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on the Global Financial Stability Report
Thursday, March 27, 2003
MR. HAWLEY: Good morning, ladies and gentlemen, and welcome to this, the press conference for the launch of the latest Global Financial Stability Report from the International Monetary Fund. My name is David Hawley. I'm from the press office of the IMF in Washington.
I should make clear at the outset that this press conference is the only press conference we're holding in connection with the launch of this report. You are, if you like, the world premiere for this publication. It is the first time that we have launched it here in Frankfurt.
Before introducing the panel, I would like to make a couple of housekeeping points. The contents of the report, copies of which are at the back of the room, together with the contents of today's briefing, are under strict embargo until noon today.
The press conference is intended to be conducted in English, however, Mr. Häusler can, of course, take questions in German, should you wish to do so. When you ask a question, we would be grateful if you would identify yourself.
Today's press conference comes shortly before the spring meetings of the IMF and World Bank in Washington, which will take place on the 12th and 13th of April. I look forward to welcoming some of you in Washington in a couple of weeks. In that connection, I should mention that on April the 9th in Washington the IMF's Economic Counselor, Ken Rogoff, will launch the latest issue of the World Economic Outlook.
Let me now introduce the panel. To my right is Gerd Häusler, Counselor and Director of the IMF's International Capital Markets Department, the department which is responsible for the production of the Global Financial Stability Report.
Mr. Häusler needs no introduction, I suspect, to this audience, having served for many years at the Deutsche Bundesbank and laterally as a member of the Directorate of the Central Bank. He has also held senior positions in the private financial sector before coming to the IMF.
To Mr. Häusler's right is Hung Tran, the Deputy Director of the International Capital Markets Department. Mr. Tran is himself no stranger to Frankfurt, having worked here between 1992 and 1995 as the Managing Director of Deutsche Bank Research. Like Mr. Häusler, he has held senior banking positions before the Fund.
I should like to thank our host, the Deutsche Bundesbank for making the arrangements for today's press conference, and before turning to questions, I would like to invite Mr. Häusler to make some opening remarks.
Copies of Mr. Häusler's remarks will be available at the conclusion of the press conference.
MR. HÄUSLER: Thank you, David.
I have been sitting, in fact, on this side of this room many times before and never did I dream that I would return to this room giving a press conference in English, but here we are. And as the protocol desires, I will do so in the working language of the IMF, but as David was saying, it's then up to you how we proceed further. As it so happens, while I was working here in Frankfurt, Hung Tran and I already met then.
I also would like to thank my ex-colleagues from Deutsche Bundesbank for the hospitality.
As David was alluding, we are trying to do the press conferences for this Global Financial Stability Report not just in Washington or in New York. We did it once in London, and now we are here in Frankfurt, and we intend to take it around the world for future issues.
We hope that with this press conference we can deepen the public understanding for IMF assessments of global financial markets, emerging- market financing and financial stability more in general. So let me highlight, if I may, just a few points in our report before taking your questions and possibly comments.
As you would imagine that this current report, as all reports of that magnitude, was written well before the war in Iraq has commenced. However, what we call in our jargon the bimodal nature of risks, meaning that you can have two risks on sort of the extreme side of the spectrum. The bimodal nature of the risk arising from the war has become clearer over the last couple of days.
So the risk assessments on where do we put the risks today in the financial system hinge very much on the market perception of the likely course, and the duration and the nature of the war in and around Iraq, and I think, most importantly, on the ramifications for global and geopolitical stability after the war. That, to me, is after the war what comes out of it is important.
So, on the one hand the market's performance last week, and for some days, suggests that there are strong expectations of a short or I maybe I should say there were expectations of a short and decisive war, which would remove a large part of the uncertainties which are plaguing financial markets presently. As you know, the markets can well price risks, but they hate uncertainties because there is no mechanism to price it.
So reduction in uncertainty would revise investors' appetite for risks, supporting a rebound in markets and other risk assets. Because what we are talking today is risk appetite, risk aversion and the question of whether or not markets are willing to take on equities and other risk asset classes, and the word "equities" will come up in my introductory remarks a few more times.
On the other hand, if uncertainty is prolonged because of sustained geopolitical instability and because of potential credible threats of terrorism, risk aversion would rise, and equities might, and probably would, slump again.
In either case, mature equity markets are a barometer of risk perceptions which directly affect the health and the well-being of the global financial system. Many financial institutions, including insurance companies, pension funds, but others as well, have been hurt by past declines in the value of the equity holdings and, as you know, remain substantially exposed to equity markets going forward.
So, therefore, the future course of equity prices is critical in boosting consumer and business sentiment, as well, and thus helping to sustain the economic recovery or reinforcing any recent signs that we have seen in softening economic activity in the United States, in Europe and probably in the whole world.
