Transcript

Monday, September 11, 2000

Washington D.C.

Garry Schinasi, Don Mathieson, Graham Hacche

MR. HACCHE: Good morning and welcome to this briefing on the IMF's latest report on international capital markets. I am Graham Hacche, Deputy Director of the Fund's External Relations Department.

The text of the report and the contents of this press briefing are under strict transmission embargo until 11:00 a.m. Washington, D.C., time today, or 3:00 p.m. Greenwich Mean Time. We will post the report and the transcript of the briefing on the IMF website after the embargo is lifted.

Before introducing today's speakers, let me first remind you, in case you need reminding, of some of the other events scheduled for the next couple of weeks. This Thursday, September the 14th, at 9:15 a.m., Mr. Stanley Fischer, First Deputy Managing Director of the Fund, will be here to lead a briefing on the 2000 Annual Report of the IMF. Then a week tomorrow, Tuesday, September 19th, at 10:00 a.m. in Prague, Mr. Michael Mussa will lead a briefing on the latest World Economic Outlook. And the following day, on September the 20th, at the same time, the Managing Director will give his pre-Annual Meetings press conference.

The subject of this briefing is the International Capital Markets Report, which, as you know, is one of the IMF's two main regular reports on global surveillance, the World Economic Outlook being the other. Let me introduce today's speakers from the IMF's Research Department, which is where the International Capital Markets Report is prepared.

To my immediate right is Don Mathieson, Chief of the Emerging Markets Studies Division, and seated next to him is Garry Schinasi, Chief of the Capital Markets and Financial Studies Division in the Research Department. Don and Garry together direct the International Capital Markets Report. I think they have some brief opening remarks and then we'll take questions about this year's report.

Don?

MR. MATHIESON: Thank you, Graham.

As in previous years, this year's report considers a number of issues related to the functioning of the international financial markets and efforts to improve the management of systemic risks. In particular, this year's report reviews and assesses recent developments and trends in mature and emerging markets, analyzes a number of key issues related to the over-the-counter derivatives market, assesses and provides market views on proposals for private sector involvement in the prevention and resolution of crises, and examines the implication of the expansion of foreign-owned banks into many emerging markets.

I will say a few words about the issues raised on the emerging markets side, and I will then turn it over to Mr. Schinasi to deal with the mature market issues.

With regard to recent developments, the report reviews what we regard as overall some favorable developments with regard to financing for emerging markets, the gradual recovery of financial flows, the increasing importance of foreign direct investment, and some modest recovery in emerging market asset prices over the year, as well as a broadening of the investor base to some degree for emerging market instruments.

However, the weaknesses that were experienced in emerging market asset prices in the March to May 2000 period illustrated some of the weaknesses and vulnerabilities that still exist for these classes of instruments and their vulnerabilities to adverse developments in mature markets, to adverse developments in the debt-servicing capacity of sovereigns and corporates, and to changes in the risk tolerance in mature market investors.

On the two analytical issues that the report considers relative to emerging markets, one of the key ones is private sector involvement in crisis prevention and crisis management. How the markets react to the precedents set by official policies with regard to what I'll call PSI will have fundamental and far-reaching implications for the future terms and nature of international financing that's available for emerging markets. As a result, the official community needs to be aware and take into account how the private sector will interpret and react to these initiatives that are underway.

This year's report looks at market assessments of both private sector involvement in crisis prevention and in crisis resolution. On the prevention side, it looks at the response to such things as efforts to strengthen transparency, improve liability management in emerging markets, credit/debtor dialogues, and the presence of collective action clauses in debt instruments.

On the resolution side, it generally looks at how the market participants have been responding to efforts related to two key instruments of crisis resolution that have emerged over the last couple of years. One is the rollover of interbank lines of credit, and the other is the restructuring of the external obligations of sovereign borrowers.

The other key issue is the sharp expansion of foreign banks into many emerging markets that has been evident since the mid-1990s, particularly in Latin America and in Central Europe. The report examines the factors that have led to the entry of banks, foreign banks into these markets and the reasons why the authorities in these countries have been reducing barriers to entry. And it looks at the effects of this entry on the efficiency and stability of emerging market banking systems. And, finally, it considers a number of policy issues related to the effects of such entry on banking system concentration, the use of new financial instruments, and the question of whether this entry raises or reduces systemic risk in the banking system.

Garry?

