Transcript of a Press Conference on the Global Financial Stability Report
September 12, 2006Monetary Authority of Singapore
Singapore, September 12, 2006
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Counsellor and Director, Monetary and Capital Markets Department
Deputy Director, Monetary and Capital Markets Department
Deputy Director, External Relations Department
MR. HACCHE: Good morning, and welcome to this live press briefing on the IMF's latest Global Financial Stability Report, or GFSR. I am Graham Hacche, Deputy Director of the IMF's External Relations Department. Let me first say how much we appreciate the help of the Monetary Authority of Singapore, the MAS, in providing us with these facilities here for this briefing.
To my right, to answer your questions, are Jaime Caruana, recently appointed as Counsellor to the Managing Director and Director of the IMF's new Monetary and Capital Markets Department, and Hung Tran, Deputy Director of the Monetary and Capital Markets Department. I should say that the Monetary and Capital Markets Department was formed very recently from a merger of our International Capital Markets Department and our Monetary and Financial Systems Department, so recently in fact that the observant among you will see from the preface of the report that it was prepared in the International Capital Markets Department.
Mr. Caruana has some opening remarks before we turn to your questions.
MR. CARUANA: Well, good morning, ladies and gentlemen. Thank you very much. This is my first press conference to present the Global Financial Stability Report, but there is a tradition to do this kind of presentation in various international financial centers and we are very grateful to have the opportunity to do it here in Singapore and we are very pleased to do it here in Singapore. Before opening the floor for your questions, I would like to make a few remarks about the main messages and policy recommendations of this present edition.
In our view, financial stability conditions remain underpinned by the favorable overall outlook for the global economy. However, international financial markets face downside risks to this baseline scenario of continued strong growth. The global economy has performed well in recent years and financial markets have reflected this; they are more resilient. Corporate balance sheets and profitability are strong; financial institutions are healthy; and many emerging markets have taken advantage of these benign conditions to improve their fundamentals.
However, as I said, risks remain and these risks are related to the uncertainty about the outlook, the uncertainty about a more pronounced slowdown in the U.S. economy led by a rapid cooling of the housing market, an intensification of inflation pressures requiring more monetary tightening than currently expected, and potential further increases in oil prices due to geopolitical uncertainties. Also, a disorderly unwinding of global economic imbalances, although unlikely, would have significant ramifications for financial markets.
So, risks are there, but markets again appear to make little provision for these risks. So, if one or some combination of these risks materialize, financial markets could experience greater turbulence, placing stresses on the international financial markets. In addition, the rapid growth of hedge funds and credit derivative mechanisms, although they have helped to enhance global financial stability-they have contributed to liquidity, they have contributed to distribute risks-have added new layers of complexity to financial markets that have yet to be tested in difficult conditions. So, all these elements merit further analysis and raise some concerns that, under some stress conditions, market turbulence could be amplified, especially if problems of market liquidity or operational problems arise.
Global markets anticipate an orderly adjustment of global imbalances, but exposures are large and growing and, therefore, risks remain. There are, however, mitigants that support this smooth adjustment of global financial flows and we analyze some them in the Global Financial Stability Report. For example, the depth in liquidity and breadth of the U.S. financial markets have played an important role in attracting capital inflows from both the foreign official and private sectors. Another element is the growing liberalization of capital outflows in a number of emerging markets, together with the diversification of official reserves; we think that this element also has contributed and has supported a smooth intermediation of global savings. These are elements that help to smooth the process.
In coming back to emerging markets, our analysis says that the turbulence that emerging markets experienced during May and June reflected corrections rather than a reassessment of fundamentals, reflecting corrections in the wake of substantial past investment flows and price increases. The resilience of risk spreads, the resilience of sovereign bond and relatively stable risk spreads reflected investor perceptions of improved fundamentals in many emerging markets, and there are reasons for that. There are lower deficits in emerging markets, a higher level of reserves, improved public debt structures. Just to give you an example, the share of emerging market countries with public debt exceeding 50 percent of GDP, although it is still one third of the total, is now at the lowest level since 1997. If you analyze different indicators, you will find the progress that emerging markets have been doing over the past years.
