Transcript

Jose Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department
Robert Sheehy, Deputy Director
Peter Dattels, Assistant Director
Matthew Jones, Advisor
October 10, 2012
Tokyo, Japan

Mr. Murray: Hello and welcome to the latest edition of the IMF's Global Financial Stability Report. Joining me today is Mr. Viñals, Financial Counselor and Director of the Financial and Capital Markets Department. With Jose is Mr. Sheehy, Deputy Director of MCM, Mr. Dattels, Assistant Director, and Mr. Jones, an advisor within that department.

Jose will have some brief opening remarks and then we'll take your questions.

Mr. Viñals: Thank you, Bill, and good morning to you all.

It is great to be here in Tokyo, and I would like to thank our hosts, the Japanese authorities, for their superb hospitality and splendid organization of these events. In presenting to you the global financial outlook, I would like to start by emphasizing some good news, which happened recently.

Policy actions taken in Europe, in the United States, here in Japan, and also in emerging markets have improved investor sentiment and helped markets rebound in recent months. Yet, our assessment, which is contained in this Global Financial Stability Report, is that confidence is still very fragile and that risks have increased compared to the last report in April. My main message is that further policy efforts are needed to gain lasting stability.

Let me start with the euro area, which remains the principle risk to global financial stability.

The forces of financial and economic fragmentation have widened the divide between the core and the periphery countries. Faltering confidence and policy uncertainty have led to a pullback of cross-border capital flows from the periphery, and this is something which is quite extraordinary within a currency union. This in turn has driven up funding costs in peripheral countries, for governments, for banks, as well as for corporates, households, and in turn threatens a vicious downward economic spiral.

The question is, can this process of fragmentation be reversed and how?, My firm belief is that it can, and I will try to explain how this can be done.

The actions taken by the European Central Bank in recent weeks has helped remove investors' worse fears, but these policies will have to be built upon both at the national and euro area level as outlined in the complete policy scenarios, which is detailed in the report.

The stakes are high. For example, if market pressures were allowed to continue, major European Union banks total assets could be forced to shrink by as much as 2.8 trillion dollars, and this would possibly lead to a contraction in the supply of credit in the periphery by 9 percent at the end of 2013. In a more adverse case, which is illustrated by our weak policy scenario, European Union banks assets could shrink by as much as 4.5 trillion dollars, and lead to a reduction in the supply of credit in the periphery by up to 18 percent, which is quite an important magnitude.

In contrast, as we also detail in the report, a rapid move toward the complete policy scenario would avoid this economic damage.

So, the question is, what is needed?

First, safer banks. Progress has been made recently, including the European banking authorities' capital augmentation, capital enhancement exercise, but weak banks still need to be restructured, and when not viable, they need to be resolved.

Second, safer sovereigns through well timed fiscal consolidation, and safer economies through structural reforms.

Third, strong firewalls. The European Stabilization Mechanism, the ESM, and the European central bank's OMT bond purchasing program must be regarded by markets as real and not virtual, and should be coupled with credible conditionality.

Finally, there is a need for a stronger union. Establishment of the single supervisory mechanism is an important step that needs to be implemented without delay, and it is also essential to provide a clear road map toward the completion of banking union in order to guide market expectations and to help break the pernicious link between sovereign and bank balance sheets.

Let me turn now to the United States and Japan.

In my view, a key lesson for the United States and Japan from the European debt crisis is that delaying policy enhancement, until market strains become evident, leads to financial turmoil and to harsher economic outcomes. Fiscal imbalances in the United States and Japan are amenable to medium-term adjustment, but a blueprint for policy actions must be developed right away.

One point that I would like to stress is that we cannot, we should not let current market conditions, which as I said at the beginning have improved, give rise to a false sense of security. Indeed, safe haven flows to the United States and to Japan and record low official interest rates through easing monetary policies have led to a suppression of risk premia in government and corporate bond markets.

Furthermore, in the United States, a potential political impasse could result in a repeat of debt ceiling strains and/or a push over the fiscal cliff which would entail significant risks to the U.S. and to the global economy. So, it is essential that both risks are avoided and an end put to these policy uncertainties.

In Japan, its high sovereign debt and the rising concentration of government bonds holdings in the banking system pose important stability risks. For example, we project that in Japan bank holdings of government bonds could rise to about one third of banks' total assets in five years' time tying banks ever closer to the sovereign and potentially weakening financial stability should interest rates rise.