So if the war—and I would say even those notes we drafted them a day or two ago—if the war is short and decisive, and question marks come up increasingly, as we know, while we speak almost, so if the war is still a short and decisive one, and if it reduces uncertainty, the gradual improvement in the financial conditions of key sectors of major economies could begin to exert a more positive effect on financial markets.
This is something that we saw coming towards the end of last year and the beginning of this year, and there was quite a potential, a positive potential for positive surprises.
And why? Because thanks, in large part, to accommodative monetary policy in major economies, and positive developments in U.S. households, corporations and financial intermediaries have built up sizeable cash positions. In the Wall Street jargon, they call it a "wall of money."
The level of liquidity in the euro area is also quite high, and as you know the ECB points that out on every occasion. Confronted with near record-low government bond yields, and continued losses in equities, the high level of liquidity has given rise to search for yield. Investors have become, to some degree, at least, yield hungry, again, and this has led to investment flows to emerging markets, as well as to corporate high-grade and high-yield bonds, fueling a rally in these markets for the past six months, especially in the emerging markets has had a rally which is almost unprecedented.
So the performance of mature equity markets has been mixed. It was rallying in the fourth quarter, then suffering in most parts of the first quarter due to heightened uncertainty, and then it was over the last, as you know, week or two, rebounding again and coming down again when military action commenced in Iraq.
The better performance of corporate bonds, relative to equities, also reflects the market perception that corporate credit risk has been declining, this is an important factor which is presently overshadowed by all that is surrounded by the war.
And this declining corporate credit risk is largely due to the fact that corporate balance sheets have stabilized and shown some improvements; if you like, the bursting of the bubble and all the aftermath of that, the effects that have started to be mitigated, shown some improvements most visibly here again in the United States.
While the degree of leverage in corporate balance sheets has declined only modestly from its high reach at the end of the bubble years, U.S. corporations, but to a lesser degree also some European corporations have improved their cash flow and net worth in recent quarters. Just to give you a number or two, the ratio of their short-term assets to short-term debt has risen significantly, and their net interest payment has fallen from a high of 33 percent in 2001 to 27 percent of corporate cash flow in 2002.
In the euro area, corporate debt consolidation has also progressed, and in the past, improvement in corporate risk has ultimately led to improvements in equity markets. That is a correlation that we have witnessed in the past, again, which we were hoping to see in 2003 if it had not been for the geopolitical uncertainties.
So in this positive scenario, long-term Treasury bond yields could rise. If there was less uncertainty, and more risk appetite, and if these improvements in the corporate bond market and the perception of creditors would translate into a higher appetite for equities, in such a scenario, long-term Treasury yields could rise as a result of portfolio rebalancing in favor of equities.
Of course, on top of all of that, you have an increased supply of Treasury securities in the future, given the enormous amount of fiscal deficits that you can see in most G7 countries.
This highlights the interest-rate risk facing many financial institutions, something I would like to point out here. Some, if not many, financial institutions have taken advantage of the steep yield curve, especially in the United States, to put on, and again to use jargon from the street, to put on carry trades, which are unhedged positions in long-term government bonds or mortgage-backed securities funded by short-term money.
These open positions, these unhedged positions are, by definition, vulnerable to potential losses if, and when, bond yields were to rise. So if heightened geopolitical uncertainty persists, however, consumer and business sentiment could remain depressed, and global risk aversion could rise again, and this is why we talk of the bimodal. You have one very positive scenario with certain types of risk, and then you have a completely different one.
So in that case, this, combined with weaker economic recovery threatening to once again disappoint earnings expectations—and you know how much the markets have been focusing recently on earnings, such scenario could trigger a renewed fall in equity prices—after three years of losses in the equities markets, additional equity price declines would weaken many financial institutions, especially insurance companies in Europe, which are still quite exposed to equities. Under this assumption, the risk of a vicious circle, whereby insurance companies feel pressured to sell equities into a falling market to raise cash as their solvency ratios are deteriorating, and equity market declines could also lead yet again to a heightening of corporate credit risk, the one that just came down recently, either by worsening their business environment or by widening the funding gap in their pension liabilities.
In return, this could trigger losses for net sellers of credit risk protection in credit derivative markets, and I will come back to that in a moment, that this credit derivative market is something we are paying increasing attention to. And those of you who followed the press conference by the Financial Stability Forum, two days ago in Berlin, know that this was also a serious issue there. That is why I'm in Germany, by the way, to represent the Fund at the Financial Stability Forum.
Since insurance companies are believed to be large net sellers of credit risk protection, and owing to a lack of transparency which we all complain about, a lack of transparency in credit derivative markets, any revelation of a potential loss could have a substantial effect on share prices for individual insurance companies.