However, this correction, the correction of May/June, also underscores that some emerging markets remain susceptible to a retrenchment by foreign investors because, for example, the greater uncertainty that I have mentioned. In particular, those countries with large balance of payments needs, coupled with excessive reliance on portfolio inflows and/or where monetary and fiscal policy credibility well established, these are the kind of countries that are more vulnerable to this turbulence.
We have in the Global Financial Stability Report of this year included a second chapter where we examine also household credit in emerging markets from a more broad sense, more structural sense. This credit, household credit has grown rapidly, although from a low base, across many emerging markets, and this is by and large a welcome development. This better access helps to smooth lifetime consumption, help to diversify portfolios, and that can improve significantly welfare.
While the recent expansion of household credit do not appear to pose a major threat to financial stability, a downturn may bring out potential vulnerabilities. This kind of growth that we have seen in this credit occurred against the backdrop of low global interest, ample domestic liquidity and international liquidity, but now we are in a situation where the monetary tightening across mature and emerging markets is a new situation and any weakness in the product design, any weakness in credit standards or in supervision could be revealed, especially as the higher service debt costs can adversely affect household balance sheets and also can affect negatively the level of nonperforming loans.
Moreover, there are some localized concerns that have surfaced in some emerging markets, and let me just mention that in some emerging markets, credit-driven expenditure has led to a deterioration of external balances with household borrowers exposed to potential changes in some of these variables that are important, potential changes in interest rates, potential changes in exchange rates, and also in property prices, and especially in those countries where prices have risen particularly in recent years. Again, this is the chapter that has been devoted to emerging markets, but some of this elements that I have mentioned could also apply to some other developed countries that are also seeing increases in property prices.
So, let me conclude and to conclude led me reiterate and perhaps complete the main message. While the global economy and financial markets have been resilient and growth prospects remain good, there are some risks, there are risks, downside risks that have increased and policymakers in both mature and emerging markets, therefore, face renewed challenges in ensuring balanced global growth and also financial stability. So, the conclusion is that we should all be prepared for a more difficult environment if these risks that I have mentioned, and again it is not the centralized scenario, but if these risks materialize.
What kind of responses? More cooperation among country authorities. Emerging markets should continue to reduce their vulnerabilities and improve their regulatory framework and prudential framework. Finally, I think it is worth also mentioning that financial institutions should continue to improve risk management practices, should continue to make sure that they have enough shock absorbers and that they consider the implications for the financial soundness and for debt liquidity of scenarios that are less benign.
Thank you very much for your time. I hope that this kind of telegraphic description of the main messages are helpful to you, and we are ready for your questions.
QUESTION: Do you have any concerns over the growth of the derivative markets, and what should be done to address those concerns?
MR. CARUANA: The analysis would be the following. First, we think that the growth of derivative markets has been very positive and that it has helped a lot to distribute risks and to distribute risks among those that are better able to hold this kind of risks. So, in normal times, it has been proved that this is a very positive development that help to sustain stability and again to distribute risks. The concern would be a little bit more in the case of stressed scenarios. The idea is that this tremendous growth in this complex product has not been tested in serious stress tests. So, that is a little bit our concern. But, again, it is a positive development and what we are concerned is that the complex financial system that we do have, and this is only part of why this is a complex financial system, could at some point of time, and if there are problems of liquidity in some segments, could help instead to absorb, could amplify some of the volatility. That would be our concern. Again, I would like to make clear that developments in the derivative markets in the sense that help to transfer risks are very positive developments that improve risk management of institutions and improve the risk management capacity of the financial system.
QUESTION: Two questions, if I may. One, on this issue of risks, what leads you to believe that markets are not pricing the risk adequately; why do you see that? Then the second question on emerging markets, you say that you fear a retrenchment by foreign investors. I wonder if you could comment on Latin America. Do you see that danger there, because the description that you made of the vulnerabilities of some of the markets seemed to be present there in that region.
