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Speaking Notes on the Global Financial Stability Report Press Conference at the Bank of England|
Counsellor and Director of the International Capital Markets Department of the International Monetary Fund
London, April 5, 2005
Good morning, ladies and gentlemen.
My name is Gerd Häusler, Counsellor and Director of the International Capital Markets Department of the IMF. To my right is Hung Tran, Deputy Director of the Department. We are here to conduct a press briefing on our upcoming Global Financial Stability Report (GFSR)—the third time we have done so in London. Again, we would like to thank the Bank of England for hosting us today.
Before opening the floor for your questions, I would like to make a few brief remarks highlighting the main themes of the report. Copies of my remarks are available.
2. In our view, the resilience of the global financial system has further improved in the past six months, contributing to and benefiting from the benign financial market conditions. However, while the financial system appears very strong, the downside risks have also become more visible. This assessment is neither excessively optimistic, nor alarmist.
3. Let me go into more detail.
4. Such a positive assessment naturally refers to the financial system as a whole, and does not exclude the possibility that individual firms or sovereign borrowers may encounter difficulties. Indeed, I personally think that individual credit events—if they were to occur—would not necessarily have a systemic impact. They could even have a salutary effect in raising the awareness of risk, and helping to reduce "overconfidence."
5. For us to change—or downgrade—our assessment of financial stability, the global economy has to fall into a prolonged recession, leading to a substantial deterioration in credit quality of corporate and sovereign borrowers, and significantly eroding the capital base of banks and other major financial institutions. At present, this is a rather remote possibility. As such, the risks to financial markets—which I will turn to next—have to be considered in the context of a healthy financial system that is in a good position to deal with them.
6. At a time when the financial sector is in a solid shape, risks are—by definition—more on the downside. Recent market developments have supported—and even confirmed—our assessment of risks. Let me discuss a few important points.
My most serious concern is not a single event described below but rather a confluence of several of them:
7. At the moment, the key risk is that long-term market rates and credit spreads may rise beyond current expectations. Currently and until this very day, long-term interest rates are considered low by most market participants and observers. We present our analysis of the reasons for this phenomenon in Chapter II: plentiful global liquidity, a benign long-term growth and inflationary outlook, and demand for long-term bonds by many institutional investors such as pension funds and life insurance companies around the world. I can elaborate on these later if you like. For now, let me just point out one aspect: we should not underestimate the power of the search for yield, driven by global liquidity. Institutional investors are measured against market indices and the performance of their peers. If everyone else searches for yield, it would be very difficult for an investor to behave differently. In other words, investors are suffering from a kind of "collective action problem." No less an authority on investment than Warren Buffett has felt the heat as his 2004 performance was "lackluster," because he stayed too much in cash. At this late stage in the search for yield, instead of simple "carry trades," we see an increase in the financing by banks and other investors of leveraged buy-outs and other merger and acquisition deals, as well as the growth of complex financial products with embedded leverage.
8. A pronounced rise in long-term bond yields could be triggered either by market reactions to signs of a disorderly adjustment of global imbalances, or by an unanticipated increase in inflation. So far, there is no visible sign of a decline in capital flows to the U.S. Nevertheless, market participants have been quite sensitive to any sign of international investors diversifying their existing, or additional financial holdings away from the dollar. In its latest quarterly report, the BIS presented a tangible piece of evidence: Asian banks reduced the share of the dollar in their international bank deposits from 81 percent in September 2001 to 67 percent in September 2004 (even though their dollar deposits rose in absolute terms—suggesting that the currency shift happened at the margins of these banks' holdings). Market participants have also scrutinized statements from Asian central banks and other officials in order to decipher their intentions regarding reserve asset diversification. Any serious doubts about the willingness of central banks to accumulate dollars could be an incentive for investors, both private and possibly public, to reduce dollar purchases. However, it is hard to pinpoint a "tipping point" when investors might be inclined to front-run a perceived reaction by others.
9. The low bond yields reflect a low premium being attached to inflation risk. As such, bond markets remain vulnerable to an unanticipated rise in inflation. This scenario was driven home in a vivid manner two weeks ago, when 10-year U.S. treasury yields rose abruptly to 4.53 percent, the highest level since last August, following the rise of the Reuter-CRB commodity price index to a fourteen-year high. The rise in U.S. yields was repeated again last week after the U.S. Fed raised its fed funds rate by one-quarter percentage point to 2.75% and observed in its statement that inflation pressure had picked up in recent months, with pricing power becoming more evident. Until now, the rise in commodity prices and the weakening of the dollar have not fed through to consumer inflation in the U.S. One of the main reasons cited by many observers is that corporations, including exporters to the U.S., have been willing to absorb higher material or foreign exchange conversion costs in their profit margin. It is at least unclear how far that process can go before exporters will have to raise prices; the answer may vary from country to country.
