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Transcript of a Press Conference on the Global Financial Stability Report
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MR. Hawley: Good morning and welcome to this press conference for the launch of the latest edition of the Global Financial Stability Report, the IMF's six monthly publication on the market developments.
Today's press conference will be led by Gerd Häusler, the Counsellor and Director of the IMF's International Capital Markets Department, and to his right is Hung Tran, the Deputy Director of the same department.
The contents of this press conference, together with the contents of the report, which you have copies there, are under embargo until 12:00 noon today, Frankfurt time.
The same embargo applies to those watching on the Webcast.
Gerd Häusler will make a few opening remarks before taking your questions.
We're going to conduct the press conference in English, although Mr. Häusler speaks perfect German, I'm told. However, the working language and good manners of this institution demand that he can speak in English, a language he speaks with equal felicity.
Gerd, would you like to start.
MR. HÄUSLER: Thank you very much and good morning to everyone, and it's always nice to be back here, and I'm very glad to be back here in Frankfurt and let me reiterate also my particular words of thanks to the European Central Bank for being willing to host this press conference this morning. In fact it's the second time we've been doing this here in Frankfurt. The first time was in the Bundesbank, which is still our shareholder.
Before opening the floor to your questions—I'm sure you will have quite a few—I would like to highlight the main messages, first of all, and policy recommendations of the latest edition of the GFSR as we call that green volume that you undoubtedly have in front of you.
For the near term, our message is a positive one. The global financial system's resilience continues to strengthen and makes us less vulnerable to crisis than in the past. When I refer to the past, I'm talking about the '90s and the very early months and years of this millennium.
This improvement is due to a benign constellation of cyclical as well as structural factors, and this has been ongoing for about four years now, starting after the bursting of the equity bubble that had weakened a number of financial intermediaries and hence, the system as a whole with it.
The main threat to this—what we call the benign outlook, the short-term benign outlook—lies more in the medium term and arises from the risk, albeit at present a small one, of a sharp slowdown in global growth prompted by an abrupt adjustment of global imbalances. Further risks. A second one, so to speak, stems from the gradual rise in credit risk of sovereign, corporate, and last, not least, the household sectors.
This is testament of the outlook leads to us, leads us to a policy recommendation that, while it may not be new to you, nonetheless, remains important. Supervisors must be constantly vigilant for weak spots in the financial fabric and policy makers more generally must address medium term imbalances swiftly.
Let me say a little about each of these points.
On the assessment of global financial stability, the improvement in financial stability has been supported by solid growth, low inflation, and benign financial markets, as you are all too familiar with.
In addition to this cyclical practice, several structural developments, which I will describe in a moment, have provided an important cushion against near-term risks, if something negative were to happen.
However, and I cannot stress enough the however—while the cushions have been expanding, risks have not disappeared altogether. In fact, again, they have been pushed into the medium term.
Now we all know that Hurricane Katrina, that has devastated the, or at least parts of the Gulf coast of the United States, is one of the most damaging natural disasters, and it is also, as we have all seen, witnessed, a human tragedy.
At this stage of its impact, the impact of this hurricane on global growth and financial markets is still uncertain, but there is reason to think that the impact on global growth may be, and hopefully will be limited.
The current configuration, as I said, of solid growth, low inflation, low bond yields, and tight credit spreads continues to support international financial markets and drives the search for yield, which has been the defining factor in financial markets for roughly the last two years—search for yield being defined with risk-free assets yielding very low real returns, investors are actively and on an ongoing basis looking for extra gains.
So on balance, we expect these conditions to continue, even though the outlook has become somewhat more uncertain for the recent rises in the oil price.
Relatively low bond yields and flat yield curves in major, in almost every major country, are likely to persist as we think, in part, owing to an increase in secular demand for fixed-income securities by pension funds, life insurance companies and institutions, investors, more generally.
So consequently, the benign financial environment will likely continue in the foreseeable future and in this benign environment, the search for yield which has compressed risk premia, could also act as a powerful countervailing force that should, and hopefully would contain market corrections and prevent asset prices from overshooting on the downside, or undershooting, or any way you want to call it. Prevent from falling too far.
