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International financial situation letter from M. Nicolas SARKOZY, President of the Republic, to Mrs Angela MERKEL, Chancellor of Germany

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Wolfeboro, 15 August 2007

Madam Chancellor, Dear Angela,

The events that are currently affecting world financial markets are of common interest to the group of G7 countries whose presidency you hold this year. These market corrections are leading the competent authorities in each of our countries to very closely monitor developments in the situation. Central banks in particular have intervened to provide liquidity when necessary. I am pleased that financial regulators and monetary authorities are coordinating their efforts.

I am convinced that these market movements will not affect the long-term growth of our economies, which is robust. Nevertheless, while remaining extremely attentive to changes in the situation, I believe it is our responsibility as heads of State and government to draw the consequences and lessons of events affecting the markets. Indeed, it is essential for us to ensure the transparency of market functioning and the latter's ability to finance the world economy in an effective and stable manner.

Significant work has already been done in this area. Financial institutions, notably the International Monetary Fund and the Financial Stability Forum, have noted the solidity of economic fundamentals and useful market innovations that have taken place. However, for several months they have been highlighting the very low level of risk pricing, particularly in American mortgage credit markets. They are also warning against the overly weak risk differentiation in market prices.

To take this work further and provide a widely awaited answer to the developments seen in recent days, it is my view that we must first ensure the transparency of international markets. That is the principal instrument of regulation on which we can rely. It allows us to move forward while pursuing our shared objectives of global growth.

Thus we see that securization operations, which were very dynamic in recent years, certainly contributed to financing the expansion of our economies but at the same time transferred bank risks to a very large number of economic players. It is clear to all that the final bearers of these risks are very poorly identified today, and that this ignorance is in itself a factor of instability. It can generate doubt, often wrongly, with respect to the financial situation of economic players with no direct relationship to the initial risk. It would therefore be useful to ensure that market players and supervisors have the means they need in order to have a better awareness of the risks to which they are actually exposed.

Likewise, we must consider the exact role to be played by rating agencies in risk mapping. Indeed, it is up to them to assess the solidity of the products resulting in credit risk transfers. Their role, combining the development of these products and the notation of these risks, should be carefully examined. That examination must also extend to the role and responsibility of banks in the proper functioning of credit markets.

Finally, given the very broad dispersion of risks in investor networks, we must ensure the effectiveness of our warning systems and the effective diffusion of liquidity to all economic players that may be confronted with sudden movements affecting credit markets: we must be able to prevent an unjustified contagion of local tensions to the real economy.

Naturally the main lines for progress that I am sketching out here should not lead us to institute measures that may rigidify the financing of our economies and rein in world growth. Rather I suggest that we expand our knowledge of the functioning of international markets and the collective vigilance demanded by their expansion and importance.

In view of my analysis, which I would like to share with you and with our other G7 colleagues, to whom I am sending a copy of this letter, I propose that we ask our finance ministers to examine these challenges in the coming weeks, in liaison with our central banks, the Financial Stability Forum and the IMF. To this end, they could submit us their analysis and proposals during the October meeting in Washington.

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