Transcript

Thursday, July 12, 2001
Washington, D.C.

Participants:

Garry SCHINASI, Chief of the Capital Markets and Financial Studies Division, Research Department, IMF

Don MATHIESON, Chief of the Emerging Markets Studies Division, Research Department, IMF

Graham HACCHE, Deputy Director, External Relations Department, IMF

Proceedings:

Graham Hacche

MR. HACCHE: Good morning, ladies and gentlemen. We may as well begin on the IMF's 2001 International Capital Markets Report.

I am Graham Hacche, Deputy Director of the External Relations Department of the Fund, and I am joined on my right by Don Mathieson, Chief of the Emerging Markets Studies Division of the Research Department, and on my left by Garry Schinasi, Chief of the Capital Markets and Financial Studies Division of the Research Department, who together directed the preparation of this report, which itself is under embargo until 11:00 o'clock Washington time this morning, and the transcript of this briefing, like the report itself, will be posted when the embargo is lifted, on our Web site.

The IMF's International Capital Markets Report is, as you know, one of the Fund's two main regular reports on global surveillance, the World Economic Outlook being the other. We have published it, annually, since 1980. The report draws in part, on informal discussions with a variety of private and public financial institutions, and is discussed by the IMF's Executive Board.

This issue was discussed by the Board on June 29, a couple of weeks ago, and a summary of the discussion is provided in Annex 5 at the end of the report, where you will see the Chairman's concluding remarks.

The 2001 report is the last to be prepared under the general direction of Michael Mussa who has, as you know, just stepped down as Economic Counsellor and head of the Research Department, after a decade of distinguished service. It is also the last to be prepared in the Research Department, because the responsibility for producing future editions will pass to the newly-created International Capital Markets Department, which will begin operations on August the 1st.

This report examines and assesses the risks in capital markets in both the mature and emerging markets in the period through May 2001.

In addition, the report focuses on two issues of ongoing systemic importance, the changing structure of major government securities markets and financial consolidation in emerging markets.

I will hand over to Don and Garry, who have brief opening remarks, and then I will invite questions, and if I may, could I ask you to confine your questions to the contents of the report.

As you know, you will have an opportunity tomorrow to ask more wide-ranging questions as well as, perhaps, some country-specific ones of Tom Dawson, who will hold his regular briefing here tomorrow at 9:30.

So I will hand over to Garry.

Garry Schinasi

MR. SCHINASI: Thank you, Graham.

I'd just like to highlight what the report says about the main developments in the mature markets, the key sources of risks and vulnerabilities, and several issues relating to structural changes in government securities markets, and then my colleague, Don Mathieson, will discuss what the report says about key developments, risks, and issues pertaining to the emerging markets.

In the year ending May 2001, market sentiment shifted, dramatically. Early in 2000, market participants were mainly concerned about what would happen to their portfolios if the U.S. economy started overheating, and inflationary pressures started picking up.

By the end of 2000, and in early 2001, this sentiment had shifted completely to the other side, as market participants had become concerned about the extent of the slowdown in the U.S. and global economies, as growth in the United States had slowed, unexpectedly sharply, and as an expected pickup in growth in Europe and Japan was failing to materialize.

Asset prices have reflected this change in sentiment. Compared to May, last year, global equity markets have corrected, corporate credit spreads are much wider, and I would say creditors are being more discriminating, and the dollar has continued to appreciate, both on a multilateral basis and against the Euro and the yen.

The volume of activity in the credit derivatives markets has also mushroomed as banks have been buying more and more credit protection for those willing to provide it, that is, those willing to own default risk as the economic situation has deteriorated. All of this is detailed in chapter two of the report.

As far as asset markets and prices are concerned, and, in particular, global equity and bond market valuations, many of the risks that we noted in the report as of the end of May have materialized to some extent.

Equity prices across a broad range of countries are presently lower than they were at end May 2001, by about 5 to 10 percent, and credit spreads for higher-risk borrowers, both in mature and emerging markets, have widened, in some cases, rather considerably. The dollar has also continued to rise.