Competitive pressure will prevent institutional investors or professional asset managers from staying in risk-free, low-yielding cash positions for low, or in jargon, they cannot sit on the fence for long but have to remain fully invested, and we have observed this countervailing force, time and again, and most recently this year doing what many people call the credit derivative turmoil in May surrounding the downgrading of General Motors and Ford.
In the context of this search for yield, the growth in interest rate differentials in favor of the U.S., as well as its deep and liquid capital markets, have attracted substantial capital flows, and I should say private sector capital flows to the U.S.
Capital inflows have so far smoothly financed the U.S. current account deficit and have supported the dollar. This is, in our view, unlikely to change abruptly in the near term, since none of the potential alternative destinations for investment flows, be it Europe, be it Japan, be it emerging Asia, possesses the true attributes the U.S. enjoys—that is, solid growth and deep and liquid markets. These are the destinations usually of one or the other but not both.
However, risk of an abrupt correction remains and I shall come to this risk in a moment.
So generally, much strengthened balance sheets of the financial, the corporate, and to a somewhat lesser degree, the household sectors, serve as cushions for financial systems against severe market corrections.
Now as to emerging market countries, many have posted solid economic performance as of late, helping to strengthen their economic fundamentals.
They've also continued to build cushions, in a similar way, against possible adverse developments by, most prominently, accumulating reserves, prefinancing their external debt, sometimes even through 2006, meanwhile, and also improving their debt structures, making them less vulnerable to, for instance, foreign exchange rate changes.
Institutional investors such as pension funds have continued to make strategic allocations to emerging bond markets, most of these pension funds are in the United States and investors have taken serious interest, meanwhile, also in local currency bonds.
These are all welcome developments, and, in particular, diversifying the foreign exchange risk away from emerging markets towards a multitude of international investors. This is prudent risk management, not only on the part of that country—Brazil is a good case in point—but also if you like, it's prudent risk management also on a systemic, on a global level.
So overall, these benign cyclical factors have reduced risks in the near term, and by the same token, they have helped sustain larger global imbalances and build up higher levels of debt, particularly in the household sector, but—and I come back—the increasing risks and vulnerabilities in the medium term are being stored up.
Now I mentioned earlier that there are also some structural, noncyclical factors that have been at work, and these structural factors have helped to strengthen the resilience of the global financial system as well. Let me just mention a few.
They include a wide dispersal of risk from the banking to the nonbanking sector, and you may recall that earlier, previous issues of the GFSR, of this green report, have, in detail, described the risk transfer, not only to the insurance sector but also to the pension fund sector, and ultimately, the last one, to the household sector.
These structural changes also include improved risk management on the part of financial intermediaries, enhanced transparency and disclosure in financial markets—you report about that every day—and also, the growing importance of institutional investors around the world, and I keep coming back to pension funds and life insurance companies, and also as well as hedge funds, and there is a more sophisticated investor base to emerging markets today compared to, say, six, seven, five years ago—six, seven, eight years ago.
In particular, pension funds and life insurance companies have focused more, and they have to, partly due to regulations—they have focused more on matching their assets to liabilities, owing to recent changes in regulation and accounting standards. The resulting increase in the diversity of investors and, hence, in investment behaviors, has supported financial stability, and last, not least, the long-term orientation and the deliberate, if not slow decision making process of these institutions, such as pension funds, has helped to underpin civility.
In plain English, it takes them a long time before they decide to invest, but if they do, they remain invested and don't leave that investment all too abruptly.
So altogether these developments have reduced the risk of knee-jerk contagion that we have observed in the late 1990's, market corrections today tend to be more linked to specific country or company developments, and not easily generalized to the whole asset class of financial markets, again, unlike the Asian crisis of 1998.
Now while these structural factors have not eliminated financial crisis, they have created cushions that provide a, as we say in the GSFR, a longer fuse to crisis, allowing market participants and policymakers alike, and allow them time to adjust. Let me now come to the medium-term risk that I have been alluding to a few times so far.
