Transcript of a Press Conference on the Global Financial Stability Report, Gerd Häusler, Counsellor and Director, International Capital Markets Department, Hung Tran, Deputy Director, International Capital Markets Department, IMF

April 6, 2004

Transcript of a Press Conference on the Global Financial Stability Report
Gerd Häusler, Counsellor and Director, International Capital Markets Department
Hung Tran, Deputy Director, International Capital Markets Department
Thomas C. Dawson, Director, External Relations Department
International Monetary Fund
Tuesday, April 6, 2004
London, England

MR. DAWSON: Gerd Häusler, Counselor and Director of the Capital Markets Department and Hung Tran, the Deputy Director of the Department will provide the introductory comments and then take your questions on the report.

This is the second time that the briefing has been held here in London, and we'd like to thank our colleagues from the Bank of England for hosting us.

If I could just set the ground rules to remind you that the contents of the briefing, as well as the report itself, are embargoed until 11 a.m. today. And I would ask you to exercise proper etiquette by identifying yourself and your organization when you do have questions. Gerd?

MR. HÄUSLER: Thank you, Tom.

Yes, it's indeed the second time that we are in this wonderful facility, and we're quite grateful. Let me then do what I did last time-I will make brief opening remarks, to give you a little bit of flavor, and then we can engage in discussions, as long as I may get my 12 o'clock train from Waterloo Station.

The main message that this report is that global financial vulnerabilities have subsided further since our last report that came out in September 2003. International financial markets over the last couple of months have remained quite buoyant, and even the corrections that you saw earlier this year by many mature equity markets and corporate emerging bond markets, from roughly, late January into March, have been proven quite mild.

We believe that the present financial markets seem to be enjoying what we call in the report a "sweet spot". Economic activity and corporate earnings, on the one hand, have recovered quite substantially after the bursting of the bubble, but policy interest rates remain quite low, can remain quite low, thanks to tame inflation. There is a lot of talk about interest rates going forward, not the least in this city here, in this building maybe even, but I think we have clearly very tame inflation.

So, overall, the balance sheets of financial institutions and other market participants have largely recovered from what you may want to call the storm after the aftermath of the asset price bubble that we saw in the late '90s and in 2000. Emerging bond markets have performed well, and that's something that is always very dear to our heart in the Fund. Emerging bond markets perform very well, thanks to the improvement in economic fundamentals in many countries. I don't want to single out some countries, but many have really quite impressive improvements.

So, as a group, emerging market companies continue to be net exporters of capital to the rest of the world. Now, you may wonder whether this is the right thing to do from a macro perspective, but purely from the narrow perspective of stability, it clearly makes these countries less vulnerable. And also emerging bond markets, as we state, have benefited from the abundance of liquidity and the search for yield by international investors.

So, consequently, as you are aware, the EMBI yield spread has declined over the last 2 years to near record lows. International bond issuance and other forms of capital flows to emerging market countries have also recovered, including, if you include the prefinancing for 2004, which took already place last year, emerging market countries have generally secured half of their 2004 external financing needs. That is quite impressive.

So, overall, the current benign financial conditions in mature and emerging markets will likely continue for some time to come. And as I mentioned before, the price consolidation in the first quarter, as we see it, is a welcome development because it does reflect a degree of caution and credit discrimination on the part of investors which we find rather positive.

However, as we state in our report, this benign outlook, which we all appreciate, is not without risks, and let me just mention three areas:

First of all, the continued abundance of liquidity, thanks to very low policy interest rates, and a perception that interest rates will remain very low for quite some time to come could, as a risk, therefore, I phrase it in a hypothetical way, could intensify the search for yield, while encouraging investors to underestimate risk factors. And this process could again then lead to an overvaluation of certain financial assets, creating the potential for disruptive corrections later on, as we say in our report.

