Transcript of a Press Conference on the Global Financial Stability Report by Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department, and Hung Tran, Deputy Director of the Monetary and Capital Markets Department
April 10, 2007By Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department, and Hung Tran, Deputy Director of the Monetary and Capital Markets Department
Washington, DC, Tuesday, April 10, 2007
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MR. MURRAY: Welcome to the Spring 2007 Briefing on the IMF's latest Global Financial Stability Report. I am William Murray, Chief of Media Relations at the IMF. I would also like to welcome journalists viewing this briefing by the on-line Media Briefing Center.
Let me introduce the speakers today. In the center of the table is Mr. Jaime Caruana, the Director of the IMF's Monetary and Capital Markets Department; and to his right is Hung Tran, Deputy Director of the Monetary and Capital Markets Department, the department that organizes and compiles the Global Financial Stability Report. Let me turn the table over now to Mr. Caruana.
MR. CARUANA: Good morning. I would like to thank you for joining us today. The Global Financial Stability Report is a semi-annual publication in which we analyze the global financial risks and relevant trends, and it is an important part of the Fund's multilateral surveillance toolkit.
Before I open the floor to your questions, I would like to provide a few remarks about the main messages of this latest edition. Certainly the most important message is that global financial stability remains underpinned by the favorable economic outlook. However, despite the solid global growth, we have seen higher risks in some areas, from our financial perspective, since the last Global Financial Stability Report in September.
Although macroeconomic risks, as well as those faced by emerging markets sovereign borrowers, have eased somewhat since September, market risk and credit risks have risen, and this has occurred against a backdrop of an extended period of benign financial conditions, low volatility, and a continued increase in risk appetite. Indeed, the recent market turbulence serves as a reminder that downside risks are still present.
Allow me to briefly point to three areas of concern treated in our report: First, the rapid deterioration in the U.S. subprime mortgage market has raised questions about the extent to which similar weaknesses in underwriting standards are going to materialize in other markets. While subprime market is still only about 14 percent of the U.S. mortgage market, credit deterioration is also now discernible in the next riskiest mortgage market segment, the so-called Alternative-A. Also, the deterioration in the credit quality of subprime mortgages has translated into wider spreads on securities collateralized by them, affecting a wide range of investors, including some international investors.
Second, the rapid growth in private equity and leveraged buyouts raises some concerns. To be sure, the current leveraged buyout boom is being driven by long-term interest rates and healthy corporate balance sheets. Nonetheless, rising leverage in target firms as well as a weakening of lending standards in the syndicated loans used to finance these deals raises the concern that credit discipline may have also eroded in this area.
Lastly, while emerging market fundamentals continue to improve overall, we are observing some pockets of vulnerability. You remember that in our last Global Financial Stability Report we highlighted strong growth in borrowing by households in emerging markets, often in foreign currencies. In this Global Financial Stability Report, we note that the increased investor risk appetite has encouraged heavy issuance of foreign exchange-denominated debt by emerging market banks and corporations, in some countries at increasingly lower credit rating as time goes on.
Also noteworthy have been flows into a number of countries that have previously received very little interest from foreign investors, particularly some countries that represent new frontiers in sub-Saharan Africa. While such flows into emerging markets are welcome signs of increased access to international capital markets, they could pose challenges to the authorities in ensuring inflows are used wisely, especially in cases where countries are running current account deficits.
While none of these near-term risks that we have identified, none of them by themselves constitutes a direct threat to global financial stability, an adverse event affecting any of them could spark a reappraisal of risks in other areas. And this concern is amplified by the difficulty in differentiating between the effects on financial stability of a genuine structural improvement in the economy and financial markets--and this is happening--, but it is difficult to differentiate from the more cyclical components which could reverse at some point in time.
Volatility across a large number of asset classes is close to historic lows and credit spreads on a variety of instruments have tightened. Moreover, the rapid growth of some innovative financial instruments to build up in leverage of segments of the financial system and the growth of current rates suggests that some market participants have been lured into expecting a continuation of the low-volatility environment.
The recent market turbulence in late February and early March, as I mentioned before, should serve to remind investors that downside risks are still present, but it did not lead to a fundamental reassessment of the global growth and inflation outlook.
One can view this correction as well as the other one last May and June as showing the resilience of markets, and we believe that the improved market infrastructure and more discriminating market participants have had the effect of making financial markets more resilient in recent years, particularly in emerging market countries. At the same time, we believe that it would be a mistake to assume that the current very benign financial conditions and the cyclical components of the low-volatility environment can last forever.
Before concluding, let me touch upon two longer-term globalization trends that we addressed also in other chapters of our current report: the secular increase in cross-border capital flows and the globalization of financial institutions. Both trends arise from profound changes, changes in demographics that have spurred the increase in savings in many countries, the new role of emerging markets in the global economy, and technological advances which enable greater price transparency, faster transfer of information processing, and the increased use of complex financial instruments to unbundle and reallocate risks.