So, in the case of Japan, macroprudential vigilance and a further strengthening of bank balance sheets and bank business models are warranted together with much needed fiscal consolidation.

Let me go now into emerging markets and ask the question, are emerging markets safe?

As a whole the emerging markets have navigated global risks skillfully, but I think it is fundamental to stress that their guard must be kept up. Vulnerabilities are most pronounced in Central and Eastern European countries, because they're directly exposed to deleveraging by European banks, and because some private balance sheets are weak in these countries. Asian and Latin America emerging markets are less impacted by shocks emanating from Europe, but are not immune to adverse external spillovers. Moreover, following a period of rapid credit growth, some key economies in both regions have reached the late stages of the credit cycle, which tend to be accompanied by peaking asset prices and early indications of worsening loan quality.

In the face of the global slowdown emerging markets need to use their available policy space wisely and address domestic vulnerabilities.

Let me now conclude by returning to what is my main message: much has been done but confidence is still fragile. This is the time when central bank actions need to be enhanced by measures taken by governments to complete policies. Central banks have acted. Now it is the time for governments to act. The choice today is between making the necessary, but tough, policy and political decisions or delaying them once more in the false hope that time is on our side. It is not.

Let me conclude here. My colleagues and I will be pleased to answer any questions that you may have.

Mr. Murray: Thank you very much, Mr. Viñals. We have microphones. I will call on you, if you could wait until the microphone gets to you.

QUESTION: Mr. Viñals, if there are risks to the financial stability of Mexico by the large presence of Spanish banks in the country, do you think that Mexico faces a risk for reversal of capital flows?

Mr. Sheehy: The Spanish banks have been quite strong and the Latin America countries in general. They have built their businesses there on the basis of strong domestic deposit funding, and I think there is not a risk, direct risk of any spillovers from Spain coming back to Latin America. The authorities in Latin America and Mexico and other countries have also been quite strong in terms of how they manage their banking systems, and making sure that the banks in Latin America are not being used as sources of capital flight back to Spain. So, I don't think that is a particularly important risk.

Mr. Viñals: Let me add one thing, to answer your second question, on the possibility that there may be capital outflows from Mexico. I think that so far emerging markets have remained quite resilient, even when circumstances were quite uncertain in advanced economies, in particular in the euro area. Capital has overall continued flowing into emerging markets, particularly in terms of bond flows, which have been more stable than equity flows.

Mexico is an economy which has strong fundamentals, which has a strong financial system, which has adequate levels of foreign exchange reserves, and which also has used exchange rate flexibility to address capital flow volatility. So, I think it is in quite a strong position, but let me reiterate the message that I mentioned. No one is immune from pressures coming either from Europe or from the United States. As you may have heard, I have also signaled some important risks associated to the United States economy in terms of the fiscal cliff, debt ceiling, medium-term fiscal challenges, and the safe haven inflows that have compressed interest rates in the United States. If interest rates in the United States were to go up in a rapid manner, then this is something that would also pose challenges for Mexico. So, the message is, keep the guard up. Preserve or increase your buffers and policy space and if needed, use them wisely.

Mr. Dattels: I'll add a little bit in terms of the potential for bond outflows. Mexico does enjoy a significant amount of foreign participation in their local bond market. We did an exercise as to the impact that this would have if under the weak policy scenario a pullback of the flows that had gone into the market since the Lehman debacle retreated. The results would be that the share of foreign participation would pull about 25 percent out of that market. And, the implication of that would be that domestic institutions would need to step in. When spread that across the Mexican financial institutions, banks would be the residual buyer of some of that. And their holdings would increase from about 2.5 percent to 7 percent of total assets, which is a significant increase. But the holdings overall of Mexican banks still is quite low relative to other emerging markets, even under that scenario.

QUESTION: Firstly, could you tell us what you think the capital needs currently are of the European banks to bring them back to where they should be? Because, you gave us a figure some years ago and I just wonder if you have a specific figure on that.

Secondly, on the firewall, irrespective on whether the firewall is accessible or not, is it large enough to withstand Spain and Italy getting themselves into trouble?

Thirdly, do you regard the U.K. as a victim of this safe haven status? And, it could have a problem if those safe haven flows start to end?

Mr. Viñals: Let me say something and then I will ask Pete to take the first part of the question.