MR. SCHINASI: Thanks, Don.

As Don indicated, I coordinate the work on mature markets, and as the report analyzes, the mature markets have been in a period of relative calm. That doesn't mean there hasn't been asset price movements of a volatile nature, but things do seem to have calmed down from the period leading up to September and October of 1998.

We detail events in the major markets, including the foreign exchange markets, the major--and by that we mean the G-5 or G-7 bond markets and the equity markets. I'm sure all of you have been following developments in those markets, so you've been seeing some corrections here and there and then markets settling down. And the report analyzes those in detail.

We identify a number of risks, and let me tell you where they are in the report. There are two sections where risks are considered for the mature markets: pages 39 through 41 of the report, and that's in the main chapter on developments; and then later on in what we call the staff appraisal there's another review of the risks in the mature markets, and that's on pages 183 and 184.

Let me identify just three areas where there are risks. This is not to say that these risks will be realized, but they are of some concern in the markets, and there would be some potential international ramifications were these risks to be realized.

As you know, the major exchange rates have been considered to be misaligned for quite some time now; that is, the dollar has widely been viewed as overvalued. We don't really take a stand on that issue. We do point out that with the current account balance where it is and with the U.S. attracting international capital the way it is, mostly because of perceptions of risk-adjusted returns, that there is the potential for some reflow of capital out of the United States to other international financial centers. This just naturally happens as capital ebbs and flows.

As always, these adjustments can occur in an orderly fashion, but they from time to time occur in a disorderly fashion, and this is a risk.

There are risks in the other major centers, Japan and Europe, which are detailed in the report. The risks we identify in Japan have to do with the consolidation that is taking place in the financial sector following the system problems experienced years ago. And there is corporate restructuring going on. And as always, while these adjustments are taking place, there are risks.

Some of the risks are associated with the present policy mix within Japan, and as the Japanese authorities respond to cyclical developments, there is the risk that some position taking within Japan's financial markets might not be sustainable. This would mean there would be asset price adjustments.

In Europe, the risks are associated mainly with the financial restructuring that's taking place. The financial restructuring includes mergers and acquisitions both at the corporate as well as the financial institution level. Again, as these transitions take place, there are risks.

There are also risks associated with these structural transformations having to do with the monetary policy transmission process. The ECB has recognized these risks and are dealing with them as best they can.

And then there are a number of structural changes within the global financial environment, including the broader process of financial restructuring and consolidation, which make it more difficult to assess the conjunctural risks because of the innovative quality of the structural changes.

Again, let me emphasize, these are risks. We're not saying any of these risks will be realized, but they are risks.

The main structural issue that the report deals with for the mature markets is the OTC derivative markets. We thought it was timely to address what we see as a gap in analysis on these markets. As you know, there have been studies on the activities of highly leveraged institutions. Those reports by and large took an institutional focus. This report takes a market focus. It looks at the OTC derivatives activities of all institutions involved in those markets and analyzes the structure of the markets and their evolution and their infrastructure.

By and large, these markets are very efficient and effective in allocating capital and helping both financial and non-financial firms manage risks and allocate capital and price it properly. But these markets in their modern form are relatively new. Some would date them as ten years old in their modern form, while recognizing that derivatives have been around since the early days of man.

So we see these markets as mostly beneficial, but we do believe that because they are new, they are not well understood. One area that we think is not well understood is how these markets have contributed to changes in systemic risk, not that they have increased or decreased systemic risk but they have been part of a transformation of global finance, and as global finance has changed, so has the nature of systemic risk.

So this chapter tries to fill a gap and identify areas where OTC derivatives markets and activities have had an impact on both private and systemic risk.

The report identifies a number of potential weaknesses in the infrastructure, a number of potential instabilities, and it then identifies efforts that can improve the identification of private and public risks. These efforts that we identify span the space of market participants, private and public, so there are things to be done or that can be done to improve the situation by private risk managers, by senior management of the private institutions, by bank supervisors, and by market surveyors.

Chapter 4 identifies all these areas, but the staff appraisal, pages 185 through 188, is probably a good summary of what the report has to say for these markets.

I'll just leave it there.

MR. HACCHE: Thanks, Garry.

We can now turn to questions from the floor...

QUESTIONER: You talk about the exchange rates falling out of medium-term equilibrium. Since you wrote your report, the euro has plunged even further and seems sort of set to hit new lows each day at the moment. Is that increasing the risk of a correction somewhere down the road?