MR. CARUANA: I mean, the first question about pricing risk, what we have observed is that if you take some of the measures of pricing risk, which are, for example, spreads or volatility, we are observing a low level, so low that it is really below all historical standards. Some people have described this situation as pricing for perfection, or pricing perfection. The markets are pricing a situation that is extremely benign. Again, the baseline scenario is a benign situation, but it is important that markets also take into account the complete spectrum of risks. In that sense, this low level of premiums and of spreads suggests that perhaps, or at least we need to understand better, how the situation is so well priced. Our concern is that if they are pricing for perfection, any development that goes into some of this risk materializing could create, of course, some repricing and some increase in volatility. So, we need to understand better why this low volatility and why credit risks are so low by historical comparisons.
The other thing about flows retrenchment and possibility of changes in international flows, first we have to differentiate between what is a baseline scenario, where we are not saying that this is going-this is not a forecast, this is a risk scenario, our role here is to try to analyze possible risks and this has happened on several occasions so we are not forecasting that this is to happen. On the contrary, I have stressed, and I would like to do it again, that there has been tremendous progress on the part of emerging markets to improve their fundamentals, and this is extremely helpful and this is part of the explanation of why perhaps the markets have been resilient on previous occasions and why, for example, after May and June, they have come to a more normal situation. So, there is a lot to say about the progress that has been achieved. What we say is that also out of the experience of this previous volatility, we have seen that those countries where the situation, the external situation, the fiscal situation or the credibility in some of the policies are weaker, these are the countries that can suffer the most. Therefore, there is a lesson to continue to try to reduce vulnerabilities and the lesson that good policies pay off and it is good to continue to progress in, again, what has happened in many countries of reducing these vulnerabilities. The structure of the debt, ratios of debt, all this has improved over the past decade and this is the reason why we have now a more resilient system, but the risks are there. That is what we would like to convey in this report.
QUESTION: I was wondering, you say imbalances remain a concern, but do you get any sort of sense if markets are really worried about imbalances or if there is more focus on a slowdown in the U.S. currently?
MR. CARUANA: Yes, I said markets are more focused on growth; they are more focused on future deviations from the scenarios, what will be necessary in terms of inflationary risks and monetary policy; I think they are more focused on that and they are not so much concerned about global imbalances. What we tried to say is that there are risks there and it is important again to differentiate between forecasts, which we do not do that, but risks are there and the message again is it would be important to be ready if some of these risks at the end materialize.
QUESTION: I am not an economics student, so pardon me if the question is very elementary. There is some mention in this report about dollar decline. What does it mean and is it directly related to the increasing foreign exchange holdings by countries like China, Japan, India, and the oil-producing Asian countries?
MR. CARUANA: What we do at GFSR is not to forecast, first of all, exchange rates; we do not do that. The analysis that in other chapters of the work of the IMF, that would be more on the WEO that will come in a few days. In any case, it is not to try to forecast exchange rates but basically to try to see whether the exchange rates are aligned with fundamentals. What we have done here, which you are referring to, is to try to see what is the consensus opinion in markets about the dollar, and what we say is basically two things. One is that any adjustment on the dollar will be limited and orderly; that is what we have found. Second, there would be a differentiation by region so that it will not happen the same to different regions and it would be those regions such as the Asian currencies that have large surpluses the ones that appreciate in relation to the dollar. That is basically what we have analyzed in the Global Financial Stability Report.
QUESTION: Just three questions. The first question is, would you able to give an assessment on whether you think that the financial markets internationally are better prepared to meet with some of the risks you highlight? Are they more stable, have they grown more resilient to cover the risks? The second question is what kind of things should Asian countries do, what kind of concerns, things they can do to improve their financial stability? Finally, what kind of concerns regarding financial stability do you hope to achieve or address at the upcoming meetings?