Is the firewall large enough? We used to have one firewall, the EFSF, which now has become, after the very recent launch this week, the ESM. But, now we have another firewall, which is the OMT program by the European Central Bank. This is a program which the ECB announced has not a limited size, so in principle is unlimited in size, has a number of conditions to be activated, but I think that this gives me a lot of comfort that the size of the firewall has become sufficiently flexible as to make a big difference. This is something that markets have already internalized, when they responded with quite a reduction in spreads in sovereign debt, particularly in the peripheral countries, countries under market strain, once the ECB made the announcement that it was contemplating to do whatever it takes to preserve the euro area together, and when it detailed the OMT program.

Mr. Dattels: As you noted, the previous GFSRs have pointed to the capital issue in banks. Subsequently we have been encouraged by the efforts of the European authorities to build capital buffers in the banking system. The latest effort and information on that is the EBA results which have highlighted about 116 to 200 billion of new capital has gone into the system. Of course, there has been the work on the Spanish stress tests and focus on building capital there. So, two or three key issues. One key issue, is that enough capital? Right now it is 9 percent of core tier 1 that is if we take the EBA standard. The question is, will that hold up over the economic cycle? And, as we highlight in our scenarios, under the weak policy scenario, even under the baseline, there are capital pressures that would build as a result of a deterioration in asset quality in some areas.

If I move on from that, though, there are several other factors, in addition to capital, and we highlight in the report that capital flight from the periphery is pushing up funding pressures on banks in the periphery, and then that adds to pressures for asset deleveraging. In addition, the pullback of foreign investors and sovereign bond markets puts additional pressure on domestic banks to absorb government issues, which crowds out private sector credit. And, finally, the forces of financial fragmentation the eurozone has put a focus on banks matching assets and liabilities by country to effectively ensure against redenomination risk. That, too, adds to pressures on bank balance sheets and credit. So the point being that capital is not the only driver here at this point. It is quite a bit broader.

QUESTION: (Microphone not on).

Mr. Viñals: With the U.S. and Japan, they have benefited to some extent from this safe haven flows, and also some core euro area countries have experienced important inflows. And, I think that is a fact. This is something that needs to be factored in to the policy making in the United Kingdom because if, as we expect, the euro area crisis is solved by moving to the complete policy scenarios, these safe haven flows would revert sooner or later.

QUESTION: Two questions for Mr. Viñals. I was wondering in your remarks about the OMT needed to be real, whether you mean that it needs to be tested and used and whether that is a call for Spain to ask for a program?

The second question is, do you feel now with the firewall in place that whatever happens in Greece won't impact the rest of Europe at this stage?

Mr. Viñals: Well, certainly, when I said that the OMT should be seen by investors, by markets as a real and not a virtual program, I wasn't making any prescription about whether a particular country should ask for it or not. But, let me tell you what I had in mind.

I think that this is an extremely important mechanism that has been deployed to enhance the defensive weapons of the euro area against pressures, fragmentation, so on. I think that this is precisely what led to the reduction in spreads, and this was a very beneficial market development.

Now, one risk there is that markets may be regarding this mechanism as virtual rather than real if either one of the two things I'm going to say now happens: If there is no demand in cases where the activation of the mechanism or asking for the mechanism is something that would be necessary or even very useful for a particular country, and when lack of demand is related to domestic political considerations, that would be unfortunate. Or, in circumstances where even if there is this appetite on the part of potential users of the mechanism to demand it, there is not the political appetite on the part of the creditor countries to agree on the use of ESM funds for this purpose. So, there is no supply.

When the mechanism activation is needed or would be very useful, but there is no demand or there is a potential demand but no supply, then, I think that would be contrary to the spirit of the announcement of the OMT some of the market gains could start unraveling. That is what I meant. It doesn't convey any prescription to any country to activate the mechanism, in the case of Spain, or the demand for the mechanism, this is a decision which is up to the best judgment of the Spanish authorities to make.

You also mentioned, does it mean now that there would be no consequences if things were to go badly in Greece. Well, we are working with the Greek authorities, as you know, very, very closely in order to ensure that the program is back on track, and we are discussing with them issues having to do with fiscal measures, structural reforms, the financing, the debt, the banking system, but more needs to be done. So, we think the best way of avoiding problems coming from Greece is that Greece solves its own problems, and this is why we're working very closely with the Greek authorities because we really want to help Greece and its people go back to better economic and social situations.

QUESTION: My first question is, what do you think of the spillover effects of the easing monetary policy in the developed world on the emerging markets? How different are they this time around compared with 2009 in terms of capital flows and inflationary pressures?

My second question is, how dangerous do you see the China's shadow banking sector?

