Transcript of a Press Briefing on the Global Financial Stability Report

Washington, D.C.

 October 08, 2014

IMF Financial Counsellor and Director of Monetary and Capital Markets Department


Deputy Director, Monetary and Capital Markets Department


Division Chief, Monetary and Capital Markets Department

Deputy Division Chief, Monetary and Capital Markets Department


Senior Communications Officer, Communications Department

Ms. Stankova: Good morning everybody. Good afternoon to those who are joining us from afar.

Welcome to the press conference on the release of Chapter 1 of the Global Financial Stability Report, which is entitled, "Risk Taking, Liquidity, and Shadow Banking: Curbing Excess While Promoting Growth."

Let me introduce the speakers today.

In the center, we have José Viñals, the Financial Counselor of the IMF and Director of the Monetary and Capital Markets Department. Immediately to my right, is Peter Dattels, Deputy Director in the MCM department. To Mr. Viñals's right is Andrea Maechler, Deputy Division Chief in the Global Markets Analysis Division of the same department. And to her right is Matthew Jones, Chief of the Global Markets Analysis Division of the MCM Department of the Fund.

An administrative announcement on the interpretation channels today. Channel 1 is English, channel 2 is Spanish, channel 3 is French, channel 4 Arabic and channel 5 Chinese.

With that, I will pass the microphone to Mr. Viñals for his opening remarks, and then we will take your questions.

Over to you, José.

Mr. Viñals: Good morning to all of you, and welcome once more to the presentation of the Global Financial Stability Report. In this edition that we are presenting today there are three key messages that I want to pass on to you. The first one is that the world is facing a new global imbalance, an imbalance between not enough economic risk taking of the sort you like, in terms of consumption, investment, to promote growth, but increasing excesses in financial risk taking which may undermine stability going forward.

The second message is that banks are now much safer, but many banks still lack the vigor to strongly support the economic recovery by providing sufficient credit in the future. At the same time, risks are shifting to the shadow banking in the form of rising market and liquidity risks and, if left unaddressed, these risks could compromise stability going forward.

The final key message is that in order to address these new global imbalances, policymakers in different parts of the world need to engage in a new balancing act, a balancing act to promote economic risk taking by improving the transmission of monetary policy to the real economy, and address financial excesses through micro prudential and macroprudential policies.

So after having laid out the key messages, let me go in turn into developing each of these issues.

First, on the imbalance between economic and financial risk taking. It is now more than six years since the beginning of the global financial crisis, and the economic recovery continues relying heavily on accommodative monetary policies in advanced economies. This has helped growth by encouraging economic risk taking in the form of higher investment and employment by firms and higher consumption by households. But the impact has been too limited and uneven. Things look better in the United States and Japan, but less so in Europe and in emerging markets. Yesterday you had an analysis of these issues during the presentation of the World Economic Outlook.

At the same time, prolonged monetary easing has encouraged the buildup of certain excesses in financial risk taking. This has been reflected in elevated asset prices across a range of financial assets; credit spreads which are now too low to compensate for the full risks in some market segments; and until recently record low volatility. All of these are clear indications that investors are indeed complacent.

What is unprecedented is that these developments in financial markets have occurred at the same time across a broad range of assets and also across many countries. On top of that, let me also signal that in emerging markets there has been a continuation of the buildup of debt on the part of corporates, an issue that we examine in detail in the last issue of the GFSR.

So, how do we address these policy challenges? For that I would like now to go into what is going on with banks and what is going on with nonbanks. So let me start with banks.

There we have good news and not-so-good news. The good news is that banks are now much safer than they used to be a few years back. Now they have much stronger capital, much stronger liquidity, and they're supported by much stronger regulatory frameworks. I think this is great because this was a most important thing to do after the crisis.

But, the not-so-good news is that, as the report finds, many banks do not yet have the financial muscle to provide enough credit to vigorously support the economic recovery. And, what it means is that after having gone through the stage of stabilizing the banking system and then repairing balance sheets, banks now face a new challenge, and that is of adapting the business models to the post-crisis economic and market realities, and also to the new regulatory environment.

We have looked at a sample of the 300 largest banks in advanced economies in the report. These banks comprise the bulk of the banking system in advanced economies. What we find is that 40 percent of the banking system in advanced economies, measured by assets, 40 percent is not strong enough to adequately support credit in helping support the recovery. They cannot supply adequate credit in support of the recovery. In the euro area, this proportion increases to about 70 percent. These banks will need a more fundamental overhaul of their business models, including a combination of repricing existing business lines, of reallocating capital internally across activities, of retrenching in some activities, even consolidation: mergers and acquisitions.

We think that in Europe the comprehensive assessment that is being carried out by the European Central Bank and which is about to finish provides a strong starting point for this much-needed change in bank business models which banks have to do themselves.

I would like to give you an example. I said banks are safer now. They're safe, but they're not strong enough to vigorously support the recovery by providing credit. This is like if you go to the doctor for a medical checkup and you get a clean bill of health, and the doctor tells you, "Now you're capable of going back and leading a normal life." And you say, "That is fine. But, you know what, I'm an athlete and I need to do more than lead a normal life. I need to run." So you're a bank which is safe, but you need to run in support of the economic recovery. That is the extra bit which is needed after you have ensured safety: the transformation of business models over time.

Let me go now to shadow banks.

