Transcript of a Press Conference on the Global Financial Stability Report

Bank of England
London, April 11, 2006

Participants:
Gerd Häusler, Counsellor and Director, International Capital Markets Department
Hung Tran, Deputy Director, International Capital Markets Department
Lucie Mboto Fouda, Senior External Relations Officer, External Relations Department

View a Webcast of the Press Conference

Good morning and thanks for joining us. I'm Lucie Mboto Fouda of the IMF Press Office and I would like to welcome all of you to this press conference for the launch of the latest Global financial Stability Report.

I would like to start by thanking our colleagues at the Bank of England for kindly hosting this event, which is the fourth time we have launched the GFSR at the Bank.

Today's press conference will be led Gerd Häusler, Counsellor and Director of the International Capital Markets Department. To Mr. Häusler's right is Hung Tran, Deputy Director of the same Department.

Now let me cover briefly some housekeeping items. This briefing, along with the Report itself is embargoed until 11:00 a.m. , which is 1500 GMT. We are web casting this press conference on the IMF's online media briefing center, so our viewers should also adhere to this embargo.

Mr. Häusler will have some opening remarks and then he will be happy to take your questions. Mr. Häusler?

Mr. Häusler: (as prepared for delivery) 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 Global Financial Stability Report (GFSR), which we will release today. We have conducted press briefings on the GFSR in various international financial centers in the past, including a few times here at the Bank of England. We are grateful to Governor Mervyn King and his colleagues for allowing us to use their facilities again.

Before opening the floor to your questions, I would like to make a few remarks to highlight the main messages and policy recommendations of the latest edition of the Global Financial Stability Report. As most of you know this will be my last press conference to present a Global Financial Stability Review for the Fund. After five years on the job as the first director of International Capital Markets (ICM) who set up the department from scratch and who created the GFSR as one of the Fund's two publications on multilateral surveillance, I have long planned to return to Europe with my family. (http://www.imf.org/external/np/sec/pr/2006/pr0629.htm)

The Managing Director of the IMF has announced that ICM will be merged with the Monetary and Financial Systems Department into a new department; however, our GFSR will continue; Mr. Tran and our staff are already working on the next volume. As we can all see, from a stability perspective—and I stress from a stability perspective—the near term outlook is "as good as it gets," or some would say, maybe even better than that. Let me for one moment take a step back and look at the difference five years can make. Some of the pressing vulnerabilities in 2001/2002 in the aftermath of the equity bubble, such as a sharp decline of risk appetite in financial markets, deflationary fears, and a number of serious crisis situations in emerging market countries (EMC) prompting the IMF to step up with programs, caused our risk assessments in the first GFSRs to sound somewhat alarmist at the time, and for good reason. As we know, this language of urgency quickly gave way to a much more relaxed tone. Financial markets over the last few years have been characterized by sharply improved resilience, at least on a broad systemic level. We have repeatedly spelled out the reasons in previous GFSRs and, yes, we take some satisfaction from the fact that our judgments have been validated throughout these years.

Today, the focus of our GFSR is much more on medium- and long-term issues of efficiency than on tomorrow's imminent crisis, especially in the context of EMCs. There is broad agreement among experts and beyond that a vibrant financial sector, including modern capital markets, is one of the key elements to emerging markets' rapid development.

Good macro-economic policies are necessary but not sufficient requirements; they have to be complemented by efficient micro-economic features. I am referring, inter alia, to better debt structures in the balance sheets of the sovereign as well as the corporate sector, an efficient and reliable clearing and settlement system, a fully developed mortgage sector, and ultimately more advanced areas such as a corporate bond market as well as a carefully developed derivatives market. They all help prepare the ground in anticipation of the next hurricane season. While I have little doubt that such stress situations will at some point and time reemerge, I question that there will be simply a replay of the old movies on "capital account crises in systemically important EMCs." We do not think that comparisons to 1997 capture recent developments well. In fact, I would expect something quite different, a variation of the old detective's motto: Go to where the "leverage trail" will lead you!

Before pursuing this issue further let me dwell for a few moments on the cyclical risks because some observers have highlighted a number of "exit risks" that could spell trouble for the global financial system. The fact that none of these risks materialized, at least not so far, provides some interesting lessons in my view.

