Speech

Remarks by Murilo Portugal, International Monetary Fund Deputy Managing Director, At the 8th IMF Public Debt Managers' Forum, July 14-15, 2008

July 15, 2008

As prepared for Delivery

Introduction

It is a great pleasure for me to welcome you today to the 8^th Public Debt Managers' Forum. This Forum is a unique and important event in the IMF calendar, which provides an opportunity for us to meet and share experiences and views on the issues that face debt managers in their day-to-day business, and to discuss new developments in debt markets.

I am very glad to see such a wide range of countries participating, which I think form a representative group of the emerging market universe. It's also particularly useful to have so many central bankers present. The links between debt management, and monetary policy are crucial. Central bank perspectives are vital—especially now when questions about monetary policy come to the fore with the increase in inflation experienced in most countries. And we are also grateful to the representatives of the mature markets and the private sector participants for giving their time and effort to this event.

I am very pleased that this eighth forum takes place in the vibrant and historic city of Warsaw and wish to thank Minister Rostowski and President Skrzypek, and their colleagues from the Ministry of Finance and National Bank of Poland for their help in organizing the meeting and for the excellent facilities they have provided for us.

Inflation

When we last met in Washington in November, the central preoccupation was the financial turmoil that had unfolded in the mature market economies, precipitated by the subprime crisis in the US and the question was how this turmoil might affect the emerging market economies, and debt management activities in particular. This remains a key question eight months later. But, unfortunately, we have another central macroeconomic concern, which is the rise of inflation across the globe. Of course last November, the prices of energy and other commodities had already been rising strongly for some time, and inflation was already on the minds of a number of participants. But I think that few anticipated just how widespread and how fast the rise in inflation would be. There are now about 50 countries around the world with inflation rates above 10 percent.¹ And while the financial turmoil has had less impact on developing countries than on advanced countries, the story with inflation is the opposite: virtually all of these 50 countries are emerging market countries, and the group includes some of the largest EM countries. Since November, average inflation across the emerging market group has risen from about 6 percent to something approaching 10 percent—a worrying increase indeed. This is not a regional phenomenon, or one restricted to countries following any particular policy regime. Emerging market countries around the world are seeing increased inflation. Of course, countries with exchange rates aligned to the depreciating US dollar are experiencing sharper increases in inflation—but countries in emerging Europe with currencies tied to the Euro are also facing higher inflation, as are many countries following flexible exchange rates. And inflation targeting countries, whether among the emerging markets or the advanced economies, are generally seeing inflation rising uncomfortably close or above their target zones.

Inflation is growing fastest in the emerging markets mainly because food and fuel typically form a much larger share of consumption baskets than in advanced countries, sometimes accounting for 60 percent of consumption compared to an average of 15 percent in the U.S. and Europe. The advice of the Fund has been that a substantial part of the increase in commodity prices seems to be of a permanent nature and as such should be allowed to feed through to relative price differentials within each country. Policies that interfere with this process—such as increases in fuel subsidies or price controls—will inhibit the demand response to rising prices, unnecessarily adding to the upward pressure of commodity prices. But beyond the initial impact of commodity prices on inflation, central banks should be extremely vigilant regarding the threat of second-round effects, in case current elevated inflation rates become entrenched in expectations of future inflation. Real interest rates are now negative in a number of countries, and there is a risk that some central banks are not reacting forcefully enough to prevent these second-round effects from oil and other commodity prices from becoming entrenched. The historical experience provides ample evidence of how slow and costly it can be to reverse unfavorable expectations once they become established.

Resilience of EM countries to market turbulence

Of course the concerns with the financial market turmoil have not disappeared. Market conditions have improved since the height of the crisis last March, but sentiment remains fragile; there is a lot of repair in balance sheets still to be done; and financing has become more expensive. But emerging market economies are still showing remarkable resilience. Emerging markets have a low level of exposure to the U.S. sub-prime related instruments. Write-downs by emerging market institutions make up a tiny fraction of the overall losses experienced by banks and other financial institutions, with losses concentrated instead in the U.S. and Europe. This is due to a number of factors. Emerging markets had attractive domestic profit opportunities and did not need to invest in leveraged structured products to increase yields. Tight banking regulation and supervision have also helped to limit exposure to these riskier assets, and the banks themselves may have lacked the sophistication to invest in these complex products. Also, a number of emerging markets used the period of high liquidity to reduce debt levels, improve the composition of the debt and accumulate international reserves, and these prudent macroeconomic policies helped to reduce vulnerabilities. But the question remains open as to whether emerging markets would still remain resilient to the current financial pressures going forward.

First, while it remains the case that direct exposure of emerging markets to the troubled sectors of advanced country financial systems appears to be low, indirect channels may come into play as global banks and markets become more constrained by their precarious balance sheets, potentially reducing the availability of funding to emerging markets and increasing its cost. In fact we are seeing some signs of this occurring: for emerging market corporates, new external debt issuance has contracted and spreads have widened substantially.

Second, there are also potential trade-related effects to consider: as growth has slowed in advanced economies, industrial production growth in emerging market economies has slowed too, and appears poised to slow further in the coming months. We in the Fund are generally skeptical of the notion that emerging market economies have "decoupled" from the advanced economies, in a world where trade and finance are ever more globalized and interlinked. It is true that the trend rate of growth of emerging markets has accelerated since the 1990s and has diverged substantially from mature economies. But diverging is not decoupling: indeed after adjusting for long-term cyclical trends, it is clear that year-to-year deviations from trend in growth between emerging and advanced economies remain closely correlated.

