortages due to the war in Ukraine.

I guess your hands are full, Kuben. In this context, at the Reserve Bank, how do you tackle financial instability risks? Thank you.

Kuben Naidoo:

Thank you, Babak. Thank you for those kind words. It's an absolute honor to be on a panel with Carmen and Ceyla and thank you to the Toronto Centre for inviting me. We've had a long history with the Toronto Centre. You've trained many of our supervisors, and we've collaborated over many years. Let me start off with the policy stance.

We would do what we have to do. We will deploy the instruments that we would have to deploy to get on top of inflation, right? That is our primary mandate. We're not insensitive to growth. We're not insensitive to the output gap. We're not insensitive to employment. We have to take those factors into accounting our thinking, but as an inflation targeting central bank, our primary mandate is to bring inflation back within the target range. And we will deploy the necessary measures to do that. Everything else is secondary in that respect.

We started increasing interest rates in November last year. We increased interest rates by about 125 basis points to date. And we will continue to increase interest rates. Our increase in inflation has not been as sharp as the US or Europe. In fact, core inflation is still below the midpoint of our target range, but headline inflation is now above our target range. Three quarters of our inflation is food and fuel, but we are acting to prevent second round effects. We are acting to prevent price spirals. We are acting to ensure that there isn't broad based inflation, that the external shocks that we've had from food and fuel principally does not transmit into broader inflation.

As Carmen pointed out, our recovery from the COVID pandemic has not been as robust as in G3 countries or in advanced economies, but also, we didn't deploy the same kind of fiscal position. So, our labor market has still got a degree of slack. We're still below pre COVID employment levels. And as I pointed out, co-inflation is still below the midpoint of the target range. And the other big difference is that we've got a trade surplus at the moment. Whereas in the run up to the financial crisis, all the debt retention, we had very large credit account deficits. Now, we've got a credit account surplus. But we are not complacent. We're taking the necessary steps on interest rate side.

But let me conclude with the fact that policy making is about fixing your roof while the sun is still shining, right? We have got a healthy financial sector, a well-regulated financial sector with very high capital adequacy ratios, very high capital requirements. We did provide regulatory relief during COVID, but we've rolled almost all of that back. And so we're in a starting position where capital ratios, liquidity ratios are back at pre COVID levels. In fact, bank ROEs are probably almost at pre COVID levels.

The fiscal space is not as good as it was pre COVID. There's no doubt about it, but again, we went into this crisis with inflation under control, a long good credibility track record of anchoring inflation expectations, closer to the midpoint of the target. And we are definitely not complacent. And that's why we've acted proactively and we will continue to act in the interest of our primary mandate.

Babak Abbaszadeh:

Thank you very much, Kuben, for that, for those remarks. And I think it's very obviously important to stick to the discipline, and you identify your priority right away, right off the bat. And just to return your compliment in a meaningful way. We find that the South African Reserve Bank and your institutions do take capacity building very, very seriously. And we're very happy to be your... honored actually to be your partner. Thank you for that.

So the first round we talked about the recession. Is it happening? Is it not happening? And all that. I think it is happening. On the second round, I guess let's focus on how can the global economy recover?

So, Carmen, let me come back to you again. In one of your recent speeches, you highlighted that the global economy is passing through a period of exceptional uncertainty, which not only impacts developed nations, but also could have disproportionate impact on the poor and vulnerable populations in developing countries, including women. How do you see the global economy navigating this uncertainty and how can policy makers do a better job? I don't mean they're not doing a good job, but how can they actually do better in this context? Thank you.

Carmen Reinhart:

Well, I mean, these are very difficult questions, as you might imagine. And on how policy makers can do better, let me just make sort of a very generic statement and then I'll get more specific. But the generic statement is a lot of past policy mistakes occur because bad shocks are treated as temporary and good shocks are treated as permanent. And the current situation highlights that, right?

I mean we went through the discourse on, is inflation transitory with both the Fed and the ECB being on camp temporary for an extended period of time, which was a delay in policy action. Why am I bringing this up now in this context? I think turning points, and this is why I was remarking on uncertainty as you pointed out.

Turning points are tough. They generate a lot of uncertainty. We went from an extended period, decades, of declining inflation, declining international interest rates, and very by historic standard accommodative international financial conditions. Now, since the early 1800s, we've only had four periods of sustained negative real interest rates, multiple years in financial centers, World War I, World War II, the 1970s, and now. All of those episodes were inflationary. And the exit from those was tough.

And so a big challenge... You asked me about what can be done to overcome the damage done by COVID and subsequently the war. I think overcoming the inflation problem is really critical. And it is critical on many facets, right? I mean, there is, of course, the fact that COVID was already a very regressive shock across countries and within countries. We've seen this. Now we're working at the World Bank on the second Poverty and Shared Prosperity report issued after COVID. The first one I worked with Ceyla, before she moved to return to the IMF.

And significant increases in poverty. These are regressive shocks, and inflation is a regressive tax. And it is particularly regressive in countries as income levels are lower. The share spent on food and energy and basic necessities is the share... The consumer baskets are larger so they're particularly recessionary. So overcoming the damage has to importantly deal with the inflation problem. And that's much easier said than done.