The "exit problems" refer to moves by various central banks from the ultra-low interest rate environment that was in place after the bursting of the equity market bubble and the 2001 recession. So far, it seems, central banks have not—yet—been caught behind the curve, but the jury may still be out. It turns out, yet again, that the "exits" were less difficult than many observers predicted.

• The most crucial one was the U.S. Fed exit strategy which started with the first Fed fund rate hike in June 2004. At that time, there were concerns that rising short-term rates would lead to losses on the carry trades that had been put on to exploit the then steep U.S. yield curve, causing stresses among banks and other investors. In addition, many analysts feared that rising short-term rates would reduce global liquidity, leading to a widening of credit spreads and causing financing problems for EMCs. We, at the time, pointed out that given the Fed's much improved communication strategy (as compared say with 1994 or even 1999), a normalization of policy rates from a very low level would not cause much of a problem to markets, and should be welcomed as a step to enhance financial stability by restraining possible excessive risk taking behavior. Indeed, financial markets have adjusted smoothly to the rise of the Fed funds rate from 1% to 4.75%.

• In the same vein, the tightening moves by the ECB since late 2005 and the recent decision by the Bank of Japan to exit its quantitative easing policy have been well communicated and, hence, expected by market participants. Again, these moves aim to bring policy rates from a very low level to a more neutral level, in the context of continued growth and subdued inflation. As such, they should not cause a major problem for financial markets. There is one caveat, however: it remains to be seen how the Japanese institutional investors will absorb the losses in their JGB portfolios once long-term interest rates rise.

• Another exit strategy: when the Japanese authorities stopped their interventions in foreign exchange markets in early 2004, there were concerns that the dollar could weaken sharply. Similar concerns were voiced when China started to loosen its currency peg. In both events, markets have adjusted quite smoothly.

I review these episodes for one reason only: to reiterate a point made in this and in previous GFSRs that such moves, being well communicated to the markets, should not cause market disruptions and, instead, should be welcomed as steps to reign in excessive risk taking behavior by investors that could pose a financial stability problem later on.

The unwinding of carry trades is one natural consequence of monetary tightening—investment strategies change all the time and the global asset allocation process is dynamic, so there is nothing inherently wrong with these developments. A lack of profitable trading strategies in financial markets does not mean the system as such is in peril.

Some questions are raised about a possible effect of the Bank of Japan's decision—namely concerns about the unwinding of yen-based carry trades. These trades involve borrowing in the low-cost yen to invest in higher-yielding commodity currencies, such as the Icelandic krona, the NZ and Australian dollars. While these currencies have weakened in recent weeks due to macroeconomic vulnerabilities, such as large current account deficits, so far we have not found any clear evidence of pervasive, or a substantial volume of, yen-based carry trades, having looked at available data and talked to major market participants. For sure, there are investors engaging in such activity, including Japanese retail investors who have bought large amount of foreign currency bonds, some of which have not been hedged against currency risk. These investors, behaving like large hedge funds, could incur losses if the yen were to strengthen, but this is part of a normal market adjustment, and I don't see evidence to suggest anything more than that.

The substantial rise and more recent corrections in the Middle Eastern stock markets are also of limited effect on the global financial system. Developments in these markets mainly reflect the deployment of a huge amount of oil surplus money to investment opportunities in the region, in particular to a limited number of listed shares on these stock exchanges. The challenge is for the authorities to develop further their equity and other capital markets to channel the funds to productive uses, and to avoid moral hazard by letting investors know that they can not expect bailouts when investing in the stock market. Otherwise, stock market bubbles could develop, leading to much sharper corrections down the road.

In our view the main risks lie elsewhere: As in the past the GFSR before you attempts not just to list them, but, more difficult, to assess how likely it is for them to materialize and what could be their potential impact on financial markets.

• Inflation and interest rate risks: as economic growth continues and resource utilization increases, inflationary pressure could build, especially if oil prices were to rise further. Current expectations are benign but if they were to be exceeded, both short and long-term interest rates could rise by much more than currently expected and leading to dislocations in financial markets. The increase in major long-term government bond yields of around 40-50 basis points in recent weeks, to some extent, reflect such market concerns, but should still be viewed as a normal market correction.