10. The very low credit spreads for corporate and EM sovereign borrowers are also vulnerable to corrections. I will come back to the financing outlook for emerging markets later, and focus on corporate bond spreads for the moment. Corporate credit spreads in the U.S., Europe and elsewhere, have fallen to near record lows, driven by a significant improvement in corporate balance sheets, a decline of corporate default rates to record lows, and again, the liquidity-led search for yield. Our concerns about the "collective action problem" caused by global liquidity are shared by many risk managers to whom we have talked. For corporate borrowers and investors, things have been as good as they could be—and therefore are likely to deteriorate going forward. In particular, the credit cycle may have turned. Moody's has reported that the global rate of default for speculative-grade debt rose to 2.5 percent in February after reaching a low of 2.3 percent in January (it is still below the historical annual average rate of 4.9 percent). Against this background, individual credit events could spark a spread widening, especially in the high-yield corporate sector.
11. I have presented to you the possible triggers for rising bond yields and other asset price losses. The price losses could then be amplified by potential liquidity issues. The liquidity risk is particularly acute in all areas with "narrow markets," but particularly relevant in the area of complex and leveraged financial products, including credit derivatives and structured products such as collateralized debt obligations (CDOs). The pricing and trading of many of these complex products depends to a large extent on models that may be constructed too similarly from institution to institution. If market conditions turn negative, many investors in these products could rush to exit at the same time, causing market liquidity shortages that could amplify price movements. A related development that could also contribute to potentially disorderly market conditions during a sell-off is the fact that many credit derivatives transactions remain unconfirmed for months, according to a recent report by the U.K. Financial Services Authority. Furthermore, elements of risk management systems designed to deal with these complex products have not been through a live test, particularly to see if in time of need, counterparties stand ready to absorb the additional market and credit risks from those who would like to shed them. This has become more relevant as the recent trend of consolidation in the financial sector has reduced the number of large intermediaries in many markets, including derivatives markets.
12. What then are the measures required to mitigate the risks I described? To be perfectly clear, I want to emphasize that the financial strength of major private international financial institutions is the first line of defense against financial risks. At present, these institutions are financially strong, and therefore in a good position to deal with the above-mentioned risks. Nevertheless, senior management of these institutions and their supervisors should ensure that risk management practices are strictly implemented. In particular, counterparty credit standards should not be relaxed due to competitive pressure. There seems to be anecdotal evidence that major banks may have relaxed their credit standards in the race to acquire hedge funds as their prime brokerage clients. More generally, issues of management discipline and control could become challenging due to the growing complexity of large and complex financial institutions (LCFIs). These issues are increasingly receiving attention at international fora of supervisors and regulators, which I fully endorse.
13. On a macroeconomic level, the authorities can help maintain market confidence by taking credible policy measures to facilitate an orderly adjustment of global imbalances. As articulated by the IMF on numerous occasions, such measures include increasing national savings in the U.S., implementing reforms and fostering growth in the euro area and Japan, and carrying out financial sector reforms and allowing more currency flexibility in many Asian countries.
14. By the same token, central banks need to ensure that inflationary expectations remain under control. As long as that is the case, they may very well continue to gradually raise policy rates to a neutral level. This will make it less compelling for market participants to engage in carry trades and other forms of leveraging. This in turn can help avoid a sudden reversal of risk appetite among financial intermediaries and investors, which has at times proven to be destabilizing.