The cushions, these cushions that I have been trying to describe, and have been created by cyclical and structural developments alike, however, these cushions could be depleted if global growth were to slow significantly.
This scenario is unlikely at the moment but it could materialize if global imbalances corrected in a way that put the highly indebted household under stress.
Let me explain a little more in detail. Specifically, a change in international investor preferences away from U.S. assets could sharply depress the dollar. It would then, hence, boost U.S. interest rates, and ultimately, as we believe, weaken global growth. Continued high oil prices could also, as we know, ultimately slow growth. It hasn't happened so far but it might happen in the future.
Financial markets, if that were to be on the horizon, financial markets would react to such developments before they fully materialized.
As we know, financial markets tend to discount expected developments in the real economy.
So significantly, lower asset prices would erode the large net worth of highly indebted households and, ultimately, putting them under stress. They would cut back on their consumption, especially if their savings rate is zero or close to zero, and which, in turn, would mean they would be reinforcing downward economic and financial trends.
As I said, and let me repeat this, this scenario carries, as we think, a low probability at present, but it would, if it were to materialize, entail high costs to economic growth and to the financial system, over time.
Another risk that I have been alluding to earlier could stem from a gradual increase in the credit risks in the sovereign, corporate, and the household sectors, not an abrupt one but a gradual one.
Indeed, there has been a growing number of signs of each increase in specific credit risk. Just to give you an example or two, these range from heightened political risk in a number of emerging market countries. Indeed, the year 2006 is full of [inaudible] in election cycle, in a number of, certainly Latin America but also a number of other emerging market countries. We have heard of downgrading of several major corporations. We have seen signs of releveraging of corporate balance sheets in the context of paying out dividends, in the context of buying back one's own shares, and we have seen a certain relaxation of lending standards in the U.S. mortgage market, something that may not be so familiar with you over here.
Now given the overall balance sheet strength of the corporate and the household sector, such credit events have been and will likely to be seen as specific events and not as a generalized worsening of the credit situation.
In German, I would say we don't expect a "Fleckenbrand". Consequently, while market corrections in specific sovereign and corporate credit have occurred, including the credit derivative, and the CDO or collateralized debt obligation sector, in those markets, financial contagion is, as I said, likely to be limited. No "Fleckenbrand" as we say.
Conclusion and policy recommendations is, as we see it, as follows.
As to policy responses to mitigate risk more generally, and that is sometimes overlooked and unlike in the macro sector, this is an ongoing sort of mantra. The ongoing risk management by individual market participants. The ongoing, day to day oversight by regulators, are the most important and they are the first line of defense.
This is "bread and butter" stuff but it deserves to be mentioned every time one speaks.
One crucial element in financial supervision today, more specifically, is the financial infrastructure, the back office in an untechnical way, if you like, where managerial responsibilities are sometimes less clear and problems could be overlooked.
The backlog in trade confirmation, in the credit derivative markets, some months ago, were a clear issue of concern, not only to the respective national supervisors but I think to us as well.
Now with regard to vulnerabilities in the relative value trades, using such CDS, such credit derivative swaps, and CDOs, the famous collateralized debt obligations, financial supervisors must ensure that regulated institutions will maintain robust counterparty risk management practices, not the least to contain the spillover effect of market corrections, should they occur. The famous prime brokers that are the counterparties to hedge funds, for instance.
But given the complexity and enormous technical complexity of these transactions and the instruments, regulators themselves need to upgrade their skill sets, where necessary at least, to be able to effectively perform their supervisory functions.
In the context of this fairly complex issue of CDOs, hedge funds, and what have you, we welcome the most recent counterparty risk management policy group, number two report, chaired by Gerry Corrigan, and updating from a report that came out in 1999, and including its many recommendations, in fact there's more than 47 recommendations in there, which are largely, if I may put this in as an advertisement here, largely consistent with our views expressed in the GFSR a year ago, when we dealt with hedge funds.
Now emerging market countries should take advantage, and they do, and they should continue to take advantage of the still-favorable global economic and financial conditions to strengthen the economic policies, their macroeconomic policies, and implement their necessary reforms, particularly, I would say, in the financial sector, both to improve the efficiency of the financial intermediation but also to reduce vulnerabilities further.
