Capital Markets in a Global Economy--Recent Developments, Remarks by Rodrigo de Rato, Managing Director, IMF
April 1, 2005
Remarks by Rodrigo de Rato
Managing Director of the International Monetary Fund
at the Institute of International Finance Spring Membership Meeting
Madrid, Spain, April 1, 2005
As Prepared for Delivery
Good morning. Thank you for inviting me. Global finance today is dominated by private capital flows, and private actors like your institutions play a critical role in the international financial system. I am therefore very pleased to be here today, as part of the continuous dialogue between the IMF and financial markets.
Given the IIF's membership and mission, I thought I would focus my remarks on capital market developments and related issues, including the relationship between private and official actors in the international financial system. I shall address those themes against the backdrop of current conditions and the outlook for the world economy.
The Global Outlook
Having grown by over 5 percent in 2004, the global economy is projected to continue expanding in 2005. Healthy corporate balance sheets, accommodative macroeconomic policies, and favorable financial market conditions are all helping to sustain the expansion.
Inflation remains reasonably subdued so far - the second-round effects of higher oil prices have not been significant. With monetary tightening underway in most cyclically advanced countries, inflation expectations are generally well-anchored. In addition to further increases in oil prices, however, one risk to this outlook in some countries is a significant rebound in unit labor costs as labor markets tighten, especially if productivity growth were to weaken. Further, strong foreign exchange inflows pose a challenge for monetary policy in some emerging markets - notably in Asia and the Commonwealth of Independent States. Without more exchange rate flexibility, these inflows will ultimately be monetized and result in higher inflation.
The behavior of interest rates is a central issue in the current economic outlook. The current low level of long-term interest rates is contributing to a very favorable global financial environment. Despite the increase in recent weeks, interest rates remain low for this stage of the business cycle, and both corporate and emerging market spreads are near their historical lows. While the low level of long-term rates can be partly explained by a number of factors - including the confidence of financial markets in central banks' commitment to low inflation, excess capacity in labor and product markets, and continued strong demand for U.S. Treasury securities by the official sector, especially in Asia - rates can be expected to rise to more neutral levels, and spreads to increase, as the global economic upswing continues. A major concern is that the rise not be so abrupt as to cause disruptions in financial markets, or impact the overall global economic outlook.
A downward bias remains on short-term risks. On the upside, strong corporate balance sheets and wealth effects from rising equity markets could lead to stronger than expected domestic demand. On the downside, the key risks include further exchange rate volatility, faster than expected rises in interest rates (for example, if triggered by inflationary pressures), and extended weakness in the euro area and Japan. Moreover, oil prices have recently risen above their October peaks and continue to be volatile. With excess capacity very low, the oil market remains highly susceptible to shocks
Divergences in regional growth rates have also widened, and global imbalances worsened, in the past few months. Growth forecasts have been revised upwards for the United States, China, and most other emerging economies. In the euro area and Japan, however, growth projections for 2005 have been marked down significantly, reflecting both faltering exports and weak final domestic demand. The U.S. current account deficit has continued to widen, to over 6 percent of GDP by the end of 2004. And it is expected to remain high in the coming years.
The continuing build-up of the large current account deficit in the United States, with counterpart surpluses and reserve accumulation concentrated mainly in emerging Asia, is a key concern. It is also a main source for many of the risks facing the global financial system, which I shall come to shortly. Solving this global imbalance problem should be an urgent priority. The steps that must be taken by the relevant players are well-known by now, but nevertheless deserve repeating. They are:
• Medium-term fiscal consolidation in the United States;
• Structural reform in Europe and Japan to increase economic growth, particularly labor market reform; and
• Greater exchange rate flexibility in China and emerging Asia.
Prospects for International Financial Markets
Against this background of an expanding world economy, global capital markets are expected to see solid, if slowing, earnings growth. As noted earlier, there is limited inflationary pressure, balance sheets of the corporate, financial and household sectors continue to strengthen in many countries, and the credit quality of emerging market borrowers continues to improve. Combined, these favorable fundamentals support financial market stability. Let me go into more detail.
The overall excellent profitability of the corporate and financial sectors over the past few years has been an important factor in the strengthening of their balance sheets. The ratio of liquid assets to debt has risen and stayed at a relatively high level for some time now. So far, this preference for liquidity reflects the caution of corporate executives in making investments. This has contributed to the slow growth in employment in many countries. By the same token, this cautious attitude has helped to contain the risk of creating investment excesses in the recovery phase that, in the past, have contributed to sharp market corrections.