MR. SCHINASI: Well, we say in the report that even though there might be these "fundamental based misalignments," in quotes, that the dollar may, in fact, strengthen further before such correction takes place. And the factors we identify in the report all point to perceptions in the markets that the United States is experiencing productivity gains and that rates of return on a risk-adjusted basis appear to be not only higher but sustainably higher in the United States than the other major financial centers.

As that perception takes even deeper hold, you would expect the dollar to at least hold its gains, if not improve them. At some point there will be productivity catch-ups in the other financial centers and in the other major economies, and as that happens, we would expect to see capital start flowing to those economies as well. And as I said, this is just the natural exhibit and flow of capital seeking high returns on a risk-adjusted basis.

There might be special factors one can point to about why the euro is particularly moving in a direction it's moving now, but I'd rather reserve those comments for Mike Mussa eight days from now, because it's in the context of the World Economic Outlook where the macroeconomic factors are best discussed.

The main motivating factors that we discuss are of a financial nature, and you can point to productivity gains as lifting the rates of return in the United States relative to other places where the international portfolio manager might allocate capital.

QUESTIONER: Can you tell me, in terms of OTC derivatives, are the risks greater now than they were two years ago when long-term capital had its problems? And if so, what are the new--the changes since then?

MR. SCHINASI: No, I would say they are not larger now than they were two years ago. I would say they're probably lower now, for a number of reasons.

First, in the aftermath of the LTCM problem, as you know, there were many reports that came out which ran parallel with reports on international architecture. There were many recommendations made. Some of these recommendations have been implemented, both by the private sector and by authorities responsible for either supervising banks or for surveying markets. So that's one factor. We know a little bit more about these markets now, where the risks are, and the authorities and firms are dealing with them.

The second factor I would say is that there has been, to some extent, a withdrawal of capital by some major financial institutions in making those markets. That means there is less scope for high leverage. That means that more consideration is given to pricing. And if you look at swap spreads and repo spreads and all those indicators of activity in those markets, you would see that there's somewhat lower activity, particularly on the exchanges. There are higher spreads, indicating the higher cost of doing that business because of the withdrawal of market making. And there's much less proprietary trading going on.

Now, one can infer that lessons have been learned and that market discipline has, to some extent, exacted its toll. Firms are more cautious about putting their capital into those areas of business and are allocating their capital to either less risky or higher return ventures on a risk-adjusted basis. So I'd say that's the second set of factors.

Now, that doesn't mean there aren't risks, and we have pointed to areas where there would be risk, and let me just identify one. There is possibly a set of institutions that are managing OTC derivatives contracts that were incurred prior to the LTCM crisis. Some of them might be long-dated, five years, six years. Those contracts need to be managed. They're cash flows that need to be managed.

To the extent that there has been a withdrawal of market making and to the extent that one or more small institutions has a considerable amount of those contracts, they may incur higher cost of managing those contracts. That always poses risks. But there's nothing we would identify that is of a systemic nature or that we can identify as a systemic nature.

So overall I would say the risks are lower and, moving forward, we think risk management would improve.

QUESTIONER: I was interested in the private sector involvement chapter, and if I read it right, there seemed to be a lot of skepticism about the benefits to be gained from all these standards and whatnot that the IMF and others are promulgating. It seemed, if I read the chapter right, that there was a lot of skepticism in the private market or even ignorance in the private market of these standards. I wonder if you could expand a little on that. And does that draw the whole sort of effort into question?

Then, secondly, you mentioned at one point there might be a move to even shorter-term debt maturity than interbank credit lines, and I wasn't quite sure what you meant by that.

MR. MATHIESON: Let me take the second one first, and I'll come back to the first one since it requires a little more elaboration.

One of the themes that the chapter brings out is that there is a dynamics between official policies and market responses to those official policies. And it often shows up in this particular area we're talking about in changes in the types of instruments that are used for emerging market financial flows.

The report makes the point, for example, that during the 1970s and up to the crisis period in 1982, medium- to long-term syndicated lending to sovereign borrowers was the dominant form of financial flows to many emerging markets. The experience of the 1980s and the losses that banks suffered as a result of the crises led to a change in the nature of bank flows. It shifted the composition of banking lending towards mainly interbank lending of shorter- to medium-term maturity. And one of the ways in which banks can respond in the nature of their activities to things like an involuntary rollover is to shorten the maturities of the loans that they make.

