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Identifying Risks and Opportunities: A Global View, Speech by Jaime Caruana, Monetary and Capital Markets Department Director, IMF
May 7, 2007
Good afternoon, ladies and gentlemen.
It is a pleasure to be here to address this Forum at a time when the global economy offers opportunities as never before, but also at a time when understanding financial risks is getting more and more difficult. My goal will be to point out to you some of the developments in the global financial markets as we see them at the IMF, and also some of the potential risks and pitfalls. I'll particularly highlight the growing concerns that we have surrounding the weakening of lending standards in some areas, after a long period of benign financial conditions. Examples are the mortgage market in this country, or some leveraged loans that are being used to finance the dramatic increase in leveraged buyouts, particularly in Europe and the U.S. I'll leave it to you to decide whether this is a risk or an opportunity from the perspective of a corporate treasurer—depending on which side of the acquisition fence you are sitting.
To set the scene for the discussion of risks, let me first highlight two longer-term trends in global markets that the Fund has recently addressed in the latest edition of our Global Financial Stability Report [and I am pleased to see that we have made copies available to you outside]. See slide 1 These are the secular increase in cross-border capital flows, including the new role of emerging markets, and the globalization of financial institutions. Over the last decade, cross-border financial flows have increased more rapidly than either global output or trade, and have tripled to around 14 per cent of world GDP (or $6.4 trillion). This trend is being driven by three dramatic changes: the rapid growth of assets under management of institutional investors; the changes in their asset allocation behavior as `home bias' declines; and the broadening of the global investor base, with an increasingly important role for the emerging market official sector, central banks, and sovereign wealth funds, and on the other side the increasing activity of hedge funds. We believe that financial stability should be enhanced by this increasing diversity of cross-border investors, given that their differing investment behaviors and time horizons should contribute to a wider distribution of risk holdings and tolerance for volatility over the longer term.
Slide 2 Also, the generally improving fundamentals and policy frameworks in many emerging market economies allow for optimism that the current low bond spreads are not merely the result of the upswing in the world economy, but are also due to well-founded improvements in creditworthiness. See slide 3
That said, the recent acceleration of flows to some emerging market countries has been challenging for the authorities there. In the past, some episodes of rapid growth of international capital flows have led to abrupt reversals. The favorable circumstances in which this round of globalization has taken place offer little guidance about the robustness of the global system under significant or sustained stress. However, the declining home bias of longer-term investors and improved fundamentals hopefully means that these increased capital flows are less volatile than in previous cycles.
At this point I would like to thank the AFP for helping with a survey for the GFSR that we conducted recently on the factors influencing foreign direct investment by multinationals, and the 30 global firms that participated. Some of the findings were as you might expect - firms said that FDI is expected to continue growing, and that governance reforms in many emerging markets had improved their attraction as investment destinations, with China attracting the lion's share of total FDI inflows to emerging market countries. Perhaps a little more surprisingly, a primary motivation behind FDI was to gain a presence in faster growing markets, rather than immediate profit, and that repatriation of those profits was heavily influenced by tax considerations. Also, the high cost of hedging in emerging markets was a deterrent to FDI, underlining the significant benefits from countries developing their financial infrastructure. That high cost may explain why cross-border FDI flows have been overtaken by debt and bank flows over the last decade. Slide 4 Investors are now more ready to achieve exposure to emerging markets directly through buying bonds. An increasingly important innovation has been the ability of financial markets to provide protection against exposure to emerging markets through credit risk transfer instruments. However, these markets also remain untested in a more volatile environment.
Turning to the globalization of financial institutions, this is proceeding apace, primarily through mergers and acquisitions of banks and life insurance companies in high income countries as well as Eastern Europe and Latin America. Indeed, whereas cross-border financial M&A accounted for only 1% of the total a decade ago, it had risen to 40% of the value of deals last year. Slide 5 In terms of the impact of globalization, we find a positive relationship between increasing cross-border activity, primarily by banks, and their performance. Although equity markets are often skeptical of the merits of internationally-diversified banks, we find that measures of financial soundness generally improve with the diversification of banks cross-border.
However, the stability benefits of cross-border mergers are less clear cut when looked at from the global perspective—indeed, large international banks as a group show signs of becoming more correlated over time as they internationalize. The intuition behind this finding is that when banks diversify abroad, their incomes become more correlated with each other, financial systems become more vulnerable to large common shocks and spillover effects, and severe crises become more complicated to deal with.
But despite the caveats I have mentioned, we nevertheless believe that these structural transformations are likely to have an overall positive impact on global financial stability.
Let me now set out where we view the current state of global financial markets. The global economy appears set for another strong year. Growth is expected to be more balanced regionally and slightly lower than past year, but risks remain tilted to the downside. We believe that market and credit risks have risen, albeit from low levels. This has occurred against a backdrop of benign financial conditions, low volatility, and a continuing increase in risk appetite by investors. I would like to highlight three areas of attention.
First, while emerging market economic fundamentals have improved overall, we continue to observe "pockets of vulnerability," particularly in countries where capital flows are financing large current account deficits and credit growth is rapid. Household credit is expanding at breakneck speed in some emerging market economies, and this naturally raises concerns about banks' ability to screen borrowers and assess risks adequately. In addition, I would like to point to the heavy issuance of foreign exchange-denominated debt at increasingly lower credit ratings by emerging market banks and corporations, encouraged by increasing investor risk appetite. See slide 6 Also noteworthy have been capital flows into a number of countries that have previously received very little interest from foreign investors, particularly some countries in sub-Saharan Africa. While such flows are a welcome sign of increased access to international capital markets, the recent acceleration of cross-border flows also poses challenges to the authorities in some countries.