Even though the failure of a single insurance company does not carry the potential for systemic risk as that of a bank, because, as you know, any implosion of an insurance company is quite different from an implosion of a bank, the growing role of the insurance companies, as a part of the financial sector and as counterparties for banks and derivative transactions has made them important for the question how strong is the banking sector. And so far, as we have said time and again in previous issues, and we say it again in this issue of our report, the banking system has remained resilient in the face of equity market collapses and spikes in credit defaults thanks to the strong capital base which was built up before and also thanks to risk management skills. However, additional losses could begin to pressure this resilience in the banking system in some parts of the world significantly, and I'm afraid we are in that part of the world at the moment.
Declines in equity markets would also aggravate the problem of underfunding facing many corporate-defined benefit pension plans in industrial countries, something that had been overlooked I think for quite a long time.
Even though current accounting standards allow corporations to close such funding gaps over several years, the existence of these gaps would dampen an already feeble recovery in earnings. So the volatility in the mature financial markets in the past two weeks reveal a high level of uncertainty, with market participants vacillating back and forth between the positive and the negative scenarios described above. This is why we call it bimodal. And continued volatilities in these markets is one uncertainty, I'm afraid, we'll have to live with for quite some time.
Let me quickly turn to emerging markets because that is obviously something where the Fund has a special role to play.
Notwithstanding the turbulence in mature market, the rally in emerging debt markets has proved also to be resilient, lasting for six months now, and strong demand—again, in our jargon—the "crossover investors," these are investors which are not dedicated to emerging markets all the time, but they can be in the high-yield market, they can be in the corporate debt market, and they can be in the emerging markets depending on circumstances.
So strong demand by crossover and local investors in search for yields has contributed to a further decline in emerging bond-market spreads, and in the volatility, and it has been able to support a strong primary market issuance by some very large emerging-market countries.
So as a result, sovereign issuers as a group have completed almost half of their financing programs for 2003. Several have even finished their financing plans for the entire year of 2003. So, overall, this shows that strong policy and progress in reforms and institution building do pay off during uncertain times.
Nevertheless, the high level of geopolitical uncertainty threatens a new rise in risk aversion in that segment of financial markets, which could then foremost affect countries with geographical proximity to the war or high-financing requirement.
Therefore, as we say in our report, policy measures to foster confidence are paramount. And given the fragility of investor, consumer, and business sentiment, policy measures are urgently needed to restore confidence, and we have elaborated a little in the overview, as some of you may have seen.
Overall, market confidence can best be improved pending a resolution of geopolitical tensions which is, you know, above the pay grade I think even of the Managing Director of the IMF, can best be improved by major countries maintaining sound macroeconomic policies, including the currently accommodative monetary stance that you can see in all G7 countries.
A supportive stance is needed to bolster faltering consumer and business sentiment and also to facilitate the gradual improvement in the financial conditions of key sectors of the economy. So maintaining a steep yield curve, as we can see in most countries, would help financial intermediaries to improve their earnings power in order to better absorb losses in other segments of their businesses.
Mature markets must also reduce vulnerabilities in the insurance industry and in funding of corporate pension plans. And, of course, I can just repeat previous issues that the still existing deficiency in corporate governance, financial market practices, accounting standards audited are still not over, as you can see in recent revelations, in the case of Ahold, but also in the case of a chaebol in Korea.
In order to foster that market confidence, regulatory forbearance, in our mind, must be avoided, and that, unless it is really needed, only in that case to break a vicious circle of selling assets into a falling market. If ever temporary relief is given, it should be, and it must be, specifically targeted without taking pressure off institutions that have yet to implement meaningful restructuring in their various markets.
Let me—and I'll be finishing very soon, as sort of almost my last remark—let me now say a few words on credit derivatives, something that played a role at the FSF meeting, as you know. This market has grown substantially in recent years. In fact, when I was in the private sector, I was quite instrumental in getting into some of the institutions. While they are beneficial to banks, and I do support them, credit derivatives have some weaknesses.
As an OTC market, as an over-the-counter market, as you know, credit derivatives are not exchange traded, and they will probably never be exchange traded because, unlike interest-rate derivatives, you can't standardize them in the way that you can trade them in a standard contract at the exchanges. So they are basically over-the-counter instruments.
Many players from different business sectors trade them under quite different regulatory regimes. So that market, by definition, lacks transparency, and it also lacks a level playing field. Some institutions, and I have to be careful, are believed to lack even the sophistication and the Management Information System infrastructure to support the dealers market because you need some very sophisticated Management Information Systems.
So, consequently, there is not only a need for much better disclosure, especially from nonbank financial institutions, so that market participants can better assess and price risk, but there is also a need for more comparable regulatory requirements, including capital adequacy and stronger supervision of weak institutions active in this market.