• The turning of the credit cycle on corporate credit market: despite strong balance sheets overall, many corporations have begun to re-leverage by increasing dividend payments, buying back their own shares, and engaging in merger and acquisition activity. Leveraged buyouts by private equity funds using a very high degree of leveraging have significantly weakened the credit quality of the targeted companies. In addition, some companies in traditional sectors such as automobile and airline continue to be under financial stress. Credit spreads of these affected companies have widened, even though spreads for the broad corporate market remain stable at low levels. However, spread corrections due to idiosyncratic risk events could propagate to wider markets through illiquid segments of the credit derivative and collateralized debt obligation (CDO) markets.

• The turning of the credit cycle on housing and mortgage markets—particularly in the U.S.: amid signs of cooling housing activities and price increases, there are concerns that personal consumption would decline and slow down the economy. Indeed, this is a downside risk to the U.S. economy—but any decline in personal consumption could be offset to some extent by increased investment spending, and accompanied by a rise in personal savings which would contribute to moderating the U.S. current account deficit. While the main U.S. mortgage market still enjoys very good credit quality, the sub-prime segment of the market—where less qualified borrowers have used new mortgage instruments such as interest only or no amortization etc., to reduce carrying costs—is more vulnerable to rising interest rates or stagnating house prices.

• The risk of a disorderly adjustment of global imbalances: given the unprecedented scale of the global imbalances, such an adjustment would have very negative consequences for financial stability and economic growth. However, flexible and global financial markets have intermediated smoothly between the surplus and deficit countries. To the extent that the U.S., being the largest deficit country, continues to have a strong potential growth rate, deep and developed capital markets as well as positive interest rate differentials vis-à-vis other mature market countries, it should continue to attract capital inflows. The major risk we can see here is a rise in protectionism which could undermine the confidence of international investors and cause them to change their global asset allocation and diversify from dollar assets.

A low probability but high impact risk is an outbreak of avian flu pandemic: this could have a serious impact on international financial systems—especially the payment, clearing and settlement systems—and the global economy. A pandemic avian flu could affect the global financial system through (i) operational disruptions caused by a sharp increase in worker absenteeism in the financial industry; and (ii) market disruptions and changes in capital flows resulting from an increase in risk aversion. These issues are discussed further in the GFSR. The IMF is working with our membership to help ensure that their financial systems are adequately prepared for such disruptions so that core financial services remain operational.

I now turn to the structural changes in the global financial system over the last decade or so, which helped boost resilience and reduce vulnerabilities. One particular development which we have discussed is the transfer of risk from the banking sector to non-banking sectors, including the household sector. This transfer of risk has occurred on various fronts and using different instruments, the most important of which is credit derivatives and structured credit products. The widespread use of these instruments has dispersed credit risk throughout the financial system, and similar to a reinsurance market, has enhanced the ability of the financial system to bear risk. In addition, active trading in these instruments has made available to market participants and financial supervisors more transparent and timely indicators of credit risk. Such information could allow market participants to adjust to changes in credit quality on a more timely basis, thus probably helping to dampen the credit cycle. However, this "brave new world" of capital markets in turn creates its own set of risks and challenges. These include a lower level of disclosed information on the distribution of risk to, and among, non-bank financial institutions, and the potential problems of crowded trades in illiquid segments of the credit derivative markets. Let us be clear: the credit derivatives market has yet to be tested in a sustained market downturn. If leverage is always an indicator of potential vulnerability, in case asset prices move the "wrong" way, then not knowing much about the leverage in some sectors of the financial industry and beyond, provides me with less comfort than I would like to have. In addition, operational risks such as delays in credit derivative trade confirmations, assignment of contracts to third parties, and contract settlements have been identified as weaknesses—but remedial actions are being taken by market participants to address them.

• With regard to the current state of the markets for emerging market (EM) assets, there have been important changes in the way investors, mostly in mature markets, and EM sovereign borrowers have behaved in the environment of growing current account imbalances between the United States and the EMCs as a group. Essentially, we find the behavior of the EM sovereign borrowers and mature market investors to be quite rational, in fact, rather conservative. I don't share the view that it is an "abnormality" that should be sharply corrected if cyclical conditions become less favorable.

• EMCs, as the surplus countries, have behaved very conservatively. Instead of taking advantage of a likely appreciation of their currencies, owing to the large and sustained current account surplus, by issuing foreign currency debt, they have done the reverse—reducing their foreign currency debt through debt buybacks and increased domestic currency issuance. They have done this in order to build up insurance against future crises. In other words, they—and in particular the strategically key EMCs—have used this episode of a benign financial environment constructively to reduce their external vulnerabilities, not to increase external debt as so many EMCs did in previous episodes of favorable global financing conditions. Of course, government leaders in EMCs set the course for this policy, but the so-far "unsung" heroes of this effort—the public debt managers—deserve a lot of credit.

