2016 03 gic j sicilia vf

Central Banking Series: Inflation Expectations, Implications & Policy Response in a New Paradigm for Commodities in partnership with the Banque de France

Paris – March 21, 2016

Financial markets, world economy and monetary policy at a crossroad: a few comments

Jorge Sicilia

BBVA/Chief Economist

GIC March 2016

Page 2Central Banking Series: Inflation Expectations, Implications & Policy Response in a New Paradigm for Commodities ‐ Paris – March 21, 2016

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Financial tensions trending upwards and repeated episodes of financial turmoil raise concerns

Asset performance in terms of risk/return: Lehman crisisSource: MSCI & Bloomberg

BBVA Research Financial Stress Index: Emerging markets and Developed Markets (normalized Index) Source: BBVA Research based on Bloomberg data

LehmanBrothers

Taperingtalks

Chinese’sconcerns

European sovereigndebt crisis

Bank’sconcerns

GIC March 2016


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More so when tensions spread to the banking sector in developed markets

Asset performance in terms of risk/return: Lehman crisisSource: MSCI & BloombergBBVA Research Financial Stress Index, Bank credit risk component:

US and EZ (normalized Index) Source: BBVA Research based on Bloomberg data

LehmanBrothers

Taperingtalks

Chinese’sconcerns

European sovereigndebt crisis

Bank’sconcerns

GIC March 2016


Is it the threat of risk scenarios going forward in this new world?

What can we read from recent developments in financial markets?

Very likely! Uncertainty about China and persistent low oil prices raised the risk of second round effects of the current environment that could become self-fulfilling…Together with policy actions and inactions....

Is it a downward revision of the baseline global outlook?

Not likely, the downside revisions have been mild and indicators are not pointing to a recession

Asset performance is radically different under the baseline and the risk scenarios. Changes in probabilities assigned to both scenarios have the potential to generate this market behavior

GIC March 2016


Asset performance in terms of risk/return: 2009-2015 Source: MSCI & Bloomberg

7-10Y Euro

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Equity Euro (MSCI index)

Equity US (MSCI index)

Equity LatAm (USD) (MSCI

index)

Cred. EMs (USD)

Sov EMs (USD)Corp US (7-10Y)

Corp Euro (7-10Y)

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Performance

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Future

Bearish MarketBullish MarketAsset performance in terms ofrisk/return: 2009-2015 Source: MSCI & Bloomberg


Markets are wondering and wandering between two scenarios: Where do we go in terms of risk/return?

GIC March 2016


How worried should we be about this risk scenario? World GDP growth remains low and fragile


World GDP(*) quarterly growth, short-term forecasts based on BBVA-GAIN (QoQ %) Source: BBVA Research and IMF

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Average 2011-15

Annualized rate: 2,6%

Growth forecasts for 2016 are of around 3%, and over 3% in 2017

GIC March 2016


Risks are higher, and mainly to the downside

Emerging Economies

Hard choices in a tougher

background (Oil prices fall and

Flow rebalancing)Source: BBVA Research

Europe“Brexit”, Banking

Union

Geopolitical Risks: (and

refugees crisis)

ChinaHard landing, policy errors

Rising Holding steady Lower

Slowdown in the US?

Market volatility

GIC March 2016


Overwhelming majority that conditions are deteriorating, to what extent?

Asset performance in terms of risk/return: Lehman crisisSource: MSCI & BloombergFrom the “fear” approach… ... To the “hope” approach

Lead among others by the BIS (is this view increasingly shared by the IMF?) that alert about the risks given the underlying economic vulnerabilities:

• High leverage• Low productivity• No room of maneuver

Still shared by G20, central banks and independent observers, but increasingly alert:

• G20: “the global recovery continues but downside risks and vulnerabilities have risen”

• IMF: “global recovery has weakened […] higher risks […] urgency of a broad-based response”

• Fed ” global economic and financial developments continue to pose risks”.

