Financial Crises: Lessons from the Past, Preparation for the Future

Chapter 6. Financial Risks Ahead: Views from the Private Sector

 Financial Risks Ahead Views from the Private Sector 6 One of the unique characteristics of the annual World Bank–Brookings conference is that it brings together academic scholars and practitioners from the “real world” to discuss developments in emerging-markets finance. This year’s conference featured a panel of three practitioners with expertise in the field: David Wyss, chief economist of Standard & Poor’s; Don Hanna, managing director and global head of emerging markets economic and market analysis of Citigroup; and Khalid Sheikh, senior vice president of ABN Amro Bank. A summary of their views and their responses to some questions from the participants follows. David Wyss led off the panel by noting that the general ratings environment is currently very favorable. Country ratings are at their historical best. Of the 107 countries being rated, more countries are rated investment grade than ever before; a record number of countries received upgrades in 2004; and few country governments have defaulted on their debt. Rating emerging economies is a relatively new phenomenon. But with ratings, more countries have access to the international bond market. More than half of the rated countries now issue investment-grade debt. Wyss acknowledged that ratings are not perfect, but he contended that they still are fairly reliable. For example, over the long run, CCC bonds have a 45 percent default rate, whereas A bonds default less than 2 percent of the time. The default rate rises sharply as ratings decline. Investors currently tend panel discussion to view lending money very favorably, because the economic environment is generally healthy, they have short memories, and they are searching for higher yields in a world of low interest rates. All the major industrial countries (with the exception of Japan) have bond yields of around 2 to 3 percent, which is a very benign environment. Growth rates have not displayed the same degree of convergence, with a noticeable split between high-growth “Anglosphere” countries and low-growth continental European countries. With respect to Europe in particular, concerns remain over the extent and number of the long-term unemployed. Wyss believes that many of them will be difficult to reintegrate into the work force. The benign interest rate environment may be coming to an end, with the Federal Reserve’s steady lifting of short-term interest rates. However, Wyss expected the “Fed funds” rate to be between 4 and 4.5 percent by the end of 2005. Wyss also believed that the record-low yields on speculative-grade bonds were not sustainable. Normal default rates on such bonds are 3.5 percent , which Wyss argued is inconsistent with the 3 percent yield spread on those bonds (relative to safe government bonds) prevalent at the time of the conference. Wyss pointed to another anomaly: sovereign debt is being priced at interest rates that are similar to those on speculative corporate bonds. Sovereigns used to have a small advantage, the disappearance of which could indicate decreased awareness of default risk. Wyss suggested that, despite media stories to the contrary, the U.S. budget deficit is not out of line with the deficits of other industrial countries, taking account of growing social security obligations. Indeed, Japan is already beginning to run into pension financing problems. He was much more concerned about the U.S. current account deficit, both because it is larger than the fiscal deficit and because he does not see what mechanism will lead to a substantial reduction of the trade gap. Normally , trade deficits are reflected in exchange rate declines, which already has happened, with the dollar falling against the euro. But in other countries that are growing slowly and where much of that growth is from exports, governments have intervened in foreign exchange markets to keep their currencies cheap relative to the dollar. This exchange rate policy began when the United States had a fiscal surplus and has continued now that the United States has a budget deficit. The essential problem is that every other country agrees that the U.S. deficit is too large, but no country seems to want to allow its currency to appreciate and thereby curtail its exports.    The U.S. trade deficit may, in fact, continue longer than most people expect. The U.S. state of New York, for example, has had a trade deficit with the rest of the United States for 200...