• Investors in mature market countries, but also in surplus EMCs, have behaved rationally in investing in EM local currency securities, as they expect the currencies of many of these countries to strengthen due to their current account surpluses, and these markets to provide additional risk and performance diversification. In doing so, mature market investors are helping to reduce EM interest rates, leading to a positive debt dynamics in most of these countries.

• In addition, the credit quality of mature market corporates and EM sovereigns has become somewhat divergent in the context of the credit cycle: the former likely to weaken a little while the latter to improve in the future. This explains the disappearance of the yield premium on EM external sovereign bonds over mature market corporate bonds.

• These factors, together with the secular broadening of the investor base and the changing composition of sovereign debt, suggest that there is no strong case for a sizable bubble in EM assets waiting to be corrected. Of course there will periodic market corrections, such as we witnessed last month or even stronger, but both the investor community and the countries themselves are much more prepared than in the past to weather such storms without crises erupting.

The changes in these EMs and the sharp reduction in their financial vulnerability have been dramatic over the past four years. In a nutshell, the crux of the debate remains over whether the improvements—whether they be spreads, capital flows, credit ratings, structural changes in the investor base, or in the increasing share local currency debt, etc.—are merely a temporary phenomenon about to swiftly reverse with the global credit cycle or whether something more fundamental has been and remains underway.

Let me explain why I believe that a paradigm shift is now well underway which will survive almost any likely cyclical deteriorations in the period ahead. But first, two caveats.

• First, we should not forget that there have been important cyclical factors at work such as the level of global liquidity, higher than average global growth, record high commodity prices, and the like.

• Second, not all EMCs have strengthened their economic and financial positions. Some still need to urgently address external or internal imbalances, or weak banking systems, and, hence, would likely be vulnerable to a sustained cyclical downturn.

Importantly, however, additional factors of a more secular nature are at work, which seem especially pronounced for the larger, systemically important EMCs:

• Most important, painful lessons from past crises seem to have been learned. Specifically:

• There is greater exchange rate flexibility than a few years ago.

• Fiscal discipline is generally greater than in previous periods of ample liquidity and strong growth.

• Much improved debt management is reducing in some cases the "original sin" (of issuing external foreign currency debt) at a rapid rate, and with it the fiscal risks of exchange rate adjustments.

• Broadly speaking, these policies have not been reversed with changes in government.

• Recent advances in debt management still have a long way to go. Traditional fiscal vulnerability should continue to decline, as more countries pursue pro-active debt management strategies and those most active continue to extend local currency yield curves. Indeed the trend increasingly will be to integrate asset and liability management given high and growing levels of reserves.

• The broadening of the investor base, which I previously discussed, appears quite different from previous episodes. While there may be some cyclical component , allocations by pension funds to emerging market assets—including growing domestic pension funds—is almost surely secular. These funds are slow to make investment decisions and, once made, the investments generally are long term rather than cyclical.

• The composition of external capital inflows has changed substantially when compared with a decade ago. Today, a much higher share is equity, especially FDI, which by definition is longer term than debt flows, especially short term bank debt which has been a large component in the past.

• Finally, one cannot ignore the record levels of official reserves which have been built up—and are still being built up—most dramatically in Asia and among oil exporters but also in Latin America and emerging Europe. At a minimum, these reserves will be an important cushion or shock absorber if needed, buying countries much more time than they had in the past to adjust to adverse shocks, even severe ones. Moreover investors know this and therefore are likely to be much more patient themselves in reacting to such shocks.

Let me turn to our policy conclusions to be drawn from our analysis, at a time when systemic risks seem to be low and risk appetite on the part of investors rather high. As always, the macro-prudential policy options are rather limited. Regulation and supervision have to be on the alert to spot weaknesses and vulnerabilities, they are essentially on auto-pilot, you could say.