• ECB ” providing substantial monetary stimulus to counteract heightened risks”

• Independent observers: “the world need a reality check from financial panic”, A. Posen, PIIE

GIC March 2016


Over longer horizons, there are little reasons to expect growth rates higher than “old normal” 3.5%...Economic Growth (annual change, %)

GDP, YoY, % 80's expansion 90's soft patch 90's soft

expansionPatch and rebound 00's expansion Crisis and rebound Anemic

expansionWorld 3.8 2.6 3.7 3.7 4.4 3.2 3.3DM 3.9 1.7 3.2 3.5 2.4 0.5 1.7EM 3.8 3.9 4.4 4.0 6.6 5.5 4.4Source: BBVA Research, IMF

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00's Expansion Crisis and Rebound AnemicExpansion

The BIG REBALANCING

WORLD DM EMSource: BBVA Research forecasts

GIC March 2016


Outstanding Debt (*)(% GDP)

…and probably less considering the high debt levels in a very low inflation environment

(*) Source: BIS, IIF

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GIC March 2016


Financial tensions is already having a toll on economic activity


Increasing financial tensions (since last summer to now) are already having an impact on GDP growth (transitory shock) mainly in EM while negligible for DM

If sustained at current levels (permanent shock) financial stress might have major impact across the board, especially in EM

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Transitoryshock

Permanentshock

USEZEM (*)

(*) estimated impact just for a sample of countries, mainly Latamcountries

Estimated impact of financial tensions on GDPTransitory and Permanent shock Source: BBVA Research

GIC March 2016


(*) BBVA Research Global volatility index constructed using analysis component from principal components of financial variables, including 10years bond yields, exchange rates, stock exchange index for developed and emerging markets.For more detail see https://www.bbvaresearch.com/wp-content/uploads/2015/01/GVI_ING.pdf

Volatile financial markets are unwanted Asset performance in terms of risk/return: Lehman crisisSource: MSCI & Bloomberg

Estimated impact of higher volatility* on world GDP Source: BBVA Research

Volatility in financial markets by itself could also have a major impact on growth: assuming a “risk” scenario where volatility spikes (less intense than LB, 30% but more persistent -about 2 times its duration-), world GDP growth could be affected by around 1 percentage point

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GIC March 2016


Central banks, the art of adjusting their strategy in real time trying to avoid unintended consequencesAsset performance in terms of risk/return: 2009-2015 Source: MSCI & Bloomberg


The deeper the central banks go in this direction, the more debate will arise over the unintended consequences of such policies• Uncertainty about how long can

they go (in magnitude and duration)?• Impairment of the monetary policy

transmission mechanism• Concerns on bank profitability• Global spillovers through exchange

rates • Tail risks (of bank runs)• Counterfactual analysis?

The case of negative rates

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Official interest rates in some developed central banks (Refi and depo rates)Source: BBVA Research

GIC March 2016


Asset performance in terms of risk/return: 2009-2015 Source: MSCI & Bloomberg


The ECB is increasingly focus on credit easing.

TLTROs improve financial condition for banks: dissipates funding risks and counterbalances the impact of negative interest rates on banks’ profitability.

The impact on the amount of creditto the real economy is uncertain.

The welcome shift of ECB’s strategy, ” from rates instruments to other, non/conventional instruments ”.

Risk perception in the EZ: Peripheral risk premia and Banks ITRAXX- index CDS (bps)Source: BBVA Research

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Central banks, the art of adjusting their strategy in real time trying to avoid unintended consequences

GIC March 2016


Challenges ahead are huge. Important question marks remains open.


Monetary policy ammunition and coordination: • Central banks, do they have ammunition left?• How could monetary policy be combined with other (most structural) policies?

Can we have a design that avoids fiscal dominance? Helicopter money, if it were legal, how could it be designed?

• Should central banks consider their international responsibility beyond their domestic mandate? [Rajan proposal]

“Financial repression”• How long can it be maintained?• Combined with digital innovation could it foster financial desintermediation?• Is credit quality endogenous to low interest rates?

Central Banking Series: Inflation Expectations, Implications & Policy Response in a New Paradigm for Commodities in partnership with the Banque de FranceParis – March 21, 2016

Jorge Sicilia, Chief Economist BBVA Research

Financial markets, world economy and monetary policy at a crossroad: a few comments

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2016 03 gic j sicilia vf