Here again we have good news and some concerns. The good news is that capital markets are now in a position to provide more financing to the economy, and that is a very welcome development. But, at the same time, what we are seeing is that there is a shift of the locus of risks to the shadow banks and that is the not-so-good news. Credit-focused mutual funds, mutual funds which invest in fixed income assets, have seen massive asset inflows and have collectively become one of the largest holders of U.S. corporate bonds and foreign bonds.

The problem is that these massive fund inflows have created an illusion of liquidity in fixed income markets. What I mean by that is a situation where the liquidity promised to investors in good times is likely to exceed significantly the liquidity which is available and provided by markets at times of stress, especially as banks have now less capacity to do market-making activities. So, people think they have much more liquid assets than they really have when the market turns around. This is certainly an issue, this liquidity illusion.

At the same time, a very important development in recent years is that emerging markets have become a very important destination for portfolio inflows from advanced economies. For example, advanced economy investors currently allocate more than 4 trillion dollars in portfolio investments to emerging market asset equities and bonds. And that is about 13 percent of their total investments, a share which has doubled over the past decade. What this means is that there are now much more closer financial interlinkages between advanced economies and emerging markets and therefore that shocks emanating from advanced economies have the potential to propagate more quickly to emerging markets.

Together, the two factors that I have just described, the liquidity illusion in markets and this greater interconnectedness between advanced economies and emerging markets, are factors which will amplify the impact of shocks on asset prices. And if shocks are adverse, this will lead to sharper price falls and more market stress.

Such an adverse scenario is something that would take a toll on the economy by hurting wealth and demand, but also at the limit could even compromise global financial stability. This chain reaction could be triggered by a variety of shocks, but let me mention the two that I think are most significant. One is geopolitical flare-ups, and the second is a bumpy normalization of U.S. monetary policy.

So, these are the risks surrounding the global financial system, but the question is what should the authorities do in order to preserve the things that go well and then to address the challenges which are still pending in the case of banks and in the case of nonbanks? What should the authorities do to safeguard financial stability while at the same time strengthening the recovery?

For this, and I come back to the main initial theme, policymakers need to address this new global imbalance between too limited economic risk taking and financial excesses. They should use various policies.

Let me say that regarding monetary policy, accommodative monetary policies remain essential in those places where demand stays weak, while in those places where demand is recovering, then over time it would be natural to normalize monetary policies as is expected to happen in the United States and maybe also in other advanced economies, but not in others.

But monetary policy cannot accomplish everything. Monetary policy cannot be the only game in town. It needs to be supported by other policies, by structural policies, like those discussed yesterday at the WEO, by smart fiscal policies, which will be discussed in detail in the Fiscal Monitor later today, but also by financial policies which is the main focus of the Global Financial Stability Report. Each of these policies needs to play its role.

What should financial policies do? Financial policies can help rebalance both the economic risk taking and the financial risk taking.

Regarding economic risk taking, financial policies must support an improved flow of bank credit to the economy. As I mentioned before, in order to do so banks need to do their homework in adapting their business models, but supervisors and other authorities can facilitate and support this structural transformation which would allow banks to enhance their profitability without taking excessive risks and provide more credit to support the recovery.

This is something which is particularly important in Europe, where banks play a major role in financing the economy.

Financial policy can also play a decisive role in addressing financial excesses through micro prudential and macroprudential policies. For example, in the asset management sector, which has been so much in the newspapers lately. Greater oversight is needed to ensure that the redemption terms are better aligned with the underlying liquidity conditions of the assets.

Basically, reduce the liquidity illusion in markets. Also, more comprehensive monitoring and reporting of leverage in the non-bank sectors and also in the corporate sector in emerging markets would be essential to help identify areas of potential vulnerabilities. And to safeguard against global liquidity strains, bilateral and multilateral swap lines could be deepened to mitigate excessive volatility.

All of these policies will strengthen the financial system by leading to more resilient financial institutions, and also by helping contain procyclical asset price and credit dynamics, something which is highly relevant given the market and liquidity risks which are accumulating in the shadow banking.

Let me conclude by emphasizing that policymakers, in advanced economies and emerging markets, need to be alert to these growing challenges to financial stability, and take further actions now, both to promote economic risk taking in support of growth, and to address excesses in financial risk taking to safeguard global financial stability. Thank you.

Ms. Stankova: We will take your questions. Please give your name and your affiliation when asking your question.

QUESTION: About the banks, there seems to be some paradoxes in what the banks should do to support the recovery. They should take more risks to increase their profitability and they should reprice. This could also lead to the now safer banks taking on more risks and to credit becoming more expensive which could hurt the recovery. I was wondering, what is your view on these paradoxes?

Mr. Viñals: I think that banks need to have sufficient muscle to provide credit and that depends on two things. It depends on how large are the capital buffers that they have in order to re-risk their balance sheets, and at the same time on how profitable are the activities in which they're going to be engaging.

So, what we suggest is that banks need to do a number of things. They, in a number of cases, need to move away from activities which may be appropriate now and may even be profitable now in the context of very cheap funding that they obtain from the European Central Bank or from other central banks, the Fed, the Bank of Japan, and in some cases this is going into very low profit-making activities or even into the purchase of government bonds. Because that is something which is safe and doesn't require any risk weight, so that doesn't consume regulatory capital. But, what we would like is for banks to be able to reallocate capital to other activities, and it may be that, as credit demand recovers in the context of an economic pickup, banks need to provide more credit at somewhat higher interest rates. But that is something which would be fine in the context of an economic recovery. If banks don't provide the credit which is demanded, then you would have a problem. So that paradox would be lessened.