Monetary policy, or the level of interest rates to be precise, traditionally caters to the real economy. There are different schools of thought on the issue of whether monetary policy should also take asset prices into account. The U.S. Federal Reserve has argued on many occasions that monetary policy has no role to play in countering the emergence of a potential asset bubble, only in cleaning up the mess if a bubble has burst. European central banks traditionally do not exclude the possibility of taking asset prices into account, without, however, saying precisely what that could mean. Personally—maybe that is my history at the Bundesbank—I see merit in using interest rate policy in the margins, less so as to the level of interest rates hikes but rather as to the timing of interest rate hikes and as to the "guidance" given to markets about future intentions. At a time when financial markets are in solid shape a bit more of the old-fashioned "constructive ambiguity" could be helpful in containing exuberant markets from going overboard. There is nothing wrong about the use of "moral suasion" or "open mouth policy" to that effect. Central banks around the world fuelled the search for yield for a bit too long, for my taste at least.

It is crucial in my view to remind bullish markets regularly about the nature of two-way risks and to support such language with a rigorous no-bail out policy. At a time when financial markets are not facing any systemic threats, only idiosyncratic risks, it is important to withstand the temptation of "bailing out investors" who had bet on higher asset prices. Occasionally, when asset prices start to fall, policy makers come under pressure to "do something."

Some overly nervous observers underestimate the benign forces of self-correction in the markets, the "countervailing forces" is my preferred expression for it. They are quintessential for the well-functioning of financial markets, not only on a micro-level as in the case of structured credit, for example, but also on a macro-prudential level. Ideally, public sector authorities should be so well versed in market analysis, financial surveillance as we say, that they can distinguish between a systemically critical situation and one where they should just wait and watch markets correct themselves. In a world of more and more professional institutional investors, declining asset prices are no reason to get nervous, say at a time when monetary stimulus is being carefully withdrawn. Any tendency to bail out investors, even under the pretext of market support, sets a dangerous precedent of "moral hazard," and encourages one-way speculation.

Let me conclude my opening statement with an almost philosophical statement as to modern capital markets. A year ago, our GFSR called private households "the shock absorber of last resort," and concluded that their risk taking activities are making the financial system safer, if for no other reason than by virtue of them reinsuring the financial sector, at least in parts. However, given their low level of financial literacy, they often know very little about appropriate risk premia when writing such insurance. If their expectations, explicit or only implicit, are not met, their dissatisfaction and disappointment may turn into a political liability for the authorities, to prompt them to support markets "which are too important to fall" as opposed to old fashioned moral hazard pertaining to "financial institutions too big to fail." Coming from the culture of Goethe, such a situation has something of an implicit Faustian pact: the household sector is invited in to participate in the search for yield, to enhance their returns in whatever way, or in systemic terms: to receive an insurance premium for making the financial sector more resilient. But the "dark side" of such a pact is, of course, to be included in the risk sharing as well; visible only when asset prices start to fall significantly and Mephisto asks for his side of the bargain to be fulfilled. There is no easy answer to that tricky issue, but public sector authorities will have to think through this new challenge long and hard. We may need in the end a shift from the traditional prudential supervisory approach towards a new paradigm of creating checks and balances between the various sectors of risk takers. Needless to say, we are talking about a mine field of potential conflicts of interest or worse, systematic cherry picking by the smart and financially educated, a new definition of "insider trading," if you will. Being particularly smart and financially astute should never be sanctioned; but such behavior could discredit a capitalist and market based financial system in regions with strong egalitarian political convictions, which would then backfire in an unprecedented way. A low level of financial literacy, combined with extensive risk taking, is politically an explosive brew.

These are all topics, on which future issues of the Fund's Global Financial Stability Report will weigh in. I look forward to reading them from the outside.

QUESTION: Just one thing, you seem remarkably comfortable about the global macro-economic imbalances. Is that really consistent with the view of the Managing Director and the Fund's economists who seem to me to have a bit of a concern that the world might be a bit complacent about those issues?

MR. HÄUSLER: Let me be very clear, the macro-economic imbalances are something that we all have concerns about and I have no exception to that and we all know that if there was ever any erosion in the confidence on the dollar, if there was any erosion in the asset allocation for the dollar, it would have very nasty consequences and so there is no disagreement on that. As a market observer, ex-[inaudible] if you will, we are just witnessing that the markets so far—and that includes institutional investors of the private nature, of the public nature—have, year after year after year, allocated very significant resources to the U.S. dollar, to the United States—mainly for two reasons. Because only the United States, and you'll find that in the report, only the United States fulfils two out of two requirements. It has a very strong growth potential, especially compared to the two market areas such as Europe and Japan. It also has a very deep liquid and highly professional capital market where you can invest your billions and trillions of dollars, as opposed to other parts of the emerging market world which have growth but do not have the same depth in capital markets. So it's a long way of saying that "Yes it is a problem, it needs to be dealt with" and the Fund is trying to persuade its membership to deal with the issue. But, on the other hand, it would not be serious for us in a stability report, which comes out twice a year, to cry wolf and pretend as if there were signs that the dollar would collapse in the next six months.