At the same time as financial institutions have improved their profitability, they have also strengthened their capital bases and risk management systems. In particular, solvency ratios in the insurance sectors of many countries have been improved. These developments have made financial institutions more "weather-proofed" against potential future shocks. All in all, there has been significant improvement in the health of the financial system up to the early part of 2005.
Amidst these positive developments, market volatility, mature government bond yields, and global credit spreads have remained low. Looking ahead, while there is little reason to believe that this benign scenario will end in the near future, the resilience of the global financial system could be tested by a number of factors.
First, there remains a risk for disturbances in the currency markets. Currency adjustments to address the growing global imbalances have so far been orderly. Portfolio inflows, largely destined for U.S. bond markets and originating increasingly from the official sector - especially in Asia - have facilitated an orderly decline of the dollar. However, such flows cannot be counted on indefinitely. A sharp reduction in such inflows, or a reversal, could entail serious consequences for currency and capital markets. Witness, for example, the recent episodes of market reaction to information and official statements on the diversification of central banks' international reserves.
Second, low short-term interest rates are encouraging investors to move out along the risk spectrum in their search for absolute or relative value. The search for yield has contributed to the compression of inflation and credit risk premiums and encouraged the rapid growth of structured products, including credit derivatives. The combination of compressed risk premiums, and the rapid growth of complex and leveraged instruments that lack transparency, is a potential source of vulnerability that merits attention. There is little cushion for bad news regarding asset valuations if expectations for continued favorable fundamentals change.
Third, expectations that U.S. monetary policy will be tightened gradually have provided a firm anchor for financial markets so far. A continued measured withdrawal of stimulus remains appropriate, and will likely contribute to continued financial stability. However, a larger than expected spike in U.S. interest rates, resulting from inflationary pressure or a sharp reduction of foreign portfolio inflows into U.S. fixed income markets, could bring about market corrections.
Fourth, financial risk-taking, encouraged by a prolonged period of abundant liquidity, may have created very high valuations. As a result, volatility may have been pushed to very low levels across a wide range of markets. Past tightening cycles have revealed hidden vulnerabilities as the incentive to reach for yield was withdrawn. In some cases, emerging markets have experienced turbulence in the wake of tightening monetary conditions.
Fifth, emerging economies have enjoyed an exceptionally favorable economic and financing environment throughout 2004 and early 2005. Solid global growth has boosted export demand and commodity prices. Interest rates and credit spreads have remained low. With liquidity abundant, investor appetite for new issues from emerging market borrowers has been quite healthy, permitting a high level of issuance at low cost. However, as in the credit markets of mature economies, the factors contributing to low interest rates and low spreads may have peaked, and less easy financing conditions are to be expected. Underlying interest rates are set to rise, and credit spreads are more likely to widen than narrow. Of course, a widening of spreads could have the salutary effect that investors better discriminate among emerging markets according to their respective fundamentals.
It is therefore appropriate that, in response to the string of emerging market crises during the second half of the 1990's, a number of countries have strengthened efforts to develop local securities and derivatives markets. As a result, some local markets have begun to provide alternative sources of funding. These will prove particularly useful when the local banking system experiences difficulties, or when access to international capital markets is curtailed. The development of these markets is already paying off in some countries, attracting international investors searching for higher yields and diversification opportunities.
Crucially, the existence of mature local financial markets and institutions is a fundamental pre-requisite for the opening of a country's capital account, which is a complex process. Country experiences, especially from the 1990's, show that the proper sequencing of measures, and coordination with other macroeconomic policies, are key for successful capital account opening. In addition to having local financial markets and institutions of a minimum degree of maturity, a country should also, before considering liberalization, first achieve macroeconomic stability, and have in place a comprehensive and effective prudential regulation framework. These factors have long been part of the IMF's advice to its members, and we will continue to seek ways to support the orderly liberalization of capital markets.
Revisiting The Relationship between Markets and Actors
That then, is a sketch of the outlook for global financial markets. The IMF continues to monitor capital market developments closely, since we are keenly aware of the role international capital markets play in ensuring financial stability. The world economy is becoming ever-more integrated and financially globalized. With private capital flows having long ago overtaken official lending as the main source of financing for many emerging market countries, it is critical that we understand the forces that drive global asset allocation.