And I can't resist just very quickly making a point on the discussion that both Ceyla and Kuben spoke to on central bank independence. I think in the advanced economies, central bank independence is being challenged. Also, not necessarily, but the fact you have high levels... Ceyla spoke to this high. This is not just an emerging market issue. We have high levels of public debt. We have high levels of private debt. This makes balance sheets more vulnerable to interest rate hikes.

We have a lot of high risk debt, corporate debt that was issued during the low rate environment. We have lost the price earnings ratios valuations in equity. So we've discussed a Fed put forever. So these factors will constrain the Fed and will constrain banks. So I think, number one, tackling the inflation issue. And I think that, of course, it's easier for me to sit here and say it than for the central banks to implement it.

And second point, and this is super quick, fragmentation, global. We prospered during an era of globalization, increased trade, increased finance. We're seeing... I'm not being melodramatic. We're not seeing a huge reversal on that, but we're seeing a big stalling. And the Russia Ukraine war is helping fragment the global system and trade. We have not one oil price, but two oil prices in terms of different markets.

We have, as the war also has impacted many countries through big spikes in food price inflation, and of course, many were already very vulnerable, high share of countries in debt distress or high risk of debt distress. That also leads to fragmentation in the financial side because those countries will not have access. An increasing share of countries will not have access to international capital markets. And higher rates also are a constraining factor. So challenges to globalization and challenges on the inflation front, I think are the two areas I'd like to highlight for policy makers. And the second one, of course, has to be done at the international level.

Babak Abbaszadeh:

Thank you very much, Carmen. One of the many reasons I enjoy speaking with you and reading your work is your impressive historical perspective. And I think you captured it extremely well. I noticed on the list of the organizations represented, for example, the Central Bank of Brazil, a big shout out to our friends in Banco Central, but also remember they dealt with inflation at a massive level back in the nineties, up to 5,000% or more. And they were not the only one. There were other countries. And until they were able to harness that, their economy didn't really have much of a chance of being able to get off the block. And I know the inflation numbers now are nowhere near that, but the cautions are very important to try to deal with.

And I think you talked about public debt, and I'm wondering if that could be a good seg for the question I'm going to pose to Ceyla. Ceyla, I have a two part question. We always have two questions. With high corporate debt, as well as public debt being at historically high levels and the sovereign credit outlook deteriorating in emerging markets, what can policy makers do about the sovereign bank crises?

And what role can financial supervisory authorities play to minimize the potential risks and enhance the resilience of their financial system? I know you don't have a financial supervisory responsibility today, but if somebody looks at your DNA, it's all about supervision. So I'm wondering if you could comment on these two questions. Thank you.

Ceyla Pazarbasioglu:

Thank you. Thank you, Babak. This is a very important question, and I'm sure Carmen will come in on this as well. We've been working on this together for a while, and it is a shared concern. Of course, with the pandemic, we had a very significant increase in both public debt and private debt, as you said, because government provided very substantial fiscal support measures, as well as other measures to help. And it was needed. It was required to help businesses and households cope with the crisis.

And what that meant is total debt public plus non-financial private debt to increase by 28 percentage points just in 2020. And that's the highest increase since World War II. So that meant that we have 256% of global GDP of public debt. This is really incredible amount. The global private debt is also very high, 156% of global GDP by the end of 2020.

So these are very large numbers, which means that we need to be very careful in managing them. Some countries are, of course, key drivers of this and some of the advanced economies and China are a large part of this increase in debt, but you see it across the board from the lowest income countries to highest income countries, across the board, large increase in debt. So what that means is we have to be careful because we have seen... We had our April World Economic Outlook Chapter Two. It shows that historically the rapid accumulation in corporate debt could slow the recovery by accumulative of almost 0.9% of GDP in advanced economies. And 1.3% in emerging markets over the next three years. So it does have very large implications on growth.

And that's amplified for countries where leverage is more concentrated among financially vulnerable corporates and households. Hence the importance of doing the asset quality reviews, where fiscal space is more limited, where insolvency regimes are inefficient and where monetary policy needs to tighten much more rapidly. We published a paper supporting and restructuring firms hit by the COVID 19 crisis that lays out policy recommendations to better target support the viable terms while calibrating the exit of exceptional support measures.

Do look at it if you haven't seen it, because it includes a novel indicator to measure the preparedness of insolvency regimes across countries for a future crisis. And, of course, vulnerabilities are much more pronounced in low income countries or in other countries where they have inadequate insolvency regimes. So in terms of sovereign bank nexus, and what needs to be done to deal with it is basically we have to make sure that countries can use macro-prudential policies to address the increasing vulnerabilities in countries.

Make sure that fiscal policy is adequately targeted, tightened, where it's needed. And, of course, taking into account distributional implications, the poverty and other aspects as Carmen mentioned, but also develop the resolution frameworks to deal with both private debt, but also sovereign domestic debt to facilitate orderly de-leveraging and restructuring as needed.