But, that is not all. Banks in addition to that need to find new, reasonable ways of improving their earnings capacity on a sustainable level. They need, for example, as some banks are already doing, to engage in partnerships with nonbanks, where both banks and nonbanks use their comparative advantage in joint ventures. There are a number of cases where banks need to think seriously about consolidating through mergers and acquisitions because maybe there are too many banks in certain parts of the world for the business which is available. That would lead to a more useful industry to basically having synergies, having more efficient banks, and banks that have the ability to thrive and provide more credit. There would be instances where the best situation, the best solution would be for banks to exit. In those cases where banks are not viable, banks which really don't have a future, because they can be kept alive, but basically little else, maybe this is a situation where exit should be facilitated so that the only players which are left are those which are vibrant and strong enough to support the economy. There are a number of things that banks can do and the authorities can certainly facilitate this process.

QUESTION: You mention in the report the risks of asset management companies investing a lot of money in emerging market bonds and high yield and corporate bonds. Would you include eurozone government bonds? There has been a lot of investment in Italian bonds and Spanish bonds by large asset management companies. And, could you also be a little bit more specific in terms of what you would recommend regulators suggest asset management companies do in terms of preparing for this type of situation that you foresee? You mention redemptions, but could you perhaps be more specific in terms of what regulators should say asset managers should do?

Mr. Dattels: Regarding what we highlight as a potential risk is the concentration of holdings of asset managers. What we flag in the report is that funds need to be aware of the portion that they are holding of particular issuers. So we shine the light a little bit on the corporate sector, where a number of large funds hold in excess of 20 percent of an individual issuer. The point being there, if there is pressure on the fund, this may have knock-on effects to the issuer and effectively a dislocation of prices unrelated to general market conditions or the credit conditions of the issuer. And that is why we flag in that context emerging markets, but also advanced economy corporates. The message there is that the funds need to think a little bit about not only a portfolio management view, but also a systemic view. In other words, the fact that they're sizable means that their actions have wider implications.

In the context of the euro area sovereign bonds, those markets are reasonably broad so that this concentration risk is not there. What we do highlight in the report is the pricing of those bonds, according to our models, looks somewhat stretched against the underlining fundamentals that would determine the spreads. So again that sort of fits into our broader notion of some stretched valuations, and that segment, high-yield eurozone peripheral bonds and emerging markets have been areas where investors have reached for yields.

Mr. Viñals: There was a second part of the question, which has to do with what we should recommend that regulators do for the asset management industry, mutual funds, so on. I think that one important thing is to raise awareness of what may be the underlying risks, particularly the market liquidity risks I have mentioned, so that investors are well informed. That is something that the industry should do in terms of clearly communicating to the investors, also, what is the underlying liquidity of the assets that they're investing.

I think it is important also that regulators stress test liquidity conditions in mutual funds in order to see what is the extent of liquidity risks there. It is also very important that there are adequate liquidity standards, minimum liquidity standards, so that these vehicles can cope with redemptions. And I think it is also very important to tighten the definition of what is really a liquid asset, so that there are no false perceptions of something which is declared to be liquid for regulatory purposes, but is not really liquid in reality. So, overall, raise awareness and strengthen oversight of those parts of the shadow banking system and including asset management and mutual fund industry which may pose the type of risks that I have referred to.

QUESTION: Italy's banks, which took money from the ECB two weeks ago, say that they fail to lend money to firms, so the firms don't have money to invest. Do you think the No. 1 problem is that banks are not strong enough? They do not have enough muscle? Is this the No. 1 problem?

Ms. Maechler: We think that Italian banks have done a lot, have really strengthened the balance sheet and we're looking forward to the results of the comprehensive assessments from the ECB. It is clear they're facing a lot of cyclical headwinds from low demand, as you mention.

Another one is, of course, also the very high outstanding stock of NPLs. In the euro area as a whole, 800 billion of NPLs outstanding that needs to be absorbed. That is clearly a challenge they have to go through.

Now, our analysis suggests that beyond these cyclical headwinds, even if you account for these cyclical headwinds, the banks in the euro area have to shift to new business models in order to be ready to meet the demand when the economy recovers. Because, at this time we find that a significant share of the banks, in fact in the euro area it is over 70 percent of the banks, are not strong enough to deliver credit growth that is greater than 5 percent on an annual basis.

Clearly they need to shift to a new business model. They need to reprice some activities. They need to shift capital across different activities. They may need to restructure. As Mr. Viñals said, they may have to consolidate in different ways in order to make sufficient profits to meet the demand on a sustainable basis of credit.

QUESTION: I think it is fair to say that in 2006 nobody saw the financial crisis stemming from the U.S. subprime mortgage market. So when you look around the world, what is the next subprime going to be, do you think?

Mr. Viñals: Well, we don't engage in that type of exercise, because we don't have a crystal ball.

I think that our job is, rather, to point out where we see risks emerging, which could over time become systemic, so that the authorities take measures in advance so that we do not have another financial crisis. And, the focus that we're putting in this report in terms of financial risks is on the shadow banking system. We have devoted a whole chapter, Chapter 2 of the Global Financial Stability Report, to analyze the shadow banking system. And that shadow banking system is becoming very important in some parts of the world. In the United States, it is at least as systemic as the banking system. And we call for special attention to be paid to shadow banking, and for the incipient risk there in terms of market and liquidity risks to be adequately controlled so that they do not create problems later on which may be too big or too complicated to handle. So, this is our job.