And the second risk that we see is the famous infamous large external imbalances, which have the potential to create market instability. So far, so good. The adjustment of the U.S. dollar has been orderly, partly thanks to the revival of foreign purchases of U.S. securities in recent months. However, since the U.S. will continue to need to attract substantial capital flows, the risk of a more pronounced dollar adjustment cannot be dismissed.

If the dollar were to weaken sharply, this could result in higher-than-expected U.S. interest rates with spillover effects on all fixed income markets around the world. And such a scenario could, again, hypothetically create head winds to the economic recovery, and therefore exposing structural weaknesses in some emerging market countries which so far have been masked by buoyant market conditions. I pointed to improved fundamentals, but it's not across-the-board, everywhere and in every respect.

And the third risk, unfortunately, is something these days that you have to bear in mind after the tragic event in Madrid, the heightened fear of terrorism and geopolitical risk if--if, and hopefully not--but if intensified, could undermine investor confidence, curb risk appetite and accelerate price losses on risky financial assets.

So to guard against these risks, policymakers in mature market countries need to find ways to encourage investors to base their investment decisions on economic fundamentals rather than on expectations of prolonged periods of very low interest rates. Indeed, creating an expectation that there is no interest rate risk for investors would lead to some form of moral hazard, as we see it. It does not necessarily mean that interest rates have to rise in order to dampen exuberance, but rather an awareness of a two-way risk on interest rates would be sufficient already to encourage investors to include an appropriate level of risk premium in their pricing of financial assets.

And it is, in our view, very important for the international community to develop a strong and sustained cooperative effort aimed at facilitating a smooth adjustment of global imbalances over the medium term. It is, therefore, also important to persevere in ongoing efforts to improve corporate governance, including accounting and auditing standards and practice. If you look at our report, we think that recent developments, such as Parmalat and a few others, give us enough food for thought not to be complacent in that regard. Enron and Worldcom incidents were not too long ago either. We are not completely out of the woods.

Let me turn to emerging markets for a moment. So, for emerging market countries, the priorities include further reduction in the level and vulnerability of public debt--that's the famous liability management--development of local capital markets, something that our Stability Report has attached importance to in many previous issues already, and continued efforts to improve the climate for foreign direct investment, which is a stable and useful form of capital inflows.

As those of you who are familiar with our report know, Chapter 2 is usually the cyclical, the conjunctional part of the report, and then you have two more chapters which deal more with structural issues, with longer term, medium-term issues. Therefore, let me now turn to these chapters and give you a fuller background or the theme, what we call "the transfer of risk from the banking sector to the nonbanking sectors," which will run through this and future analytical chapters of the GFSR going forward.

This theme is a shorthand way to describe many important changes in financial intermediation that has taken place in mature market countries. As you know, banks have reduced the warehousing of credit risk in order to economize on the use of their balance sheets. In this process, they have become less of a shock-absorber in the financial system compared to what they used to be. And traditional financial institutions, like insurance companies and pension funds, are taking on new activities, both on their asset and on their liability sides, and new institutions or newer institutions like hedge funds or the financial affiliates of industrial companies have become important players in international financial markets.

New and complex financial instruments, such as the famous OTC derivatives, including credit derivatives, meanwhile, have facilitated the transfer of risk to a wider circle of market participants--again, compared to what you used to see only 5 to 10 years ago. As we have stated in an earlier report 2 years ago, there is not enough transparency in these transactions to this very date.

So these developments have naturally prompted concerns about the distribution of risk, the ability of new recipients to understand and manage risk properly and whether there exists potential gaps in current regulations and accounting standards that could lead to vulnerabilities. By examining the transfer of risk from the banking sector to various nonbanking sectors, we expect to better understand these developments and assess their implications for financial stability. This is in the context for us to look at institutions such as insurance companies which traditionally have not been associated with financial stability issues. Some people have been surprised when all of a sudden these insurance companies or pension funds pop up in our report. As I said, another example is the pension fund industry, and normally thought of in the context of fiscal problems and not so much in financial stability issues. Pension funds have become important players in international capital markets, including also in emerging markets. And we will pick up the issue of pension funds, I can already tell you, in the next stability report which will come out in September. I can't promise you the press conference will be in London again.