So it's very important to make sure... Of course, it's very difficult to make these institutional changes overnight, but there are ways to use out of court settlement systems and other ways to really ramp up the insolvency and resolution frameworks for private debt. And also I would underline sovereign domestic debt, which has been really lagging. And I will finish with what you also mentioned, the important role of financial supervision. This is really very critical and the supervisors have a very important role. Of course, they don't supervise the corporate sector. We have been talking about private sector now, but they do have the relationship with the banking system, which is critical to make sure that the corporate sector vulnerabilities are taken into account because most of the time, except in some of the very large advanced economies, corporate sector is borrowing majority from the financial sector from the banking sector.

And there the role of the supervisors in terms of understanding the quality of assets and the exposures, foreign exchange exposures, mismatches of the corporate sector through working closely with the banking system is feasible. And it has been done many times in the past. And I think this is what really has to be front and center at this point in time for supervisors.

Babak Abbaszadeh:

Yeah. Thank you very much, Ceyla. The second part of your answer, I think is a big plug for crisis preparedness and risk based supervision because you're raising really important issues there. And before we go to Kuben, two things, one for the audience. I see some questions. This is a good time for you to post your questions because we're going to go through as many as we can.

Carmen, your name was mentioned and you also brought up public debt. Before we go to Kuben, is there anything you want to add to what Ceyla said at this point? Or you can always do that intervention later, but I just wanted to give you the floor for a second if there's a thought that you wanted to get out.

Carmen Reinhart:

I think it's important to highlight that the heyday, the big introduction of central bank independence, which we've also been talking about was at a point in time when public debt, after the World War II bulge had declined, so there is... The dis-inflationary '80s was associated with much lower levels of public and private debt. So the debt story is very much connected to our earlier discussion as well. Let me leave you there, because I'd love to hear what Kuben... I'm waiting on that also from Kuben.

Babak Abbaszadeh:

So there goes again, the power of your historical understanding. So, Kuben, let's go to you because I think you can sort of see how it all comes down to the practitioner, the central banker. Everyone keeps talking about the central banker and I also notice you have a deposit insurance responsibility as well. So from your vantage point, what can supervisors do to build their own resilience as well as their financial system's resilience to prepare for upcoming storms? And as you reflect on this, you have a lot of knowledge about your peers in other countries as well. So I mean, maybe your answer could be not just about South Africa, but in general, as you see the landscape. Thank you.

Kuben Naidoo:

I think Ceyla covered much of it. There's no substitute for good supervision over a long period. There's no substitute for risk based supervision, tools like stress testing and getting independent people to come and do stress testing, be it the IMF, the World Bank through the FCEF process. Or getting academics in other countries, saying, "Open up, here's our data. Come and do a stress test on our banks. Can they survive these kinds of shocks?" Independent peer-reviewed stress testing. All of those kinds of things are part of the toolkit.

But again, it's about repairing the roof while the sun is shining. Right? And I think in part we've done that. I think the implementation of Basel III and the regulatory reform since the financial crisis have helped. So while I'm not pretending that this time is different, I do think that, in general, the financial sector is robust and resilient, well capitalized and well supervised. It's not to say that there are no risks, not to say that things cannot go wrong.

We've got to look at risks from multiple perspectives. Default risk and credit risk is a key issue, large exposures. Does the banks have excessively large exposures to a few counterparties? Are they exposed to the mining sector or the food chain, food supply chain? What are those risks? But we've also got to look at the risk of capital outflows, right? And significant currency weakness. And what's that likely to do to our banking system?

Something that's quite old in South Africa is that banks are not allowed to have, or banks can only have unhedged foreign currency exposure of 10% of tier one capital. Right? So if tier one capital is around 12.5% on average, then they're only allowed to have unhedged foreign currency exposure of 1.25% of the balance sheet. And that's something that's been in place for at least 25, 30 years. And it's put us in good stead.

When we had QE, we did not have a credit boom year. We had credit booms in other emerging markets. It's not to say that when the rand depreciates or the dollar appreciates, you don't get a titling of financial conditions, but we've used those kinds of tools to insulate the banking sector from the direct effect of those elements, Babak.

Babak Abbaszadeh:

Thank you very much. So I'm going to go through the Q&A as much as possible. So it's just a couple of observations for our questioners. If you write your questions in a way that on the screen looks like a War and Peace novel, your chance of me reading it is going to be very low. So let's go for concision if we can help. And for our speakers, let's do this CNN style. So break the world down for us in 20 seconds, 30 seconds so we get to as many questions as possible. Sorry about that, but we'll do the best we can.

Carmen, there's a question here that I think, let me pose it to you at least, and then maybe Kuben or Ceyla can also come in. What do the recent steep hikes in US interest rates mean for capital flows to developing economies? And I guess the next part of it is, what are the financial stability risks, and how should financial supervisors prepare? So maybe we can answer this as a bit of a community.

