Vittorio Corbo: Recent trends and perspectives for the Chilean economy
Speech by Mr Vittorio Corbo, Governor of the Central Bank of Chile, at the Seminar
"Business and Economic vision 2007-2008", organized by Sofofa and Universidad del
Desarrollo, Santiago, 17 October 2007.
* * *
The insertion of the Chilean economy into global markets has implied that its economic cycle
has been determined by a mix of domestic macroeconomic policies, world economic events
and by idiosyncratic conditions, such as recent energy supply shocks. In recent years, the
prominent external environment for the Chilean economy has been favorable. On the one
hand, a rising demand and high prices of our exports, and on the other hand, low import
prices of consumption and capital goods. In addition, firms have also faced favorable
financing conditions. In this presentation I will start by discussing the outlook for the World
Economy. Next, I will discuss recent trends in the Chilean economy and, finally, some
reflections on the conduct of monetary policy and the main risks we currently face.
Perspectives of the world economy
The last five years have been the best five-year period in growth, inflation and financial
conditions that the World Economy has experienced in over 30 years. However, this scenario
has been changing in the recent months. Although the turmoils in global financial markets
that started in July have been reduced by the determined actions taken by the central banks
of industrial countries, especially the Fed, risk aversion is still high, credit maturity has been
reduced considerably and, except for prime firms, financial conditions have narrowed around
the world.
It is foreseen that turbulences in global financial markets will have effects on the perspectives
of the world economic growth. In any case, this adjustment comes at a time in which most
firms and the banking sector around the world are on solid footing, perhaps with the sole
exception of some economies in Eastern Europe.
The epicenter of this trembling is in the United States, which economy already was
experiencing an important adjustment in its housing market, now expected to be more
intense and extended as a result of the deterioration in the credit conditions that experiences
its mortgage market. At the same time, the drop in US housing prices and the less favorable
financial conditions faced by US consumers will affect the dynamism of private consumption.
Although the deterioration of financial conditions has no direct effect on prime firms, their
economic perspectives have been negatively affected by lower dynamism expected for
consumption and by more restrictive financial conditions faced by their consumers and
suppliers. Nevertheless, it is important to emphasize that the indicators of real activity of the
third quarter have shown a surprising strength of the labor markets and consumption.
In the Euro Zone and Japan, partial indicators show that the third quarter GDP growth has
strengthened after the contraction of the economic activity in Japan during the second
quarter. However, consumption is still weak in both zones and, especially in the Euro Zone,
financial conditions have also been deteriorated with potential effects on consumption and
investment. In this sense, confidence indicators so much for consumers as for firms are
showing less favorable perspectives.
Despite the still uncertain effects that the adjustment of global financial markets would have,
projections of the world GDP growth have already been reduced (moderately). It is not a
surprise that these reviews affect chiefly projected GDP growth of industrial economies. The
World Economic Outlook, presented by the IMF today, reduces the forecast for World
Economy growth for 2008, by half a percentage point, to 4.8%, with a forecast for the US
GDP growth of only 1.9%. In the same report, growth projections for the Euro Zone and
Japan are also corrected downward for 2008. Corrections for emerging economies are
marginal, particularly for China, India and Russia.
In spite of adjustments in global financial markets and of reductions in the GDP growth
perspectives for advanced economies, the appreciation of stock markets in emerging
countries is surprising. Apparently, markets have anticipated that the deceleration of
industrial countries will have reduced the effects on these economies and their financial
conditions will not deteriorate as much. The reason is the combination of a higher risk premia
and lower interest rates in industrial countries, as a result of flight to quality and expectations
of lower monetary policy rates than previously expected so much for the US as for the Euro
Zone.
In this external setting, commodity prices have remained high and, particularly, crude oil
prices are reaching record nominal levels in dollars. Besides, international prices of food are
showing a rising trend. Accordingly, emerging economies have been more dynamic than
previously expected, contributing to worldwide GDP growth. Thus, China, India and Russia
as a group explain more than a half of the world GDP growth during the first semester of this
year.
The Chilean economy
Chile's current framework of macroeconomic and financial policies and institutions has
insulated the economy from the turbulences in international financial markets. In particular,
the fiscal solvency and the conduction of an inflation-targeting monetary policy under a
floating exchange rate regime have increased the economy's resilience to external shocks.
