Transcript of a Press Conference on the Global Financial Stability Report

IMF News, April 11, 2006

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• Published: April 11, 2006

Key messages on global financial stability and outlook

• Near-term outlook: from a stability perspective the near term outlook is "as good as it gets."
• Focus of this GFSR: more on medium- and long-term issues of efficiency (especially in EMCs) than on imminent crises.
• Paradigm shift for EMCs: a structural improvement is underway—greater exchange rate flexibility; stronger fiscal discipline; improved debt management; broadened investor base; higher share of equity and FDI; record levels of official reserves.
• Caveats: cyclical factors (global liquidity, higher than average global growth, record high commodity prices) and remaining vulnerabilities in some EMCs with internal or external imbalances or weak banking systems.

Cyclical risks and past "exit" episodes

• Central bank exits have generally been well communicated and absorbed by markets:
  • U.S. Fed funds rate rose from 1% to 4.75% beginning with the first hike in June 2004; markets adjusted smoothly.
  • ECB tightening since late 2005 and BoJ exit from quantitative easing also well communicated.
  • Japanese institutional investors may face losses in JGB portfolios as long-term rates rise.
• Currency-management exits (Japan stopping FX interventions in early 2004; China loosening its peg) adjusted smoothly in markets.
• Carry trades and related concerns:
  • Yen-based carry trades exist but no clear evidence from available data of pervasive or substantial yen-based carry trades.
  • Japanese retail investors have bought large amounts of foreign currency bonds, some unhedged.
  • In small, thin markets (e.g., Iceland, New Zealand) crowded carry trades can have dramatic local effects.

Principal risks identified (likelihood and potential impact)

• Inflation and interest-rate risks:
  • If inflation expectations are exceeded, short and long-term interest rates could rise by much more than currently expected.
  • Recent increase in major long-term government bond yields of around 40-50 basis points reflects such concerns.
• Turning of the corporate credit cycle:
  • Corporations have begun to re-leverage via higher dividends, share buybacks, and M&A.
  • Leveraged buyouts using high leverage have weakened credit quality of targeted companies.
  • Spread corrections from idiosyncratic events could propagate through illiquid segments of credit derivatives and CDO markets.
• Turning of the housing and mortgage cycle, particularly in the U.S.:
  • Cooling housing activity and prices could reduce personal consumption; offsetting forces could include higher investment and higher personal savings.
  • Main U.S. mortgage market retains good credit quality; sub-prime segment is more vulnerable (interest-only, no amortization products).
• Disorderly adjustment of global imbalances:
  • Would have very negative consequences, but flexible and global financial markets have so far intermediated smoothly.
  • Major risk is a rise in protectionism undermining investor confidence and prompting diversification away from dollar assets.
• Low-probability/high-impact: avian flu pandemic
  • Potential effects: (i) operational disruptions from worker absenteeism in the financial industry; (ii) market disruptions and changes in capital flows from higher risk aversion.
  • IMF is working with members to prepare financial systems to keep core services operational.

Structural changes and new configurations of risk

• Risk transfer from banking to non-banking sectors (including households) via credit derivatives and structured credit products:
  • Dispersal of credit risk has enhanced system ability to bear risk and provided transparent indicators of credit risk.
  • New risks: lower disclosure on risk distribution among non-bank institutions; crowded trades in illiquid credit derivative segments; operational weaknesses (trade confirmations, contract assignments, settlements).
  • Credit derivatives market has yet to be tested in a sustained market downturn.
• Emerging market (EM) asset markets behavior:
  • EMCs have reduced foreign currency debt (via buybacks) and increased domestic currency issuance to build insurance.
  • Mature market and surplus EMC investors have rationally invested in EM local-currency securities expecting currency appreciation and diversification benefits.
  • Credit quality divergence: mature market corporates may weaken bit while EM sovereigns may improve, explaining the disappearance of the yield premium on EM external sovereign bonds over mature market corporate bonds.
  • No strong case for a sizable bubble in EM assets, though periodic corrections are expected.

Policy recommendations and supervisory stance

• Regulation and supervision must remain vigilant to spot weaknesses and vulnerabilities; macro-prudential options limited.
• Monetary policy stance:
  • Debate on whether monetary policy should take asset prices into account; author supports limited use of interest-rate policy in the margins (timing and guidance) and constructive ambiguity to contain exuberance.
  • Use of "moral suasion" or "open mouth policy" to remind markets of two-way risks and uphold a rigorous no-bailout stance.
• Avoid bailouts that create moral hazard: resist pressure to "do something" when asset prices fall unless systemic threats exist.
• Enhance financial surveillance capacity to distinguish systemically critical situations from idiosyncratic corrections.
• Prepare financial systems for operational shocks (e.g., pandemic scenarios) to preserve payment, clearing, and settlement systems.
• Policy priority for EMCs: continue improving debt management, extending local currency yield curves, and integrating asset and liability management given growing reserves.

Specific observations and illustrative figures

• Fed funds rate: rise from 1% to 4.75%.
• Increase in major long-term government bond yields: around 40-50 basis points in recent weeks.
• Oil price referenced: hit a high of $68.89 in London yesterday (as cited in Q&A).
• Timeframe for near-term risk assessment often considered as six-12 months by IMF presenters.

Transcript of a Press Conference on the Global Financial Stability Report, April 11, 2006.

References

• Brazil and the IMF
• United Kingdom and the IMF
• Iceland and the IMF
• Japan and the IMF
• United States and the IMF
• New Zealand and the IMF
• Transcripts
• Global Financial Stability Report: Market Developments and Issues
• PRESS CENTER
• Webcast
• http://www.imf.org/external/np/sec/pr/2006/pr0629.htm
• https://www.imf.org/en/home