It is also important to note that emerging market economies are not a single, homogeneous block. There are critical differences between different EM countries, just as there are within the advanced country group. There are a range of country characteristics that are relevant, such as growth of domestic credit and the extent of inflation increases. But the most significant indicator of potential stress appears to be a current account deficit. Financial markets are discriminating strongly between deficit and surplus countries. Sovereign CDS spreads for emerging market countries with current account deficits above 5 percent of GDP have widened by roughly 400 basis points more than the other countries, compared to last in November. Similarly we have seen markedly greater local currency volatility and higher stock market falls among the high deficit group. Generally, emerging markets in Asia and Latin America seem to be in a stronger position than those in Eastern Europe where a number of these vulnerabilities are present.

So while it is clear that policy improvements have been critical in helping a number of emerging market economies to withstand the pressures from advanced country financial markets, for those countries that are vulnerable to external financing shocks and higher inflation, there may be a need to adjust to tighter financing conditions and tackle rising inflation expectations. Depending on country situations, the policy responses may need to include regulatory changes, tightening of fiscal and monetary policies, and allowing more fluctuation in exchange rates, among other possible responses.

Implications for debt managers

These twin macroeconomic concerns—financial market turbulence and resurgent inflation—form the backdrop against which we will frame our discussions in the next two days. I look forward very much to hearing from debt managers on how the changes in the market environment are affecting their debt management operations and decisions, and what the appropriate responses should be. Should borrowing plans be revised, or the instrument mix reconsidered? In particular, what will higher inflation mean for local debt markets? Will we see a marked increase in demand for inflation protection?

When we discussed similar questions in November, most debt managers felt that their overall debt strategies remained robust to the changes in the market. Since then we have seen some cases of countries limiting or cancelling domestic debt auctions, particularly of longer-term fixed rate debt. In recent months we have also seen some pick-up in external sovereign bond issuance, which had previously been on a declining trend for a number of years. Perhaps this reflects a view that the increase in yields demanded on domestic instruments makes external financing look relatively cheap: although country spreads have risen, the underlying U.S. Treasury curve remains quite low. If so, it will be interesting to hear how countries are approaching such decisions in the context of cost and risk considerations. And further, whether they see these changes as marginal adjustments to their existing debt strategies, or whether some debt managers see a need for a more substantive reoptimization of these strategies.

Contingent risks from vulnerabilities in private sector balance sheets

We will devote a session tomorrow to the possible contingent risk facing country debt managers due to problems on private sector balance sheets, and what are the appropriate responses to these risks. This is a crucial area, which has perhaps received insufficient attention in the past. Yet, when we look back at the experience, there have been very many examples of private sector balance sheet problems that have come to haunt the public sector, from the debt crises of the 1980s, to the Asian crisis and the other emerging market crises of the late 1990s. Indeed, there have been a number of cases in which banking crises have precipitated sovereign debt crises.

The continuing financial market turmoil makes this a timely occasion to discuss these issues. We have already seen a number of cases of advanced countries having to intervene with public resources to rescue failing private institutions, such as in Germany, the UK and the U.S. Private sector exposures have risen in many emerging market countries in recent years, especially emerging Europe where private sector external borrowing has increased sharply. Public debt managers have reduced direct exposure by reducing their own external debt ratios, but the country as a whole may be facing higher contingent exposures through offsetting actions of the private sector. And in many countries we have seen very sharp growth of bank credit to the corporate and household sectors. If problems emerge in these sectors that lead to systemic losses to bank balance sheets, these losses could end up being transferred to the public sector.

How can policymakers assess, manage and mitigate these risks? Even to identify the balance sheet positions and vulnerabilities of the private sector can be a difficult task. As the recent financial crisis emanating from the U.S. demonstrated, vulnerabilities emerge from unexpected sources, and transmission takes place via unexpected channels. This heightens the need for caution in setting policies, from macroeconomic policy to supervisory and regulatory policy.

This discussion is one important element of a broader set of issues that lie at the core of the IMF's effort to improve its understanding of macro-financial linkages. The financial market crisis has made clear that economic and financial market developments can have effects across sectors and across borders, and across both sectors and borders at the same time. The Fund works with both Ministries of Finance and Central Banks and therefore is uniquely placed to advance the understanding of these linkages, to make the right connections between events and trends, and to provide early warning of problems to our members. Our Managing Director recently announced the establishment of a new Macro-Financial Unit in the Fund which will coordinate our research and analysis in this area. I am sure that the interactions we have via fora such as this will help inform the Fund's work, and that the outputs of the Fund in this area will be relevant and useful for your work.

Conclusion

In conclusion, I think we have a rich agenda in front of us for the next two days. All that remains for me is to welcome you again to the Forum, and to encourage you to speak freely and openly on this rich agenda that has been set out for us. As in previous occasions, this is a private meeting, and information and opinions given will not be attributed, or passed on to the press. I look forward to hearing your views on the important issues before us.

¹ Reference is to the "Double-Digit Inflation Club" report by Morgan Stanley Research, June 25, 2008.