QUESTION: Given that, how much probability do you actually attach to the serious unwinding of global imbalances and [inaudible] for the value of the dollar? Can you quantify how risky you feel the situation is?

MR. HÄUSLER: If I knew this I would be working on Wall Street or in the City and not for the IMF. No, nobody can seriously put any numbers to that and maybe my colleague, Mr. Tran had numbers. I don't. All I said is and all I can say is that it's hard to see how this could happen very soon but the truth conversely is, the longer these imbalances carry on, the nastier if you like, a sudden or disorderly unwinding, this is the term of the [inaudible], would be.

QUESTION: I have a couple of questions, the first one is related to interest rates. You say that it is a risk that if inflation increased more than expected, perhaps the interest rate increase and I was wondering if you had any...how much concern do you have on that, that it could be the case? And on the second issue, we have been witnessing in the last couple of years but very recently, increases in prices in commodity markets and Belgian, France and [inaudible] returning their [inaudible], pumping in the markets. Is there any concern from the [inaudible] point of view of too much money going to these markets and is there any concern from the IMF that some pension funds or some investors have taken too many risks on commodities?

MR. HÄUSLER: If you agree, I'll take the first question and refer the second one to make Mr Tran work for his lunch as well. On the first one, on the inflation and interest rates, it is very difficult to really have a firm handle on it. One thing is clear, that the fact that inflation today is so benign compared to previous decades and has something to do with globalisation and I could walk you through the number of research that the IMF has put up, and others, but it is very clear, the bottom line is without globalisation, which also shows you how important it is to avoid protectionism. Without globalisation, inflation may have crept up quite a bit more and it is now important that we keep these inflationary expectations as firmly anchored as they are . And if you look at the term [inaudible] in fixed income, you will see that they are firmly anchored. Equally important is that the so-called second round inflationary effects, wages, are not being [inaudible], if you like. There was always the big problem in the 1980s and to some degree, the 1990s and I said ,"So far, so good," but we hope that this can stay that way—so the flat, the in-curve that you can see and where we think this flat in-curve in some shape or form is yet to escape for quite some time, is of course all predicated on the fact that inflationary expectation and inflation ultimately is anchored and so far, I'm fairly positive but again if capacity utilisation is increasing as it does, it is coming to a point where I think inflation is....monetary policy has to be quite vigilant. Mr Tran, on the commodities maybe?

MR. TRAN: Yes, well first I have just one additional comment on the inflation thing. So far, the problem is not inflation, as yet, the problem is like Mr Häusler said, it's more—certainly increases in the degree of resources [inaudible] as growth continues to be very globally across the board. So if you have higher employment rate, lower unemployment rate, higher [inaudible] utilisation rate and on top of that, continued rises in [inaudible] commodity prices, inflationary pressure could develop and if it develops in a way that it exceeds the current expectation, the reason we [inaudible] is that what short and long-term rates may rise more than currently priced [inaudible] financial matters. And we think that such a scenario would be having negative consequences to a whole array of financial assets markets, from home markets to equity markets, to credit markets. So that is something that we highlight. On commodities, it is obvious that both in the oil market and non-fuel [inaudible] markets have been experiencing the main [inaudible] of [inaudible] in terms of price developments and on top of that we also see a lot of financial investments pulling into these markets on a variety of grounds. One is the [inaudible] of [inaudible] and suddenly many funds are seeking a new way of getting return and less correlation with the traditional asset classes like equities and [inaudible] markets. The concern so far it is not very acute, to the extent that there has been no spill over of commodity price increases but inflation. But when that begins to happen, then of course, that could become a very serious issue to be concerned.

QUESTION: Can you try, well not to fortify the likeliness of the different risks that you drew, but at least in which order are the most likely or less likely?