Mr. Viñals: Let me start by answering your questions in reverse order. China's shadow banking system. This is an area of concern in the sense that this is something that has been growing quite a bit in the recent past through the development of a number of vehicles and intermediaries which are providing lending to the economy. And, this is a risk. There are estimates that say that lending provided through the shadow banking system in China amounts to something like 40 percent of GDP, as compared to 130 percent, which would be the lending through the banks. This is certainly not small. I think that the important thing there is to exercise strong oversight and vigilance to make sure that risks are contained and governance of these financial processes is appropriate.

On the issue of the impact of quantitative easing on emerging markets, it is true that quantitative easing, by increasing the supply of liquidity in advanced economies and record low interest rates tend to exert a force, displacing, let's say, capital to the emerging markets. That is something that emerging markets have to deal with. But, I think that this is a price worth paying, if the easy monetary policies, both conventional and nonconventional, which are employed by advanced economies, are important to keep the recovery ongoing or to diminish big fears in the euro area, and this is positive for the advanced economies, and it is positive for the emerging markets and should be part of the equation. I think overall quantitative easing policies in the United States and Europe are justified and while there may be some financial spillover into emerging markets, which may pose some complications, I think that emerging markets benefit overall from the sense of security that these policies introduce in the economies of advanced economies, and therefore in the global economy.

QUESTION: You are calling for in the complete policy scenario for banking union in the eurozone with the common fiscal backstop, which implies a direct recap of Spanish banks from the ESM in the near future. And the common deposit guarantee scheme. Given the legal constraints in Europe and resistance from banks, especially in Germany, to make transfers for legacy assets particularly in Spain, it is likely to take years until this banking union will be completed. What do you reply to concerns from European capitals that you are creating expectations in the market that the eurozone can only disappoint?

Mr. Viñals: I think it is important that the agreements that we reach by the end of June in the European summit are followed. These agreements were to me an important potential game changer, together with announcements and actions taken by the European Central Bank. And, I think that this was a game changer. The agreements of going towards a banking union. should be implemented without delay. For example, in the establishment of the single supervisory mechanism. And, I agree that not all the pieces of the banking union can be put in place overnight. First, one needs to focus on the establishment of the single supervisor, and try to do it rightbecause, this is quite complex. But, do not delay the process. And, then, I think that for the other elements, in terms of resolution, deposit resolution scheme, this is something that will come a at later stage, but it is important to provide a clear road map so that market expectations can be guided and markets know that it is still the case that agreement to put in place a banking union, a complete banking union, is going to happen in the future. So, I think that this is what is most important and there may be noises here and there, but I think that sticking to the spirit of these agreements is very, very important, not only for further integrating the euro area, but also stability of the euro area.

QUESTION: I would like to ask my question in French, please. (Interpreted).

Thank you very much. Today, as yesterday, we have the feeling that black Africa -- that is the developing countries -- are not sufficiently taken into account in the reports of the IMF. That was the case, and is the case, we believe, in the report that we're discussing just now. My question, in any event, relates to the following: The persistence of the crisis in the eurozone is that not a phenomenon that will greatly impact the sub-Saharan African countries, in particular, where the financial systems depend greatly on the European banks? Secondly, is the European crisis not also a break to greater monetary union in the countries of sub-Saharan Africa.

Mr. Sheehy: I didn't catch your second question quite well, so we may have to come back to that. In terms of the consequences of developments in the eurozone for African countries, through the banking systems, obviously there are some linkages and you have, for example, many African central banks or domestic banks holding large assets in European banks, and in that sense they need to be cautious of making sure that they understand the consequences for them, if there is an intensification of the crisis. But, the direct impact is probably not through the financial system of what happens in Europe. The direct impact on Africa is more likely to come through trade channels.

And your second question, if you don't mind repeating?

Mr. Murray: Next question, please. Right side of the room.

QUESTION: How are developing countries being affected by higher funding costs and USA risks, and what is the suggestion for new participants of capital markets, especially from Latin America?

Mr. Sheehy: Just to comment in general on funding costs, I think the general risk aversion implications of what is happening in the world economy right now are having effects in terms of a lot of developing countries, a lot of -- certainly in Latin America, making funding a little more difficult. But, what has happened in the past several years in Latin America is that there has been a very good strengthening of the domestic banking systems and the domestic financial systems. They're a lot more resilient than they were a few years ago, there is a lot more ability of domestic capital markets to handle domestic financing needs. The vulnerability is not as much as it was during the last crisis.

QUESTION: (No English audio provided).