Now that many emerging market countries have achieved a high degree of macroeconomic stability, they have begun to develop local institutional investors and infrastructures for capital markets alike, and this is now the time to take concerted actions to develop local capital markets where this has not been done yet, including corporate bond markets, hence chapter four in this GFSR, and to bring all these markets closer to what we call international best practice.
Returning to global imbalances one more, and one last time at least in my opening statement, policymakers in the major countries need to avoid complacency and they need to take collective measures to reduce them, and the point that I'm trying to make, they should not be complacent by the fact that these imbalances have been financed so smoothly, as I indicated earlier, and without going into details, I sort of make a sweeping, I make a sweeping reference to the IMF's World Economic Outlook, the next one which is due to come out on September 21st, and these measures, as you have heard, they are not new every time.
The measures as we see them, the policy measures include the sort of the "holy trinity," if you like, of raising national savings in the United States, both public and private, by the way; structural reforms and supporting measures to raise the trend growth rate in Europe, underline big time, and Japan, for that matter; and financial sector reforms and greater currency flexibility by many Asian countries.
We welcome what we have seen but I think there's more to go.
So in concluding, and on balance, the global financial system has become more resilient, that is good news, owing to the cyclical and structural developments that I've briefly described, and you'll find a lot more in the report, and the improvement of the financial resilience has built up a substantial cushion which is also good news and we should welcome that. So that in the event a risk were to materialize, financial systems today are better equipped to weather a storm, should it occur.
We all hope it won't but should it occur, I hope we are somewhat better off than we were some time ago. Thank you very much, ladies and gentlemen. I think now is the time for you to shoot at me and my colleague, Hung Tran, with your questions.
MR. Hawley: Please identify yourself when you ask a question. Sir?
QUESTION: [inaudible] summary of structural factors, you seem quite unambiguously positive that they have helped to enhance stability and you cite growing importance of institutional investors, including hedge funds.
I remember times when growing importance of hedge funds was regarded as a problem due to their intransparency. Is that not the case anymore? And certain lack of oversight. And also the credit derivatives market, which I think in your report say shows phenomenal growth.
There has also been some concerns by the BIS, for example, that this market is rather intransparent. Is that not a concern anymore?
MR. HÄUSLER: If you follow our publications closely, and remember, I gave you a very crude overview. This was not the details, and I strongly recommend that you should read this. I think you are slightly misrepresenting our view, in the sense that we have always had the same view, number one, that hedge funds, as such, and credit derivatives, as such, and CDOs as such are to be seen in a positive way.
Credit transfer, and putting the burden, if you like, or the risk of credit on many shoulders may not please individuals sometimes, certainly when deals go wrong, but from a systemic point of view it's positive. And as to hedge funds, let me remind you of what we wrote a year ago, in the September 04 report. We think that hedge funds, by and large, are positive. They add liquidity. They allow people to offload risk. They take risk. I think the system needs risk-takers.
You cannot have a financial system that is viable without risk-takers. So that is, I think in itself, as a matter of principle, is positive.
You are referring to some of the details and I'm not saying everything that we see is perfect, and as to the oversight, I am not particularly concerned.
Again, if you go back to last year's report, what we said is there could be more transparency through direct oversight, or through the prime brokers. And I think the debate should focus—and we are focusing, when it comes to hedge funds, on the systemic issue.
We are not—our job in the Fund is not to focus on consumer protection. Our job is not to focus whether shareholder activism, more generally, is a good thing or a bad thing.
I know in Germany, there's a debate about that; but that is not our issue. Our issue at the fund is a systemic issue, and we cannot see how hedge funds, at this very moment, we don't see much leverage, and in any way that is comparable to the LTCM.
Now on credit derivatives, you were referring, I said earlier that the oversight on the part of regulators needs to be enhanced, when necessary. I refer to the backlog in clearing and settlement, and we are endorsed, if you like, broadly, the recommendations of the, what I call the Corrigan Group, the counterparty risk management policy group, where they make a lot of recommendations directed at their own industry, if you like, asked themselves, what is best practice? And there needs to be further progress.