Carmen Reinhart:

So if you really want me to answer quickly, the first is bad news, look, rate hikes historically, again, have not only the direct effects that they make capital staying at home more attractive, but they have multiplier effects. They go hand in hand with rising risk premium. So during periods of rising rates, what you typically have seen is the global financial cycle having a negative effect on capital flows.

So that's the rate hike story, which is associated with rising risk premia, i.e. higher risk of default. This is in the aggregate, right? This is what you see in a lot of the spreads and so on. Second part is, one, underappreciated, but very connected to the core of the question on capital flows is China. We've been focused on the rate hikes of the West, but financing for emerging markets from the East soared up through around 2015.

And in 2019, my work with Christoph Trebesch and Sebastian Horn, we've seen the first reversal in net lending from China. So capital flows from both lending from China and from the West. The rising rates which also tend to increase market volatility, the VIX. All those things translate into more skittish, more selective, other things equal, lower capital flows, definitely more discriminating. So domestic fundamentals acquire increased importance.

Babak Abbaszadeh:

Great. Thank you. So, Ceyla, let me pose the next question to you from Valentine. On the impact of the war in Ukraine, apart from the food and energy price impacts, there's little to no discussion on the impact or potential impact on international payment systems. Should we be worried about this aspect also?

Ceyla Pazarbasioglu:

CNN style answer, yes. I think-

Babak Abbaszadeh:

You could do National Public Radio too.

Ceyla Pazarbasioglu:

Yes. I mean, it is a fact that the payment system has been fragmented. We have been discussing some of this in terms of also trade flows and other aspects. And it's the war, the related sanctions, the other measures that are being taken by countries. So, yes, this is something that we are very worried about. Carmen talked about fragmentation in her introductory remarks, or rather in the response to your first question. And this is top of mind for many of us.

And part of it is the fragmentation in the payment system with different... Of course, we have reserve currencies. It'll take a long time for any reversals on that, given the characteristics that are needed for that. But we do see fragmentation in certain blocks of countries starting to do payments among them. So I am quite worried.

There's also another aspect of this, not just the war in Ukraine, but also the increase in digital payments. That's also leading to fragmentation in terms of different types of currencies and stable currencies and the risks that brings. So I think there is an important aspect of acceleration, of use of digital currencies and implications on the payment system. And that should be, for the international community, a first order development that requires collaboration at multinational level.

Babak Abbaszadeh:

Great. Thank you. And, Ceyla, earlier in the program, you did talk about a report and you urged us to take a look at it. If you want to send a link to us, to me, to Demet, we'll post it on the Zoom. And if it's after the program, we're happy to put it out in our website. So feel free to do that or one of your staff members.

There's a question here from Tom Belleck. Kuben, I'm going to give this to you. It's an interesting question. We are aware of most of the current global risks, concerns. Are there global risks not openly discussed or not as well known? So this is one of those in a category of Donald Rumsfeld, unknown unknowns. Is there something that we are not talking about that we should be?

Kuben Naidoo:

I don't know. I think central banks must deal in the realm of transparency. If we think something is a risk, we must talk to our citizens about it. I don't think there's anything that we are hiding in particular, but let me talk a little bit about the central bank independence issue, the pressure. I fully understand the pressure, the political economy issue facing central banks, right? We've had COVID, which as Carmen pointed out, negatively affected the poor. In fact, in South Africa, the unskilled job losses were massive and are still not recovered, right? I mean, I'm a skilled person. I can work from home. If you are a burger flipper in McDonald's or a shelf packer in Walmart, or if you work in a restaurant in the tourism industry, you can't work from home. And those have been the jobs that's lost.

And now all of a sudden you've got inflation, taking the US sort of 8% inflation. And the job of central banks is to make it hard for firms to provide salary increases, right? We want to prevent wage price spirals. And we do that by making the economic conditions such that people can't pass on price increases and price hedgers can't just provide wage increases and then transfer those costs to consumers.

We do that by either taking our foot off the accelerator or by actually pressing the brake on the economy. That poses a significant political economy challenge, right? You could argue that inflation has negatively affected mainly the poor, certainly in South Africa's case, food and fuel. If you are in the bottom half of the income spectrum, you're spending almost half your income on food and fuel or energy and food, and that's where the price increases have been.

And all of a sudden the central bank says, "Well, we are going to make conditions even tighter," but let me say that the alternative is worse, right? The alternative is we allow inflation to run away. That is likely to have an even greater negative impact on the poor, on their savings, on the ability of the economy to recover quickly, on the ability of people to get jobs quickly, on the ability to grow labor intensive competitive industries is even harder. Right?

And so if we fail in our job of getting on top of inflation, the victims will be the poorest half of the income spectrum. So, yes, of course there's pain. There's no doubt about it. Yes, of course, we must be sensitive to that and recognize that, and we must be honest with our citizens about it, but the alternative is worse, right? The alternative is far worse.