The old saying which I have been trumpeting for many years applies to credit derivatives more than anything else. If various institutions do the same business, they are taking the same risks, and they should be, in my mind, subjected to the same rules and not be able to benefit from regulatory arbitrage.
Finally—and that's my last remark on the emerging markets—the feast or famine, that's, again, a bit of the jargon that we use, the "feast or famine" dynamic in financing for emerging- market economies, and the persistent differentiation by credit quality underscore the need for these countries, for the large emerging-market countries to pursue strong macroeconomic policies in order for them to facilitate their access to international capital markets at a reasonable cost.
In addition to that, because there always will be vagaries in the international markets, continued efforts on their part to develop local securities markets could eventually provide an alternative source of financing and help to buffer against changing global financial market conditions. And this is why there is a whole chapter this time devoted to policy conclusions, and those who follow our publications know this is the fourth chapter, out of a series of four chapters, where we deal with the development of local securities markets.
I have been speaking a bit too long. Thank you very much for your attention so far, and Hung Tran and I are most willing and look forward to take your questions.
QUESTION: [Off microphone.] [Inaudible] —understood what carry trades are exactly and who is engaged in this.
And then from the ledger of your report, I did not understand what exactly is convexity risk in mortgage-backed securities.
And the third question is could you kindly outline a little more in detail where exactly are the risks of the U.S. agencies, the government agencies, against the background that even Mr. Greenspan seemed a little worried about U.S. housing market.
That's it. Thank you.
MR. HÄUSLER: Since I have been talking a lot, and I want my colleague also to work a little, why don't I sort of quickly tackle the carry trades, and maybe I'll say one word about the mortgage markets and leave the convexity to Hung.
Carry trades are simply what you do is you refund yourself short term in the money market, 3-month, 6-month market or deposit market, and then you invest this money into longer-term instruments. That is something where the steep yield curve is quite beneficial to your P&L while it lasts.
The U.S. mortgage, and you asked who is participating in that. Well, I suppose everybody, at least my hunch is. In the U.S. mortgage market, if you look at the balance sheets of some of the very large players there—Fannie Mae and Freddie Mac—what you will find is they are, of course, refinancing mortgages, and they do take on risk in terms of swapping fixed liabilities into variable rates and vice versa, but what you can see is they have built up a very large balance sheet on a fairly small capital base.
And this is something maybe Hung wants to elaborate a little further and also on the convexity.
MR. TRAN: Yes. The two issues are, to some extent, related; convexity risk and mortgage-backed securities. To make it simple, convexity risks are, in the case of mortgage-backed securities, means that when investment[?] rise, price on the bond will decline, but the price on the mortgage-backed securities will decline even more.
So, for institutions holding mortgage-backed securities when bond yields increase, they face a more significantly higher risk of price declines compared to holding a normal bond.
So what we are trying to say is that if the uncertainty is somehow lifted, if risk appetite comes back in favor of equities, and in addition to the increased supply of Treasury bonds, Treasury bond yields could well rise. And many institutions, banks, portfolio managers are now exposed to this high and long end of the government and mortgage-backed securities market in the U.S. They are exposed to price losses, and mortgage-backed securities carry with it more substantial risk of price declines compared to a normal bond.
That is the issue that we highlight because the mortgage-backed securities is now very big in the U.S. It is almost half of the bond market in the U.S., in terms of size compared to the Treasury securities market—roughly $3 trillion each. And since they are so large, the [inaudible] is high, and to manage it completely will be very difficult. Any small error or any small losses on such a huge portfolio would have an impact on the equity position of the institutions involved in this market.
So what we are trying to highlight early on is that there is such a potential risk and that supervisory authorities should make sure that risk-management skills and capabilities of participants in this market should be up to the task of managing that risk.
QUESTION: [?]. I have two questions. A general question is the proper damages we have now, looking back at [?] and [?] last week, why did price stability not produce financial stability? Was the monetary policy reaction too late? That was one point you mentioned. Also, looking at the impact, I am especially looking here at that.
Second question is, in your concluding remarks, you mentioned the difficult situation of the German banks. Can you just elaborate more.
MR. HÄUSLER: The first one is certainly easier to respond to.
I think there is no doubt that price stability or the absence of inflation is helping to produce financial stability as well. I think that is motherhood and apple pie almost.
But while this is a necessary condition, it may not be sufficient, and if we go back and revisit the 1990s, and I think this will be done increasingly so going forward, it is not easy to pinpoint why this bubble occurred.