In Chapter II, we examine the sharp increase of cross-border financial asset accumulation, which has tripled over the last decade. There are three relevant trends affecting the level and the nature of cross-border flows: the rapid growth under management of institutional investors, the changes in their asset allocation behavior--that's important--and also the broadening global investor base with an increasing relevant role of emerging market official sector and sovereign wealth funds. We find that financial stability should be enhanced by the growing number of types of cross-border investors since their differing investment behaviors and time horizons should contribute to a wider distribution of risk holdings over the long term.
That said, the recent acceleration of flows to some emerging market countries has been challenging for the authorities there. In the past, some episodes of rapid growth or international capital flows have led to abrupt reversals. The favorable circumstances in which this round of globalization has taken place is offering little guidance or at least not complete guidance of the robustness of the system under significant or sustained stress.
As regards the globalization of institutions, we find a positive relationship between the globalization of individual financial institutions, mostly banks, and their accounting and market performance. That said, the benefits are less clear at the system-wide level. Considered as a group, our preliminary results suggest that the risk reducing benefits of the diversification are less powerful. We tend to think that this is because when most banks diversify internationally, systems become more vulnerable to large common shocks and spillover effects and make severe crisis more complicated to deal with.
Overall, then, we note that the structural transformations occurring in global financial markets are likely to have a positive impact on financial stability. However, the increased complexity of instruments and linkages and the very benign circumstances associated with the rapid rise in the types of institutions investing abroad and increasing global reach of financial institution suggests there may be pockets of vulnerability, and that we must continue to analyze all these trends in greater depth. Our existing work suggests that there are still areas that need to be addressed. For instance, we have insufficient data covering the types of capital flows entering countries and their sources, and we have only a hazy awareness of where the risks of the increasingly complex structured products are being housed. Our intuition is that more broadly sourced and placed risks are enhancing financial stability, but we must work with our counterparts in member countries and other international groupings to assure that gaps in data collection, cross-border oversight, and crisis resolution are being addressed. Fortunately, the benign economic environment continues to provide policymakers the opportunity to make further progress to mitigate risks.
Thank you for your attention, and we would be very happy to entertain your questions.
MR. MURRAY: Thank you, Mr. Caruana. Let's open the floor to questions.
QUESTIONER: A couple of questions for Mr. Caruana. Could you expand on where you see the biggest risk in financial markets at the moment? You said that the risk has increased, but I would like to know in which markets you see most of the risk increasing.
And on leveraged buyouts, I would like to know if you are particularly concerned about any particular region where leveraged buyouts present a bigger risk, maybe the United States or maybe Europe?
MR. CARUANA: In terms of the biggest risks, I think I mentioned already the main risks we're seeing at the moment, which is the subprime mortgage market --that is, credit risks-- and the leveraged buyouts.
We stress also that in the emerging markets, the situation has improved, so globally, the risks have diminished, but there are pockets of risk, pockets of vulnerabilities that we need to follow, pockets of exposures of some countries. And in this edition of the Global Financial Stability Report, we have signaled the increasing corporate debt that some of these emerging markets have been issuing. So, these are, from our point of view, the areas that we need to pay attention to.
In terms of leveraged buyouts, more than being concerned of what is going on in one region, the question is to what extent also in this area there has been some relaxation of standards and to what extent the companies that are subject to this leveraged buyouts are, after the leveraged buyouts, in a more difficult situation to cope with changing economic conditions.
So, it is more a question of the specific operations, specific deals, more than really concern that is related to one region or another.
QUESTIONER: The third chapter mentions the fact that there is a rapid growth of foreign banks in emerging markets and they kind of suggest that the benefits offset the possible risks. For example, in Mexico, you mentioned that the foreign banks account for 75 percent of assets in the whole industry. I am wondering if you could be more specific about what kind of benefits you see from this situation and what kind of potential risks.
MR. CARUANA: What we have analyzed is the impact of banks expanding globally in terms of financial stability. We find that there is evidence that it helps to improve financial stability at the level of the institution because there is more diversification. We could add to that that it usually helps also in terms of improving the financial system where these banks are present in terms of bringing a new perspective, new risk management abilities, and new techniques and capital. So, from that point of view, we see positive developments in this global expansion of banks.
What we also say is that when you take into account that there are a number of banks that are expanding at the same time, the benefit that you can see at the level of individual banks is not that evident when you take all these banks together because they tend then to be a little bit more correlated, and that's where we have to continue to analyze the situation. This trend to increase correlations and reduce the benefits of diversification that we mentioned in this chapter is also present in other chapters and other capital markets. When you tend to become more globalized, there is a trend to increase correlations among the return of assets and then reduce the benefits of diversification, and that's something that needs to be monitored.