MR. HÄUSLER: We think that the most likely risk is the one that is the more cyclical of them all, the corporate imbalance sheets—what we call the turning of the credit cycle. And we devote quite a bit of space, if you look into the GFSR on that, because it's a national event. Now it seems that the corporate earnings season that is just starting, there are some very high expectations still attached to that. So maybe, maybe the timing of that turning of the credit cycle might be slightly later. In terms of likelihood, I think the issue if you talk about a timeframe of six-12 months, which is usually with our timeframe, because if you turn out more reports meanwhile, the second one is probably the one on inflation. As I said, we don't think it's a high probability but given what Mr Tran just reiterated, there is a risk that inflation could go higher and as you all know, the markets, at least until recently, have priced inflation to perfection as the jargon goes, and I wouldn't rule out that there would be a little more in terms of inflation, hopefully just a little. And then again the bond markets for years have gone up about 50 basis points, is a clear reflection. Now the global imbalances is a bit out of this equation because as they like to say, in the short-term we don't have a lot of expectations of a major accident. However, if it were to happen, if there was some, all of a sudden, some events triggered by some very unforeseeable events, some military conflict or something, that could be very nasty. Much nastier than the turning of the credit cycle and if you like, even less likely, but of even higher impact would be a real fully fledged avian flu pandemic. I'm not talking about birds being killed, I'm talking about a pandemic amongst humans where then, in turn, a large part of the workforce would not show up for work which would ultimately result obviously in a sharp and deep reflection for that and this is why we are encouraging our membership and [inaudible] through that membership to do all you can to avoid and to prepare for a situation where people do not panic and stay home from work.

QUESTION: In both your major [inaudible] markets, could you tell me which regions you see as most vulnerable? You mentioned Latin America, increasing concerns about the political cycle there. Could you talk a little about that? Thank you.

MR. HÄUSLER: This is a minefield, I am aware of that. Let me put it this way. As I said in my opening remarks, so far, in the past few years, most regions in the world including Latin American have made enormous progress in macroeconomic stability and also in their debt management. And broadly speaking, changes in political governments have not reversed that, or in the case of Brazil to be very clear, the 2002 presidential elections did not only not reverse the previous politics but in fact the new [inaudible] administration even took enormous strides in making Brazil a much stronger economy and certainly making its debt far more viable. Now going forward, I made a reference to the election cycle in Latin American and I said, "So let's hope for the best, that things remain that way." So I'm basically optimistic that the emerging market countries including Latin America have used this global liquidity pour on the liquidity glut almost quite wisely, and if you look at the debt to GDP ratios in countries, if you look at the external debt, if you look at the foreign exchange risks that countries such as Brazil have today brought us, to what they had two or three or four years ago, there are great improvements. And I think that gives these countries much longer fuses and times to react from macroeconomic policy if ever there was something unpleasant of these risks that we just pointed out in the global economy, if any of these risks materialised, the policies, the domestic policy-makers would have more time, longer fuses to react.

QUESTION: A couple of questions if that's okay. The first of which is on the corporate credit market. There's a quite striking chart on page 20, figure 1.12 about an [inaudible]. And I just wonder, in that chart whether we in the UK ought to be concerned about the disparity between [inaudible] back to the UK and elsewhere. And secondly I just wanted some clarification, in your final remarks on this Faustian pact, I just wondered whether specifically are you talking about the risk of a house-price crash in the US or something along those lines? Are you specifically talking about the household sector suffering some major downturn or is there some other kind of angle that you're trying to [inaudible].

MR. HÄUSLER Let me lean towards—Mr. Tran will come back on the credit cycle. Let me just—all these metaphors have their risks and I make light, I obviously did, but the Faustian pact is where you see all the benefits. This was meant especially in the context of pension [inaudible] which poses also hot topic in this country, I know this very well but its relevant in almost every country, especially with those with relatively unfavourable demographics. What I meant to say is you include, you give the household sector chances to participate in capital markets in an unprecedented way to the upside, and you offer them products, many product [inaudible] paved the way for participation in hedge funds as you are undoubtedly are aware and that's fine. And other countries do similar things but I am not sure, in fact I doubt that these same people who are offered these chances to receive this are fully aware that this is a risk that if financial market assets, (I'm thinking less of house prices, I'm thinking more of pure financial markets), if these assets were to go down and they realise that for their pension for the old age savings so to speak, they had something that whose price can move possibly quite dramatically, that this could create a backlash in political terms. Maybe not so much in the U.K but I'm thinking more of continental Europe. So it's something that—what I am saying is basically, I am not sure that these household sectors really fully have digested the fact that they are in also for the downward of financial markets if they ever were to occur. As to the [inaudible] gain by [inaudible], Mr Tran will pick that up.