Mr. Dattels: The clear point has been on the case in Spain. There has been a stress test and that is being worked through, including addressing bad assets through asset management companies. So that process is ongoing. Some questions associated with that process includethe transfer price, which will affect the capital position of the banks.

Our warning here is that given the pressures, particularly on the periphery, is that if we get another down leg, this can create a second wave of a deterioration in bank asset quality. And therefore, I think, the key message is to guard against that by implementing the policies that Jose has outlined.

QUESTION: (No English audio provided).

Mr. Dattels: I would not call our base case as sanguine, because the funding pressures are still there.

QUESTION: (No English audio provided).

Mr. Viñals: In the report we warn about the very close linkages between sovereigns and banks in the case of Japan. Of course, this is in a very different phase as compared to the euro area. Japanese government bonds are safe. In fact, they have benefited from the safe haven inflows. But, precisely because there is such a close connection between sovereigns and banks, in terms of the amount of bonds, public bonds held by banks in Japan, it is fundamental first and most of all, to preserve the safety of the risk-free assets, to preserve the safety of the Japanese government bonds through appropriate medium-term fiscal consolidation strategies. So, that would be the first thing to do.

And then, as a complement from the prudential side, in terms of financial policies, I think that it would be very important to conduct thematic, or prudential bank risk assessments, to look at how much risk is in banks balance sheets coming from the sovereign bond holdings. In the case of the regional banks, which are the ones that are more charged with JGBs, it would be a useful measure to subject them to the same capital ratios as the internationally active banks in Japan. Those things would be important. And in the case of the internationally active banks, which have expanded their activities outside of Japan, I think that the issue of consolidated, effective supervision, on their overseas activities, is something which is most important. So, there are a number of things that we detail in the report that we think would be useful for the Japanese authorities to contemplate. And many of these things, also, have been put forward as recommendations in the Financial Sector Assessment Program, the FSAP, that was conducted of the Japanese financial system.

QUESTION: (No English audio provided).

Mr. Jones: (No English audio provided).

QUESTION: (No English audio provided).

Mr. Sheehy: As you point out, there is a difficult situation in the regional banks and the situation in the three major banks. Three major banks have been by and large shedding JGBs, keeping their exposures low and keeping them relatively short, where the regional banks have been buying longer maturities. I think the issue is really one of other investment opportunities for a lot of these banks. And, making sure that as they move into these other investment opportunities, that you do it in a sound way. So, I think what Jose mentioned a few minutes ago about the issue of the level of capital in the regional banks versus the major banks, that is certainly one where we have focused. I think there is also room to increase lending to the SME sector. Currently, that is done largely through directed type of programs. I think there is room for more market-based lending to that sector.

Finally, we have looked -- and Jose mentioned this earlier. We look at the potential expansion of Japanese investments abroad, from the banking system, as something that could help in this environment.

Mr. Murray: One last question.

QUESTION: You mentioned nobody is immune in the face of these risks. But, as Mr. Sheehy said, Latin America has responded better via its systems. But of course we're close to the U.S., and there are risks from there. What are precisely the risks that you have identified? What might impact the financial systems in Latin America if things get worse in the U.S.?

Mr. Viñals: I think that Latin America, after suffering successive crises in the past, has done its homework, in terms of reducing its domestic and external vulnerabilities over the past ten years. I think that this is what explains in large part why it is that it has weathered this crisis so much better. Of course, Latin America is not a homogeneous region. You have very heterogeneous mapping of countries, not everybody is in the same position. If we're talking about countries like Mexico, larger economies, Mexico, Brazil, certainly I think that is the case, as it is the case in Chile, Colombia, Peru, and I could increase the list.

Now in terms of the risks coming from the United States, certainly, if the U.S. economy were to take a turn for the worse, because, for example, if the fiscal cliff is hit, and you have automatic spending cuts and tax increases, which we have estimated in the reports which are being presented these days, as something which accounts for 4 percent of GDP, and which could put the U.S. economy back into recession, this is something that would certainly take a toll on Latin America, especially in those countries like Mexico, which have more heavy trade relationships with the United States. This is something that will contribute to the level of global anxiety. This is something which is not good for confidence, and is not good for the behavior of financial markets. So, as I said, Latin America and other emerging economies face potentially external spillovers from advanced economies, not only from Europe but also for from the United States. This is why keeping the guard up, exerting vigilance, is very important, because there may be a rainy day, and if that is the case, you want to have your umbrella to remain dry.

Mr. Murray - Thank you, Jose.