Global fix for global problem

Global fix for global problem | The Australian

My seven-point plan will solve the crisis, contends Kevin Rudd | March 06, 2009
Article from: The Australian

AS the global economic recession increasingly weighs on the Australian economy, the prospects for recovery hinge on the success of efforts to deal with the problems that caused the global financial crisis.

That is why it is so critical for Australia, as for other economies, that the world's leading economies agree to implement a clear plan of action to cleanse the global financial system of the trillions of dollars of toxic assets that are stopping credit flows and driving the world into recession.

The global private credit process is not working because bank balance sheets in the US and Europe are weighed down with toxic assets: loans and securities infected by bad sub-prime lending. These toxic assets have become a poison in the bloodstream of the global financial system. While US and European banks have regulatory capital of about $US3.4 trillion ($5.2trillion), estimates of the potential losses from these toxic loans and securities range from $US2.2 trillion to as high as $US3.6 trillion, and as the global recession creates even more non-performing loans, these numbers could go higher.

Without new capital, writing off these bad loans would result in the US and European banking systems breaching capital adequacy, with some institutions being left insolvent. The International Monetary Fund has estimated that the net capital shortfall in US and European financial institutions is likely to be at least $500 billion. Some market estimates say the shortfall could be as much as $1 trillion.

Australian banks have very little exposure to toxic assets, and that is one of the reasons they are among the best performing banks in the world today. But Australia is closely integrated with the global economy and the global financial system. Many of our businesses sell goods overseas and rely on finance from overseas to invest and grow. The crisis in global credit markets has direct impacts for Australian banks, Australian businesses and Australian households.

If the flow of global credit is restricted to Australia because of the impact of toxic assets on the major banks' global balance sheets, then it becomes harder for banks to lend money and, as a result, business investment and consumer spending get choked off. This creates a vicious cycle: as the economy slows, unemployment rises and household incomes fall. As household incomes fall, demand falls further and business investment is further reduced.

We need to break the vicious cycle caused by the build-up of toxic assets in the global financial system. That is why the Group of 20 Leaders Summit on April 2 in London is so important. It represents the best opportunity to reach agreement on a global strategy to cleanse banks of toxic assets. Australia has been working intensively on this strategy with other G20 members. This is the central element of a wider strategy to strengthen the regulatory framework for the financial system and move towards economic recovery. So what does this mean in substance?

Australia is actively pressing for a seven-part strategy to cleanse balance sheets of toxic assets.

First, all weak and all systemically significant financial institutions should be subject to a stress test. The public and governments need to know with confidence that the assets on bank balance sheets are sound. There should be no more surprises.

Second, all non-viable banks must be closed or nationalised. Keeping insolvent banks alive is itself systemically damaging.

Third, toxic assets on bank balance sheets must be neutralised. This can be achieved by the creation of a "bad bank" or through an insurance mechanism. This needs to be done quickly and comprehensively, and may require compulsion.

Fourth, the prices of bad assets should be derived from a transparent and simple formula that is consistent across jurisdictions.

Fifth, it is essential that the public and private sectors, and international financial institutions, work closely together. If governments go down the route of nationalisation, it should be temporary. Nevertheless, the details of a future resale to private buyers do not need to be addressed now.

Sixth, a critical element of the stress test must be to recapitalise banks, so they have the capital they need to lend and reopen the arteries of credit.

Seventh, once banks have been adequately capitalised, they must formally agree to maintain regulated levels of lending in return for government support through sovereign guarantees on deposits and/or interbank lending.

We are in a global economic emergency. We have seen the sharpest synchronised downturn in the global economy in our lifetimes, and Australia has not been immune from that.

Australians know we are coping with this downturn better than other countries, but our medium-term prospects depend on global efforts to deal with the cause of this emergency. That is why a strong co-ordinated response to the toxic assets crisis is so important, and that is why Australia will press so strongly for a clear plan of action in London next month.