But coming back again to banks, I think one of the benefits--and I think that would address a little bit more your question--is that it is important for those banks that have a global view to have a global risk management. From that perspective, it is important to balance the need to have a global view of the risks and, therefore, to understand and compound the different risks that global institutions have in different markets, with the need to be sensitive to the needs of the markets and different regions where these banks are present.
So, that's another element that is important to be taken into account by these banks that are global institutions.
QUESTIONER: So, do you see it as the countries (inaudible) so they have better access to these foreign banks (inaudible) they could put some kind of limits while you really assess what kind of risk you could have from such a large concentration of foreign banks in local assets?
MR. CARUANA: We have not dealt with that in this chapter. We have expressed the positive benefits that this kind of globalization brings and also some of the challenges. But, in addition to that, it's obvious that the countries have to improve their own regulation, their own prudential regulation, and their own competition regulation in different countries, and then you could get the most of these banks being global and bringing again some positive elements to the financial system in these markets.
QUESTIONER: Do you see any risk in the recent trends of the currency market? I mean, the currency market on the strength of euro or something like that.
MR. CARUANA: We have not dealt with that...
QUESTIONER: I know you are a former central banker.
MR. CARUANA: You know that former Central Bankers usually do not talk much about currencies. Talking about my background does not help a lot in that sense.
I think we have not dealt with those risks, so I will not address that question, thanks.
MR. MURRAY: Just for a footnote here, the World Economic Outlook Global Forecast press briefing is tomorrow morning, and you could ask the economic counsel a little bit more about exchange rates.
QUESTION: The report shows NTNBs, resident NTNBs, and what happened to those notes during last year's turmoil. So, in Brazil, what and where would be the pockets of vulnerabilities?
MR. TRAN: The analysis that we have done in this GFSR and previous one suggests why sovereign borrowers have reduced their borrowing in international foreign currency-denominated loans. They have increased their reliance on domestic local currency on markets for funding. And also from the international investors' perspective in the continued search for yield, many investors have also entered into the local currency markets in many emerging market countries.
Overall, we think that is a very positive development because it tends to reduce the foreign exchange risk of the sovereign, and it therefore helps with the overall financial stability. However, the pocket of vulnerability that Mr. Caruana mentioned earlier concentrated in the few instances where you have a local market which is still small in size, not very liquid and doesn't have heft. If there is a lot of international investors moving into such a market, it could cause so-called indigestion of boosting up prices too much. And when the international investors, because of adjustment to their overall risk appetite or market sentiment, decide to move out, and if they move out, certainly in all together it might cause volatility in the local market, and that is the experience we saw in May-June of last year and, to some lesser extent, in the correction in February and March of this year.
So, the risk is that if you open up domestic market, you attract international investors' flow, then you also will have take steps to improve and strengthen the infrastructure of your markets to enhance the local institutional investor base, as well, so as to minimize the risk of volatile flow costs by changes in the investment sentiment of the international investors.
QUESTIONER: In the box on the February-March Market Correction, 1.5, you take a relatively sanguine view of the disruption in markets at that time, but you also explore the potential that investors have become complacent about market risks. In the context of February and March, would you say or characterize that as sort of a wake-up call over the risks of underappreciation of the threats that you have outlined? How would you characterize what happened in February and March? Do you expect that reappraisal of risk to continue? You talk about how additional risk premia being re-established would tighten financial conditions, but you also seem to say in the report that that doesn't really seem to have emerged yet?
MR. CARUANA: I think the way we see this correction is that it has been kind of a short-lived correction. It has been short, most of the assets have recovered to pre-correction levels, but we think that this is important to underline that the risks are there, and therefore it should be regarded as a reminder that there are downside risks.
We also think that markets are going to be more focused on the outlook of the economies, especially on the outlook of the U.S. economy; and, therefore, they would focus on the news. So, they would be, in that sense, perhaps more data-dependent or more focused on additional pieces of information. Certainly, the central scenario that we are proposing, which is a benign scenario, would be to encourage the investors to continue to be exposed and to remain exposed to some of these risky asset classes. But, again, I think we would like to underline the importance of being conscious of the risks, and these market corrections are a good reminder of that.
QUESTIONER: One quick follow-up. You go into quite a lot of detail on the risks surrounding the leveraged buyout trends that the report outlines. Are there specific examples or cases that have particularly caused you to have those anxieties?
MR. CARUANA: We wouldn't like to mention specific cases. I think this is a more general issue of, again, the standards, the relaxation of the standards, where this happened, and also perhaps that, despite the fact that leveraged buyouts in relation to the global market are still a small amount, they are increasing the leverage. And also the fact that, in some occasions, the time to recover the investment, some return of the investment, is really becoming quite rapid. So, there are some elements in the leveraged buyouts that deserve some attention, but we are not concentrating on certain deals.
