Call to maintain risk management standards

This year’s Institute of International Finance (IIF) meeting was held in Athens, a city steeped in history and myth but now a vibrant and modern metropolis. Wandering the streets of Plaka or Psyrri you will find the Parthenon looming large over the city, and in a similar vein this year’s meeting of the IIF was dominated by talk of the need for global financial market stability.

More than 500 leading financiers and economic policymakers were in attendance to discuss the world’s economy. Speakers ranged from central bank governors, such as Durmus Yilmas, governor of the Central Bank of the Republic of Turkey and Mugur Isarescu, the governor of the National Bank of Romania, to politicians such as the prime minister of Greece, Konstantinos A Karamanlis and Hungary’s premier Ferenc Gyurcscany.

Risks and uncertainties

Joseph Ackermann, chairman of the IIF board of directors, opened the meeting with a warning that, despite the generally positive economic environment, there were risks and uncertainties and both borrowers and investors should be looking more at how to pursue “prudent risk management”.

With private capital flows rising to $570bn in 2006 from $425bn in 2002, according to figures from the IIF, it would appear that investors certainly have a “heightened risk appetite”.

Mr Ackermann warned that, at a time of increased liquidity and an accelerating deal flow, there could be a tendency to water down standards and for lenders not to follow best practice – a move he condemned as unwise and ultimately dangerous. He was also concerned over the need for leading emerging economies to strengthen their architecture in terms of preventing financial crises – or managing them, if they do arise.

Capital flows to emerging markets have recovered from a dip earlier this year, a reaction to the sudden negative shift in global financial market sentiment as a result of growing fears over the US sub-prime market, and are now on course to match the record flows seen in 2006 of more than $550bn. Latest projections expect capital flows to top $545bn in 2007.

The IIF expects, from a geographical perspective, that emerging Europe will receive the largest share – 43% in 2007. The region is expected to see real gross domestic product (GDP) growth of 6.2% in 2007 compared to 6.4% in 2006. Among the region’s main economies, Russia and the Ukraine are expected to see slower growth. Private creditor flows will make up the largest source of external financing in emerging Europe with Russia remaining the primary recipient. It is likely to receive $73bn this year.

Current account deficits

One concern for the region will be a rise in its balance of payments deficit, which is expected to top 1.4% of GDP in 2007. However, in a clear message to the IIF’s audience, leading bankers from emerging Europe suggested that large current account deficits were something that markets would have to get use to.

According to Mr Isarescu, it was the price of rapid expansion and though 80%-100% of deficits were covered by foreign and direct investment it was something the region, as well as the financial markets, could live with.

Beyond Europe, Mr Ackermann highlighted issues on a range of national economies, in particular the US and China. He suggested that the weaknesses recently identified in the US housing market and the problems associated with the sub-prime market were certainly a concern.

The IIF’s chief economist, Yusuke Horiguchi, suggested that worries over the possible macro impact of the sub-prime market were being over-sold. Although it was a “big mess”, the sub-prime market accounted for just 0.4% of US GDP and what appeared to have been a disaster in the making already appeared to have been brushed aside by US consumers.

Housing fears

Retail sales figures for May seem to support that view, showing a rise of 1.4%, double what analysts had expected. However, it should be noted that the US sub-prime housing market seems to be getting worse, not better, and rising interest rates are certainly having an impact.

Mr Ackermann also expressed doubts over the frenetic growth that continues to be the norm in China. He spoke before the most recent industrial production figures were released showing annual Chinese industrial growth speeding up in May, a rise that surprised analysts. According to figures from the country’s National Bureau of Statistics, industrial production surged rising to 18.1% year on year, up from 17.4% in April, and was being driven by a combination of strong exports and higher investment, which in turn was raising the risk of higher inflation.

The IIF believed that the world economy was experiencing a period of strong and sustained growth. Not only that, but there have been significant improvements in the economic fundamentals of emerging economies and the world is currently awash with liquidity.

William Rhodes, IIF first vice-chairman and senior vice-chairman of Citigroup, said the current surge in liquidity was the greatest he had ever seen, with investors chasing yield and a lack of risk differentiation in the financial markets. Markets were being affected by three increasingly dominant factors: hedge funds, private equity firms and credit derivatives, he said.

The consensus on what the global economy was expected to do over the next 12-18 months was that the strong growth of the past few years would continue. Larry Summers, the former US Treasury secretary, recently calculated that up to 2007, the world has just enjoyed the strongest five-year period of growth in all of recorded economic history.

Growth forecast

The IIF appears to agree. It is forecasting growth of 2.4% for the US this year, 2.5% in Europe, 2.2% in Japan and a resounding 10.5% in China – that would mean China has seen double-digit growth for five consecutive years. Next year, growth in the US is expected to rise to 3%, while China’s is expected to ‘ease’ to 10%.

While the world may see faster economic growth, other characteristics of the world economy include huge current account imbalances, low real interest rates and risk spreads and easy access to finance.

Inflation seems harder to call. Questions included: is it a threat? Are US inflationary pressures more stubborn than appears to be the case, especially in the light of a tight labour market? How worried should the world economy be about the sudden jump in US Treasury yields – has the trend over the past 20 years towards cheaper money and lower bond yields come to an end?

Speaking about the eurozone, the European Central Bank’s vice-president Lucas Papademos warned: “Given the vigorous monetary and credit growth... upside risks to price stability prevail over the medium to long term.”

He warned of the need for strong vigilance and suggested that “modern, developed financial markets are like a superhighway. They get you where you want to go faster but accidents may be worse than before”.

More than 30 years ago, the 1960s was seen as another golden economic period of high growth levels. Levels of productivity were improving, inflationary pressures subdued and interest rates were low. Could the next few years follow the fate of the 1970s with soaring inflation and rising unemployment? The beneficiaries of the current oil price boom, such as Russia and the Middle East states, have embarked on a massive infrastructure spending spree, and together with China are helping to keep the price of raw materials, from copper to iron ore, at very high levels.

Positive outlook

The assumption at the IIF meeting seemed to be that the global economy was fundamentally sound. Speaker after speaker talked of strong economic growth; record capital flows and massive currency reserves. There has not been a collapse in an emerging market, which seemed to be the norm in the 1990s, and which had the effect of helping to slow global growth. With vast and growing currency reserves, emerging markets were seen to be less vulnerable to sudden global shocks, according to speakers.

So how sound is the global economy? How vulnerable is it to the activities of hedge funds and private equity? What impact will greater competition have on the supply and price of raw materials? What will happen if oil prices rise above $100 a barrel, especially if the perennial political problems in the Middle East bubble destructively to the surface again, let alone whether rising inflation triggers a tightening of monetary policy and in turn a credit crunch. All these issues were touched upon but financial policy makers will need to ensure that they guard against any complacency at a time of strong economic growth.

Lucas Papademos: ‘upside risks to price stability prevail over the medium to long term’

William Rhodes: current surge in liquidity is the greatest he has seen