Between July 19 and August 16 - the day before the Fed reduced its discounted rate in 50
basis points and authorized the use of bonds supported by mortgages and collaterals - the
Chilean peso depreciated slightly, the 10-year bond rates decreased and the stock exchange
experienced one of the lowest falls among industrial and emerging economies.
The Chilean economy started a period of above-trend-growth in the third quarter of 2006.
This growth has been supported by expansive domestic macroeconomic policies and
favorable external conditions. As a result, we estimate the GDP to reach its long-run trend
level during the second quarter of this year. Partial indicators for the third quarter suggest
that growth has slowed, and will be lower than expected in the September's Monetary Policy
Report (MPR). This has been mainly the result of the weak behavior of the natural resources
sectors (mining, fishing and electricity, gas and water) because of supply shocks due to
technical problems in mining, and substitution of hydroelectric power with thermal generation
based on oil. In addition, the manufacturing industry has slowed down surprisingly. We are
yet uncertain as to the causes and persistency of this slow-down. On the demand side:
private consumption is growing at close to 7% (yoy) while investment in fixed capital picked
up after the slow-down of the second and third quarters of 2006. Partial indicators for the
third quarter show a moderate growth in investment and a slight reduction in consumption
growth. Capital good imports are still growing fast, while investment in building construction
is growing at around an annual rate of 5%.
The expansion of private consumption is still supported by a solid labor market, with
employment growing at an annual rate of 3% and a seasonally-adjusted unemployment rate
under 7%, the lowest since 1998. Financial conditions are also still favorable. The 10-year
bond interest rates are low and the annual growth of monetary and credit aggregates
continue high, specially the growth of firm credit. At the same time, stock issuance up to the
third quarter of 2007 is higher than that of 1996. Notice, however, that the persistent
weakness of expectations indicators and the effect of the recent increases in inflation on
families' purchasing power imply a risk for private consumption growth.
As a result of the above, the GDP and aggregate demand growth have been somewhat
below the forecasts of the September 2007 MPR. There, the GDP growth forecast for this
year was 5.75% to 6.25%, with a downward bias. The evidence accumulated so far, indicate
that the GDP growth will be in the lower part of the range. The turbulences in international
financial markets could be affecting expectations of consumers and entrepreneurs. In fact,
consumer expectations have worsened and the forecast of the GDP growth in expectation
surveys has fallen.
The most important development in recent months, however, has been inflation. Inflation has
picked up, reaching annual rates of 5.8% in September, both for total CPI and core CPI
(which excludes perishable foods, energy and regulated tariffs). This surprising rise of
inflation has been influenced by unusual (and simultaneous) increases in the prices of food
items, given rises in their foreign similes and harsh weather conditions in Chile. These high
prices have not only persisted but also intensified in the last months. Additionally, electricity
power rates have also increased, as a result of natural gas restrictions coming from
Argentina, and the replacement of hydro by oil-based electrical generation.
Rising inflation due to a food price shock is a problem affecting many emerging economies
such as Brazil, China, Mexico and South Africa. In turn, the impact of this food price shock
on inflation in industrial countries has been smaller, because the share of food items in the
CPI basket is lower in high-income economies.
As a result of these price shocks, now it is foreseen that projected annual inflation will be
above those published in the last MPR. In line with inflation, short-term inflation forecasts
have also risen. However, long-run inflation expectations are still anchored at 3%. This
reflects the confidence of economic agents in the Central Bank's commitment with the
inflation target, and the transitory character of the recent hike in inflation.
The different measures of trend inflation have also been rising during the last months,
following the rising perishables prices and the reduction of the output gap (effective minus
potential GDP) as observed up to the second quarter of this year. At the same time, the
growth rate of wages shows increases in recent months (except in August). In addition, the
Chilean peso has appreciated in nominal and real terms during the last month.