Babak Abbaszadeh:

That is so true. For many of our viewers who live in developed economies and haven't had experience in developing countries, might be bizarre, some of this stuff, but let me just give it an anecdotal example... It's not even anecdotal, it's a real example. I remember. I was in Sao Paulo, Brazil again in the nineties, and I remember inflation was runaway. So this is the second time I'm talking about it. You'd go to the store to buy sugar, half an hour later, you go back or an hour you go back, the price has gone up. And that's just one example, right? So we've never had that. So we're talking about five, six, 7% here, maybe 10% in some of the developed countries, but the specter of runaway inflation actually can be very scary for those who have experiences. So thank you very much for bringing that back.

Carmen, I'm going to give a question to you. It's a bit of a hybrid question. Unfortunately, we don't have anyone from Latin America on this panel, but they're very much on our mind. Can you give us some insight regarding the economic perspective of Latin America? And then the hybrid from another question down below is really the impact of the poor and what's going on here. And as you know, Latin America is not alone in the world, but they have some governance issues and other things, and many countries around the world have that as well. So as a World Bank chief economist, when you look at that region, what are some of the top mind things that come to your mind that you could share with us in the context of this conversation? Thank you.

Carmen Reinhart:

So Latin America was hit really hard by COVID, in terms of the actual health statistics, the impacts are quite severe by international comparisons. Many of the issues that we've been discussing from lack of recovery, let's start with that, to the inflation challenges, to the debt challenges and to the financial stability challenges that Ceyla talked about are all present in Latin America.

If you look at credit rating downgrades during 2020, they've slowed down during 2021, but view credit ratings almost as a summary statistic of some of these risks. And this highlights a point that Latin America has been hit hard. What is one concern? And by the way, a lot of the new poor is urban poor and women, and that's very much alive and well as a phenomenon. It's not unique to Latin America, but it's certainly very present there.

The other factor that I'd like to highlight in the context of Latin America is that... I don't have time to belabor this now, but look for a short blog called the Reversal Problem, which is setbacks to development. And that also includes the discussion of the impacts on COVID on education. And those impacts actually are estimated to be higher for middle income countries than for many low income countries during the COVID pandemic and LatAm falls squarely into that.

Last, I am concerned that the shrinkage of the pie and the worsening in distribution of the pie is also leading in Latin America, very visibly, to a pendulum swing in the political economy. We've seen a return of social unrest, of more populist. And economic reversals often lead to policy reversals. And that's a big concern that I have for the region. Right now, many countries are being helped by the boom in commodities. Word of warning, if you're a policy maker in Latin America, do not treat the commodity price boom as permanent. That is the root cost of so many fiscal problems down the road. But it was a very particularly hard hit region during the last two years.

Babak Abbaszadeh:

Thank you. And we wish them all the best. And I guess there was another question, this time from another part of the world. Kuben, I'm going to go to you. This is from another courageous anonymous. Drawing from the consensus that we are heading to a recession, to what extent should Sub-Saharan African countries be worried about this imminent eventuality? Thank you.

Kuben Naidoo:

It is a worry, but did you fix the roof when the sun was shining? Right? And that's the million dollar question, and again, in my own country's case, we fixed part of the roof. We didn't fix part of the roof, right? And we are not in a good fiscal position relative to pre GFC or even pre COVID. You've got significant levels of public debt. The deficit has come down in the last two years because of good commodity prices, but there's a big temptation for politicians to spend that and some of that on fuel subsidies or food subsidies.

And I understand the political imperative of that, but if those commodity prices, as Carmen said, were to fall, you've got a big fiscal hole again. And so in some ways you could be facing a situation where you're back at neutral levels of GDP growth, but a budget deficit of five, 6% of GDP, which will put you in trouble, right? And you'll get punished for that kind of policy by markets and bond markets, et cetera.

So the issue is about repairing the roof when the sun is shining, or in the best of times, or even in the worst of times, and then two or three very simple elements to that, right? I mean, fiscal policy you can choose your own tax GDP ratio, but in general, when times are good, you bring down the budget deficit. When times are bad, you widen them, right?

And if you go into a crisis, the lower the level of debt you go into the crisis, the better. You don't have to put numbers to that. It's not rocket science, but that's a simple rule of thumb. In COVID, we went into COVID with good inflation, well-anchored and that gave us the space to cut interest rates very dramatically. And that provided significant stimulus to the economy. And we could keep interest rates relatively low for long.

And we started hiking six months before we breached the inflation target on the upper end. Right? And, again, if you go into a crisis well prepared, then you're likely to be more resilient. And lastly, on the financial sector, you have to make sure that your banks are well capitalized, that they are robust, resilient from everything, from capital to credit issues, to cyber issues. Right?

And if they can withstand those kinds of pressures, then yeah, I think you'll manage. Again, I don't want to belittle the problem, right? In South Africa, about a third of the population have wheat as their stable diet. And we import a significant amount of wheat and wheat prices have gone up. There's no doubt about it. Right? Food prices have gone up. Food inflation in South Africa is now running at 7.8%, right? I mean, it's above the headline rate of inflation. And it might not be as high as some other countries. We might not be as bad as Egypt, for example, where food inflation is running at 30, 40%. But again, we don't want that kind of spiral, right? We don't want it to get there.