MR. CARUANA: Okay. Are markets better prepared, more resilient? Yes, they are more resilient, for several reasons. I think there has been progress. I mentioned the first reason in the case of emerging markets, improving fundamentals. I will not repeat, but let me stress again that there has been better management of data and all that. This is one reason. I think there have been improvements, significant improvements in the frameworks, for example, of supervision in the implementing of standards and codes. Therefore, I think markets are better able; the regulatory framework, the supervisory framework had been improved. I think that markets are also more resilient, because also the market participants, the institutions, financial institutions over the past few years have significantly improved their risk management capabilities. These, in addition to being able to get more shock absorbers because of these conditions, I think all these elements provide markets that are now much more resilient. So, it is a mixture of a good situation of the economy and also the fundamentals that have been improved in many areas.
This applies certainly, also, in Asia where the frameworks, again supervisory frameworks, have been significantly improved. So, what I said would also apply in the case of Asia. I am not sure what was the third part. What do we expect here? Well, there will be a continuation of some of the discussions about, for example, global imbalances, which I think is one of the key issues that should be discussed. In addition to that, I think that the idea that we discuss, we do have this new edition of the publication. It is quite helpful in order to understand what are the trends and the risks of the financial system.
QUESTION: Two questions. I was wondering if you could elaborate a bit more on the risks posed by carry trades. We have seen that there has been quite a significant sort of carry trades going around the world from Iceland, New Zealand, now Japan, is probably the big issue. I was just wondering how serious a risk that is. I apologize whether this question is a bit micro, but I was just thinking about political risks to stability. We have seen in the U.K. recently quite a shift in sterling because of doubts over the political stability there, and I was just wondering globally or locally how much you saw sort of an outbreak of political instability, whether it was on a protectionist basis or just internally within markets, how much that could threaten stability.
MR. TRAN: On the carry trades, we have seen since the beginning of this year some instances of unwinding of carry trades, starting with the Icelandic krona and the New Zealand dollar, high-yielding currencies that have attracted huge investment inflows. Since the monetary tightening has spread from major countries to several other emerging market countries as well, we have seen this unwinding continuing to happen, particularly through May and June. One clear impression throughout these episodes of correction is that the unwinding and the corrections, while producing losses to some individual and specific participants, have tended to be quite orderly, gradual, and well absorbed by the international financial system. So, we continue to think that that should remain the case going forward.
The concerns about different factors impacting on exchange rate movements and cross rate movements, particularly in the short timeframe, is very, very noisy in the sense that many things can dictate the concern and the fixation of foreign exchange traders from day to day. So we do not really spend a lot of time focusing too much on this short-term trading behavior. What we try do to see if over the medium term are there patterns of imbalances or patterns of exposure that could potentially become a threat to financial stability in the future.
QUESTION: Could you give us some sense as to what could cause the next market shock and how prepared is, say, Asia to that?
MR. CARUANA - I would say that there will always be surprises but, by definition, surprises are surprises and difficult to foresee. I think the important part is the second one, to what extent we are ready, and that is basically what we tried to do with this kind of publication. We tried to analyze what are the exposures, what are the risks and, therefore, what are the policy implications that could help to increase resilience to unexpected shocks. But frankly speaking, I would not speculate much about what possible shocks there will be at some point of time, and I think our work is to try to make at this very moment systems more resilient and to contribute to that.
QUESTION: I have two questions. The first is regarding household credit. You mentioned a deterioration of external balances. I just wondered if you are particularly worried about any markets or regions. My second question is, what can the IMF actually do to better monitor or gauge capital markets and what kind of restructuring might be needed?
MR. CARUANA: In relation to household credit, I would say that we are concerned about all countries where credit is growing very rapidly, that this is accompanied by also rapid growth of prices, and especially this is accompanied by external imbalances and by some kind of currency exposure. This happens in a few countries, for example in Eastern Europe, but I would say we would be concerned with the concept. The question is that the households then are more sensitive to any change in the different parameters that will be more sensitive in terms of consumption to changes in interest rates, to changes in exchange rates, or to changes to the underlying price of housing. This could change the sensibility in terms of their expenditure. So, this is an important element but, again, there are more than one and two examples of this kind of countries.