The analysis of capital market developments, and their implications on our members' policies and on international financial stability, is therefore an important part of the IMF's work. To be effective, such analysis needs to be founded on strong and open channels of communication between the IMF and financial markets. IMF staff continue to reach out to market participants, in major international financial centers as well as in the local markets of our member countries. Initiatives like the Capital Markets Consultative Group - or "CMCG," a grouping of capital markets participants established to provide feedback to the IMF - have been invaluable in helping deepen our understanding and analysis of market developments. I was in Shanghai two weeks ago for the most recent CMCG meeting, and was very encouraged by the quality of discussion and interaction between IMF staff and CMCG members.
The relationship between the IMF and market participants aside, communication between countries and market participants can also be very useful. To this end, we encourage emerging economies to establish investor relations programs. These programs can serve not only as a channel for transmitting data and information from countries to investors, but also as a vehicle for open two-way communication.
Efforts to strengthen crisis prevention and resolution have also benefited from increasing interaction between the public sector, international organizations, and the private sector. A welcome development here is the adoption of collective action clauses, or "CAC's." CAC's have traditionally been a standard feature of bonds issued under English and Japanese law. Over the last two years, they have increasingly become standard for bonds issued under New York law as well. As of end-February 2005, over 45 percent of sovereign bond issues in international markets contained CAC's. This increasing use of CAC's is contributing to fill an important gap in the international financial architecture.
Another positive step in crisis prevention and resolution is the development of the "Principles for Capital Flows and for Debt Restructuring in Emerging Market Countries." These Principles aim to establish a market-based, voluntary, and flexible framework for enhanced creditor-debtor cooperation, both at times of relative tranquility and in the context of crisis resolution. The Principles have yet to be tested in a crisis situation. However, it is noteworthy that they were forged through agreement between official and private sector representatives, and have benefited from discussions between IIF market participants and several emerging market countries. At the minimum, the Principles could help guide expectations about the conduct of debtors and creditors when seeking to overcome unsustainable debt.
Finally in the context of crisis avoidance and resolution, let me offer a few remarks on Argentina. The roots of the crisis are manifold and it is important that we learn from this difficult and unfortunate experience. The IMF, most notably through the report of our Independent Evaluation Office, has carefully assessed the role it played and is already internalizing important policy lessons related to our own activities. The Argentine authorities have recognized that past inconsistent policies contributed to the build-up of external debt. I would suggest that it is also important for the international financial sector itself to analyze the role it played in facilitating over-borrowing, and the placement of an important part of the debt in the hands of relatively unsophisticated retail investors.
As you know, progress in the debt restructuring process has been a key consideration in the IMF's engagement with Buenos Aires, especially in the context of our lending into arrears policy. The recent debt exchange achieved participation of about 76 percent, which clearly is an important step. However, it will be in the interests of Argentina as well as the international community for the authorities now to formulate a realistic strategy to address the issue of remaining arrears.
The world of international finance is an essential source of innovation and opportunity. In the 60 years since the IMF was established, the growth of private international capital flows has given rise to new possibilities for investment and growth, as well as new risks. The IMF contributes to sustained growth in the global economy by safeguarding financial stability, in member countries and in the system as a whole, and by promoting open economies. That objective is as relevant today as it was when first drafted into our Articles of Agreement. The challenge now, and for the future, is to ensure that the IMF's instruments, policies, and procedures continue to evolve as necessary to meet this key objective.
In response to that challenge, I have initiated an internal review of the IMF's strategic direction. The review is still in its initial stages, and I expect there will be a significant amount of discussion and consultation before consensus emerges on the outcomes. However, it is important that we consider all the questions - including awkward ones that may come from our critics and the public - even though we may not have the answers.
For instance, given countries' access to today's advanced international capital markets, what should be the role of IMF financing? Related to that, do we have the policies and instruments we need for the prevention of capital account crises and the orderly resolution of sovereign debt problems? What are the best ways to deepen the IMF's role in anticipating sources of financial instability in global capital markets, and generating cooperative action to address them? How can the IMF best contribute to the fight against world poverty? And on internal governance, what are the implications of international developments in democracy, transparency, and accountability on the IMF's own governance structure?
Notwithstanding any new issues that may emerge, there is a sense that the IMF's main priority over the medium-term should be to ensure that its surveillance process is effective, especially in encouraging all IMF members to adopt policies and reforms that support stability and sustained growth. In that regard, more focus may need to be directed at surveillance at the regional level, given increasing regional economic integration worldwide. Careful attention will also be needed on systemically important countries and issues, and the possible spillover or contagion effects of developments in those areas.
These and other issues will be explored and discussed intensively in the months ahead. In fact, the current relatively strong outlook for the global economic and financial system offers a good opportunity for this process of reflection. I therefore look forward to the contributions of market participants like yourselves to the debate and dialogue that will ensue.