The Global Economy and Financial Markets: Where Next?, Speech by John Lipsky, First Deputy Managing Director, International Monetary Fund

IMF News, July 31, 2007

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The Global Economy and Financial Markets: Where Next?, Speech by John Lipsky, First Deputy Managing Director, International Monetary Fund

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• Published: July 31, 2007

Global macroeconomic backdrop and outlook

• IMF baseline global forecast: 2007/2008 growth will register at an annual rate of "just over 5%".
• Virtually universal growth envisaged to continue; over half of global growth this year and next is anticipated to be accounted for by emerging market economies.
• Domestic demand growth in Japan and the euro area has strengthened in recent quarters.
• China's contribution this year to global GDP in dollars, measured at market exchange rates, is "quite likely to exceed that of the United States."
• Downside risks to the baseline forecast are judged to be tilted and include:
  • inflation pressures from capacity constraints or rising energy prices;
  • heightened financial market instability;
  • rising protectionism;
  • the possibility of a disorderly unwinding of global payments imbalances.
• Upside risks include stronger-than-expected growth in emerging markets and a stronger-than-expected recovery in the euro area and Japan.
• A sharp US growth slowdown would likely test growth outcomes elsewhere.

Financial innovation, globalization, and key structural features

• Three hallmarks of the current period:
  • Securitization: progressive replacement of bank credit to households and corporates by tradable instruments.
  • Development of new risk transfer instruments (e.g., interest rate swaps, a liquid market for credit default swaps (CDS), and other derivatives).
  • Effects on asset management: hedge funds and private equity at the forefront of innovation and active management.
• Hedge funds account for "between 2% and 5% of global assets under management" but a far larger share of market turnover and sometimes act as marginal price setters, especially in newer markets such as CDS and structured credit products (CDOs and CLOs).

Cross-border flows, portfolio patterns, and reduced home bias

• Cross-border capital flows as a share of world GDP:
  • have "doubled since the beginning of this decade";
  • are "more than triple the share of the early 1990s."
• Average share of international equities in developed-economy pension fund portfolios grew "anywhere from two to sixteen-fold between 1990 and 2005."
• Reduced home bias has been more marked among conservative institutions (pension funds) and would be even more striking if mutual funds, hedge funds, sovereign wealth funds, and other asset managers were included.

The recent market challenge: re-pricing of credit risk and the US sub‑prime epicenter

• Epicenter: US sub-prime mortgage market, a relatively new market facilitated by new risk transfer instruments.
• Delinquency trends:
  • Improvement in delinquency rates for 2000 and 2003 vintages;
  • rapid market growth accompanied by notable deterioration in delinquency rates;
  • by the 2006 vintage, deterioration "had become extreme."
• Sub-prime ARMs have a long-tailed impact because the calendar of scheduled resets is "still increasing, and will not subside for some time to come."
• If credit woes remain largely confined to the sub-prime ARM sector (a relatively small proportion of the overall mortgage market), the broader economic impact is likely to be limited—but problems are likely to extend longer than initially anticipated.

Corporate credit markets and covenant erosion

• Post-2003 weakening of credit discipline evident in marked dilution of loan covenants.
• Covenant-lite loans:
  • totaled "around $110 billion during the first half of this year";
  • up from "about $30 billion last year";
  • and "less than $10 billion the year before."
• The trend has abruptly reversed, implying a likely slowdown in leveraged buyout (LBO) activity.

Collateralized Debt Obligations (CDOs) and exposures

• Total volume of CDOs outstanding from US-based issuers is estimated to be "about $900 billion."
  • About "17 percent" of this has been created out of sub-prime ARM mortgages, with an average credit quality of "BBB."
  • Another "30 percent" has been created out of leveraged loans in the form of collateralized loan obligations (CLOs).
• Comparison magnitude: CDOs versus aggregate marketable US financial assets of "about $ 46 trillion."
• Ownership pattern and stability implications:
  • Hedge funds own a relatively small percentage of CDOs outstanding but appear concentrated in the riskiest "equity" tranches—one market estimate is that "about 50 percent of hedge funds' structured credit holdings are in the riskiest equity tranches."
  • Banks and insurance companies hold a larger share of the overall CDO market but such holdings are a small share of their overall portfolios and are concentrated in less risky tranches.
  • Stability implications are mixed: hedge funds are more at risk and more active in turnover; traditional investors are better positioned to absorb losses given portfolio composition.