Ms. Stankova - A question on line to follow up on the question of the shadow banking.

Can you elaborate on the risks of shadow banking in Latin America, particularly for the Caribbean region and the Dominican Republic?

Mr. Dattels: What we observe in the Latin American region in general is a shift from bank-sourced financing to international capital markets, so we have observed the corporate sector take advantage of the rather benign and low-interest-rate environment to tap international markets. And that growth in corporate issuance, some of this has been used to stabilize the liability structure, so there has been some terming out. That has helped strengthen the corporate balance sheets. But, also, to a degree it has increased the leverage levels in Latin America in general. The concern that we have pointed out to in the last report, in April, and we follow-up to an extent in this report, is the impact of this increased leverage against the broad slowdown in the economy. These economies are weakening. The commodity prices have declined. So they're faced with an external shock, if you like, from the slowing global growth.

And that is impacting their earnings. So, what we flag is because the earnings, the corporate earnings are rather weak, even though interest rates are low, the relationship between the earnings on the one hand, and the interest service on that debt is weakening, it is weakening to the point that over the broad scope of corporates, almost 25 percent of the corporate debt is what we would classify as debt at risk. And, debt at risk, by our definition, is where earnings are covering interest expense only at two times or less. So we have that.

Mr. Viñals: Let me add one thing, which I forgot before, but it is very relevant to the question on shadow banking.

One should not get the idea that nothing is done on the regulatory front to address the risks in the shadow banking. In fact, there are a number of initiatives which are being put together at the global level under the Financial Stability Board, and which are quite advanced, but these regulations need to be finalized, and these regulations need to be implemented, but that is something which is in the pipeline. So, I think that regulators are already doing work which goes in the direction of tackling some of the risks that we are outlining, and it is important that these things are put in place soon, because the risks are growing quite rapidly as well.

Ms. Stankova: One more question on line to perhaps follow-up also some questions, this combined question that we already answered. This is a question from Turkey.

The global banking system insists on postponing the Basel reforms, what should be done to contain risks regarding shadow banking? Also, can you elaborate on risks regarding Russia?

Are you expecting any kind of massive outflows from emerging markets such as Turkey, Brazil, and others?

Mr. Viñals: Let me say a couple of things. In terms of Russia, I think what we have seen so far is that the geopolitical uncertainties surrounding the Ukraine - Russia issue have remained quite localized, and have affected only some of the countries which are most closely linked to these two economies.

So, unless there is a very substantial escalation that can lead to real global concerns, and which may trigger something like a significant increase in global risk aversion, and let's hope that things are put in place so that doesn't happen, if things remain the way they are I don't think this is something which would lead to massive outflows from emerging markets. But, if you have an exacerbation of geopolitical risks, yes, this is one of the shocks that we think could lead to an unravelling of present market conditions and which could be quite damaging.

Regarding the Basel norms, Basel III is finalized in most aspects, has been finalized and there is now a process of implementation in a number of advanced economies and emerging markets, so implementation is going forward. So I don't think that this is something which is not happening or which is being excessively delayed. Implementation is happening. Although it is true that there are a couple of things on the net stable funding ratio and the leverage ratio there are a couple of decisions which are important that need to be made, all the other parts of the Basle III package have been finalized and have been implemented.

QUESTION: So in your remarks you mention, you cite two examples, geopolitical risk and exit strategy of the Federal Reserve, may be the trigger of a serious chain reaction. I wonder if you can elaborate more on that, and what kind of incidents might also be the trigger and then we will see a series of chain reactions? How serious it might be on the global economy if it happens?

Mr. Viñals: Taking into account that we start from a situation where although there are no financial assets which are way out of line with fundamentals, there are many assets which are somewhat richly valued relative to fundamentals. And, we start from a situation where volatility is very, very low. All of this has the potential for decompressing, if there are important adverse shocks. I've mentioned two types of shocks, geopolitical shocks, and a bumpy U.S. exit from easy monetary policy.

Now in terms of geopolitical shocks, something which is interesting is that outside of the specifically affected regions in terms of geopolitical issues, Russia, Ukraine I mentioned and some in the Middle East, markets at the global level, market sentiment has been quite resilient so far. But one cannot count on that being always the case if somehow these geopolitical issues were to take a much higher profile. That is certainly a risk.

In terms of the exit from the United States's very low interest rates at present, zero policy interest rates, near zero interest rates, the fundamental thing is how is the process going to be conducted on the part of the Fed, in terms of the timing of the process, and in terms of the communication of the process. And, I think that it is very important that the Fed is very aware that they have to conduct the process in a gradual manner consistent with the state of the economy, with the developments in the price domain, in the employment domain, but being mindful of the repercussions for the rest world.

The question there is whether, at the end, the exit from monetary policy would be a smooth process, and this is our baseline, or would be bumpy. And that is the adverse scenario. So let's hope that both on the part of the Fed and on the part of markets, we end up with a smooth scenario.

But, we could end up in an adverse, bumpy scenario, and because we don't know what the future is going to be like, that is why it is important that policymakers already prepare and try to prevent the potential complications that could arise from a less orderly unraveling of the present financial market excesses.

QUESTION: (In Spanish; no interpretation provided).

Mr. Viñals: Yes, the liquidity illusion is a very important issue that we have flagged.