Stepping back from all of the detail of the report, there are two key risks in the period ahead.

First, it is still an open question whether all of the excesses of the past have been removed from global equity markets.

Second, and related to this, it is also difficult to gauge whether asset prices, more generally, are fully reflecting real economic fundamentals. That is, whether asset market valuations are fully consistent with the as-yet unknown extent of the slowdown in the U.S. and the global economies. The main source of financial risk and vulnerability in the period ahead is the uncertainty about the depth and duration of the ongoing slowdown in the global economy.

While I'm sure many of you have questions about this, there really is no way of calibrating how much further asset prices will adjust, and as you know, we are not in the business of making projections, either about asset prices or transactions flows.

Having said this, there still seems to be some room for equity prices to adjust further, but this depends, importantly, on international investor perceptions of the sustainability of high U.S. productivity growth, and whether and how some of the imbalances in the household sector will adjust.

There is no reason to expect these adjustments to be disorderly. Regarding the major currencies, if one thought the major currencies were misaligned a year ago, as the dollar has appreciated further, one would see them as even more misaligned today, but, again, this depends on the sustainability of relative productivities and productivity growth in the major economies, and how and when imbalances are reduced or eliminated.

There is nothing that would suggest, at this point in time, that a realignment of the major currencies is likely to occur abruptly, or disorderly, but it is a risk.

The situation in Japan's financial and corporate sectors has not improved much and the short-term prospects for the economy seem to have worsened, and this, too, is a risk that bears on international markets.

Let me now turn to the systemic issue that we take up in chapter four.

The government securities markets in Europe, Japan, and the United States are going through major structural changes. For example, and as many of you already know, the market for U.S. Treasury securities is predicted to shrink fairly rapidly, given current projections for surpluses, and U.S. financial markets are already adjusting to this new reality.

Private substitutes are being used for pricing and hedging, and to a lesser extent, as collateral. A key unresolved issue is how will dollar markets perform and behave during a period of turbulence, if U.S. Treasuries can no longer be relied upon as a secure, safe haven during times of stress?

This raises a larger issue of the desirability of preserving the public benefits of well-functioning, deep, and liquid government securities markets.

One of these benefits is that deep and liquid securities markets may be instrumental in fostering the development of private finance, and in fostering financial stability, more generally.

There are specific issues in Europe and Japan as well. In Europe, the issues are associated with the fact that the European Monetary Union has one currency and twelve converging but still separate government securities markets.

Because the markets are still fragmented, there are financial inefficiencies that affect pricing and risk management, but there also may be financial stability issues.

On the one hand, fragmented markets mean that linkages between national markets are not complete, and so turbulence in one market may not spread that quickly to others.

On the other hand, fragmentation also means there are separate pools of Euro liquidity and this could, during times of turbulence, lead to more stress and strains than would be the case were these pools of liquidity perfectly merged.

Finally, in Japan, there is the question of how well the market infrastructure of the Japanese government bond market will perform as Japan issues more and more public debt.

Don Mathieson

MR. MATHIESON: Thank you, Garry.

I'd like to deal with two key issues on the emerging markets side in terms of recent developments. One is what we call the "stop-go" nature of market access. That's become quite evident for many emerging markets. Also the divergence between gross and net capital flows that has taken place over the past year, and then I'll turn, finally, to discuss the issue of financial sector consolidation in emerging markets.

In the past year, global asset price volatility and the prospect of slowing growth in the mature markets played an especially important role in determining the terms and conditions under which emerging markets could access international capital markets.

This reflected a number of factors, including the fact that there is not yet a significant dedicated investor base for emerging market instruments, and as a result the investor base is dominated by what we call crossover investors, which I'll go into in a moment.

Also the extent of the increase in asset price volatility in the mature markets was quite high, particularly in markets like the Nasdaq, and then, finally, the prospect of a sharp slowdown in global growth impinged on market access as well.