These changes in the inflationary front have been the main concern of the Central Bank of
Chile in the design of monetary policy, considering the purpose of keeping the inflation
around 3% most of the time, with a tolerance range of +/-1 percentage points. Given this
objective, the monetary policy has been adjusted to avoid persistent deviations from 3% due
to the second-round effects of supply shocks or the widening output gap. This is why the
Board increased the monetary policy rate in 25 basis points in July, August and September
2007, to a current level of 5.75%. In September, due to the turbulences in global financial
markets and their possible consequences on the Chilean GDP growth, the Board decided to
change the upward bias in the monetary policy rate to a neutral bias. This was then
confirmed in the monetary policy meeting of October, when the Board decided to maintain
the monetary policy rate and remarked that future trends would depend on new information
and its implications on inflation forecasts. This time the Board added that the future of
monetary policy would depend on developments of the World Economy, the eventual
propagation of the inflationary shock to other prices, wage trends, medium and long-term
expectations of inflation, and the evolution of the output gap.
The market has also adjusted its expectations on the future course of the monetary policy,
given both the news on the internal inflationary front and the expected evolution of the
worldwide GPD growth. As a result, financial prices have internalized the fact that the
monetary policy rate will increase another 25 basis points during this year and another equal
increase during 2008. In contrast, most of the market analysts who participate in the monthly
survey of inflation expectations, expect an additional increase of 25 basis points for the
whole period from now until the end of 2008.
The recent evolution of the exchange rate deserves to be specially mentioned. The Chilean
peso has appreciated against the US dollar in the last few weeks, reflecting, in part, the
depreciation of this last currency in international markets. This in turn has been the result of
the monetary impulse to compensate for narrowing financial conditions in the developed
markets and the necessary adjustment of the current account imbalances among the main
economic areas. This phenomenon has stressed international financial markets and is a
main concern among the economic authorities in industrial countries, especially in the Euro
Zone. In Chile, the appreciation of the Chilean peso reduces profits in those tradable sectors
that have not been able to adjust their prices in dollars. However, it is important to mention
that, thanks to the combination of a fiscal policy, anchored to a structural fiscal surplus and
that saves transitory income, and the inflation-targeting monetary policy framework with
floating exchange rate regime, the appreciation of the Chilean peso with respect to the US
dollar has been one of the lowest among countries all around the world, since the beginning
of the US dollar depreciation in international money markets in February 2002.
By contrast, multilateral measures of the real exchange rate have shown a lower
appreciation of the Chilean peso, both due to fundamentals (the important improvement of
the terms of trade) and financial factors that are not easy to quantify. All in all, the effective
real exchange rate is slightly lower than the average of the last 15 years, in spite of the
important improvement in terms of trade. Again, the fiscal and monetary policies followed by
the Chilean authorities have prevented a higher real appreciation of the Chilean peso and
have minimized possible effects as the Dutch disease, i.e., a transitory overvalued currency
associated to unsustainable expenditures.
Nevertheless, it must be emphasized that the Central Bank authorities are continuously
monitoring the evolution of the real exchange rate considering changes in fundamentals. In
particular, the Central Bank is always ready to use the available instruments to avoid
negative effects on the Chilean economy derived from sudden and erratic movements in the
real exchange rate.
Final remarks
In the last few months, the Chilean economy has faced different shocks, demanding special
monetary policy attention so as to fulfil the obligation of ensuring price stability, as it was
enacted in the Constitutional Law of the Central Bank of Chile. This objective is a necessary
condition to achieve sustainable growth at a rate around its trend.
The main risks currently being considered by the Central Bank are: (1) an eventual
propagation of food and energy price shocks to inflation dynamics, in the context of a closing
output gap and transitory high inflation rates. This propagation could be materialized via
rising wages, due to wage CPI indexation and a reduced unemployment rate; or via rising
medium and long-run inflation expectations that significantly could diverge from the inflation
target; (2) larger adjustments in global financial markets, with more severe consequences for
world growth and commodity prices; (3) signs of more rapid moderation of internal GDP
growth dynamism, beyond expected.
In particular taking into account these risks, the Central Bank continues conducting the
course of monetary policy according to its constitutional mandate to safeguard price stability.
Yves Mersch: Recent financial market developments
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 50th
anniversary of ACI Luxembourg, Luxembourg, 12 October 2007.
* * *
Since my first invitation to an ACI event as a speaker a few months after assuming my first
mandate 9 years ago, the markets have undergone many turbulent sequences, although I
could not detect a correlation between market upheavals and my regular appearance at ACI
events. Let me therefore thank the Luxembourg chapter for inviting me again today. I feel
honoured.