It still might be an interbank credit. It just would be of a shorter maturity as it became more and more likely, for example, that maybe an involuntary rollover was likely to take place. You would just see the maturity of those credits begin to shrink as the loans are matured and rolled over. So that was the only sense in which we have said they would use the shorter-term instruments. It was just they'd shrink the maturities down pretty...

QUESTIONER: Well, I guess what confused me was that it says, "even shorter maturities than interbank lines," which sort of implied that it wasn't interbank lines. But you're saying it is interbank lines. Is that--

MR. MATHIESON: I think, admittedly, the phrasing wasn't quite right. It can be other instruments, but the main instrument is still like to be interbank lines, it's just that they'll be of shorter maturities.

On the standards and codes, I think when we initially went out to the markets and talked to various market participants about the work on standards and codes, I think one of the surprises for us was indeed the degree of ignorance that existed in even some of the key financial centers about the nature of this work. And I think during the--as summarized in the report, during our discussions of this issue in the Executive Board, a number of Executive Directors also expressed concern about this particular issue.

It's a little hard to ask somebody why aren't you aware of something because it's just a question that's a little difficult for them to answer. But we did talk to other participants who were aware of the standards and codes and sort of asked them the question: What was it that seemed to be either inhibiting the use of this or creating a lack of incentives for the private sector to become aware of this?

And I might say that those market participants that were aware of the work were very supportive of it, and in their view, they felt the level of transparency with regard to many emerging markets had increased, as they put it, more in the last two years than in the last two decades. So I think there was that point to be made.

With regard to the others, the most common explanation that we've heard of this was--well, two things.

One was there was a question of whether there was, especially on the data side, all of the relevant data that were needed by market participants, whether they were being published and whether they were being published on a timely basis. I think a number of emerging markets have begun to address this issue. The ones that come to mind on this are, say, for example, Mexico and Brazil, which now have websites which are updated daily with key information. So I think there is that issue.

And the other factor that people cited was just the fact that it takes time for people to become used to using this type of data and to seeing its relevance and seeing whether or not, indeed, for example, as a crisis approaches, whether countries continue to maintain the same reporting standards over time. If that is true and if the data remains timely, then I think there will be even more attention given--the market participants thought there would be even more attention given to this particular issue.

But it is clear that there needs to be, I think, more effort put into making available what information there is and also making an effort to increase knowledge of the availability of the data.

MR. HACCHE: Next?

QUESTIONER: A question about--in that same vein. In terms of bond restructuring, you said that as a result of the previous restructurings, creditors will be more likely to make it more difficult to restructure. Is that a--can you just elaborate on that a little bit and also comment on whether or not that's a good development or not?

MR. MATHIESON: I think we haven't really seen the full response yet to the bond restructurings that have taken place. I mean, as I said, it's likely to take place over a medium-term period.

What I think the report says--and it relates to what we heard in the marketplace--is that one way of attempting to deal with this would be to go to more heavily collateralized instruments. That might include dedicated revenues that are collected offshore and then used to pay the proceeds of the bonds, or having other assets that might be required to be placed offshore with a trustee to serve as a security for the bond principal, things like that.

As I say, we haven't seen the extent of the market's response to that, but it's certainly one of the things we're going to be monitoring as we go forward in the next couple of years.

Is it a good thing or a bad thing? Well, I think what I would say there is that, you know, financial crises and debt-servicing difficulties for emerging market borrowers have been a fact of life over the last probably 100, 150 years, if not longer than that. Probably you could trace it back to the Greeks. I'm not sure. But there will be a need from time to time to restructure the external obligations of various sovereign borrowers, and that will happen in the future, just as it has happened in the past.

From the perspective of international markets, it's important to properly price those credits so that the likelihood of that occurring is reflected in the price of the credit that is obtained by the emerging market borrower. But there are going to be occasional large crises which will make it virtually impossible for a country to service its existing debt obligations from time to time in the future, and these sorts of restructurings will occur.

QUESTIONER: You highlight the Japanese banking system as one of your potential risks because they've got used to the zero interest rate policy. How vulnerable do you think they are?

MR. SCHINASI: Well, quantifying it is very difficult. Let me just give you some of the analysis that you can come to your own judgment on that.