Among these factors, the activities of crossover investors have been a key element both in transmitting asset price volatility from mature to emerging markets and inducing a "stop-go" pattern of market access.

Crossover investors, which include global and high-yield funds, pension funds, insurance companies, and the proprietary trading desks of investment banks, typically invest primarily in mature market instruments, but, at times, hold a relatively small fraction of their large portfolios as claims on emerging markets.

However, these investors have shown that they can scale back or eliminate their holdings of emerging market claims during periods when there's uncertainty about emerging markets prospects, when there's a general increase in risk aversion, or when investment opportunities in the mature markets become relatively more attractive.

This type of investment pattern has contributed to periods where the emerging market borrowers have not been able to access the markets very readily, and have faced high costs.

They have been, however, adapting to this process in a number of ways. In many of the debt offices in emerging markets, you now find individuals who have served in investment banks or have been traders themselves, and they're used to this pattern in market access.

As a result, many emerging markets now make use of windows of opportunity to prefund their annual funding needs in very short periods of time. That has occurred in the last two Januarys. And they've also engaged in a variety of debt exchanges to extend maturities and to avoid a bunching of maturities, and also they have made much greater use of local bond markets over the past year.

For the first time since 1990, there's been a sharp divergence between the level of gross and net capital flows to emerging markets. While gross issuance of international bonds, equities, and syndicated loans rose for the third year in a row to reach about $216 billion, the highest level since 1997, just before the emergence of the Asian crisis, net flows to emerging markets actually declined from $72 billion to $32 billion during the year.

This represents a sharp break in the positive correlation that has traditionally been evident between these two measures of capital flows. However, this divergence in this particular case primarily reflects the experience of fuel-exporting emerging markets, which, because of the higher price of oil, experienced large current account surpluses during the year, and they therefore increased their net claims on international banks, mainly in the form of higher holdings of deposits in these banks.

Nonetheless, last year was the first year in which foreign direct investment also declined since 1990, primarily because of a slowdown in privatizations, and mergers and acquisitions.

Recently, the issue of financial sector consolidation in the mature markets was addressed in the so-called Ferguson Report, put together by the G-10. In this year's report, we also look at this consolidation process in the emerging markets.

This process is not as far along in the emerging markets as it is in some of the mature economies, but it is gathering momentum in many regions.

This financial sector consolidation is one element in the ongoing globalization of international financial activities, and what we call in the report the quiet capital account opening that is taking place in many emerging market countries.

The globalization of international financial activities is being accompanied by both the consolidation of the financial sector to capture economies of scale and scope, and the migration of financial activities to financial centers that offer the lowest cost source of funding and/or trading.

Although some of the same economic forces driving financial sector consolidation in the mature markets are also operating in the emerging markets, there are a number of aspects of the consolidation process that differ between the two sets of countries.

First, while cross-border mergers and acquisitions account for a large share of the consolidation in emerging markets, they have been relatively rare in mature markets.

Second, while consolidation in the mature markets has been a way of eliminating excess capacity, the process of consolidation in emerging markets has been prominently a vehicle for restructuring the financial system following major financial crises.

And third, the authorities have played a much larger role in the consolidation process in emerging markets, whereas market forces have been the dominant factor in mature markets.

Ownership structures, particularly family ownership, is seen by many analysts as the main obstacle to faster market consolidation in the emerging markets.

The consolidation process raises a number of policy issues which are examined in the chapter on consolidation. One of the key issues is how to create sufficient market discipline and official supervision for institutions that are becoming too large to fail.

Experience in the mature markets suggest that this may need to involve the removal of entry restrictions, in some cases on foreign institutions, the establishment of clear exit rules, and prompt corrective action toward distressed institutions, as well as the creation of supervisory teams that are capable of monitoring the activities of large, complex financial institutions.

Consolidation, in and of itself, may either increase or reduce systemic risks in a financial system. If consolidation leads to the creation of adequately capitalized financial institutions holding diversified portfolios that are well-managed and supervised, then these large complex institutions can contribute to greater systemic stability.