A second area that has received a lot of media attention is the rapid deterioration in the U.S. sub prime mortgage market. This was initially prompted by a sharp rise in early payment defaults, See slide 7 perhaps due to a rash of questionable mortgage applications at the top of the housing market. This has resulted in 2006 vintage of loans being the poorest quality thus far this decade. Slide 8 While the sub prime market is only about 14 percent of the U.S. mortgage market, credit deterioration has also occurred in the riskiest segments of `Alt - A' mortgages and the impact of declining credit quality of sub prime loans has translated into wider spreads on securities collateralized by them, affecting a wide range of investors, including international investors. So far, however, mortgage-related losses look manageable, as lower-rated tranches will absorb most of the risk of default first. While the tightening of lending standards and rise in foreclosures may prolong the U.S. housing slowdown and may cause distress in some local housing markets, the situation does not appear sufficient to cause a systemic problem to the U.S. or global financial system, due in part, to the dispersal of risk through derivatives and structured credit markets to a wide variety of investors. However, two concerns remain. Rising subprime losses have highlighted a general trend towards falling lending standards in the U.S. mortgage market, making households more vulnerable to a macroeconomic shock to employment or incomes. And they have raised questions about the extent to which similar weaknesses in underwriting standards have spread to other loan markets.
Finally, continuing the theme of weakening lending standards, the leveraged loan market is expanding rapidly to finance the explosive growth in private equity and leveraged buyouts. See slide 9 Some months ago, a Financial Times journalist speculated that a private equity bid could be assembled even for a company with $300 billion in market capitalization. It is a sign of how far the market has gone that, to the journalist's surprise, some readers took him seriously. Indeed, deals as large as $50 or $100 billion are now conceivable, placing only a few quoted companies out of reach of a private equity bid. The current leveraged buyout boom is being driven by healthy corporate balance sheets and easy financing, a seeming reluctance by companies to invest in capital equipment, the attractions of taking a company private for regulatory reasons, and the strong demand for investments in private equity firms and collateralized loan obligations from hedge funds and other investors. While indicators of deal risk are not yet as stretched as they were in the last LBO expansions in the 1980s and `90s, there are now numerous signs that credit discipline is weakening and deal financing is becoming more stretched. The more highly leveraged target firms are, of course, more vulnerable to a slowdown in economic activity, raising credit risks for banks and investors when the cycle turns. Corporate indebtedness is now rising, especially in Europe, as companies leverage their balance sheets - perhaps as a defensive measure against a private equity approach.
It is worth drawing an analogy between leveraged buy-outs and U.S. subprime lending. Just as subprime mortgages were strongly sought after in 2005 and 2006 to be packaged into asset-backed securities and, in turn, into collateralized debt obligations, so leveraged loans are now in strong demand for collateralized loan obligation production. In turn, low funding costs and strong investor demand for alternative assets are being felt further up the supply chain, so that deals of greater size and risk become easier to finance, thereby putting pressure on banks to relax their covenant conditions on loans in order to compete. In parallel to the `low-doc' subprime mortgages, `covenant-lite' leveraged loans are now becoming more prevalent as borrowers exercise their market power over lenders. No one knows how long this process can continue, and predictions of an imminent turn in the credit cycle have become so familiar that they have lost credibility. But the music will stop one day, a major company taken private will face difficulties, and a warranted reappraisal of credit risk will occur. While this is likely to result in losses for some banks on the loans that they have extended, the securitization and transfer of much of the risk should mean that the core financial system is not threatened by a turn in the corporate credit cycle. However, it could also mean that corporate borrowing conditions could tighten sharply and is a reminder that, despite rapid financial innovation and growing complexity, credit cycles are not being abolished, but are just manifesting themselves in different ways that may be harder to predict.
By themselves, none of these risks constitute a direct threat to global financial stability, but a sufficiently adverse event affecting any one of them could spark a reappraisal of risks in other areas. Moreover, correlations across asset classes are increasing over time, making the benefits to portfolio diversification less clear. The rapid build-up of leverage in segments of the financial system, including in "carry trades" in high-yielding currencies, suggests that some market participants are expecting the low volatility environment to continue. This makes it likely that the pattern of increasingly benign market conditions will continue to be punctuated by reversals and spikes in volatility.
Against this backdrop, let me close by summarizing some of the risks and opportunities I have suggested.
On the one hand, opportunities seem to be abundant. Debt financing is cheap by historical standards for even the riskiest of corporates. The world economy is enjoying its longest period of sustained growth since the 1960s and is forecast to continue to do so. Globalization has contributed to the highest ratio of profits to GDP seen in a generation. Emerging market fundamentals and policymaking continue to improve, encouraging the further expansion of trade and capital flows. Financial innovation is pricing risk more precisely, perhaps too generously, and facilitating its spread among a wide diversity of investors who are hungry for yield. Hedge funds and insurance companies are willing to innovate to allow corporates to lay-off firm-specific risks as never before. Private equity offers a liquid outlet for underperforming subsidiaries. Conditions for capital investment have rarely seemed so favorable.
The problem is that, to match these opportunities come various harsh disciplines - most notably from activist investors (be they institutions or hedge funds) increasingly impatient for performance and faster returns on their investment. Also, the prospect of a hostile bid or a buy-out approach is now ever-present if any company, no matter how large, is perceived to underperform. Meanwhile, companies can no longer rely on a near-captive and docile investor base for their equity, as capital controls have been relaxed and the home bias of domestic institutions declines. And from an investment perspective, global markets seem to be prone to periodic bouts of turbulence when volatility spikes up and few places seem safe to invest.
Perhaps I can best summarize the current situation for the global corporate treasurer by quoting Charles Dickens - "It was the best of times, it was the worst of times...."
Thank you for your attention.
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