After a first ripple in the first quarter of this year and an increasing number of central banks
pointing to the need to reprice certain risks (I gave a warning in that respect at a conference
by the European Institute in Washington in April) the market reaction over the last couple of
months witnessed what needs to be seen as a basically healthy reaction to mispricing. This
reaction however was accompanied by the unpleasant effects of a crisis of confidence
among the participants of the global credit markets prompting central bank intervention.
Since I agreed to speak about the turbulence in financial markets, many actions have been
taken and a policy agenda for drawing the lessons is emerging.
Allow me therefore briefly to highlight the main events, before commenting on the experience
we acquired inside the Eurosystem during these weeks and months with our elaborate
toolbox of instruments and operations.
I will conclude with some tentative lessons to be drawn in terms of transparency, valuation,
market functioning and supervisory framework adjustment.
At this stage of collecting evidence, I will not dwell on the macroeconomic consequences of
this turbulence which took place against the background of a strong performance of the
global economy. The momentum of past dynamics still outweighs potential downward risks to
the baseline scenario.
I. What happened in the markets
If many expected turbulence, the specific features and the transmission mechanisms were
less clearly anticipated.
Many were barking up the wrong tree: Hedge funds and private equity were not the main
culprits but suffered.
Let me sum up the unfolding of events in 6 points:
1. Credit spreads reach record lows in the first half of 2007.
The combination of relatively low interest rates for a long period of time, the trend to
lay off credit risk out of balance sheets and to securitize and an increasing focus on
short-term returns have led to a strong demand for credit risk, especially from
nonbank investors. As a result credit spreads fell to all-time lows, leading to a
mispricing of credit risks. Additionally, many investors relied greatly on credit rating
agencies for the valuation of complex financial instruments and their use as
collateral.
2. Strong economies and higher commodity prices were fuelling expectations of
tighter monetary policy before the crisis started.
In the first half of the year the economic situation proved to be very robust. Most
major central banks were normalising interest rates. Strong demand for commodities
put upward pressure on prices so that interest rates were rising in the first half of the
year.
3. Mortgage rate re-settings at higher interest rate levels caused delinquency
rates to rise, most pronounced in the sub-prime mortgage market.
This led to losses in the hedge fund sector and increasing difficulties in finding a fair
value price for structured deals. Moreover, investment funds experienced difficulties
in NAV pricing, resulting in the temporary closures of some funds. Asset-backed
securities with high credit ratings have proved not to be as sound, nor as liquid as
they appeared. Some of those structured investment vehicles or conduits were
extensively leveraged and strongly dependent on short-term funding. In the absence
of liquidity, sponsoring banks had to fund off-balance-sheet vehicles from their own
balance sheet. This led to de-leveraging and forced asset sales.
4. Higher default rates caused the first bankruptcies in the US and credit spreads
started to rise. Risk aversion spread to all asset classes.
Forced sales to cover margin requirements saw volatility rise sharply (VIX doubled
from 15 to 30 %). The unwinding of riskier positions caused stock markets to fall
(Stoxx50 -11 %) and carry trades were liquidated (EURJPY fell from 169 to 152, a
10 % appreciation). As markets fell, margin requirements rose further. The
uncertainty about the pricing of some instruments added additional pressure.
5. As the credit crisis spread further short-term liquidity evaporated.
Short-term funding in the interbank market became unavailable, causing casualties
amongst banks and funds. In Europe, IKB and Landesbank Sachsen were rescued
from insolvency. Northern Rock followed later.
Funding in the primary market was impossible for banks. Trading in the secondary
market stopped, with the exception of government issues.
6. The effective shut-down of the refinancing pipeline left banks to rely on
shortterm funding from central banks.
Neither primary issues nor short-term papers, such as ABS or ABCP, could be
placed in the market. Banks hoarded liquidity in order to be safe from unexpected
outflows or the unknown extent of write-downs. Because the usual market
refinancing possibilities were blocked banks relied on highly rated collateral for their
funding and the liquidity provided by the central bank.
The spread between EONIA and three-month Euribor rose to the highest level ever
at 70 bps and has remained high. Unsecured trading in the money market beyond
one week effectively ceased to exist.