And so, while I'm genuinely sympathetic to the fact that inflation is hitting the poorest harder, our job at central banks is to ensure that we nip it in the bud. We are part of an economic team. We are not the full economic team. There are fiscal players. There are economic policy players. There are trade players. There are tax players, right? We are the central bank, and we must do our part of the job as part of that team. We can't do everything.

Babak Abbaszadeh:

That's true. And a couple of quick observations. As all of these issues are becoming politicized, it looks like central banks, going back to Ceyla's point about independence and the consensus of this panel, they become sort of like their political football, right? Governments can blame them. And, in fact, as you said, it's an architecture, and your comments are very much in line with Benjamin Franklin, "Failing to prepare is preparing to fail."

So in other words, in good times, call a roofer. In bad times, central bank is there for you, right? So it's very important. Ceyla, coming back to you. There's a question here from Anna, since you brought it up. Could you mention some methods on how the public and private debt should be reduced?

Ceyla Pazarbasioglu:

So I guess, as Kuben was saying, it's good to fix the roof when sun is shining, but yes. I mean, there are ways to deal with increase in public debt at the time when you are already almost in a crisis, and there are ways to deal with it in a much more preemptive way. So some of the measures like Kuben mentioned in terms of making sure that the foreign exposure limit, this is really critical for not getting into trouble, are in place to ensure that the private sector households and corporate sector do not leverage themselves too much if they don't have foreign earnings, foreign exchange earnings. And if they borrow in foreign exchange, that's really usually the rest of people disasters.

So both at the sovereign level, but also at the corporate and household level, making sure that there are enough regulations and rules in place to ensure that there is not large leveraging, especially in terms of foreign currency. So I think that's a very key aspect of it. The second one is maturity, because usually you also get into trouble because of maturity mismatch, rollover risk, refinancing risk. So really making sure that as much as possible issuing for government, issuing in local currency, issuing as much as possible longer maturity instruments. So I think these are really critical, and of course the regular methods of stress tests and other ways of making sure that one is prepared as these risks increase.

There's, of course, global coordination. You know this very well, at the regulatory level, to make sure that we learn... This was the lesson from the global financial crisis. You can have each of your individual institutions strong, but the system as a whole, because of interdependencies may not be strong. So having the macro-prudential tools in place to look at, what are the inter-linkages between different institutions? And making sure that those are kept in reasonable levels is also very important. So there are measures at the domestic level, international level, that needs to be in place to make sure that we don't end up with very high levels of debt that ends up triggering systemic risks.

Babak Abbaszadeh:

Sure. Thank you. And you know what? A nightmare of a moderator in this situation's lack of questions. In this case, we are overwhelmed by a lot of questions. So you have done amazing to be able to light up the switchboards here. Let me go to a question from a good friend of Toronto Centre. If she's still... the name is there. Yeah. [inaudible 00:57:52] of Singapore who used to work here.

Kuben, I'm going to give this to you. It's an interesting question. And it deals not just with policy, but also with communication. How do countries facing rising food and energy prices, sounds like all of them, tighten policies? And, moreover, how do you artfully communicate the need to sacrifice growth to bring down inflation? This is where there's a clash probably between central bankers and politicians, right? So what should countries do in these situations?

Kuben Naidoo:

Again, this is a difficult issue, right? I mean, this is the worst position that central bankers like to be in. We like to be in the situation where you've got high growth, high inflation, and we can take a bit of edge off the inflation rate to bring the growth rate, to bring inflation down. Alternatively, if you've got low growth, low inflation, we can stimulate a bit.

We hate to be in this position where you've got high inflation, low growth. And we are, and it's not a nice place to be, but somebody's got to do it. And we've got to be true to our mandate. It's not always that we are in this position, but in the particular circumstances that we find ourselves in this position, our primary mandate as a central bank is price stability.

If there is fiscal space, I think in some countries you may subsidize food. You may subsidize fuel by giving cash transfers to the poorest households, right? If you've got the fiscal space. I mean, what we've seen here, and again, there are efficient and inefficient ways of doing this. I think it is a political economy choice to want to cushion the impact of rising food and fuel prices on the poor. And I think some governments can do that. And if they have the space should do that. If they can reprioritize public spending from one area to another, that's even better. Right? But those are fiscal policy choices. Those are political choices, right?

If we don't nip inflation in the bud, we will be accused of eroding people's savings, of causing an even greater economic mess and problem. And if we do raise interest rates, try and nip inflation in the bud, we'll be accused of sacrificing growth to get prices down. So damned if you do and damned if you don't, but again, I think we've got to stick to our mandate. And in this particular case we have no choice, but to prioritize bringing down inflation. It's not a nice place to be. And I think being honest with the government and with the country and with the public is probably a better strategy, but be true to the mandate, we have to be.

Babak Abbaszadeh:

You know what? It's interesting. I mean, yes, honesty and integrity always takes the cake. But especially in situations like today, when there's such a high level of mistrust of government, authorities around the world and the social media keeps fermenting these. So maybe you're absolutely correct. Just being upfront and honest. Doesn't take away the pain, but might be a strategy that actually people will say, "Okay, I get it."