As you can see, in Chapter 3, some broad themes have emerged from our analysis of the investment activities of insurance companies. Let me just state a few. First, financial institutions are generally more stable if they invest in a comprehensive range of assets, including corporate bonds and other credit instruments. This word "credit instruments" is a word that you will find many times throughout this report because they are--obviously, they shouldn't concentrate too much on volatile assets such as equities, and you will find quite a bit of empirical evidence in that regard in Chapter 3. So, consequently, it is desirable for countries to foster the development of credit markets in which many countries are not as well-developed as equity or government bond markets. That is true for smaller mature markets, but it's certainly true for some of the emerging markets where we give advice.

Second, and equally important, the regulatory environment, including risk-based capital regimes and accounting/reporting standards, and actions by supervisors, play an important role in fostering appropriate risk-management culture and capability on the part of institutions. And then the final analysis, improving risk-management capability is what helps to enhance financial stability. Those skill sets that the banks were known for, for decades, have to be developed by nonbanks as well. It's good for them to take on credit risk, but it's equally, under the condition if they have the need to have the same skill set of credit analysis, risk management for credit instruments as the banks have had for a long time.

So, in recent years, progress has been made in both of these areas in many countries. Credit markets have developed further. Many insurers have rebalanced their portfolios in favor of credit instruments, strengthened their risk management capabilities, in addition to beefing up their capital bases. Now, meanwhile, the banking sector has shown their remarkable resilience during the past few stressful years. And maybe this is all true because they have not taken on as much credit risk as they used to. This is why basically we concluded that the relative reallocation of credit risk between the banking and the insurance sectors has helped enhance the stability of both as well as overall financial stability.

So, if I may just draw a few lessons for emerging market companies, it is important for emerging market countries to have a comprehensive plan to develop local markets, local capital markets in conjunction with developing local institution investors, such as pension funds, insurance companies and mutual funds. You cannot have or it's not good enough to develop a pension fund system for all of the fiscal reasons we know if you don't have the instruments available for such pension funds.

A key consideration is to develop a comprehensive range, therefore, of financial assets, including credit instruments in sufficient size and duration to meet the investment needs of local institutional investors. In this context, efforts by national and regional authorities to develop local bond markets ought to be welcome. And as this report notes, especially in Asia, you have various initiatives--the Asian Bond Initiative, et cetera--that we describe more in detail.

And last, but not least, as local pension funds and insurance companies continue to develop, prescriptive regulations, including restrictions on foreign investments, should be gradually eased and replaced by risk-based capital regimes. But this will be, as I emphasize, a gradual process and cannot be overnight. I think it would be a mistake to rush. This will encourage the development of risk management capability on the part of local institutional investors, helping them to be in a strong position to invest internationally.

In a nutshell, the point that we are trying to make time and again is it's not good enough to have reforms in some isolated areas. You need to have a real game plan, including instruments, including institutions, including foreign exchange restrictions, and only if that all fits together, then you can have the progress that you've all been looking for.

Thank you very much.

MR. DAWSON: Questions?

PARTICIPANT: In your risk section, in your overview, there's no mention of the price of crude. Is that because you don't see the price of crude [audio break] at least relevant?

MR. HÄUSLER: First of all, the rise of crude oil has been a fairly recent phenomenon, and we have a certain cutoff date in this report which is, for all practical reasons, about 2 to 3 weeks ago. That is not an excuse, but just sort of a little explanation.

Now, the price of crude oil, first and foremost, if it has any negative impacts, it would have these impacts on the real economy of various countries, not on all countries, but some and only in potential spillover effects into financial markets, ultimately. That would be a secondary effect. And we do not deal with the real economy in this. We have our sort of sister publication, the World Economic Outlook, which will be presented to the press in a little over 2 weeks. It will, I am sure, have some section on the oil price. But as to financial markets, I cannot, at this point, see any specific risks that are associated with the rise in crude oil.