II. Central bank reaction function
As liquidity retracted first from the credit markets, then money markets, intermediation
vanishing, central banks had to move in: to restore orderly market conditions; ensure the
integrity of monetary transmission channels, and to ensure financial stability or prevent a
systemic crisis.
In view of the confidence crisis among market participants, due to uncertainty about financial
individual exposures, the issues at stake were:
1) to have money market rates evolve close to the policy rates;
2) to address the term structure problem to the extent that it was threatening the first
issue;
3) and thirdly to address the distributional problem of liquidity among market
participants for reasons of financial stability.
The somewhat more complex and elaborate toolbox of the Eurosystem proved very valuable
in this respect.
- this applies to the instruments used to provide liquidity: the MRO and LTRO
- this applies to minimum reserve features
- this applies to the number of counterparties with direct access to central bank
money
- this applies finally to the range of eligible collateral
Let me say a word about each of these features of the Eurosystem operational framework:
1. At moments of term structure difficulties and shortening of the liquidity constraints, it
is of advantage to have both: one-week and three-month liquidity providing tenders
conducted weekly and monthly. Fine tuning operations and extraordinary additional
tenders, according to standard procedures, allowed a commensurate response
within a familiar context, rather than adding to prevailing uncertainty by introducing,
in an emergency context, untested new facilities, instruments or procedures.
2. In monetary policy operations, the Eurosystem grants direct access to liquidity to a
large number of credit institutions. All euro-area institutions subject to minimum
reserve requirements and which fulfil the relevant contractual or regulatory
arrangements applied by their respective NCB, may access the standing facilities
and/or participate in open market operations based on standard tenders. At the end
of August 07, 1 676 counterparties had access to the open market operations, 2 809
to the facility, and 2 141 to the marginal lending facility.
3. The combination of relatively high reserve requirements at 2% and the monthly
averaging principle allowed banks to dip into their reserves to meet their liquidity
needs.
This averaging principle, which grants the banks more flexibility in meeting their
reserve requirements, is conducive to more orderly market conditions.
Since the start of EMU in January 1999 the ECB has been providing its (weekly)
refinancing to the euro area banking system based on the concept of a benchmark
allotment. This benchmark allotment is defined by the ECB as the allotment amount
which allows counterparties to smoothly fulfil their reserve requirements until the end
of the day before the settlement of the next MRO, when taking into account the
aggregate liquidity need of the banking system.
4. The Eurosystem accepts a wide range of collateral to underlie its operations,
including marketable and non-marketable assets.
The Eurosystem has put in place a single framework for eligible collateral, which
covers marketable and non-marketable assets that fulfil euro area-wide eligibility
criteria.
As far as marketable assets are concerned, there are four liquidity categories: The
first and best category is made up by central government debt instruments, the
second by jumbo covered bonds, agency, and local or regional government debt
instruments, the third by covered and uncovered bank bonds and the fourth by asset
backed securities.
There are two types of non-marketable assets that are accepted as collateral: credit
claims and non-marketable retail mortgage-backed debt instruments. Although
different levels of haircuts are applied to the different categories, one might say that
the Eurosystem also allows banks to use collateral easily where either the interbank
Repo markets are less liquid (such as in category 3+4) or where there is even no
interbank Repo market at all (such as for non-marketable assets).
Banks have the choice to use more or less liquid assets as collateral, a facility which
constitutes a big advantage in critical liquidity conditions such as those currently
experienced by market participants.
Some recent figures:
The available eligible marketable collateral amounts to EUR 9 trillion.
While the amount submitted to the Eurosystem nearly reached 11% of all eligible
collateral by 31 August 2007 (nearly EUR 1 trillion), around 6% is effectively used to
collateralize outstanding credit operations with the Eurosystem.
By the end of 2006, uncovered bank bonds had become the largest single asset
class put forward in Eurosystem operations (31%), surpassing government bonds
for the first time (21%). ABS have also shown a steady growth, reaching 11.4 % of
all collateral submitted by the end of 2006, and 19% by the end of August 2007
(+4% in August 2007).
The year 2007 has also shown a steady increase in the use of credit claims, which
by end of July 2007 represented roughly 10% of all assets submitted as collateral to
the Eurosystem. Even though handling procedures for credit claims are sometime
more cumbersome, counterparties show an increasing interest for this asset class
with very low opportunity cost.