Carmen, actually, you mentioned in the question. Miss Reinhart mentioned the problem of fragmentation. What is your opinion on the impact of fragmentation on globalization in terms of changes in distribution channels and new trends such as near shoring?

Carmen Reinhart:

Yeah. But let me just quickly... You asked a question to Kuben that was just so tempting: What is it that we don't see?

Babak Abbaszadeh:


Carmen Reinhart:

And crises, economic, whether they're financial or debt, are often characterized by, it's not what you see that gets you, it's what you don't see. I think also we have issues relating to hidden debts. We have issues relating to hidden non-performing loans. Ceyla and I also wrote about this in a recent finance and development piece in the world development report.

In other words, one constant through history in financial crisis is often balance sheets are a lot worse than they seem, and the true risks are revealed during the crisis. So I am concerned also about... Far less so, and Kuben has highlighted that point. And I agree with it, that banks are well capitalized, but non-banking, and shadow banks are a far more nebulous story. Let me leave it there.

Fragmentation, very quickly. Look, I noted that fragmentation already exists in what used to be, until not long ago, an integrated commodity market. We have oil being sold and that kind of fragmentation is already there. We have the kind of evidence during COVID of significant increases in transport costs, international transport costs that have spiked to levels that are way off the charts. That's also indicative of the fragmentation of supply chains, of the less than perfect synchronization in shocks and policies.

And I think capital markets are also at the risk of seeing further fragmentation, if indeed a rising share of developing countries also do face debt distress and are shut out altogether. One element to not lose sight of is we kind of have it in our background, but the USSR era was one of not a global capital market. You clearly had a divided world. And I think there is a question of, to what extent? And I alluded to oil. I alluded to finance and I alluded to trade.

A Cold War dimension that has been dormant and that has been overrun by a distinct trend towards more integrated capital and markets and goods market, whether we're back peddling, whether we're reversing some of that. Reversals in globalization are not new. We had a golden era of globalization in the late 1800s and World War I and the Great Depression. Then the setbacks and the return to [inaudible 01:05:29]. I'm not suggesting anything that dramatic, but the events that we're having, I think do impact those long cycles in globalization.

Babak Abbaszadeh:

Yeah. Thank you. That's critical. Ceyla, I'm going to go to you on a couple of questions that I want to make a hybrid. I see a couple of comments on, again, going back to debt, forgiving debt of developing countries. And they're trying to do all of this. Is there any discussion at all happening at the global stage about forgiving debt? And there are precedence’s where debt of some countries in Latin American and elsewhere was forgiven. Are we anywhere there now? Or is this still a very far out discussion? And is that actually a good thing, bad thing? I mean, any views you have would be very helpful for us.

Ceyla Pazarbasioglu:

So we did have a Debt Service Suspension Initiative right after the pandemic, right in March. This was actually a call by the IMF and the World Bank and the president and the managing director at the time. And the G20 actually established it. This was for the poorest countries, the World Banks IDA countries, 73 of them. And the Debt Service Suspension Initiative was basically due to the pandemic to give the space to countries that are the poorest to be able to deal with the pandemic rather than trying to make their debt service payments. And that was a G20 initiative. Not every country applied for it, that was eligible, but there were about 44 countries and there's all sorts of reports at IMF and the World Bank website that provides information on what happened in the context of the DSSI.

What then was discussed at the G20 and established was the common framework for debt treatments, which is basically the problem with the DSSI was that the private sector, it wasn't mandatory for the private sector, and they didn't volunteer, obviously. So you had official sector providing debt service relief, whereas private sector exposures remain the same. And I think that's what is in the back of everyone's mind with any other initiative that may be necessary.

Right now, I think there is the common framework. There are other ways of dealing with the increase in debt, but if there was a need for another debt initiative, I think it's going to be very important to think through the role of the private sector because no official creditor wants to participate in any debt relief effort when the private sector is not included. So I think that's going to be very critical as we think about these issues.

My concern is we have very large increase in debt, financial conditions tightening globally, and this is a very difficult period for capital flows to emerging markets and developing economies. So reverse of what we saw since the GFC, and we also have slow down in China, which will mean China was one of the largest creditors to many countries, which also means retractions of China from most of the low income and emerging market countries. So all this coming together to provide a credit crunch to many of the countries. And I think that's also in the context of fragmentation that Carmen also just talked about, right?

We all agree that we learned during the pandemic that supply chain needs to be more resilient, have more diversification, but we are moving towards the other extreme of quote-unquote all sorts of different types of alignment among different countries, which will fragment trade, which will fragment financial growth. And I think that's highly worrisome in the context of high debt and difficult conditions in many countries and food and energy price increases, which puts them in a very difficult place.

Babak Abbaszadeh:

Thank you. And I can't resist, but just a quick food plug for Canada. So I know everyone talks about Ukraine and Russia as amongst the largest exporters of grain and food and Canada is one too. So hopefully countries can access that. But I also understand that trade flows are not one that one can replace the other. It's very complicated, but anyway...