My personal view, and other people may have different views, is that it was a decade or a number of years characterized by exuberance. Alan Greenspan himself mentioned irrational exuberance. I think, going forward, what we were confronted was with the belief that the enormous push and productivity gains not only in the United States, but, first and foremost in the United States, that these push in productivity gains produced a new era, a new economic era, a new paradigm, as some people said at the time, and in this new paradigm, many things contributed.
It was the technology, it was the Internet and so on that all of a sudden traditional ratios didn't matter so much any more. A P&L, a cash flow, you know, having certain ratios in your balance sheet, all of a sudden people felt it didn't matter so much. You could walk on water.
Now, many people contributed to that bubble, as we know. We talk a lot about analysts, we talk a lot about investment banks, we talk a lot about many others, I think the auditing profession, and you know, at random, you can almost mention any participant in financial markets, in one way or the other have contributed to this belief that the traditional laws of gravity didn't apply any more, and all of the more it became apparent that, at some point, when the bubble burst, it's no coincidence that today the old industry, as we call it, the old industry, the equities of the car industry, the car equities even of the steel industry sometimes in better shape than many of the so-called new economy.
This is trying to give a shorthand answer to a very complex problem. The point is, yes, price stability does matter as a necessary, but probably, as it turned out, not a sufficient condition for having no bubbles.
And the second point on the German banking system. Well, it's a long, long story. We all know Germany's banking market is a peculiar one. It's the only market that I can think of in Europe where you have not had any significant amount of consolidation.
In all of the other major European, and even the smaller European markets, the banking market has consolidated. Consolidation means that you take out the cost base. You create larger entities. I mean, in the banking market, like in any other industry, you have a very large cost base, what you sometimes call the back offices. It's not just the back offices.
You have a cost basis in terms of branches. You know that the density of branching here is higher than anywhere else, and so on and so on. So the absence of such a large-scale consolidation has, of course, diminished the profitability of German banks tremendously, and this was overshadowed.
And I think the asset bubble boom we spoke about in the 1990s has papered over some of those inherent difficulties at that time, and now with that bubble having been burst and with the cushions of some of the equity valuations gone all of a sudden, this absence of consolidation is exposing the weaknesses of the German banks as we see them.
QUESTION: Bloomberg News. A question for Mr. Häusler—actually, two questions, first.
You say a short war could help global growth; a long war could hurt confidence further. What's short? What's long? Is 2 months a long war? Is 3 months a long war?
And a second question, in case of a prolonged war, could you elaborate a little bit on what the risks are for Turkey.
MR. HÄUSLER: I think about Turkey. I'll leave the first one to Hung Tran, if I may.
MR. TRAN: I think there is no answer to your question, what is the market perception of how long is short and how long is long.
As we said in both the report and in Mr. Häusler's opening remark, the equity markets in mature countries serve as the barometer of market sentiments and perception.
So you watch the Dax Index or the Dow Jones Industrial Index every day, and you can see if this collective perception of market participants is that the war will be short and clean or it will be long and messy.
MR. HÄUSLER: If I may add one sentence and come to your point. In my mind, the length of the war is not what is really important. What is important is what comes after the war. In our jargon, you can call it the question of post-conflict uncertainties.
Will the war, I mean, we all have a strong view of probably how the war will end in the strict military sense, but what it will mean for the region and whether or not the likelihood of major terrorist attacks will diminish or some people say might even increase, this issue, whether the consumer in G7 countries will feel safer and have a propensity to spend or the reverse, and whether any further conflicts might loom or not, these are the issues I think which are far more important than the issue of whether or not the war in Iraq takes a week longer or a week less.
In Turkey, this may be slightly different because Turkey is certainly suffering from the war, as such, in a narrow sense, no doubt about that, and I think this will not be easy. But this is a—obviously, the whole area at this moment is very much in a fluid state and almost day-by-day and hour-by-hour you have new developments.
So for me to speculate would be, I think, improper at this moment, other than saying what the Turks have said themselves, that it would be extremely important for them to keep their program with the International Monetary Fund on track, which they have said they want to, and to make sure that they have a bit of a cushion for them in case there are some adverse developments.
QUESTION: Yes, please, you were speaking of credit derivatives. So what are the risks of such an exponentially growing sector? This is the first.
Can you express with some figures or do you have in this report some projection because you were speaking of the German—yes, you were saying additional [?] of the resiliency of banks, additional losses could hurt the resilience of banks in some parts of the world, and we are in that part of the world. Can you express this with figures, how—yes, can you express it with some figures?
MR. HÄUSLER: I think the two issues, credit derivatives and the resilience of the financial system, and I was referring to euros, since we are in Europe here I was referring to euros. The two have something to do with each other, but only in the loose relationships. So I would take the two different apart.