So I endorse all that but I would not think that these issues that I alluded to, the backlogs and clearing and settlement, et cetera, by themselves, would sort of put the credit risk transfer instruments in question. I think, on balance, and overall, this has turned out to be a positive development over the years.
MR. TRAN: And I had one more small point in that question because it is a very important question. We highlight the fact that the growth of not only the hedge funds but the growth of hedge funds in the context of the growth and growing importance of more generally institutional investors such as pension funds and life insurance companies, result in a situation where you have increasing diversity of institutional investors, diversity of players, and diversity of investment behaviors, with different liquidity needs, different liability structures.
That diversity will be very helpful to maintain financial stability.
MR. HÄUSLER: If you only had pension funds with a buy and hold strategy, you would not have the necessary amount of liquidity.
MR. HÄUSLER: Would you just identify yourself.
QUESTION: Yes. Nicky Houston from Dow-Jones. So could you just maybe elaborate a little bit, perhaps a diversity issue.
You mentioned in the report, or in the summary of the report, that these instruments are very crowded and yet you don't expect to see a "Fleckenbrand". Could you just talk about that a little bit, please.
MR. HÄUSLER: I didn't say they were crowded. Many people say, speak of crowded trades. I don't recall having said crowded trades this morning. I think crowded trades just refers to investment position which are all too much alike and it's not necessarily an issue of CDOs or any particular—it could happen to any other thing, any other position.
The point is when I said "Fleckenbrand," I was referring to the General Motors/Ford issue. I don't even know how to call it. It wasn't even a crisis in April and in May, where many people at the time felt this was, you know, this might have sort of built-in dynamics. The fact of the matter is it turns out to be a blip in the aftermath because—and let me just underscore one more time what Mr. Tran just said a moment. Yes, there were hedge funds being hurt at the time but they were also buying hold. It was a different brand of investors who were holding this type of credit risk and they didn't move. Not everybody was [inaudible]. So I think this nonemergence of a "Fleckenbrand" makes direct reference to the diversity of the investor base where some people just don't follow the trend.
In other words, I have a certain hope that the famous herd behavior may be somewhat curtailed by the emergence of such a, you know, variety of investors, with different strategies of course and different time horizons.
QUESTION: You make this intriguing conclusion about these structural factors which have created longer fuses to—or a longer fuse to crisis. The structural factors, the cushions, whatever, refer mainly to institutions.
I just wonder whether you also see a longer fuse when it comes to the household factor and the risk of a possible housing price collapse or at least substantial slowdown in growth rates.
MR. HÄUSLER: Let me make a few remarks and then I think Mr. Tran is probably a better expert on this than I am.
The whole issue of housing sector, and this is why we devoted a whole chapter last time, is something relatively new, and I think the transmission mechanism of monetary policy, referring to the household sector, is different today than what it used to be, especially when the household sector is exposed to variable rate drafts, when the household sector is exposed to negative amortizations, if you have a fairly sizeable chunk of liabilities.
So this is all uncharted territory. Now on financial stability issue, whether the fuses are longer or shorter depends on the individual balance sheet position of a household, and by definition that is very diverse.
There are what we—to some degree, they're longer, but there are also areas where we have some concerns which I alluded to and maybe I'll let Mr. Tran explain a little bit of some of the new developments in specifically in the United States mortgage markets, which I think has unfortunately also shortened the fuses.
MR. TRAN: I think that is also is in the strengthening of the balance sheet of the household sector, they have increased their indebtedness, particularly in mortgage debt to buy houses, but their assets has increased even more. So their net worth or their capital position has improved steady over the past four years, so that the household sector is in many major countries, U.S., many countries in Europe, even in Japan, enjoy a higher degree of net worth than before.
Of course net worth is dependent and vulnerable movement in asset prices. If asset prices go down, at some point the net worth will be eroded, but the accumulated increase in net worth in the past few years created this long fuse and this cushion, that you really indeed have to have very major market declines over some time before this accumulated increase in net worth is completely eroded.