MR. TRAN: I would like to add some comments to that question of yours. We do mention not oil price, per se, but commodity prices, and the sharp increase in commodity prices in the recent period, in recent years. And that goes a long way in helping many commodity exporting developing countries, emerging market countries, to register sharp improvement in their external account behavior, though they largely posted strong trade improvement. And as Mr. HÄUSLER said before, as a group, emerging market countries run a current account surplus, and therefore continue to be net exporter of capital to the rest of the world. And the improvement in terms of trade, including commodity prices, play a role in that improvement.

MR. DAWSON: If I could just add, this will be a theme in the World Economic Outlook, which is out I believe 2 weeks from Wednesday or Thursday. And the impact on the real economy of oil price increases, of course, needs to be sustained to see the impact, and there will be analysis of that particular question on what the impact is. We traditionally have rules of thumb for how an increase in oil prices flows through to the global economy, but that is an issue that's a slightly longer term issue, but it will be addressed in the WEO.

PARTICIPANT: Could you please elaborate on the importance of terrorism and political instability to financial stability and what's happening at the moment.

MR. HÄUSLER: Clearly, this is all hypothetical, but it is clear that if there were more incidents along the lines of the Madrid incident or even worse than that, it would have impacts on the real economy. Consumer confidence would probably the first one to be hit, but what usually happens--and we've seen it before in the aftermath of September 11th--that risk appetite of investors can be curbed substantially. You have the famous flight to quality to government securities and away from riskier assets. Equities are one, but others, fixed-income instruments with risk attached, like corporate bonds, emerging market bonds could be hit as well.

Now, as we saw, if the perception was this is only a single incident, then this risk appetite may, before long, return. It may return, but as I said, if this was something more pronounced, and if investors felt that these kind of terrorist incidents could strike more than once or twice, I would be somewhat concerned about the fact that an additional risk premium would be built into some asset classes that would, in my view, be quite unwelcome.

PARTICIPANT: What about the infrastructure capabilities of capital markets? What's your evaluation?

MR. HÄUSLER: I think--I'll also ask my colleague--but my sense was that, in terms of purely financial infrastructure, if you think payment system, and clearing and settlement system, I think I'm not so concerned, actually, because many countries have taken some measures after September 11th, back-up systems of all sorts. It's decentralized, in terms of geographic locations. You very often don't have these systems in a clustered area like lower Manhattan or probably not even the City of London. It's so dispersed that it is not very likely that any such incidents would disrupt the financial infrastructure.

PARTICIPANT: Brazil. Many economists, even Mr. Ken Rogoff, the former Chief Economist, has been saying about the danger of the bubble in the emerging markets. You said that the fundamentals have improved, but there is the danger that they might not discriminate between fundamentals and, you know, just views. Could you specify a little more about that, maybe what are the real dangers.

MR. HÄUSLER: I will let my colleague work a little, if he'd like.

MR. TRAN: I think that is a question that both policymakers and market participants try to understand better. It is clear that the fundamental improvement on the part of many emerging market countries have been very impressive.

If you look at the emerging market, market capitalization, about 50 percent of the emerging market bond market capitalization is now at investment grade or better. Whereas, only 5 years ago, it was only 10 percent. And that improvement in rating is, as we all know, is a lagging indicator. So, going forward, the chances are there will be further upgrades, as compared to downgrades. So improvement in fundamentals clearly play a very important role.

However, the very low interest rates and the sea of liquidity that has been available for some time clearly induce search for yield and investment behavior that might be less risky [inaudible] naturally than people would have liked to see. If you see in our report, Appendix I, Chapter 2, where we try to do some empirical testing and work, to disentangle the influence of different factors on the emerging market bond yields, the MB yield spread, between fundamentals, and liquidity, interest rate, risk appetite and so on and so forth. And, basically, over time, both fundamental factors and interest rate/liquidity factors played equally important roles in shaping yield spread of emerging market bonds.