On credit derivatives, as I was trying to say, what is important is the issue that it's a very in transparent market; at the same time, a market being used by nonbanks, by insurance companies and even by nonfinancial institutions. You don't even have numbers from exchanges. You don't even, in a derivatives exchange, you may have numbers, but here you don't, and therefore do we think we have to worry? We don't know whether we should worry or not.
And on the resilience, I can only say we should just be aware that some insurance companies and banks are exposed to the equity markets, and how much—I mean, you see there the 2002 numbers. It is pretty sure that all of the cushions have gone, and any further decline in the equity markets will hit some of the insurance companies quite a bit, and if you listen to what some of the insurance lobby groups said yesterday or the day before yesterday about accounting rules, I find this rather disturbing. They were asking for more even extensive exemptions from normal accounting, and you only make such demands if you have a reason.
MR. TRAN: Can I follow Mr. Häusler and give you some figures, just to give the dimension of the problem we are talking about.
If you talk about the worldwide market for derivatives, including everything, interest rate, options, credit derivatives, the size in notional value is about more than US$100 trillion. U.S. banks accounted for more than half of that value, but that is the notional value.
The actual amount that participants are exposed to in terms of potential loss, if their counterparties fail to perform according to the contract, it's only 1 percent of the notional amount.
However, there are problems. One is the degree of concentration in the market. In the credit derivatives market and the size of which is about 2 to 3 percent of the big $100 trillion number I gave. Seven U.S. banks account for 96 percent of the exposure—so high degree of concentration.
Lack of transparency, like Mr. Häusler said before, and therefore any losses could, one, come to the attention of the market participant in a surprise manner and therefore could produce very adverse price effect on the share price, on the corporate securities of those participants.
Also, weak institutions turn out to be participating in this market, taking on risk without properly understanding and managing the risk. So we see the need on several fronts. One is better disclosure; second is making sure that weak institutions really know what they are doing in this market; and the third is improving the comparability of bilateral regimes for different players.
MR. HÄUSLER: May I add one sentence on credit derivatives because it's important? I would recommend to you, as journalists, when you go to press conferences of large financial institutions in this part of the world to have a look at the annual reports, at the footnotes on credit derivatives and ask some tough questions to those who sit on the podium.
Because it's amazing. If you look at the, if you take the pain in taking the publicly available information, including the footnotes, which is important, you can distill from there some remarkable results.
And some banks which are highly exposed to credit already during their regular business may be exposed to that line of business even more so through the selling of credit protection through the credit derivatives market.
And you may, again, I can only recommend that you use this to ask some tough questions.
QUESTION: [?] Reuters.
In the report, you quote the scenario of a steep fall in the dollar. Could you elaborate a bit on that? How likely do you think that scenario is?
And my second question is you have said that low interest rates are a good thing to restore confidence and credibility. Do you think there's room for even lower rates from the major central banks across the world.
MR. HÄUSLER: Let me start with the second one first, on the interest rates. I think what we were saying is that the yield curve, what we call the steep yield curve, is helpful for financial institutions to profit and to bolster their earnings.
Whether the short-term interest rates because when you say "fall in interest rates," the only part of the yield curve which is under the control of the central banks are, by definition, the short end. A little more or less doesn't make so much a difference of that, and you would certainly not lower or not lower interest rates purely for this one reason only. Lowering interest rates, by definition—
[Tape change: Side A to Side B.]
MR. HÄUSLER: [Continuing] On the question of the dollar, what we are trying to say is basically that the composition of the capital flows to the United States—which United States obviously needs to finance its very large current account deficit—but the composition of these capital flows have changed quite significantly over the last two years or so. While earlier—and again, associated with the bubble years—these capital flows were largely coming from foreign direct investment and portfolio investment in the equity markets, given the developments as we describe them, today this is quite different. It's largely investment in the fixed-income market and, here again, mostly in either treasuries or in so-called agency, in the sort of semi-public agency trades. Also mortgage-backed securities, by the way.
Now this, of course, is far more driven by interest rate considerations, as opposed to when you do FDI, foreign direct investments, equity investments. This is much more driven by growth differential considerations. So interest rate differentials matter, and also the question, of course, you have enormous amount of in-flow in terms of capital from those central banks who are, if you like, who are buying up surplus dollars in their countries coming from a current account surplus—not the least, the Asian central banks.
The question is, therefore, it's a long way of saying that these composition of capital in-flows to the United States may be more fragile than the one that you had seen before, and maybe more susceptible to changes. And therefore, all other things being equal, the dollar has come down somewhat, as we know, and may be looking slightly more vulnerable than it did in the time when the growth differential was the decisive factor—somebody's thing stopped here—was the growth differential was a decisive factor. Because the growth differential in favor of the United States will probably remain in favor of the United States going forward.