However, large, complex institutions could increase systemic risks if they inadequately manage the internal risks they face, associated with multiple product lines, or if they create interdependencies through, for example, the interbank market, by reducing the number of counter parties.

Although there is not at this time evidence of these problems in emerging markets today, it is a situation which needs to be monitored.

MR. HACCHE: Thank you. Turning to questions, can I please ask you, in the usual way, to identify yourselves by your name and affiliation, and also to make sure that your microphone is switched on when I identify you. Please.

Questioner: This question I guess should go to Mr. Schinasi but can be answered by either. With what degree of urgency should the Japanese government be taking the sort of reforms and steps that are suggested in the report to help improve the functioning of its debt market, given the projections of gross public debt going up to 150 percent of GDP by about 2005? Is this something that needs to be addressed rapidly, given that sort of scenario, or is there an opportunity to take it at a pace that could take a couple of years?

MR. SCHINASI: I would answer the question with your latter statement, that it's not a matter of urgency. In fact reforms are ongoing, they've been going on for the last year and a half, or two years. The market functions reasonably well now. So, no, it's not a matter of urgency. These are measures that can be taken over the next several years and will be taken over the next several years, it is my understanding. So it's a question of the measures being implemented, and assimilated by market participants as time goes by.

This may also require some institutional structural changes on the part of securities firms, and banks, but it's all part of the transformation of the Japanese financial and corporate systems over a period of time.

Questioner: This is for Mr. Mathieson. It seems, in the report you mention the problems in Argentina and Turkey, and their effects on emerging markets. How have the events in the last week changed that analysis? Have they made the risk much greater, in your analysis, and, related to that, if Argentina is forced to default, what would be the effect on emerging market finance, in general?

MR. MATHIESON: Well, I think what we've talked about here in the report are participants have been looking at the experiences in Argentina and Turkey. The period we covered in the report is primarily during the last year, the events in Argentina through, say, March of this year.

It is evident that, you know, market participants are really focused in on the events in these two countries at this point in time, and I'm sure they're equally focused on the more recent events that have been going on in both countries.

We cite in the report the fact, that it's the general conclusion that, you know, difficulties in these countries could have impacts on both other neighboring countries and, more generally, on other emerging market borrowers or issuers.

I don't think we would modify those conclusions based on recent events. I would suspect the same sorts of concerns exist right at this moment in time.

Again, on the issue of a default, I think it was in the minds of market participants, so it's been there for a period of time, and it is a source of concern, and whether they've changed their views on that in the last week, I think we'd have to check with them to see.

Questioner: I see that in the discussion that the members of the Board had on the report, they noted how important the role could be of these external debt swaps, like Argentina has done. My question is, they are, in a way, saying that it's positive, how can it be that they are talking about default, now, in Wall Street?

MR. MATHIESON: I think the sense in which the Board saw debt swaps was a means of dealing with a bunching of maturities, and this has been the concern of most of the debt swaps, a means of either lengthening the maturity of the existing debt, or alternatively, smoothing out the debt service payment over time. It's in that regard that—well, it's hard for me to put words into the mouth of the Executive Board—that the discussion occurred, as a general tool of debt management, that might be useful for emerging markets.

Again, this is, to some degree, related to the issue of market access and how sustainable it is. We've had this phenomena, which we talk about in the report, of the "stop-and-go" market access. That tends to induce a lot of issuance at a single point in time, which could lead to a bunching of maturities.

So, in some sense, if you're going to get that phenomena, and then you want to smooth it out, later on, then the debt exchanges could be used as a vehicle for that.

Questioner: This is a question for Mr. Schinasi. You refer to a decline in the market for U.S. Treasury securities. Does it mean that on a long term, a reduction of the U.S. national debt will have an impact on financial markets, and if you can describe what this impact is.

MR. SCHINASI: It's less a question of having an impact on the market per se. It's more a question of having an impact on how the market prices risk, how it hedges interest rate risk, what it uses for collateral, and so on.