Kuben, there's a bunch of questions on central bank independence. Let me try to abstract them all. So especially in relation to emerging market countries, is it a question of balancing the different and conflicting objectives of central bank between inflation, inclusive growth and social development? Or is this straight about political interference? I recognize a sensitive question. So you don't necessarily need to comment on South Africa, but in general, when people talk about central bank independence, what are they trying to advocate? Thank you.

Kuben Naidoo:

Babak, we've chosen a set of institutions, and there's no perfect model. I'm not arguing that one model is better than the other, but the set of institutions that we've chosen is that we give fiscal policy to government, elected officials, right? If you don't have an independent central bank, you go back to an era where nobody wants to deal with the problem of procyclicality in an economy.

It is always the incentive for politicians to deliver goods today with tomorrow's money, and I understand this. I mean, I've worked in the public sector. You want to deliver goods today with tomorrow's money, right? I'm going to be voted in today. In the next three to five years, I may be voted out, and I'm going to use tomorrow's money to deliver goods today. Who's going to discipline you?

And that's the unfortunate job of the central bank is to play that disciplinary role. It says, "Okay, if you got to borrow from tomorrow for today's benefits, there are limits. There's a price you got to pay, and we are going to set that price." And if you take central bank independence away, that institution collapses, then there's no limits. Right? I think that sort of liberal democracies with fiscal autonomy need central bank independence in the medium to long run. Without it, I don't see those institutions holding together. They'll collapse.

And so I also want to make the point that I fully understand that central bank independence is never permanent. It's never absolute. It depends on public trust, right? It depends on our ability to communicate to the public. It depends on the broad social compact. And, again, to reassert the social compact that the central bank must be humble enough to know what we have the ability to do and what we don't have the ability to do. I can't fix the potholes in the road. I can't solve age seven literacy. I'm incapable of doing that. If there's a water leak down my road, as a central bank, I'm incapable of solving that problem.

We've got power shortages in South Africa. The central bank is incapable of helping, right? We must stick to our knitting, right? We must stick to what we've been given the responsibility. We've been given the price stability responsibility, and a financial stability responsibility in law. Stick to that. There are other economic actors, economic participants, economic members of the team.

I like to use the football analogy or to use the American word, the soccer analogy. Central banks are goalkeepers. We're the last line of defense. We can prevent collapse, but we can't score goals. We are incapable of scoring goals. Scoring goals is where you create the jobs. We're incapable of doing that on a permanent basis. Right? And so shouting at the goalkeeper because your team is not scoring goals is not going to help. Firing the goalkeeper or reducing his room or degrees of freedom is not going to help. It's not going to help the team. And I think it also requires central bankers to be a bit humble that we don't have the ability to score goals, certainly not sustainably.

Babak Abbaszadeh:

Well, Kuben, we will cheer for central bankers, remembering South Africa's World Cup and Buzelis and hopefully everyone will fall in line. And, Carmen, the last question goes to you. Super complicated question so you're going to hate me for asking it, but how long will this recession last? So, the fear sometimes we have is by the time governments actually call the recessions, two quarters have gone, GDP growth is negative, and then we're out of it. Is this one of those, or is this going to last a long time because of some of the fragmentation and global architectural cracks that you've identified? Thank you.

Carmen Reinhart:

So last how long for whom? This is not a one size fits all response. And I think when Paul Volcker in October of '79, between October of '79 and March of 1980 raised interest rates by 600 basis points almost. We actually didn't have one recession in the US. We had two. But really that defining division between the two was really thin and shallow. So that was at that time the worst recession, since World War II.

Are we going to have a short, shallow recession? I think, for many countries, let me start with the developing, that seems to me improbable because of some of the reasons also that we have been discussing. That there are debt challenges that there are challenges relating to high inflation, which require tighter monetary policy. Therefore no stimulus from the monetary policy side. There's limited fiscal space. So there's unlikely to be stimulus from the fiscal side.

Somebody else earlier also posed the question on how do you reduce debt? Well, one of the ways you reduce debt also is by belt tightening, which is never pleasant, easy and often recessionary. So for many developing countries, I think, again, this is not a cookie cutter because fiscal positions incredibly and credibility, initial conditions are very different. Some of the things I'm saying are very hybrid.

For the advanced economies, I think Europe is maybe in for a longer haul than the US, because their dependence on Russian oil and Russian energy is something that you don't get rid of at the drop of a hat. So, I don't want to be wishy washy, but the idea that this is going to fit into a tidy mold where there is short, medium or long... We're facing a very different set of initial conditions, which influence resilience.

Babak Abbaszadeh:

Thank you very much, Carmen, especially for those frank comments at the end, which I think is going to be a good way to wrap things up. I really appreciate every one of you. Just by the interest that we saw from the audience, this was a very dynamic conversation. I apologize to the audience for leaving some questions on the table, but we will have them. We will deal with them in one way or another through additional conversations or our courses at Toronto Centre. As a moderator, I apologize that I failed you by two minutes, but this conversation was captivating, and you all have our gratitude. Thank you and have a pleasant day or evening wherever you are. Take care. Bye-bye.