15. Before coming to emerging markets, I would like to say a few words on Chapter III on the household sector. As explained in the GFSR, the household chapter is the last in a series of three chapters examining the transfer of risk from the banking sector to non-banking sectors such as insurance companies, pension funds and ultimately, households. The shift of risk to the household sector has happened gradually over time, following changes in the behavior of financial institutions and the process of pension reform, as well as the behavior of households. Let me make clear that in this chapter, we aim to assess the changes in the risk profile of households, and not try to evaluate pension systems or pension reforms in different countries. While households have always been the final stakeholders of the financial system, the changes described in Chapter III show that households are taking more direct responsibility for their financial affairs, especially to provide for an increasing part of their retirement income. Thus, households have become more directly exposed to market and longevity risks. But to some degree, this is a pendulum swinging back from "wholesale insurance," which was introduced only in the 20th Century. Consequently, households need to understand the financial responsibility they have to shoulder, and have ready access to information—including unbiased and quality advice—about investment and saving options, as well as suitable products to manage their risks. Gradually over time, this process will have a major impact on household behavior and financial markets. Overall, the key message coming out of the three chapter series is that the transfer of risk from the banking sector to the nonbanking sectors appears to have enhanced the resilience and stability of the financial system—mainly by widely dispersing financial risk, including throughout the household sector. When I coined the phrase, the "household as shock absorber of last resort," I meant it in a purely factual way. Policymakers now need to take the next logical step by helping households to improve their financial education and obtain quality advice and products to manage their financial affairs. At present, there are a number of initiatives on this front, including those sponsored by the OECD and by several national authorities.
16. Emerging market countries have enjoyed favorable financing conditions over the past two years, benefiting from improvements in their economic fundamentals and abundant global liquidity. There seems to be a gradual transformation of the emerging market asset class, driven by a steady improvement in its quality and the ten-year track record of good risk-adjusted returns. Let me elaborate on these points.
17. In terms of quality, more than half of the EMBIG index—in terms of outstanding volume—now carries an investment grade or better, and there are more credit upgrades in the pipeline. While abundant global liquidity has helped the asset class, the credit upgrades reflect improvements in economic fundamentals in emerging market countries, including a reduction in external borrowing requirements. These fundamental improvements should eventually allow different emerging market countries to be assessed on their own merit, and less affected by the "knee-jerk" contagions we witnessed in the late 1990s and early 2000s. Naturally, if there is a general reduction of investors' risk appetite, many asset classes will be impacted, but this differs from a situation where a credit event in one emerging market country automatically leads to price losses on other emerging market debt.
18. In terms of performance, the asset class has accumulated a long enough track record (of at least ten years) to allow institutional investors and their consultants to analyze its long term performance. The asset class comes out very well: offering one of the top risk-adjusted returns (despite all the crises) and low correlations to other asset classes. As a result, many pension funds have made a strategic allocation to emerging bond markets. Indeed, an estimated $12 billion of pension money was channeled into emerging bond markets in 2004, and an equivalent amount is estimated for this year. It is important to realize that these are strategic allocations by pension funds—long-term investors—to add an attractive asset class with significant diversification benefits to their portfolios. As such, the growing involvement of pension funds in emerging bond markets should bring a measure of stability to the asset class.
19. After emerging market sovereign bonds, the corporate sector has become the next segment of investor interest, as we have highlighted. Indeed, corporates accounted for 60 percent of emerging market international bond issuance in 2004, the third year in a row that corporate issuance exceeded that of sovereigns. Again, international investor interest has been driven by the search for yield and the improvement in corporate balance sheets in many countries. Partly as a result of international bond issuance, corporates in many emerging market countries continue to face considerable currency mismatches on their balance sheets—as we highlighted in Chapter IV. These corporates also have maturity mismatches as well.
20. Furthermore, international interest in local currency emerging market bonds has also grown, whether issued globally as in the case of Colombia, or issued domestically as in the case of other countries. In fact, international investors have bought a significant portion of recent long-term, local currency government bonds issued in some countries, such as Mexico. As we mentioned in the GFSR, local currency bonds of selected investment grade emerging market countries (Chile, the Czech Republic, Hungary, Mexico, Poland, Slovenia and South Africa) were recently included in the Lehman Global Aggregate Index, opening these countries to a wide range of institutional investors.
21. The developments I just described have brought significant opportunities as well as risks to many emerging market countries. Both are clear and straightforward. As I have said before, emerging market countries should take advantage of the currently favorable financing conditions to implement strong economic policies and structural reforms to improve their economic performance and the resilience of their financial system. They should continue to undertake debt management operations to lengthen the maturity and cut the coupon rate on their debt, as well as to reduce the share of foreign currency debt in their total debt stock.
22. Furthermore, emerging market countries should leverage the strong international interest in further developing their local capital markets—a well developed capital market has been shown to foster a country's economic growth and development. Countries can do this by maintaining a stable macroeconomic environment, developing local institutional investor bases, and improving the legal and regulatory framework as well as market infrastructure. We have presented some of these issues in Chapter IV, and will analyze them in more detail in the future, making use of a rich body of experience of many countries that have made good progress in these areas.
23. Thank you very much for your attention.
IMF EXTERNAL RELATIONS DEPARTMENT