As you know, the banks are not lending much. They're not lending much in part because of their own financial situation, but there doesn't seem to have been much demand for loans either. And they have shifted their portfolio towards relatively safe assets. One of the safest assets in Japan are the JGBs, low return but safe.

To some extent, they have accumulated reserves because of the way these markets have been performing, and should there be a substantial adjustment at the long end of the yield curve, the value of those portfolios would decline. So their reserve cushion would decline. So that's one element of adjustment that might occur.

If the yield curve were to adjust very abruptly at the long end, that is, an already steep yield curve anchored at about 25 basis points now, stretching up to about 200 basis points--I haven't looked at the numbers in the last day or so. If that yield curve were to steepen significantly further, then there are probably some institutions that would suffer capital losses on that part of their asset portfolio.

But that's the business they're in, and sometimes they win and sometimes they lose. It doesn't mean that the Japanese financial system would become vulnerable. But if there are a large number of institutions holding those portfolios and a sudden adjustment takes place, there is the potential for large capital losses, and some firms could experience difficulties.

Now, offsetting that is that, as Japanese interest rates rise at the long end, the demand for those securities would also increase because of the higher return. So that would offset some of the pressure for rates at the long end to raise. So it's a risk, but it's difficult to quantify how large that risk is, particularly because there are mitigating circumstances.

QUESTIONER: You talk about on page 39--you list five risks there, and the first two are the U.S. interest rates and growth, that issue, and then the second is the uncertainty over the correction in technology stocks. Was this written--I assume this was written in May. Is that correct?

MR. SCHINASI: The closing date was end of June.

QUESTIONER: Oh, okay. Can you tell us what your assessments are on both of those? It would seem to some people that both of those risks would have lessened since that time?

MR. SCHINASI: That would be our opinion at this time as well, that it seems that numbers that have rolled in since the end of June, certainly by the Fed's accounts, would suggest that the productivity improvements have at least been sustained if not even increased in the United States, and that this would lessen the need for an unexpected sharp interest rate adjustment. And, in fact, I think if you look at interest rate futures now, they're flat over the next 18 months or so, meaning the markets are anticipating no rise in the federal funds rate. So they, too, have adjusted their expectations about the need for an interest rate adjustment.

So the inflation risks are probably lower over the next 6, 12, 18 months. So we would agree with that assessment.

Now, on the equity markets, we were writing this and analyzing it at a time when it wasn't clear what investor sentiment was about the impact of a decline in the technology sector on the broader market. I think the market has spoken on that, and spoken quite clearly. And so we would assess that as an indicating that the broader market and its valuations are sustainable within some range that you have seen over the last six or nine months, not necessarily where it is now but not much lower than it has been.

QUESTIONER: If I could follow up, in your discussions today you talked more about the current account. Is that now in your view a greater risk than before? Or should I say the leading risk?

MR. SCHINASI: Well, there are two sides to that analysis, and I would say that it depends on whether you view the major exchange rates as being driven by the goods markets or the capital markets at this point. And analyses surrounding the dollar have been over this ground before during the '80s when the dollar was riding high. These same discussions took place both within and outside of official circles.

And I think the feeling now is that, given the productivity improvements in the United States, if they are sustained, then whatever capital is flowing in to finance expenditure might be financing expenditure that will generate returns that will allow the U.S. economy to finance the capital inflow.

If investor sentiment were to shift in the other direction, probably gradually if it were to shift, then you would start seeing less capital coming in and you might see exchange rate adjustments. But it's hard to predict when investor sentiment would change, and it's hard to predict when data will start coming in that would indicate that the productivity increases cannot be sustained for much longer. We just haven't seen any evidence of that yet.

So my personal and my professional opinion is that it's capital flows that are driving exchange rates right now, and judging from exchange rate movements, I would suggest that international portfolio managers see the U.S. as still offering the highest risk-adjusted returns for investments. And until that changes, it's difficult to see why the dollar would decline much in value.

Now, at some point the current account may take over; that is, portfolio managers may think that the goods and services that are being purchased with foreign capital cannot be sustainably financed in the future. That sentiment may change. It's hard to say when.

MR. HACCHE: The next question? Last call? Okay. We'll stop there. Thank you very much for coming. Just to remind you that the report and the contents of the briefing are embargoed until 11:00 a.m. today. Thank you.
[Whereupon, the press briefing was concluded.]