Regarding banks, before the crisis banks did many things which they should not have done, and even recent discoveries have told us that some inappropriate practices have continued up to recently and that is something which should not have happened, and that should be discontinued right away. As we keep emphasizing in the report, banks need to think that the present situation of very easy financial conditions, monetary conditions, in terms of the funding they get, will not be there in the future, and they need to adapt to this new reality. So, that is more of an issue in advanced economies than emerging markets, but let's not forget that a key role of banks in a market-oriented economy is to support economic growth by providing sufficient financing for the real economy. And, you're right, perhaps before the crisis there were too many resources devoted by banks to financing activities which were inappropriate, which were not reasonable, which were growing too fast, which were not prudent, and also banks engageg in a lot of practices with vehicles which at the end of the day did not serve the purpose of the real economy. And that is a focus of the report. Banks should be strong, and they should refocus the business models so as to provide more lending to the economy because that is needed.

QUESTION: You talk about the necessary changes in the business model of banks in Europe, especially, but what you expect to be the trigger of those changes? Do you expect the banks to do that spontaneously? Would you say that there is a need for some regulatory reforms? As you know there is now a European law in the pipeline about the changes needed in the structures of banks. Is that the right fix for this business model issue?

And second, you talked about consolidation, but you didn't say a word about too big to fail, too complex to resolve issue. Is that not a problem anymore? Are very large banks still a problem for financial stability or not?

Mr. Viñals: Let me tackle at least part of the question, and then my colleague on the right may complement what I would say.

I think that in Europe things go in stages. I think it is very important that the comprehensive assessment is finalized. That is something which is going to happen -- the purpose of it is to bring transparency and to enhance confidence in European banks. And, we're looking forward to the publication of the results later in the month, to be done in a way that achieves this end.

The fact that you are going to have a single supervisor at the European level for banks, with strong powers, without national biases, the fact that you are going to have a framework like the bank recovery and resolution directive, like the single resolution mechanism, like the single resolution fund, all of this is a framework that was not there before, and which is there in order to help resolve banks. And, I am confident that with a better, higher-quality supervisory framework at the European level, and with a strong framework for resolution, this is something which is going to be very helpful for banks to move forward in all of the dimensions that we're talking about in the report.

Now, regarding the too-big-to-fail issue, the question is, how much has been done and what remains to be done. I think that this is an issue which is not yet settled, I prefer to talk about too important to fail rather too big to fail because it is not size that matters, it is size and many other things, such as complexity, interconnectedness, etcetera. But there have been important steps taken by agreeing on systemic capital surcharges on systemically important banks at the global level. And, now there is a process also to do that with domestically systemically important banks.

There is a supervisory framework which is being put in place in order to exercise more intense supervisory scrutiny on systemically important banks, but there are issues that still need further advancement. For example, the so-called living wills, the recovery and resolution plans for individual institution, they need to be finalized and implemented. You also need to make more progress on the issue of resolution, national frameworks, which can achieve more effective and efficient resolution.

Cooperation to deal with cross-border resolution, what happens when you have banks which operate in different countries and they need to be resolved, and ensuring that systemically important banks at the global level have sufficient loss absorption capacity in the case of resolution, all of this is part of the regulatory initiatives which are being developed but which yet have to be implemented. So, progress is being made, but the regulatory reform agenda has not yet been completed.

Mr. Jones: Regarding your question about whether banks will do this voluntarily, in some sense they will because equity markets will reward banks that are able to make changes in their business models and generate sustainable levels of capital on an ongoing basis. Regulators also have a role to play in terms of facilitating mergers and acquisitions of weaker banks across borders. They also can encourage banks to avoid cross subsidizing different business lines and to ensure that banks business models are aligned appropriately to the risks they are taking.

They can also ensure that the weak tail of banks has been in a sense artificially suppressing the returns in the banking system, are cleaned up, and that may involve some banks exiting altogether. So there are a number of steps that regulators can take to encourage that process and to facilitate that process. And also financial markets will encourage that through the natural rewards of making capital raising easier for banks that have better business models and more viable business models. So, both financial markets and the supervisors have a role to play in ensuring that this happens in a smooth process.

Ms. Stankova: Let me take another question from online, which is:

What is your assessment of the state of the shadow banking in China?

Mr. Jones: On China, I think the ongoing challenge is really to find the right mix of policies to reduce the debt related vulnerabilities while maintaining adequate growth. I think in terms of the shadow banking system, the authorities have taken a number of measures to make progress to reduce the risks in the shadow banking system such as the tighter regulation of trusts that has happened in wealth management products and some of the restrictions on interbank activity. But, the growth of non-bank lending has decelerated as a result, so that is a positive development, and growth remains strong. So some vulnerabilities continue to be accumulated.

The policy recommendations that we have in the report are both for the authorities to continue to monitor and contain the rapid growth in leverage in the corporate sector, and also particularly in the real estate and construction sectors where declining profitability and cash flows have become an issue. But more broadly, to help rebalance credit allocation toward more productive areas in the economy, and this requires a more efficient risk pricing in the financial system, a gradual rolling back of the implicit guarantees, and a gradual increase in the default of nonviable firms.

So building on these current policy efforts that they have already taken, we see further steps that would be helpful to introduce into the financial system and ensure proper regulation of the shadow banking system.

Ms. Stankova: Thank you. With this we conclude the press conference.


domingo, octubre 12, 2014



Tocqueville Gold Strategy Investor Letter

Third Quarter 2014

John Hathaway
Portfolio Manager and Senior Managing Director

Through September 30, the $US gold price declined 6%, after giving up much of the stronger gains that had been achieved through most of the year. The recent bout of weakness began in late August and coincided with the breakdown of the Yen and the Euro vs. the US dollar.