However, in the latest period from 2001 until now, when interest rate was cut and came to a very low level, there seems to be indication that low interest rate might have played a little bit more important role. So, yes, there is some dimension of the search for yield pushing up the price of some emerging market bonds, particularly those which have not made equal improvement in their fundamental economic performance, structural reform, and particularly countries where they still have a vulnerability due to the high level of public indebtedness.

PARTICIPANT: Just to follow up [inaudible] have investors in the [audio break].

MR. HÄUSLER: It's not a concern. And I don't think the hedge funds, the word "hedge funds" always evokes a little bit of uneasiness with Fund people, including in our membership sometimes. I don't think so.

Let me sort of turn this slightly from a different angle. As the report tells you in Chapter 4, in the structural chapter, you have new players. That's not so much the hedge funds. You have very traditional players like pension funds having invested in emerging markets. And they are not people who go in and out on a daily or even a weekly basis, but they are extremely big players. And if a huge hedge fund is deciding to allocate a fraction of their assets to the emerging markets, it makes a tremendous impact because the emerging market world, compared to the whole universe of other asset classes--and if you just take the fixed-income world, emerging world bond markets are still a fairly small segment. So, if a huge pension fund allocates a fraction of their resources, it makes a difference or, if they decide at some point it wasn't worth it, we'll take 50 percent of what we had back out again, this is something very serious.

So, given the relative size of the players and the size of the marketplace, a huge player going in or a huge player going out will have more of an impact, if I may say so, compared to whether hedge funds do a little bit of flip-flopping if you like.

PARTICIPANT: In your section on hedge funds, in Chapter 2, you rather dodged the issue of whether or not you think there should be or should not be more regulation of hedge funds. What do you actually think?

MR. HÄUSLER: Let me start and then--you say "dodge." Maybe that is not totally incorrect. We are doing work or we have started some work on hedge funds. To me, it is not a clear-cut case. This is why we would like to do some more work before we come down one way or the other, if we can come down way or the other.

I think with regard to hedge funds people tend to confuse various issues. One issue is the consumer protection issue, something that is very relevant in continental Europe, for instance. What about investors when the minimum investment has come down from--it used to be a 6-digit number in dollar terms--and now you can invest 10,000 euros in a hedge fund, which is not an outrageous amount. What are you buying? What kind of guarantees do you have in case all of the money is lost at some point? That is something which is very relevant for an FSA, for instance--but for us, in terms of macro prudential stability, this is not an issue whether some smaller investors use money. This is all deplorable and should be looked after, but we're not the SEC.

Then, there is the issue of macro prudential stability. At this point, we don't have the impression that hedge funds are in danger or risk at the moment because many of them are much smaller and do not follow the same kind of macro strategies that the famous funds by Soros and others used to follow about 10 years ago. And many of them have different strategies like the famous long/short strategies in certain equity segments, but not the kind of macro hedge funds that you used to have with quantum funds and others.

There is, however, one particular issue, a third issue, if you like, worthwhile looking at. If you had a number of hedge funds or one or two larger hedge funds, going into smallish, medium-sized emerging market countries with open capital accounts. You know, such activities could potentially be disruptive, and this is why I was saying some of our members are slightly uneasy when the notion of hedge funds come up. In a nutshell, at this moment I am not overly concerned, but, Hung, you may want to describe what kind of work we are intending to do.

MR. TRAN: I think that for us the key issue is transparency and disclosure, and the object of the disclosure is really leveraging of the hedge funds because this is where hedge fund activity could have a systemic financial stability impact. So we call for, we ask for, and we suggest ways and means to have more disclosure, and more information, more transparency. Having said that, however, in our work and our discussion with different prime brokers, some hedge funds and hedge fund industry suggest some interesting developments:

One, we are now having more hedge funds, but offer smaller size compared to the degree of concentration that we had 5, 8 years ago. So you don't have one or two big funds being in the position of being able to dictate terms to their prime brokers. We don't have that any more. That is at least what we are being told.

