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 Remarks of Emil Henry, Assistant Secretary for Financial Institutions U.S. Department of the Treasury Before the Real Return III Conference




Paris, France- Thank you.  It is a great pleasure for me to be here today.  I would like to take this opportunity to review recent U.S. economic performance and to touch on some areas that have frequently been cited as potential risk factors for the U.S. economy going forward.


But before I address that topic, because this conference is dedicated to inflation-linked products, let me first say a few words about Treasury Inflation-Protected Securities, or TIPS.  TIPS offer investors a unique asset class � dollar-denominated, inflation-protected, and full faith and credit of the United States � that improves portfolio diversification.  TIPS are an asset for investors focused on the future real purchasing power of their savings, they offer low volatility and attractive returns, have a higher long-run correlation with inflation than real estate, commodities, or other real assets, and are a deflation floor ( i.e., investors don't receive back less than nominal principal value at maturity).

A natural demand base for TIPS has emerged as evidenced by the big and growing market for TIPS.  Currently, there are over $300 billion of TIPS outstanding and about $800 billion of inflation-indexed securities outstanding worldwide.  We do not announce future issuance ahead of time, but projections of issuance based on current auction sizes and frequencies would lead to TIPS as a share of the portfolio reaching 13% in 2011 (from 8% now).  In addition, liquidity in the TIPS market is improving. Daily turnover in TIPS has more than doubled in the past three years (2002-2005). 

Because of this strong demand, Treasury now offers maturities from one to ten years.  And issuance at the 5-year, 10-year and 20-year points demonstrates Treasury's commitment to the product as an integral part of its funding strategy. 

Recent Economic Performance

Let me now move on to the U.S economy and start with the good news.  I am pleased to report that U.S. economic performance is robust on so many levels.  The facts speak for themselves: 

  • The U.S. economy expanded at over 3.5 percent pace last year and registered 4.8 percent growth over the first quarter of this year.  Moreover, most forecasts anticipate further solid growth over the remainder of this year despite the headwinds we face from factors such as elevated energy prices and the devastation wrought by last year's hurricanes. 
  • The robust economic expansion has been accompanied by impressive job creation.  More than 5.1 million new jobs have been created since May of 2003; two million of them in the last year alone.
  • Unemployment is running at 4.7 percent � lower than the average for any decade since the 1950s � payrolls are rising, and household wealth is at an all-time high.
  • Productivity growth remains strong.  Output per hour in the non-farm business sector has risen at an average annual rate of 3.4 percent since 2001, faster than any five-year period in the 1970s, 1980s or 1990s. 
  • That productivity growth is feeding through to wages.  Inflation-adjusted hourly wages are in fact rising, growing 1.6 percent between September and December.
  • More Americans than ever now own their own homes.  As expected, we have seen some signs of slowing in the housing sector lately.  But we expect that activity in the housing sector will remain quite strong, buoyed by moderate long-term interest rates and rising incomes.
  • And our home values reflect underlying growth, liquidity and low interest rates.
  • The strength in the U.S. economy has boosted federal tax revenues; indeed, as Secretary Snow noted recently, it now appears that we are well ahead of schedule in moving toward President Bush's goal of cutting the federal deficit in half.
  • All of this has been achieved in an environment of low inflation despite rising energy prices.
  • As a result, judging from a range of financial indicators including stock prices and credit spreads, investors are quite optimistic about the future.

Debt and Deficits

As is often the case in a politically-charged environment, some observers have looked hard for cracks in our economic edifice.  In many cases, the critics have focused on the federal government's finances, specifically the nominal value of the federal debt. 

Of course, simply focusing on nominal magnitudes is highly misleading.  Most economists, for example, tend to focus on the ratio of debt to GDP as a more appropriate indicator of a country's debt burdens.   For the United States, debt held by the public amounted to 37 percent of GDP at the end of FY 2005.  This ratio is significantly lower than the average of 47 percent for the 1990s and has remained fairly stable since the Bush administration took office, ranging from 33 percent to 37 percent. 

Moreover, interest costs on federal debt as a percentage of GDP represented just 1.5 percent of GDP in FY 2005, well below the 3 percent average of the 1990s.  In fact, the average interest expense ratio since FY 2001 has been at the lowest level in more than 25 years.  

In short, federal debt and deficits relative to GDP for the United States are both in quite manageable ranges and are in no way a fundamental threat to the U.S. economy.  Moreover, the budget outlook is quite promising.

In 2004, the administration articulated a program of shrinking the deficit in half as a percentage of GDP over the following five years.  The deficit as a percentage of GDP was projected to be 4.2 percent in the year this objective was set out, and thus the aim was to reduce the deficit to 2.1 percent of GDP by 2009.  In fact, the administration is ahead of schedule in meeting this objective:  The 2004 deficit, which had been projected at over $477 billion in fact came in at only 3.6 percent of GDP and last year's deficit at only 2.6 percent   We currently project that the deficit will be 1.4 percent of GDP in 2009, substantially lower than the 2.1 percent goal.