Market developments and near-term financial implications

• Since June 15, when certain hedge fund difficulties became public, "spreads have more than doubled on CDOs backed by collateral with an average quality of BBB."
• Possible channels for broader spillovers:
  • Investors who relied on credit ratings for CDOs and CLOs may question the value of ratings in other markets.
  • A backup in the CLO market is likely to slow or temporarily halt LBO activity, which could pressure equity valuations if corporate profitability weakens.
• Second quarter US corporate profit data "once again exceeded consensus expectations," which could help allay some concerns if profits remain strong.

Emerging markets outlook amid global credit strains

• A positive development: international investors increasingly purchase sovereign and leading-corporate debt of emerging markets, suggesting a partial overcoming of "original sin."
• This trend can mitigate a key source of financial vulnerability that exacerbated the 1997/98 Asian crisis.
• Carry trade flows have been a source of inflows to New Zealand (most notably) and, to a lesser extent, Australia; abrupt unwinding is a risk but less likely if the global outlook and funding-currency economies remain stable.
• The IMF baseline forecast remains favorable, and the overcoming of "original sin" likely reflects improving fundamentals rather than solely a broad credit tide—if good policies are maintained, favorable credit trends should survive current difficulties.

Policy implications and IMF actions

• Policymaker guidance:
  • Take stock of whether new actions are needed to reduce financial market risks.
  • Pay close attention to the evolution of new markets and seek to help them function smoothly without stifling financial innovation.
  • Implement credible medium-term measures to gradually reduce current account imbalances.
  • Seek successful completion of the Doha round of trade talks to bolster global confidence.
• IMF initiatives and instruments:
  • Convened a Multilateral Consultation on Global Imbalances beginning last year involving five principal economies: China, the euro area, Japan, Saudi Arabia, and the United States—aiming to construct medium-term policies to significantly reduce imbalances while keeping global growth strong.
  • Stepped up analysis of financial markets and integrated it into regular macroeconomic analyses.
  • Conduct Financial Sector Assessment Programs (FSAPs) focusing on financial sector soundness.
  • Conduct reviews of member countries' relevant standards and codes through ROSCs.
  • Promote transparency and improved reporting via the Special Data Dissemination Standards (SDDS).
  • Developing new liquidity instruments to augment existing lending facilities to strengthen crisis prevention capabilities.
  • Rebalancing IMF quotas to reflect changes in relative economic weights and to raise the voting share of emerging market countries.

Italic: Speech by John Lipsky, First Deputy Managing Director, International Monetary Fund, July 31, 2007.

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References

• PRESS CENTER
• Slide 1: Title Slide
• Slide 2: The Favorable Global Backdrop
• Slide 3: The Global Expansion Has Been Strong
• Slide 4: Global Risk Factors Tilted to the Downside
• Slide 5: Three Hallmarks
• Slide 6: The Effects - Record Cross-Border Flows
• Slide 7:The Effects—Reduced Home Bias
• Slide 8: The Latest Challenge—The Re-Pricing of Credit Risk
• Slide 9: US Sub-Prime Market Credit Quality Deterioration
• Slide 10: Sub-Prime Mortgages: Long Tailed Impact
• Slide 11: Discipline weakening in Corporate Credit Markets
• Slide 12: CDOs
• Slide 13: Riskiest Positions Are Held By a Wide Variety of Investors
• Slide 14: CDO Spreads Have Widened
• Slide 15: Implications
• https://www.imf.org/en/home