Secondly, the prime brokers and the banks behind them are really the ones that extend line of credits or repo lines through the hedge funds. So the leveraging really come from the lending institution, the prime brokers, and these people are generally looking at their counterpart risk and credit risk much more stringently now than before. And they even demand collateral from the hedge fund clients.

Now, it is a matter of competition if you have more hedge funds, bigger hedge funds, and a lot of prime brokers compete for business and the standards will be relaxed. So that is something that is ongoing, and we have to talk with them to see how things are. But presumably all of these credit extension by prime brokers are fully reported to their respective supervisors. Therefore, somewhere among the supervisory community--at the SEC, the central banks--there should be some knowledge of the degree of credit being extended by the prime brokers through the hedge fund.

So what we tried to say is that if there is a way that can be found to make this information more widely available to the investing public, including ourselves, someone in the official sector looking into the financial stability impact of these activities.

PARTICIPANT: You mentioned Parmalat, Enron, and WorldCom, and a need for greater transparency in accounting standards. Chapter 3 does mention the work that the International Accounting Standards Board is doing on an insurance standard. It says it's similar to IAS 39, Financial Instrument Standard, but that is by no means a done deal.

So I'm wondering if you could comment on European resistance, particularly of the French banks, to an international accounting standard, and whether specifically you think that there's great losses being hidden in derivatives by European banks.

MR. TRAN: I don't think that there is resistance on the part of any banks, let alone European banks, against international accounting standards. You are talking about very specifically one aspect of IAS 39, particularly the accounting for derivatives. And it takes some time because the issue is truly complex. It's not straightforward, but the FAS 133 in the U.S., which IAS 39 has been compared to, is the best or the optimal way to deal with derivatives either, and if you look at even in the U.S., many institutions, including Fannie Mae and Freddie Mac, they have had a problem with accounting for derivatives one way, and auditors and regulators come in, look at that, and say, no, that's not the right way. They have to do it another way. But they claim that all of the time they are doing things inconsistent with generally accepted accounting standards.

So what I tried to say is that the issue is truly complex, and therefore, following the discussion in Europe between banks, and insurance companies and the Commission on the one hand, and the IASB on the other hand, we think that it is a healthy discussion that should take place, that people should have a view and participate fully in the discussion because, by next year, European companies will have to adopt International Accounting Standards. I understand that things are making slow progress, so, without prejudging the final outcome of that, I think that is something that is very healthy to happen.

MR. HÄUSLER: Do you realize that if you have a cluster of derivatives--I used to be an investment banker myself, so I remember very well that derivatives can be valued quite differently, on the one hand, if you sort of instrument-by-instrument in isolation is one thing--it's not easy, but you can do it on a fair value accounting basis--but if these cluster of derivatives are meant to be the counterpart of another asset, in the case of you mentioned Fannie and Freddie to a whole portfolio of, for instance, mortgages or mortgage-backed securities, this, as an entity together, this may make no sense because you may have losses in one and unrealized gains in another. All together, they make a lot of sense in the lingo of investment banking or, rather, it's not investment banking--accounting, rather--it's the macro edge that you sometimes have for a whole host of portfolios, and sort of therefore there is no right or wrong I think in this aspect. It's a very difficult subject. So I would not say some European banks are right or wrong in that respect.

PARTICIPANT: Could you just expand a little bit about the dollar. You said that it's adjusting fairly well, but what's the downside and what are the dangers in those?

MR. HÄUSLER: Well, it's obvious that as long as the growth differential persists between the United States and much of the rest of the world, and especially with Europe--Continental Europe --the current account imbalance or the current account deficit of the United States needs to be financed by capital imports. As we know, we have seen enormous amount of capital inflows in the late '90s. Much of that was portfolio flows into U.S. equities and last, not least, foreign direct investment.