Commentary from all quarters is aggressively negative. Technical analysts are virtually unanimous in their bearishness. On a near term basis, this looks and feels like a bottom to us. On a longer term view, we are more bullish than ever.

Notwithstanding near term weakness in the gold price, most of our key holdings in the gold mining sector have managed decent gains, compared to a 2.78% decline for our XAU benchmark. We attribute our positive performance to our selection of well managed companies which are able to create value independently of gold price action. Value creation can come about in many ways, including accretive merger and acquisition activity, progress in the construction of new mines, or successful exploration. We continue to believe that investing in the securities of well managed gold mining companies offers the most dynamic and reliable exposure to the upside potential in the gold price. Our research activity and portfolio selection is based on emphasizing the value creators in the sector and avoiding the value destroyers.

The long term fundamentals for gold are stronger than ever, in our opinion. Overt currency debasement is the chosen path in Europe and Japan. The race to the bottom in these currency wars is not limited to our trading partners. In a recent article, Kenneth Austin, former chief economist for the Obama administration, calls for an end to US Dollar reserve status, seeing it as a drag on domestic growth. The use of the Chinese Renminbi to settle trades away from the dollar has grown dramatically in recent years. In the first half of 2014, the Bank of China cleared RMB payments equivalent to an impressive $18.3 trillion, double the previous year.

The formation of institutions such as the new BRICs Bank and the Shanghai Gold Exchange enable participants to circumvent the $US and US financial institutions in the conduct of trade. The Chinese Central Bank has opened 1200 non-Chinese interbank clearing accounts to settle trades in Renminbi. In September, Britain announced plans to issue a Renminbi denominated bond. These are perfectly logical developments given the size of the Chinese economy and do not in and of themselves foreshadow a decline in the dollar. However, the advance of the Renminbi as a reserve currency does raise the question as to what central banks will do with a potentially huge surplus of dollars.

The US dollar strength that has been credited for the weakness in gold is in our opinion both an illusion and a misconception. The “strength” reflects only weakness of alternate reserve currencies and flight of speculative capital. We believe the condition to be of limited duration both long and short term. CFTC speculative trader dollar longs stand at a 15 year high, an extreme that typically marks an inflection point. The misconception is the notion that the dollar and gold trade inversely. The correlation coefficient between the dollar index and $US gold is only a weak .3389 since 12/31/03. The chart below demonstrates that the relationship between the gold price and the dollar index is quite tenuous.

The “strong” dollar, should it persist, will represent a dilemma for policy makers and politicians in the form of undesired deflationary pressures spanning the globe. For example, the weak yen threatens Chinese economic strength. Should that result in a round of currency debasement throughout Southeast Asia, the effect would be analogous to global monetary tightening via exchange rates, as suggested in a September note by Albert Edwards of SocGen.

Since the financial crisis of 2008, global leverage is greater than ever, both relative to GDP and in absolute terms. Global debt has increased 40% since 2008 versus a 22% increase in global GDP. The increased debt burden is manageable only because interest rates are at record lows. A rise in interest rates would in our opinion cause severe damage to financial assets, whose valuations have been inflated by money creation and zero rate of interest for risk free assets.

Financial assets are valued based on discounted cash flows. In the ultra-low interest rate environment, what are the chances that the discount rate will decline from here? We suspect this could happen only if a collapse of expected earnings was foreseen. The prospect of higher rates would also create havoc, in our opinion, for credit quality. We believe that three things must happen to not upset the very unstable applecart in which financial asset values reside: 1) the pace of global growth must increase meaningfully; 2) debt issuance must stabilize; 3) inflation must remain tame. We also believe that the odds of achieving this trifecta are non-existent.

The just published 16th report on the global economy by The International Centre for Monetary and Banking Studies warns of “a poisonous combination of high and rising global debt and slowing nominal GDP….Contrary to widely held beliefs, the world has not yet begun to de-lever and the global debt to GDP ratio is still growing and breaking to new highs (160% in 2001; 200% in 2009; and 215% in 2013).”

Strong equity markets have been the major headwind for gold over the past three years, in our view. Who needs financial insurance when the weather is clear? Zero interest rates fostered by central bankers have forced money into risky and illiquid assets stretching valuations of lower quality categories to near record levels. Three years of positive returns have resulted in investor complacency.

Lofty financial asset valuations are not the only issue. What if fundamentals, economic growth and rising corporate earnings, begin to deteriorate? What if the Fed, intent on staying the course, begins to tighten into economic weakness? There are numerous examples of spreading economic weakness in the U.S. including recent soft data for housing, retail, and durable goods. Europe, already struggling, is facing increased headwinds from economic sanctions on Russia.

The gold/silver ratio has broken above a multiyear top of 68 and now stands at 71.3. As with credit spreads, this ratio is often a reliable signal of impending economic contraction. The behavior of this indicator is consistent with the persistent weakness of commodity prices. Credit spreads have begun to widen as well.


Expanding earnings and valuations, the underpinnings of the four year bull market in financial assets, may be approaching an inflection point. A reversal of this cycle would in our opinion restore interest in gold.