QUESTION: I would like to come back to the question of my colleague. Do you have a scenario for the dollar, how it will develop? And how large do you assess the risk that it might drop significantly?
And my second question is do you think it's helpful that the Bank of Japan intervenes in the market, in the currency markets, trying to boost the dollar, or is that rather sort of uncertainty?
MR. HÄUSLER: It's very difficult to make any forecasts about the dollar. Over and above what I have just said, I can probably not say it is, you know, decline is—I think there—I'm fairly sanguine about these events because I do believe that there is still a potential for the United States to have a growth advantage over Europe, and therefore I'm not alarmed by it. But of course it has a lot to do with these uncertainties in the geopolitical sense also. I mean, just people—investors have to be comfortable investing in the United States. And anything over and above that is pure speculation at this moment.
What was the other question, again, on—
Oh, Bank of Japan. No, I think it would not be very appropriate for me to comment on a—Japan is a shareholder, obviously, of the IMF—to comment on very specific actions on their part. I mean, coming from where I come from, 18 years in the Bundesbank, as you know, I have always been educated in a way where you had a certain skepticism about foreign interventions in general with the fundamentals. I think what the Japanese have to do is to reflate their economy and to do it in a very aggressive way, to tackle the fundamentals, which is the corporate debt problem, the NPL problem, the non-performing loan problem. And if they did this, the rest would be okay. And I think the rest are symptoms to me.
QUESTION: Mr. Häusler, given the interview Mr. Kohler has given to the [?] yesterday, has the IMF been in touch with the White House? Has the White House consulted the IMF about the possible economics outcome of the war, and have you actually advised the White House maybe not to start this war because of the looming recession?
MR. HÄUSLER: If there had been such consultation, I don't think that this press conference would be the appropriate venue to talk about it. What you can take for granted, however, is that the IMF and certainly its managing director has a regular round of consultations with all large shareholders. And given that the largest shareholder of the IMF is next door, you can take it for granted that there is a regular contact going on on that level. Whether or not it happened yesterday or the day before yesterday or last week is something for the managing director to say, not for me.
QUESTION: [?] from [?] Zeitung. I have a question concerning your report. As far as I have seen, you don't warn about the over-valuation of equities in the U.S. This is for some experts still a risk for the global economy because it might mean that there might come another blow to the equity market. If you compare the development of equity markets in U.S. and Europe, there is quite a difference.
And the second question has to do with this. I got the impression that you think the adjustment process after the explosion of the bubble is nearly over, it's just hampered by, now, uncertainties connected with the Iraq war.
MR. HÄUSLER: If you agree, I will ask my colleague Hung Tran to take on that.
MR. TRAN: Yes. On the valuation of U.S. equities, we indeed point out in our report that the P/E ratio, looking at 12-month forward earnings expectation, is coming back closer to longer-term average. Therefore, the safe way to conclude is that whatever degree of overvaluation and therefore vulnerability for U.S. equities that existed some years ago is much less now. That doesn't mean that there is no more outside risk, but we think that the exuberance, the over-expectation, the optimistic thinking that played a role in the formation of the bubble is now, to a large extent, being corrected.
Will there be more to go? Probably yes. But I think that it is also very important not to get carried away with, again, many years ago with optimistic projection and now with very pessimistic projection on a straight-line basis.
That leads me to the second part of your question. What we try to point out is that the key ingredient of response to the bubble years is to repair the balance sheets of corporations, households, and financial intermediaries. And in the U.S. particularly, if we look at things in the past few quarters, as we point out in our report, indeed there are signs of improvement in terms of cash flow, in terms of net worth, in terms of what the interest rates were and what they have to bear, and so on and so forth. And these things are already being accepted and acted upon by market participants. That is why you see the corporate bond sector out-perform the equities sector in the past six months.
MR. HÄUSLER: Can I add one thing? The idea about a fallout is not the—only the right thing. What I said before, especially here in Europe, is that there were insufficient—there were weaknesses in the financial system, like the insufficient consolidation in the insurance and the banking system. This was sort of discovered and disguised by this huge bubble. Now that the bubble has gone out, this has been coming to the forefront again. This is not a fallout from the bubble, it is simply that the bursting of the bubble has taken away this mantle, if you like, and is now exposing the—so that we are back to square one, and it's an urgent need to address these issues.
QUESTION: [?]. There is widespread and growing concern about the role of rating agencies. Do you see any need for changes of the rules and, if yes, do you have any proposals?
MR. HÄUSLER: Yes, there is some concern. The Fund, of course, takes a great interest in this issue because, as you know, rating agencies do not only rate corporations but also countries, our members. And therefore whether or not a country in Latin America gets downrated by two notches overnight and what the reasons are is of course, for us, of great interest. And I think, given the growing importance of the rating agencies, there are now various activities under way to look at those.