Let me add to that that perhaps one of the differences between the present leveraged buyouts wave and previous one is that the size of the leveraged buyouts on this occasion is quite big, quite relevant.
QUESTIONER: Several emerging markets have been trying to reduce their exposure to foreign debt; for example, Brazil. They have been reducing the foreign debt exposure, but at the same time the foreign investor participation in local markets has been increasing. Which is riskier? I mean, because that was intended to reduce volatility, but since we have seen in March and last year that doesn't really help.
MR. CARUANA: I think that these developments that you are mentioning are positive developments that have contributed to improve the fundamentals of these emerging markets. It is true that, on the one hand, it reduces the volatility or vulnerability of your budgetary process in the sense that the size of your debt is less sensitive to foreign exchange changes, but some of these risks are now there by foreign investors and, therefore, may add some volatility in the flows to the local capital markets.
There is no free lunch here, but we think that this is a positive development. The fact that local markets and local currency are developed is one of the elements that I was mentioning at the beginning that has contributed to reduce the vulnerabilities of emerging markets, and Brazil is a very good example of that.
And in many occasions, as it is in this case, it has been accompanied by improved fundamentals in terms of managing the budget, managing debt, and again developing local capital markets. It tends to improve fundamentals of these countries. But at the same time, as I mentioned, you have to be aware of how risk profiles have moved and how now foreign investors are subject to additional risk, and they may react in a different manner. So, you have to be conscious of what is changing.
QUESTIONER: There is a lot of liquidity in the system, so everyone seems to be comfortable with those risks. Is the financial system well prepared to deal with those risks and measure them? Are control systems in banks and funds well prepared to deal with those risks? Is this is a source of concern for you?
MR. CARUANA: We think that over the last years the improvements in risk management techniques and processes in many financial institutions has been really very important, very relevant, and very positive, and this has contributed to strengthen the resilience of the financial system. We see these developments positively. There is liquidity in the financial system, and I would like to say that part of this liquidity comes from the innovation of the financial systems, so it is the very financial system that also is helping to create additional liquidity in the system.
As I said, we think that there are trends that are strengthening the resilience of the financial system. However, the system is becoming more complex, more interlinked, and therefore it requires some monitoring because, although it has been able to cope with some shocks--we have seen some shocks, and it has been managed quite properly--, we think that the growth in some of these elements of markets--for example, the credit risk transfer market--has been dramatic over the past few years and it has not been exposed completely to a sustained or persistent slowdown or shock.
So, again, we see positively all these developments, especially improvements in risk management, but we think that we need to continue to monitor, especially when some turbulence or some productive downturn comes to the market.
QUESTIONER: I want to ask you about the risk of the housing market here in the United States. Basically, what are the worrying signs? What could be a sign that this risk is materializing? Would you worry, for example, if there is system-wide contagion to the housing market or maybe an impact on consumption?
MR. CARUANA: I think there are different channels, and it is clear that this subprime deterioration that we have seen, that has been more rapid than everybody expected, will have an impact. This impact has already been taken into account in most of the figures of the analysts of the U.S. growth. So, we don't think that this is going to change fundamentally, but it certainly is going to reduce growth. And again, in the chapter of risk, still we consider that this is a relevant risk.
One of the risks there is through additional tightening conditions of the lending process because of the deterioration in the asset quality, and this could reinforce some of the issues about home sales and home activity. Again, we tend to think that this is contained and that there are risks, but that provided that income and employment continue to be strong in this economy, and so far it has proved to be strong, the impact of these channels would be contained.
QUESTIONER: I would like to follow up on the question on the issue of leveraged buyouts and the growth of their private equity market. Do you have any advice about how governments should monitor or what remedies they may pursue to make sure that this phenomenon doesn't get completely out of control?
MR. TRAN: The concern we have regarding the financing of leveraged buyouts and private equity activities is more from the financial stability perspective; and from such perspective, we are concerned with the relaxation of credit standard and credit discipline that one begins to see in some of the financing for LBO activities and dividend-related financing deals, which continue to run very strongly in the first quarter of this year compared to previous quarters.
What we see is a side of relaxation and due diligence by the financial investors, relaxation in the terms of the leveraged loans, including the growth of the so-called government light loans, which, altogether, if we learn anything from the deterioration into subprime market segment of the U.S. mortgage market is that the relaxation of the credit standard will come home to roost at some point.
So, from the financial stability perspective, we would urge regulators in the major markets to make sure that lenders and/or investors operating in their regions try to exercise due diligence and make sure that the credit quality of the investment is up to standards.
MR. MURRAY: Thank you very much.