Now, lately, this has changed the composition more into fixed income, not the least government securities. Therefore, you have not seen any noticeable risk premium attached to the world of U.S. financial assets. If, for some reason, a combination of an abruptly falling dollar, plus a lowering or some reduced appetite for U.S. financial assets for whatever other reason could, hypothetically--that's the point that I made or I was alluding to in my opening statement and that you find in Chapter 1--such a combination could in theory, hypothetically, lead to a risk premium for U.S. financial assets especially in the way of market interest rates. And that would be something that we would be concerned about because not only for the United States, but de facto the U.S. interest rates have a leading role in the globalized financial markets. Those of you who remember 1994, when U.S. interest rates trended upwards quite abruptly, the rest of the world, notwithstanding textbooks, did not go unscathed. In fact, the correlation between U.S. interest rates and, say, European euro-related interest rates quite substantial, and the emerging market world would also not go unscathed.

In other words, the whole world has an interest for such a premium not to arise, which is another way of saying that the adjustment of these current account imbalances should happen smoothly, as opposed to abruptly.

PARTICIPANT: That's why you're putting the '94 example. You think that is the danger, that interest rates could shoot up again.

MR. HÄUSLER: That is, again, in theory and hypothetically, so I'm not predicting this at all. I'm just saying that, in theory, this would be something that, for financial markets, would not be a happy event.

MR. TRAN: Yes, but the main point of that comparison is to draw attention to the differences in the circumstances between now and 1994. So it is not just the similarities.

PARTICIPANT: You said a rise in interest rates could have negative effects on some emerging market economies. Could you maybe be specific on which ones or which areas would be most affected. And, also, given what you said about emerging market economies getting their act together and getting their credit ratings boosted, is there some case for recategorizing emerging markets?

MR. HÄUSLER: It is clear that those emerging markets, with dollar-denominated debt or dollar-indexed debt--would be the hardest hit. Those countries, predominantly accession countries in Europe, the so-called Eastern Europe accession countries, will probably be less hit. And those who have local currency debt might also be somewhat better off. This is why we say, by the way, to make that point again, that while things are going well--what we call the "sweet spot"--countries should try to make themselves less vulnerable.

And, in fact, since we have a colleague here from Brazil, I think the Brazilians have very effectively reduced their vulnerability by reducing the index proportion, the dollar index proportion of their debt quite substantially.

Now, the question that you seem to be raising is I think the interest would go up across-the-board, and I presume also credit spreads would rise. But the credit spreads would not necessarily rise across-the-board because investors would clearly want to differentiate between those countries that could take such a hit better than others. Clearly, the credit discrimination would become stronger, which is why, in a way, and I may sound like a broken record here or my colleague from the Fund, this is again why we tell countries--more privately than publicly, usually--that they should use this "sweet spot," to use that word again, to make themselves more bulletproof, to work on their fundamentals and on their debt structure, just in case something of that nature might arise.

MR. TRAN: I would like to add something to your question. To me, the context in which interest rates were to rise is equally important. If bond yields, interest rates were to rise because of further strengthening of global economy recovery, if commodity prices, including perhaps oil prices, remain buoyant, these circumstances will find many emerging market countries, particularly again the commodity exporting countries, to be doing relatively okay, even though they have to cope with higher financing costs, but overall their economic performance should be underpinned.

PARTICIPANT: On the classification of them, do you think it's still fair to describe them as emerging market countries, even if they have investment-grade debt?

MR. TRAN: I think that is a very interesting question to see when a market in the emerging market categories will graduate into more major market indexes. I think that is particularly relevant to the group of Eastern and Central European markets, which will be a full member of the European Union next month, at which time countries like those and countries with investment grade rating on their debt will graduate.