Sentiment indicators are at rock bottom levels. The Ned Davis Gold sentiment index has dropped to “0”, a level approached only once in the past eight years. Over the past 20 years, readings below 35 have reliably been followed by rallies. The Hulbert Gold Newsletter Sentiment Index currently stands at 46.9%, the second lowest reading in 30 years. These are cheery numbers to a contrarian, reminiscent of the low regard held for gold in the late 1990’s.

There is more than bleak sentiment going for gold. In our opinion, a gold supply crunch is around the corner. Headlines and front page stories on this are yet to come. Gold mining capital expenditures and exploration spending are in a virtual freeze mode. There have been almost no discoveries of large new gold ore bodies in the past 8 years. Ore grades are steadily declining and the world has become less hospitable in general to hard rock mining. We agree with Goldcorp CEO Chuck Jeannes’ prediction of peak gold production this year or next, to be followed by a multi-year decline. In our opinion, many producers are liquidating capital and reserves to tread water financially. We believe this will ultimately lead to a frenzy of takeovers, targeting both explorers and developers, the back bone of our portfolio. The Osisko takeover battle earlier this year exemplifies what we believe lies ahead.

Another noteworthy development is the accelerated flow of gold bars from vaults in Western financial capitals to Asia and especially China. The magnitude of this shift can only be approximated and probably understated by official import statistics. A recent note by Na Liu of CnC China offers convincing arguments that 2013 Chinese demand was twice the 1000 tonnes reported by the World Gold Council and the China Gold Association, based on withdrawals from the Shanghai Gold Exchange. It must be noted, according to Mr. Liu, that none of the withdrawals from the SGE are accounted for by official sector demand. The puzzle of robust demand for physical gold accompanied by a declining gold price can in our opinion be understood only as a massive destocking by Western investors resulting in the transfer of bars from vaults in Western financial capitals to their counterparts in Asia. If Chinese consumption has been seriously underestimated as suggested here, the physical market is much tighter than conventionally believed. Therefore, only a modest reawakening of interest by Western investors could have an outsized impact to the upside.

The launch of the Shanghai Gold Exchange on September 18th is, in our opinion, emblematic of China’s intent to become a major force in the bullion market. In an editorial published July 30, 2014, Song Xin, President of the China Gold Association and Party secretary, stated that China should accumulate 8500 tonnes in official gold reserves, and that accumulation of the metal for official and private use was a matter of national interest. For reference, 8500 tonnes would require more than three years of global mine supply. Song’s predecessor had previously published an article in Quishi magazine (2012), the main academic journal of the Chinese Communist Party’s central committee which included the following passage:

 The state will need to elevate gold to an equal strategic resource as oil. Currently, there are more and more people recognizing that “gold is useless” story contains too many lies. Gold now suffers from a “smokescreen” designed by the US, which stores 74% of official gold reserves, to put down other currencies and maintain the US Dollar hegemony. Going to the source, the rise of the US dollar and British pound and later the euro currency, from a single country currency to a global or regional currency was supported by their huge gold reserves.

 Individual investment demand is an important component of China’s gold reserve system, we should encourage individual investment demand for gold. Practice shows that gold possession by citizens is an effective supplement to national reserves and is very important to national financial security.

This is a clear statement of China’s objective to elevate the Renminbi to reserve currency status, employing in part a strong backing of physical gold, if achieved, will dislodge the US dollar as a dominant reserve currency and in our opinion cause a significant re-pricing of the metal in US dollar terms. We do not believe that this outcome is what the bullish US dollar camp has in mind. The aggressive divestiture of gold by Western investors has been of immense assistance to Chinese ambitions. As suggested by Alan Greenspan in the latest issue of Foreign Affairs, the accumulation of a sizable gold reserve is a low risk, high reward path for China to offset the risk that their $4 trillion in foreign exchange reserves will be debased by their respective issuers.

We take comfort that our positive view of the future dollar gold price is shared by those who understand the difference between synthetic and physical metal, and who regard the real substance as a matter of strategic imperative, not as plaything for macro traders. We believe that China’s negative assessment of the future prospects for the US dollar is correct and that our investment strategy of investing in the shares of value creating gold miners offers sensible and dynamic exposure to the inevitable re pricing of gold in US dollars.


Mr. Erdogan’s Dangerous Game

Turkey’s Refusal to Fight ISIS Hurts the Kurds


OCT. 8, 2014

Turkey’s president, Recep Tayyip Erdogan, once aspired to lead the Muslim world. At this time of regional crisis, he has been anything but a leader. Turkish troops and tanks have been standing passively behind a chicken-wire border fence while a mile away in Syria, Islamic extremists are besieging the town of Kobani and its Kurdish population.
This is an indictment of Mr. Erdogan and his cynical political calculations. By keeping his forces on the sidelines and refusing to help in other ways — like allowing Kurdish fighters to pass through Turkey — he seeks not only to weaken the Kurds, but also, in a test of will with President Obama, to force the United States to help him oust President Bashar al-Assad of Syria, whom he detests.

It is also evidence of the confusion and internal tensions that affect Mr. Obama’s work-in-progress strategy to degrade and defeat the Islamic State, the Sunni Muslim extremist group also called ISIS or ISIL. Kurdish fighters in Kobani have been struggling for weeks to repel the Islamic State. To help, the Americans stepped up airstrikes that began to push the ISIS fighters back, although gun battles and explosions continued on Wednesday.
But all sides — the Americans, Mr. Erdogan and the Kurds — agree that ground forces are necessary to capitalize on the air power. No dice, says Mr. Erdogan, unless the United States provides more support to rebels trying to overthrow Mr. Assad and creates a no-fly zone to deter the Syrian Air Force as well as a buffer zone along the Turkish border to shelter thousands of Syrian refugees who have fled the fighting.