MR. TRAN: Your question about the corporate credit market, share [inaudible] backed in my view is a very normal activity when companies are recording huge amounts of profit, they have a large position of cash on their balance sheets and if they don't feel that they are far enough, profitable opportunities to deploy the cash, it's very normal and very reasonable to give it back to share owners so that shareholders can use the cash elsewhere. However, if you look at the share buy-backs on top of the high dividend payout policy, the merger and acquisition activities and so on and so forth, what we try to highlight here is that the improvement in the balance sheet of companies which we saw asset [inaudible] trend form the bursting of the equity bubble in 2000/2001 has come to an end at the very high level [inaudible]. And because of these activities are clearly geared toward rewarding shareholders at the expense of bond holders. And [inaudible] raised that the environment is from a strong corporate balance sheet but moving toward more shareholders than the activities at the expense of bond holders. On top of that, the [inaudible] raised the risk of idiosyncratic credit risk for companies. All of that suggests that moving forward, the very strong development on the credit market might come to some resistance [inaudible]?

QUESTION: Can I just also clarify what you're saying about the carry trades in Iceland and the recent events there? Are you saying that you don't believe that it's the unwinding of the carry trades that's the main cause of the market instability that we've seen in Iceland in the last few weeks? And if so, do you have any view on what the implications of what's been going on in Iceland where you know, they've obviously got high trade deficit and so on like certain other countries in the world, but does it have...what's been going on there? Does that have any implications for some of the larger global economies in your view?

MR. HÄUSLER: Let's say, let me say a few words about carry trade and then Mr Tran can...there have been carry trades in many areas. First of all, I think they may get more attention in the media than they really deserve. You take the yen carry trades for example. I'll come back to Iceland, I'm not trying to evade you, but just generally speaking on Japan, yen carry trades. If you look into as much as you know, and we are not perfect, it may be not as relevant or not as big an involvement compared to all the others, I mean this is all that is the difference to Iceland where everything, where small numbers can make you see the difference. But in the case of carry trades in the yen there's a lot of talk and I don't think it's a bit blown out of proportion. By the way, one sector in Japan that is using the yen carry trades a lot is the Japanese household sector, which comes back to the household sector. The Japanese household sector buy New Zealand Dollar bonds, so that's a carry trade, period. So I think it's a bit...in the case of Iceland, and maybe to a lesser extent New Zealand, it's a very small country, it's a very small market so if its not [inaudible] but it has the features of a very small and narrow market and if you have crowded trades there, you may get and you did get quite some drastic changes in terms of crisis. Now you are obviously making reference to the fact that it's a high-yield currency and it has a current account deficit like other countries which...of quite significant proportions. I think you cannot compare a small country to by definition, to any big countries. Especially if "the big country" is a reserve currency country with very deep and broad and liquid markets, I think you need the comparison is a bit far-fetched for my taste. I don't know whether Mr Tran has any....

QUESTION: You allude to the possibility of military, unforeseen military conflict, there is now the reasonable prospect that we could see some kind of military action in Iran, or if not certainly [inaudible] tension, very [inaudible], oil prices hit a high of $68.89 in London yesterday. How concerned are you about the implications of that kind of [inaudible] pensions could have?

MR. HÄUSLER: That's a tough nut because whatever you say—look, financial markets do not, usually do not, like attention like that. They certainly don't like uncertainties and military confrontations are usually not very good. But there's a world out there beyond financial markets and I'm not the person here, the spokesperson to comment on whether this world of non-financial markets should be this or should be that. We will have to live with these uncertainties and I think, as you just said yourself, markets are starting to price in some of these uncertainties and this maybe an element in oil prices and elsewhere. But it's a bit like the—forgive me the comparison—like the flu pandemic. We all hope it never happens. If it happens, it's not nice, we all know that, but for me to speculate in either case...you could have asked the same question about the flu pandemic. What if you have so many million dead in some part of the world, how, what does it's so speculative and unprecedented that I think I may do this over a beer in some pub but not in a public press conference for me to speculate on that.

MS. MBOTO FOUDA: Thank you very much for coming, and thank you to Mr Häusler for his kind remarks and we hope to see you next year. No, in September this year.



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