The bottom line of these figures is that the increasing use of lower opportunity cost
collateral shows that a growing number of counterparties are becoming more active
and efficient in managing their collateral, and thus their liquidity.
Finally, the recent market turmoil provided tangible evidence that the collateral
framework of the Eurosystem is broad enough to ensure that counterparties do not
face collateral shortages, even in difficult situations.
Where do we stand today?
The degree of uncertainty concerning risk - where is it?, how much?, at what price? - is
declining with every forthcoming disclosure. Some asset classes have already fully
recovered their risk appetite.
Bank profits will be impacted, but their capacity to absorb adverse developments has also
been strengthened by buoyant results over the last years.
However, we are not back to normal yet, especially in the unsecured interbank term money
market. We are not fully safe from a low probability but potentially high impact negative
event.
Before drawing some tentative lessons, let me add that there is no trade-off between liquidity
provision and monetary policy, with its primary objective of maintaining price stability to which
we are resolutely attached.
III. Key issues
At the international and at EU level a tentative agenda is emerging around 4 axes for further
examination.
First: Transparency
Enhance transparency for investors, markets and regulators (including improvements at the
level of data reporting). Credit risk transfer has facilitated the dispersion and sharing of risks
across the financial markets, thus potentially enhancing their efficiency and stability.
However, the recent market turbulence confirmed concerns about the risks stemming from
the lack of transparency as to where the risks ultimately reside in the financial system, and in
particular if those risks have been acquired by market participants that can properly manage
them. The existing reporting requirements of the banking sector did not allow for a full
assessment of banks' exposures to the structured products, leading to the absence of
accurate and timely information.
Are Basel II requirements sufficient concerning the sponsoring by banks of SPV?
Is bank disclosure of securitization operations, and exposures to SIV adequate?
Questions also arise in relation to the functioning of markets for complex financial
instruments.
How to inform the individual investor when there are difficulties in measuring risk in
structured finance products and valuate them?
In this category of improved transparency, I shall also mention the need to implement
ESCBCESR standards for payment and settlement including ICSDs and large custodians in order
obtain more information on intraday market liquidity.
Second: Valuation
More work is needed on standards to ensure reliable valuation of assets particularly of those
assets where markets are potentially illiquid in time of stress. At the same time compatibility
with international financial reporting standards must be assured.
Third: Market functioning
I have to mention first the assessment of the role of credit rating agencies, their small
number, the transparency of their rating methodology, possible conflicts of interest in
particular as regards structured finance instruments. Excessive exclusive reliance on credit
ratings by investors without carrying out due diligence or conducting further own risk
assessment is a problem as well.
The road map also includes a reflection on the consequences of the originate and distribute
model of banks for credit markets. Does it induce wrong incentives?
A last item in this list relates to non-regulated debt markets and mortgage markets, which
might deserve a hard look in the light of recent experience.
Finally: The regulatory framework
Above all, liquidity risk management relating to complex structured products needs to be
investigated. We need a wider concept of concentration risk including wholesale and
interbank markets as well as intragroup exposures. We have to look at warehousing and
pipeline risk, deal with possible regulatory incentives to move risk off balance sheet into
SPVs.
We have to assess the links between the regulated and the non-regulated part of the system,
including the optimal perimeter of supervision. Special purpose investment vehicles and
conduits were used as off-balance sheet investment vehicles. These were prone to liquidity
mismatches between their assets and liabilities, causing contingent credit and liquidity lines
to be drawn on banks, and resulting in an increased demand for money market liquidity.
Closer examination of procyclical effects of credit market developments and the treatment of
risk embedded in structured products held for trading is also warranted.
The Deposit Guarantee Schemes, in the light of recent events, also need to be revisited. This
is a piece of advice I would most urgently give to the authorities of this country with its
unfunded DGS.
Last but not least
If there is one major lesson recent market developments have clearly shown, it is the
shortcoming of a prudential framework which sidelines the central bank.
Cooperation at international level is only as good as cooperation at domestic level. Liquidity
issues cannot be segmented between an FSA and a central bank with no contacts of an
institutional nature.
With this personal remark for domestic consumption I thank you for your attention.