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

Financial tensions trending upwards and repeated episodes of financial turmoil raise concerns Asset performance BBVA Research Financial Stress Index: Emerging markets andin terms of risk/return: Lehman crisis Developed Markets (normalized Index) Source: MSCI & Bloomberg Source: BBVA Research based on Bloomberg data

6 5

Lehman Brothers

4

European sovereign debt crisis Chinese’s concerns

3 2

Bank’s concerns

Tapering talks

1 0 -1 -2 Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Developed

Mar-13

Mar-14

Mar-15

Mar-16

Emerging

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

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GIC March 2016

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

Asset performance in of risk risk/return: Lehman crisis BBVA Research Financial Stress Index, Bankterms credit component: Source: MSCI & Bloomberg

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

6 5

Lehman Brothers

4

European sovereign debt crisis

3 2

Tapering talks

Chinese’s concerns

Bank’s concerns

1 0 -1 -2

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16

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

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GIC March 2016

What can we read from recent developments in financial markets?

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

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

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....

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

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GIC March 2016

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

Asset performance in Bullish Market 2009-2015 terms of risk/return:

?

Source: MSCI & Bloomberg

Bearish Market

Asset performance in terms of risk/return: 2009-2015

Asset performance in terms of risk/return: Lehman crisis

Source: MSCI & Bloomberg

Source: MSCI & Bloomberg

30

70

Equity LatAm (USD) (MSCI index)

60

Equity Euro (MSCI index)

Volatility

20

50

15

Equity US (MSCI index)

10

7-10Y Bonds 7-10Y Bonds US Euro

5

Sov EMs (USD) 0

5

10 Performance

Equity US (MSCI index)

40 Equity Euro (MSCI index)

30

Cred. EMs (USD)

20

Corp US (7-10Y)

Cred. EMs (USD)

Corp Euro (7-10Y)

0

Volatility

25

Equity LatAm (USD) (MSCI index)

15

20

Future 25

10

Corp Euro (7-10Y)

Corp US (7-10Y)

0 -80

-60

-40

7-10Y US

Sov EMs (USD) 7-10Y Euro

-20

0

20

Performance 9/05/08 - 6/03/09

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

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GIC March 2016

How worried should we be about this risk scenario?

World GDP growth remains low and fragile Asset performance World GDP(*) quarterly growth, short-term forecasts based onin terms of risk/return: Lehman crisis BBVA-GAIN (QoQ %) Source: MSCI & Bloomberg

Source: BBVA Research and IMF

1,6

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

1,4

1,2

Average 2000-07 1,0

0,8

Average 2011-15

0,6

Annualized rate: 2,6% 0,4 Jun-09

Mar-10

Dec-10

Sep-11

Jun-12

Mar-13

Dec-13

Sep-14

Jun-15

Mar-16

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

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GIC March 2016

Risks are higher, and mainly to the downside Slowdown in the US?

Market volatility

Emerging Economies Hard choices in a tougher background (Oil prices fall and Flow rebalancing) Source: BBVA Research

Europe “Brexit”, Banking Union

China Hard landing, policy errors

Geopolitical Risks: (and refugees crisis)

Rising

Holding steady

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

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GIC March 2016

Overwhelming majority that conditions are deteriorating, to what extent?

Asset performance in terms of risk/return: Lehman crisis

From the “fear” approach…

MSCI & Bloomberg ... To theSource: “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:

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

• • •

•

High leverage Low productivity No room of maneuver

• •

• •

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

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

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GIC March 2016

Over longer horizons, there are little reasons to expect growth rates higher than “old normal” 3.5%...

Economic Growth (annual change, %) 8 6 4 2 0 -2 -4 83 84 85 86 87 88 89 90 80's Expansion

91 92 93

94 95 96 97

98 99 00

90's soft patch 90's soft Expansion

01 02 03 04 05 06 07

Patch and Rebound

00's Expansion

08 09 10 11 12

13 14 15 16 (e) (f)

Crisis and Rebound

Anemic Expansion

The BIG REBALANCING

Source: BBVA Research forecasts

WORLD

GDP, YoY, %

80's expansion

90's soft patch

World

3.8

2.6

DM EM

3.9 3.8

1.7 3.9

90's soft expansion

DM

EM

Patch and rebound

00's expansion

Crisis and rebound

Anemic expansion

3.7

3.7

4.4

3.2

3.3

3.2 4.4

3.5 4.0

2.4 6.6

0.5 5.5

1.7 4.4

Source: BBVA Research, IMF

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

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GIC March 2016

…and probably less considering the high debt levels in a very low inflation environment Outstanding Debt (*) (% GDP) Mature markets

Emerging Markets 150,0

150,0

Households Non-fin corporates Government Financial Corporates

125,0

125,0

100,0

100,0

75,0

75,0

50,0

50,0

25,0

25,0

0,0

0,0

Households Non-fin corporates

Jun-15

Jun-11

Jun-07

Jun-03

Jun-99

Jun-15

Jun-11

Jun-07

Jun-03

Jun-99

Jun-95

Financial Corporates

Jun-95

Government

(*) Source: BIS, IIF

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

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GIC March 2016

Financial tensions is already having a toll on economic activity Estimated impact of financial tensions on GDP

Asset performance in Increasing financialLehman tensions (since terms of risk/return: crisis

Transitory and Permanent shock

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

Source: MSCI & Bloomberg

Source: BBVA Research

Permanent shock

US EZ EM (*)

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

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

Transitory shock

-1,5

-1,0

-0,5

0,0

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

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GIC March 2016

Volatile financial markets are unwanted Asset performance in Estimated impact of higher volatility* on world GDP Source: BBVA Research

terms of risk/return: Lehman crisis

25.0

Source: MSCI & Bloomberg

20.0

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

15.0 10.0 5.0 0.0 -5.0 -10.0 08

09

10

11

12 Risk

13

14

15

16

17

18

Base

(*) 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

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

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GIC March 2016

Central banks, the art of adjusting their strategy in real time trying to avoid unintended consequences Asset performance in Official interest rates in some developed terms of risk/return: central banks (Refi2009-2015 and depo rates) Source: MSCI & Bloomberg

Source: BBVA Research 6 5 4 3 2 1 0

-1 -2 Mar-07

Sep-08

Mar-10 EZ

BoJ

Sep-11 SW

Mar-13 DEN

Sep-14 SWI

Mar-16

Asset performance in terms risk/return: Lehman crisis Theofcase of negative rates 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?

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

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GIC March 2016

Central banks, the art of adjusting their strategy in real time trying to avoid unintended consequences Asset performance in EZ: Peripheral risk Risk perception in the terms ofand risk/return: 2009-2015 index CDS (bps) premia Banks ITRAXX-

Asset performance in of ECB’s strategy, The welcome shift terms of rates risk/return: Lehman crisis ” from instruments to other,

Source: MSCI & Bloomberg Source: BBVA Research

Source: MSCI & Bloomberg

non/conventional instruments ”.

300

The ECB is increasingly focus on credit easing.

250 200

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

150 100 50 0 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16

Senior Bank debt Subordinated bank debt Peripheral risk premiun (avrg ITA SPA POR)

The impact on the amount of credit to the real economy is uncertain.

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

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GIC March 2016

Challenges ahead are huge.

Important question marks remains open.

Asset performance in Monetary policy ammunition and coordination: terms of risk/return: Lehman crisis • Central banks, do they have ammunition left?

Source: MSCI & Bloomberg • 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 ‐ Paris – March 21, 2016

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

Jorge Sicilia, Chief Economist BBVA Research