In pricing, hedging, and using securities for collateral, market participants like to rely on as credit risk-free instruments as possible, and the U.S. Treasury is free of credit risk, or at least that's how market participants view government securities issued by the major governments, more generally. They're free of credit risk.

They have all the other risks associated with other instruments, like market risk, liquidity risk, and so on. But the credit risk is minimal.

Now in the presence of deep and liquid markets for U.S. Treasury securities, which are traded internationally, international private finance has relied on them, pretty heavily, for all the roles I mentioned, including an additional role, and that is when there is market stress, and you want to shed credit risk, what instruments do you go to?

You go to instruments that have less credit risk, and so market participants generally go to a government bond that they are most familiar with. In many cases, it's the U.S. Treasury security. In some cases, it's the government securities of Germany, Japan, and other major governments.

Now as the supply of U.S. Treasuries shrinks, the market risk and the liquidity risk will change. So if you're holding a portfolio of U.S. Treasury securities as collateral against interest rate risk, but the U.S. Treasury market itself has more price movement in it, then that's less reliable collateral. So they may shift into other instruments that have less market risk.

One such instrument, going to the extreme, is cash. They will hold dollars rather than U.S. Treasury securities denominated in dollars. To some extent, that happens already for some transactions.

So, in the extreme case, were U.S. Treasury securities to completely disappear, markets would then have to come up with a set of other instruments to use as pricing, hedging vehicles for collateral and for seeking a safe haven during times of turbulence.

Alan Greenspan has said that although the absolute disappearance of U.S. Treasuries is probably not going to occur, even if it did, the market would probably create very high-quality securities, what he calls quadruple A securities, and they would probably be hybrids of agency type securities, not just in the United States but probably elsewhere in the world.

Europe has a huge supply of municipal debt which the market is now beginning to think about pooling into mutual funds, and those securities for Europe may start playing the role of agencies in the United States.

So there are substitutes, but it's an open question how the market will adapt as the supply of these safe haven instruments is reduced through time. I hope that answers your question.

Questioner: Looking at where we are now in the markets, do you think that risk of contagion in emerging markets has been reduced since the last set of crises?

MR. MATHIESON: I think predicting the extent of contagion that's likely to occur from crisis to crisis is a difficult task. Just looking back at the two key episodes that we looked at in the report, they were quite different in terms of the amount of contagion that took place.

When Turkey had its difficulties, there was, from everything we heard, relatively limited contagion to neighboring countries or even to emerging markets in general.

In contrast, there was more of a spillover effect associated with Argentina's difficulties in March, it particularly affected Brazil, but it's had more generalized effects.

I think the issue here is really one of the portfolio behavior of the investors that deal in emerging markets instruments, and in order to identify the extent of the contagion, you really have to ask the question, how much are they going to pull back, or where are they going to, if they're exposed to risk in one country—will they short that instrument, or will they attempt to find another proxy which they can short, if that instrument is too expensive to short.

You know, this depends on decisions of a large number of asset managers and fund managers, and those reactions tend to differ from case to case. But it can be a feature of the markets, and as long as we don't have a fully dedicated investor base for emerging market instruments, which is still relatively small, there is always going to be a potential for a drawback by the crossover investors.

Questioner: A question on your analysis of the 55 percent decline on net private capital flows from '99 to 2000, and I understand what you said about the oil-exporting countries increasing their deposits in international banks. But the report also says that FDI has slowed down for, I think it's the first time since 1990, and there's some explanation of that.

But can you make some comment as to the direction of FDIs in the current year, and whether that trend will continue.

MR. MATHIESON: Again, the forecast for foreign direct investment that is contained in the World Economic Outlook, if I remember it correctly, is one where there's pretty much stability in the near-term forecast but no big recovery, if I can put it that way. I think the slowdown may be also affected, or the future path of foreign direct investment is going to be tightly linked, I think, to what is going to be happening in the global economy over the next year.