We are doing a lot, I would say, in the Fund to better monitor financial markets. We know that this is key, that this is extremely important. There are programs that perhaps started more than one decade ago in terms of, at the beginning of the 1990s, for example, all the programs related to the FSAPs, Financial Sector Assessment Programs, that have been extremely helpful to understand what is the situation of different countries and to help to find the fragilities and vulnerabilities that need to be addressed. We do a lot of technical analysis; we do this kind of multilateral surveillance that comes in the form in which the final product could be this Global Financial Stability Report. We will continue to sharpen our capacity to analyze financial markets. We know that this is of key importance. This department will have as a mission first to be in contact with markets, to be in contact with supervisors, with regulators, and to try to bring this perspective, this financial perspective to the day-to-day work of the IMF. I think this is again a very important part of the strategy that the Managing Director has put forward in the medium-term strategy.
QUESTION: Markets are pretty focused at the moment on the risk of a U.S. housing market correction gathering further steam through the remainder of this year and into next. Could you give us some sense of what your assessment is of where the principal financial vulnerabilities lie that could be crystallized if the housing market in the U.S. continues to slow, which kinds of institutions are most vulnerable, and what you think the main risks surrounding that would be? Secondly, you talked a lot about the resilience of the system, the financial system across the world generally, and the way that credit risk transfers and so on has help to mitigate some of the risks that you have outlined. But could you give us also a stronger sense of where there are particular vulnerabilities that are most likely to be the ones that pose the greatest risk that come to fruition, as it were.
MR. TRAN: First question, I think that the degree to which the cooling off of the housing sector in the U.S. is now regarded by many market participants as a very important risk in the period ahead. Indeed, we have seen many indicators showing that activity has declined quite substantially. So far this year, the inventory of housing has increased, prices have started to decelerate, and so on and so forth. I think that at the moment, particularly looking at the experience of the two other comparable countries, the U.K. on the one hand and Australia on the other hand, both experienced a strong run-up in prices and then deceleration of prices. For most of the past year, the overall process has been rather described by soft landing and the situation is well contained. So there is, many hope, a central case scenario that the U.S. will probably experience similar developments. However, it is clear that there are risks on the downside in the sense that the sharper than currently expected slowdown in the housing activity in the U.S. would produce a weaker than expected U.S. growth, with negative implication for global growth overall and negative implication for financial markets. So, that is something that one needs to monitor closely. Who would be more exposed and vulnerable? In our view, the subprime segments of the U.S. mortgage market bear watching, both for the borrowers many of whom tend to be not very high income and highly financially qualified borrowers who had to resort to these exotic or new mortgage instruments with low up-front payment in order to improve their ability to borrow and to buy high-priced houses. They could be vulnerable to an increase in interest rates, and on the other side of the coin investors buying up mortgage-backed securities and collateralized debt obligations using the subprime mortgage instruments as collateral could be therefore exposed to an increase in delinquency rates among the subprime borrowers. Indeed, we have seen that the delinquency rates among subprime borrowers have started to increase from a very low base and still very low historically, but has shown an increase in recent months. Again, that is an area of potential vulnerabilities.
In the financial system overall, I think that the risk, as Mr. Caruana indicated earlier, is for the markets to react and adjust to slower than expected growth stemming from housing developments in the U.S. economy. What we tried to point out in the report is that market exposures, market structures, potential carry trades or potential illiquid conditions in some segments of the more complex instruments could amplify a market correction and make it sharper than otherwise it could have been and, therefore, the potential amplification of these new developments, while overall being positive, is something that we urge national supervisory authorities and market participants to pay attention to.
MR. HACCHE - I think we can wrap it up there. Thanks very much for coming.