One that you may have noticed or not is that the Sarbanes-Oxley Act in the United States has asked the SEC, the Securities and Exchange Commission in the United States to come up with a report on the rating agencies, which will probably be published, I understand, in May.
Now, also the Financial Stability Forum, as a press communique said, addressed that issue. And I think we have to look very carefully at rating agencies because—most importantly in the context of potential conflicts of interests, because, as you know, they are paid by those who they rate. And this is just one potential issue. Is there enough competition; is there enough expertise to look at corporations and countries in various parts of the world; do they have unfortunately understanding of those local practices? And so on and so forth.
So I think there is, given the growing importance, especially in the United States, where—and also given the growing importance under Basel 2, as you know, where internal and external rating is vital for the whole process. So there's not only justification, there is—I think there is a good reason to have a close and hard look. And both the SEC and the FSF—and the Fund, for that matter—over the next six months or so will have a close look.
QUESTION: [Off-microphone] I ask myself if you would like to stick to your introductory statement, to the first part, where you say "case of a short war." What is a short war? And listening to you, I come to the conclusion that the risks are very much on the downside.
MR. HÄUSLER: That is a typical European view. If you live in Washington, people are always more optimistic, as you know. I always make the joke that all the optimists in Europe probably emigrated to the United States at some point in time.
And so "short and decisive" is not necessarily a war of a week or two. What matters, I think, for financial markets, as I said before, is that once the war is ended, there's an end to terrorist threats, there's an end to all other things. And if that was the perception by markets—and here the New York market I think, after all, is probably the most important barometer for that—if that was the perception, you might see a very, very strong rally. Remember last week, you had—I forgot what the day was, whether it was Wednesday or Thursday, when this perception was there. You had a very strong—the strongest rally this year.
So I would not—while, you know, while we speak you may have doubts on that, but we should not prematurely discount the possibility of this enormous amount of liquidity at some point in time coming to the market and picking up many, you know, various risky asset classes.
MR. HAWLEY: One last question here in the corner. Okay, two last questions.
QUESTION: [?] from Reuters. You mentioned the risks of investments in long-term treasuries. Is there anything unusual in that situation in comparison to the situations in former times when there was a market turnaround to be expected?
MR. TRAN: Nothing very unusual, because that is how financial intermediaries make their money. We highlight that because, one, the absolute amount is getting very big and therefore exposure to a large position carries higher risk; and secondly, it is something that not many market participants pay a lot of attention at the moment. Because we are still in a very weak economic environment, the risk of long-term bond yields rising significantly is not foremost in many investors' minds. But that is where I think that we would like to try to look ahead and to highlight some risk beyond the immediate horizon.
QUESTION: Just about interest rates. When do you see the upturn of the interest rate, long-term? Do you see probably that the end of the war could cause it, and what are the risks behind that?
MR. HÄUSLER: Some of you will remember there was a time when equity prices and bond yields were very much correlated; whereas over the last year—two, three years, they have been inversely correlated. And you can see that almost on a daily basis now. When I spoke about this surge in equities last week, at the same time you had a surge in yields and drop in prices—you know, any way you want to describe it. It was very clear.
So if there was a scenario as we—you know, in my introductory remarks and our discussion Hung and I focused on the equity market, but it goes without saying that if equity markets were to rally and all other risky asset classes as well, you may see a significant decline in bond prices and a surge in yield. Because to some degree, as we all know, this is being regarded as a safe haven. And so a double whammy of safe-haven considerations going away and at the same time having very—the perception all of a sudden here are fiscal deficits in practically all the G7 countries of a magnitude that you didn't—you know, every fiscal account, United States, elsewhere, has moved, you know, very much into the deficit side, either further into the deficit, like in many European countries or, as in the case of the United States, you have almost a brutal swing from a substantial surplus into a very substantial deficit.
And this, all in all in the perception, could trigger a very powerful—or quite a powerful, I don't want to exaggerate—quite a powerful drop in bond prices and treasury prices.
QUESTION: [Off-microphone] the risks?
MR. HÄUSLER: The risks are on either side, the fiscal side, that refinancing for treasuries may become more expensive. The risks are for those who are caught with their long positions. That can be institutional investors, that can be financial intermediaries; it can also be the retail sector, that they're caught wrong-footed and may all of a sudden— Now, you may say, and we said that in various other fora, it doesn't matter because at the same time equity prices were to rise and so that this squares this off, there's a counterbalance. That may be true on average, but for individual institutions who are exposed to one market and not to the other, that would cause difficulty.
What we are saying is one thing. We would encourage these institutions and the supervisors to have a close look.
[End of recorded segment.]
IMF EXTERNAL RELATIONS DEPARTMENT