So in that sense we refer to the cushion, also in the household sector. Number one.
Number two. If we have this situation again, household sector being highly indebted, you have to react by reducing consumption and this reduction in personal consumption in these circumstances will reinforce the downward trends in economic and financial developments, which is the risk that we highlight.
And last but not least, we have concern about some marginal developments, particularly in the U.S. mortgage markets where new instruments such as no amortization mortgages or negative amortization mortgages, interest only in adjustable rate mortgages, all designed to minimize the payment of the borrowers in the first few years, at the cost of either increasing the outstanding amount of the debt later on, or increasing the burden later on. These kind of developments, coupled with side of relaxation of credit standards by some lending institutions, raise concerns because it increases the credit risk of this segment of new mortgage borrowers that will be least able to deal with any abrupt changes in markets, including rise in interest rates.
And I think that the U.S. authorities have properly taken this into account and they have issued guidance and caution to their banks to increase credit standards. But this is an area that we need to monitor closely.
QUESTION: And in Europe?
MR. TRAN: In Europe, we have seen less sign of these developments that I just highlight to you but this will be something that everyone needs to be vigilant and watch out for.
MR. HÄUSLER: Europe has less of a history of extracting equity from the real estate sector compared to the U.S. and probably to a lesser—even lesser than the U.K., I think.
QUESTION: [inaudible] the Chinese really [inaudible]. It seems banks have very large credit exposure to the Chinese real estate market.
MR. TRAN: I think that they have—basically the issue concerns some major urban centers in China, Shanghai, for example, where commercial properties and some high-end residential property prices have increased significantly in recent years.
But for internationally active banks, these investment exposures represent still a small proportion of their overall balance sheets and their overall activities.
So for the local markets, for the local investors in China, and for the local economy, and a correction of such sharp and rapidly rising property prices could be a problem, but I don't see that as a problem for internationally active banks.
QUESTION: Reading your report, it looks like everything is fine except for the global imbalances, which we have seen for quite some years now. What, in your view, could trigger a abrupt correction of the U.S. and current account deficits? Is that about to occur?
MR. HÄUSLER: That is difficult to forecast. If I knew the exact answer to that, I probably would stop working for the IMF and would run a very successful hedge fund, and anybody can join me in that.
I said earlier that the smooth financing of the [inaudible] current account deficit has been—I'm not saying this exhaustively but basically hinged on the deep and liquid markets that others do not have, and at the same time at the growth in interest rate differentials.
If any of these two comparative advantages of the United States were to erode significantly, this in itself would probably make it more difficult.
It is probably true, if Europe and Japan were to really get its act together, and would really do all the reforms—I mean as a European, I know it's not very likely that this will happen overnight. But if they really became a more attractive haven, a more attractive destination for capital from the growth/return perspective, this would, to some degree, I think undermine this advantage that the U.S. is enjoying.
Deep and liquid markets. Well, the Asians are clearly working as you know, and I mean, everybody—and we certainly support the building more efficient financial markets, not just on a national basis but to some degree on a pan-Asian basis. The Chaing Mai initiative, or the Asian bond initiative, Roman one, Roman two, this is a very long-term endeavor that you—you know—to match and rival the U.S. on that, create corporate bond markets and mortgage markets and asset-backed and MBS, you know, mortgage-backed securities, et cetera, this is a long, long, long term to go.
So I think any of that, yes, it could happen, but it's a long, drawn-out process.
On the short term basis, on an abrupt basis so to speak, it would have to be something that would undermine the credit standing, if you like, the creditworthiness of the U.S. and it's not easy to see. I mean, you can speculate all sort of wild things but, frankly, I would rather not do that, at least not publicly.
MR. Hawley: Any other questions?
Okay. If there are no further questions we will conclude this press conference. Thanks once again to the European Central Bank for hosting this event today and thank you very much Mr. HÄusler and Mr. Tran for your responses to the journalists and thank you for coming along this morning.
IMF EXTERNAL RELATIONS DEPARTMENT