I think that linkage is probably a little stronger at this point in time. You know, there's always the difference between the "hard landing" and the "soft landing" for the U.S., and I think that would have a major impact on foreign direct investment flows as well, going forward.

MR. SCHINASI: I would like to say something about FDI, more generally. I know your question pertained to the emerging markets, but FDI picked up, I would say, in the last couple of years in the United States as investors around the world saw the U.S. as a place where real investment was profitable. That's my first point. My second point is more of a technical nature and it's a measurement issue.

I think 20 years ago, measures of FDI were probably more meaningful than they are today, in part, because while the initial flow of FDI might signal that an investor is providing resources to build a plant, or buy a piece of newly-produced equipment, in today's international financial market, the modern financial market, FDI may no longer be signaling what we think it is.

That is, it could just be an extension of portfolio investment. So there are definitional issues about how these statistics are collected, and I think it's something that needs further work.

So I would caution you against drawing too many inferences from wiggles in these figures. Probably over a long span of time, the FDI numbers are more meaningful, but quarter to quarter, or even year to year, they may be difficult to interpret.

Questioner: Can you say what is the likelihood now that Argentina will drop its peg?

MR. HACCHE: I don't think that is a question on the content of this report. Perhaps it would be better for you to return with that question tomorrow morning, and give it to somebody at a higher pay grade. Next.

Questioner: I just want to clarify Mr. Schinasi's opening statement. You said that asset prices should reflect fundamentals. I'm assuming this is global asset prices and that you are suggesting that they currently do not reflect fundamentals, and if there is a continuing slowdown in the global economy, then it is currently overpriced, and vice-versa. If the slowdown is not as sharp as some fear, then it is underpriced.

MR. SCHINASI: What you say pretty much lays out the risks. I was referring to global asset prices, and by that I mean prices in the major equity markets, prices in the major bonds markets.

I noted that it was a risk. It's an open question, whether or not, for example, global equity prices have shed their excesses, and by excesses by I mean that we now all know that there was a dot-com bubble, and that bubble has now been removed, but has it been completely removed? That's open to judgment and question, and it really depends on whether or not market participants are correctly perceiving and discounting future earnings.

So I would say all of the risks about the configuration of asset prices ultimately come down to whether or not market participants are correctly or incorrectly perceiving future revenue streams in the case of equities, and the ability of debtors to pay in the future, which, again, is related to their earning power.

Questioner: If I could just follow on that. I thought I heard you saying something in the opening, which you were saying that it seems to be that asset prices are overvalued now. Is that what I heard? If so, does that represent a more negative outlook for economic growth for the world ahead?

MR. SCHINASI: What I think I said was that there seems to be room for further downward adjustments, and I would say that there is information, backward-looking, that would suggest there still might be some room, and there are still doubts about the future, that might suggest that there's still room for downward pressure. Let me explain each of those, briefly.

There's a box in the report on equity valuations, and this is a variation of a box we've been doing for the last several years, and the box tried to extract from existing equity market valuations what future revenue growth is underlying those valuations. What would revenue growth have to be in the future for these prices, today, to be justified? I think what we find, and what others who do this analysis find, with other assumptions, is that revenue streams still are assumed to be pretty high and robust.

So if one expects future revenues to decline further as a result of, say, a deeper and more prolonged slowdown in the global economy, then there is room for equity prices to reflect that and therefore decline. Looking back, if you compare price earnings ratios, now, market capitalizations to size of economy, measured by GDP, and other indicators like that, they're closer to average but they're still above average, and so, again, if you just look at historical information, there seems to be some room for further downward adjustment.

But I would argue that the overwhelming piece of information that is important is how the global economy evolves and what that means for earnings streams in the future, for companies whose shares are traded.

MR. HACCHE: One more question.

No more questions. Okay. Thank you very much for coming. I'll remind you of the embargo till 11:00 o'clock this morning, and I hope to see you here tomorrow at 9:30. Thank you.