Speech

Opening Remarks by John Lipsky, First Deputy Managing Director, At the Tenth Annual OECD-World Bank-IMF Bond Market Forum

April 29, 2008

Good morning, ladies and gentlemen. It is my pleasure to welcome you to the 10th Annual OECD-World Bank Group-IMF Global Bond Market Forum. The topic of this conference is particularly timely, given the current global market turbulence and the importance of liquidity in today's financial markets.

After a prolonged period of sustained economic growth and rapid financial innovation, global financial stability is facing a significant test. The two key sectors of the financial system—traditional banking activities and the dramatically expanded securities markets—have faltered simultaneously. Asset prices have declined, causing stress in markets virtually across the board. Some sectors of the securities markets have become effectively immobilized at the same time that several major banks are shrinking their balance sheets after suffering large losses.

As we all know, significant financial innovations eventually are subjected to market stress tests. Not all innovations survive, and sometimes the tests themselves can be stressful for the entire system. Surely, the current period of market turmoil represents a very significant test. Already in 2007, banks' aggregate loan-loss provisions broke the previous record set in 1987 (when banks reported significant losses from the Latin American debt crisis and the subsequent sovereign-debt defaults and rescheduling). As with many previous episodes of financial distress, the problems this time appeared following an unusually benign period. In the latest episode, market stress has exposed lax underwriting standards, weaknesses in product design and failures in risk management of both originators and investors. The result has been a serious decline in market liquidity. Moreover, uncertainties have arisen regarding which of the latest market innovations will survive in the coming years.

It was to be expected that the current bout of market stress has given rise to serious questions about the role of regulations, accounting standards and disclosure practices in conveying information regarding financial entities' risk profiles. The Fund is an active participant in the process of evaluating pre-existing practices, and we will continue to distill key lessons and refine our work agenda to be able to assist our membership.

In particular, we are drawing the implications of the latest developments for emerging markets. I am pleased to note that emerging market economies so far have proven to be broadly resilient. Nevertheless, the heightened risk aversion and liquidity retrenchment from the ongoing turbulence in global capital markets has affected EM financial markets through higher volatility, increasing yields and sharply lower issuance—albeit with considerable differentiation among them. These developments clearly demonstrate the interdependence of both risks and their transmission in an increasingly integrated global financial market.

A key question, then, is how emerging market authorities can best protect their economies against market disruption. In the short-term, we would endorse the close monitoring of liquidity and rollover risks and the formulation of contingency plans to deal with potential disruptions.

Over the long-run, deep and liquid local capital markets in emerging economies could act, if needed, as a stabilizer, potentially substituting for a hypothetical drop in external bond issuance by emerging market banks and corporates. In fact, many emerging economies have pursued policies in recent years to broaden and deepen local capital markets. In response, local debt markets have grown rapidly, with the outstanding stock of domestically issued bonds having reached US$6.1 trillion as of September 2007, though still largely dominated by government securities. This compares with only US$1.3 trillion a decade earlier.

That said, the impressive increase in local currency debt issuance in emerging market countries has yet to translate into adequate secondary market liquidity. In fact, lack of liquidity remains a major obstacle to the development of many of these markets. Typically, liquidity decreases soon after the market debut of a security. This is true even in markets where sovereigns have well established benchmarks. With price discovery less than ideal and liquidity premia high, many issuers still do not see the advantage of raising funds through these bond markets.

The lack of repo and derivatives markets also inhibits liquidity in the cash market. Many large local investors that adopt a buy-and-hold strategy often are constrained by regulation. As a result, currency risk may be replaced by rollover risk, if the switch to local currency bonds entails a shortening of the maturity profile due to lack of liquidity at the long end of the yield curve.

There are several key conditions required to establish a liquid and well functioning market for long term government and corporate debt. These include:

• A well diversified domestic and foreign institutional investor base (including pension, insurance, mutual, and hedge funds) that can shift financial intermediation from banks to capital markets by increasing the demand for long-term financial assets;
  
  
• A credible rating system (which we have learned can be a challenge), good corporate governance standards, transparency in reporting requirements, and the adoption of international accounting standards all help to foster market discipline;
  
  
• Pricing transparency and improving microstructures—such as effective trading mechanisms, and custody and settlement systems—can play a crucial role in enhancing liquidity and efficiency, while reducing trading costs and volatility.

The Fund has an active and growing interest in promoting the deepening of emerging bond markets. In recent years, the Fund has assisted several emerging market countries in establishing an enabling environment in areas such as sovereign debt management and debt restructuring operations. Moreover, the Fund has supported diagnostic work and strategic reforms both in a regional context as well as part of the broader G-8 Action Plan for Developing Domestic Bond Markets.

We also are working on an important initiative under the auspices of the Fund's Capital Markets Consultative Group (CMCG). I am co-chairing a Working Group with Roberto Setubal, the CEO of Banco Itaú, on a project entitled, "Globalization of Emerging Capital Markets: Opportunities, Challenges, and Responses" that is very relevant for this conference. The Working Group's draft report (prepared by Fund staff in collaboration with private sector participants) aims to provide a private sector perspective on major impediments to capital market development in emerging market countries; on how market participants are gaining exposure to these markets via various access instruments; and on related policy perspectives.

The study finds that the high costs of access to some of these markets are symptomatic of the diversity of tax treatments, of investment restrictions such as capital controls, and of inefficiencies in market infrastructure. The report stresses the importance of easing access to local markets, of lowering transaction costs and of broadening the local institutional investor base.

The Fund is also gleaning important lessons from the current crisis to enrich our policy advice to the member countries. Notably, with the rapid growth of local bond markets in emerging market countries, it is important to ensure that market participants have the appropriate incentives to monitor and manage the risks underlying new instruments, while making sure that credit discipline is not weakened. At the same time, regulatory frameworks need to be reevaluated, taking on board lessons learned through the current difficulties in advanced markets. Furthermore, the absence of adequate transparency and disclosure by financial institutions can erode investor confidence, and may cause institutions to become far more cautious because of concerns about counterparty exposures. Once again, recent events have shown the importance of adequate capital and liquidity buffers to withstand shocks.

Looking forward, I am confident that the ongoing capital market deepening in emerging market countries will continue, as the economic growth prospects of the major emerging market countries remain strong and demographic trends will continue to foster the sustained growth of institutional investor assets.

Thank you and I wish you all a very successful and productive forum.