Borrowing From Abroad

Another commonly expressed concern is the view that the United States � not merely the government but the country as a whole � is relying too heavily on foreign capital to finance its spending.   The reliance on foreign capital is counterpart of the U.S. current account deficit, which has grown steadily over the last 9 years to reach over 7 percent of GDP.  There are a number of reasons to believe, however, that the United States is capable of maintaining a sizable current account deficit for a much longer period than most other countries. The net external liabilities of the US were quite low relative to the size of the economy when the existing period of current account deficits began in 1995, rose markedly during the next 5 years to between 20 percent and 25 percent of GDP, then stabilized at roughly that level since 2002.   A net external liability position of 20 to 25 percent of GDP is very manageable for the United States, and suggests that there is substantial room for it to increase before it would begin to pose a financing problem.

In addition, because US citizens have a large store of foreign assets, changes in our net external liability position are not simply a function of the current account deficit, but can be affected � for both good and ill � by changes in the valuation of those assets.  This is why the US net external position has remained fairly stable over the last few years even in the face of a large and growing current account deficit.  The dollar value of our foreign assets has increased in a way that has substantially reduced the effect of the additions to foreign holdings of US assets implied by the current account deficit.  We cannot expect such sizable valuation effects in perpetuity of course � perhaps not even for very much longer � but the available data suggests that they have continued throughout 2005 thus, at the very least, postponing for a further period the time when US net external liabilities will begin to rise from their current moderate level.

Fundamentally though, the U.S. current account deficit is part of a larger global pattern in which countries running surpluses have � until recently � had relatively few attractive investment opportunities other than those in the United States.  As a result, the United States has attracted savings from around the world.  Now, however, there are encouraging signs of stronger growth prospects around the globe.  That changing picture should over time work to restore balance in global trade and capital flows by stimulating U.S. exports and providing new outlets for global savings. 

Hedge Funds and Derivatives

Finally, some point to purported vulnerabilities in the U.S. financial system, often focusing on the potential systemic risks posed by hedge funds and derivatives. 

As you know, in the last few years, hedge funds have garnered much attention in Washington, largely the result of the Securities and Exchange Commission's rulemaking to bring hedge fund advisers further within the SEC's regulatory reach. 

Hedge funds have registered explosive growth in recent years and now represent about a trillion dollars of capital.  In contrast to traditional investment vehicles, which are subject to various regulatory restrictions, hedge funds enjoy almost complete flexibility in implementing their investment strategy.

All strategies are on the table � long positions, short selling, leveraged holdings, equities, bonds, currencies, derivatives, multiple industries, etc. All of these approaches are available and widely utilized by the hedge fund community.  Of course, the experience of LTCM in 1998 has given investor and regulators pause about the rapid growth of hedge funds.  But the hedge fund industry has matured over time--investors have become much more focused on risk management, creating a strong element of market discipline.  For example,

  • Counterparties are more disciplined about extension of leverage and collateral requirements;
  • Capital is now much more reluctant to seed a new hedge fund comprised of the proverbial "Three guys in a garage";
  • Investors now demand transparency (you may recall that LTCM principals notoriously provided little, if any, transparency);
  • There is now a more profound recognition among hedge fund professionals that liquidity is, indeed, king and that in its absence, all bets might be directional;
  • Investors recognize the infrastructure requirements of many arbitrage strategists (who seek Street treatment) and demand to see such infrastructure before committing their capital.

These are important and welcome developments.  And yet we do need to remain abreast of new developments in the industry and any potential developing risks.  To that end, I will be heading up a Treasury initiative to reach out to the hedge fund industry in an effort to identify developing issues with a special focus on the risks presented by credit derivatives.  As part of that effort, we will be seeking answers to a range of questions including:

  • What are the unintended consequences of hedge fund growth on competition for lending and the provision of private equity?
  • Is leverage properly disclosed for transactions such as credit default swaps in which no money is actually borrowed but where there can be high implied leverage?
  • Do our largest financial institutions properly value and disclose their derivative exposure?
  • Is the settlement infrastructure � even with recent attention and modification -- capable of handling the volume of activity in a manner that does not create undue risk � especially in a meltdown environment?
  • Do counterparties such as banks and prime brokers take a false comfort in their myopic views of their individual exposure to and collateral with an individual hedge fund when there is little transparency on the broader financial community's aggregate exposure to that very same fund?
  • Can the regulatory regime keep pace with the quickly evolving marketplace? Even so, will our oversight system devolve into tacit acceptance of the risk metrics they are provided.
  • Are investment managers using derivatives to create near-term return in "hail Mary" fashion at the potential expense of their entire franchise?  
  • As prime brokerage grows to meet the needs of the hedge fund community, will such providers increase leverage and relax collateral requirements as these are their principal means of competition?
  • Should U.S. regulators avail themselves of hedge fund and portfolio risk data readily available through the prime brokerage business of their regulated broker-dealers?

To sum up, our sense is that hedge funds are fundamentally serving a positive role in the U.S. and global economy by providing market liquidity, facilitating price discovery, and distributing risk.  As always, there are risks in the financial sector, but we are working hard to stay ahead of the curve on any developing issues.


Let me close today by simply noting that President Bush's economic program has been a resounding success.  The U.S. economy and financial system are in excellent shape today and we expect continued solid economic performance going forward.  As always, we are mindful of the risks to the outlook, but we are fundamentally optimistic about U.S. and global economic prospects.  Thank you very much.


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