No one can deny Mr. Assad’s brutality in the civil war, but Mr. Obama has rightly resisted involvement in that war and has insisted that the focus should be on degrading ISIS, not going after the Syrian leader. The biggest risk in his decision to attack ISIS in Syria from the air is that it could put America on a slippery slope to a war that he has otherwise sought to avoid.

Mr. Erdogan’s behavior is hardly worthy of a NATO ally. He was so eager to oust Mr. Assad that he enabled ISIS and other militants by allowing fighters, weapons and revenues to flow through Turkey. If Mr. Erdogan refuses to defend Kobani and seriously join the fight against the Islamic State, he will further enable a savage terrorist group and ensure a poisonous long-term instability on his border.
He has also complicated his standing at home. His hesitation in helping the Syrian Kurds has enraged Turkey’s Kurdish minority, which staged protests against the Turkish government on Wednesday that reportedly led to the deaths of 21 people. Mr. Erdogan fears that defending Kobani would strengthen the Syrian Kurds, who have won de facto control of many border areas as they seek autonomy much like their Kurdish brethren in Iraq. But if Kobani falls, Kurdish fury will undoubtedly grow.
The Americans have been trying hard to resolve differences with Mr. Erdogan in recent days, but these large gaps are deeply threatening to the 50-plus-nation coalition that the United States has assembled. One has to wonder why such a profound dispute was not worked out before Mr. Obama took action in Syria.

Putin Seeks Solitude Amid Russia's Perfect Storm 

Russian President Vladimir Putin celebrated his 62nd birthday Tuesday in a peculiar fashion: by himself in the Siberian forests. For the past few days, Putin's spokesman, Dmitri Peskov, has brushed off journalists' questions about why the president decided not to celebrate his birthday in Moscow or do other work as he has in previous years. This is just another odd piece to an increasingly complex puzzle surrounding the stability and future of the Russian president and his government.

Current Instabilities

Russia is in the eye of the perfect storm. Though the crisis with Ukraine has been reduced to a simmer, Russia has seen a strategic reversal in its critical borderland. In addition, the crisis moved the West to enact sanctions on Russia and loosen many financial and economic ties to the country. Now the Kremlin is in the midst of an economic crisis that is every bit as serious as the Ukraine situation.

In the past two days, Russia's central bank used $1.6 billion of its currency reserves to shore up the Russian ruble. Since the start of 2014, the central bank has injected $51 billion in currency reserves to keep the currency stable. The Russian economy is projecting flat growth for 2014, while foreign investment into Russia has fallen by 50 percent. The Kremlin may have $630 billion in its reserves, but these funds are being used quickly in an attempt to fill the cracks.

Concerns over Russia's financial stability have erupted into public battles between the various Kremlin factions. On Tuesday, Russian Finance Minister Anton Siluanov, a key figure in the liberal economic clans, publicly called on Putin to cut Russia's ambitious defense spending program. Russia is set to start a 10-year, $770 billion defense rearmament program in 2015.

Siluanov reportedly rejected the plan during recent budget drafts in September, prompting Putin to move decision-making on defense spending under his office and away from the Cabinet.

While Siluanov's argument against defense spending is financial, Putin also has to consider the security and political ramifications of such a decision. Russia's continued struggles in its borderlands will require a robust military. Moreover, Putin is using the defense budget to appease Russia's various security and defense circles.

The Rise and Fall of Russian Leaders

Though Putin has ruled Russia for 15 years in a centralized and autocratic fashion, like any other leader he must balance various factions within the country. His ability to manipulate the various political clans is what brought him to power. The lack of that ability is what caused the downfall of Boris Yeltsin in the 1990s, and many leaders before him. Yeltsin was unable to manage the competition between his own loyalists, the more liberal circles of economists and the security and defense circles. Yeltsin wildly shifted policies in order to retain a grip on power, such as his economic shock policies and the restructuring of the Federal Security Services. Such erratic moves contributed to the Russian economic crash, the breakdown of the security services and the erosion of Russia's military as it fought a savage war in the North Caucasus.

Yeltsin's stumbling enabled Putin's rise to power. Putin understood that a Russian leader could rule only as long as he could balance the competing groups. Putin is a former KGB agent, tying him into the security circles, while his knowledge of Russia's need for Western technologies gives him an understanding of the more liberal economists. In his first years in power, Putin divided Russia's assets and tools of power between the clans, keeping them in constant competition and positioning himself as the ultimate arbitrator.

The problem now is that the clan system has begun to crumble. The security circles are being blamed for failures in Ukraine, while the liberal economic circles are being blamed for the sour economy. Many personalities and groups are putting their own positions (and financial revenues) before the betterment of the state. Putin continues to try to maintain balance, as seen in the recent weeks of budget debates between the liberals and security circles. But Putin's 15 years of success at balancing the clans came during times of rebuilding and resurging for Russia. Now, Putin is attempting to find balance from a position of weakness.

Putin's grasp on power is not easy to gauge from outside the Kremlin. The decision for new leadership is made within the Kremlin walls, not among the people. Previous Russian leaders, from Nikita Khrushchev to Leonid Brezhnev to Yeltsin, were removed or pushed aside by the ones closest to them. Thus, it seems fitting that the current Russian leader chose to celebrate his birthday far from the Kremlin and its clans.