I think that, one, we have to follow carefully market development and market conventions to see how market investors and market participants will address this question. But beyond economic performance, there are other market foundation and infrastructure questions that categorize a market as emerging--things like the robustness of infrastructure, settlement trading clearing system and so on and so forth. And so we need to see improvement there as well and not just the macroeconomic performance.

PARTICIPANT: In your remarks on Parmalat, you identify lessons for credit rating agencies, for investors, for various parties, but you don't actually identify any lessons for the banks in particular.

MR. HÄUSLER: Well, indirectly, yes, of course. I mean, if you identify lessons for supervisors, you also say something went wrong. And I think what Parmalat is teaching us is very clearly that what was perceived as a fairly provincial Italian company somewhere in the wonderful province of Parma, turns out to be a huge net of SPVs, Special Purpose Vehicles, in off-shore financial centers. And I think that is something that supervisors learned the hard way. Meanwhile, unless you--and this is why you have a lot of activities going on as to off-shore financial centers--filed the publications of the Financial Stability Forum, which took place last week--I happened to be representing the Fund there--

[Tape change.]

MR. HÄUSLER: --there was quite some discussion on the activities of off-shore financial centers. And I think this is what we refer to in our Global Financial Stability Report, that supervisors have to get their hand around such activities, otherwise companies--we mentioned Parmalat, but it could be others--could be escaping the radar screen of supervisors too easily.

PARTICIPANT: In response to my colleague from the Daily Mail, you said that if, for some reason, there was a combination of an abruptly falling dollar and reduced appetite for U.S. financial assets, that could hypothetically lead to a risk premium on U.S. financial assets which would be a concern to globalized financial markets. "If, for some reason"--what could those reasons be?

MR. HÄUSLER: An abrupt fall in the dollar, as opposed to a soft, gliding fall of the dollar, could, certainly, for the non-U.S.-based investors, who do their math in other currencies, would have implications for their P&L, and therefore potentially for their appetite to invest. This is one aspect. Another aspect that is not relevant, at least not at the moment was, but which was relevant since we just spoke about Parmalat a moment ago, if, hypothetically, further substantial scandals-- corporate sector scandals--were to emerge, that could be another one. You have to remember it's not that people disinvest in the United States [audio break], they need to invest on an ongoing basis to the tune of, say, $500 billion dollars on a yearly basis.

Now, again, as we said earlier this year, in fact, the capital in-flows to the United States have been extremely strong. In fact, they outpaced the pro rata current account deficit of the United States. Therefore, at this moment, I am not concerned, but if something, for some reason, a wrench were to be thrown into those capital in-flows, and you have to remember, I mean, this is also something we all know about, that these capital imports, while be very large, to some degree, we are relying on capital flows from public institutions, central banks of the [inaudible] and East Asia, who were buying a substantial amount of dollars to be reinvested in the U.S. market.

Now, any substantial glitches, not just temporary--that wouldn't hurt very much--but on an ongoing, more substantial basis, would be something that then could have a snowballing effect. Again, it's many "coulds," and "woulds," and hypothetical. I want to make sure that, when you write about it, that these "coulds" and "woulds" are all in there, including in the headlines, please.


PARTICIPANT: I'm sorry to press this, but you said "could" and "would." How significant, how likely do you think it is?

MR. HÄUSLER: At this moment, I'm quite relaxed.

PARTICIPANT: A parochial question, I suppose, but on Page 43, you spend quite a long paragraph about the risks of household balance sheets and the rising debt burdens in the U.K. And you seem to, looking at the analysis, suggest that those are more severe in the U.K. than in the U.S. or in Europe. How big a risk do you believe those potentially pose to the financial stability situation here?

MR. TRAN: There is a risk only because in terms of how housing price development relative to our other benchmark like income and so on and so forth. The development in the U.K. stands out compared to developments in other countries.

So it is an area that we believe the authorities and ourselves have to look at carefully to see if, going forward, if rates were to rise in the future, the sustainability and the ability of householders to finance their indebtedness would not be impaired.

MR. DAWSON: Thank you very much.


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