FT Debt Capital Markets Outlook—Securing Stability amid ‘The Great Distortion’
Opening Keynote Address by José Viñals
Financial Stability: Vulnerabilities, Challenges and Enhancements
Financial Counsellor and Director of the Monetary and Capital Markets Department, IMF
London, February 10, 2016
As prepared for delivery
Good morning Ladies and Gentlemen,
I am delighted to be with you in London today. I want to thank the Financial Times for inviting me to speak at what promises to be an extremely interesting and engaging event. And thank you, FT Editor Patrick Jenkins, for your kind introduction.
The event title is: Securing Stability amid the ‘Great Distortion.’ And as we all know, financial markets have given us cause for concern since the start of the year. This has raised questions about the economic outlook—is the recovery still on track? And it has also raised questions about whether policies are sufficient to keep us on the right track. So today, I want to discuss how to meet the challenges we face head on; to move away from the “Great Distortion” to achieve the ‘Great Normalization’; and by so doing to avoid market dislocation. I will argue that to succeed policymakers, ultimately, need to upgrade policies, as we have been calling for a while now at the IMF. The cost of inaction is high, as markets are signaling their restlessness with the status quo.
The world is recovering…
At the outset, let us look at the macroeconomic picture, which is an important anchor for global financial market developments. The IMF’s latest macroeconomic projections, released in mid-January, suggest that recovery is on the way, but we expect it will remain modest and uneven. Growth projections have been revised slightly downwards for the world, as the pickup in global activity is projected to be more gradual. You might think: “again!” But taking a step back, growth in 2016 is projected to reach 3.4 percent, up from 3.1 percent in 2015. This is a recovery. It is weak and uneven in different part of the world, but it is a recovery. Much needs to be done to secure these hard-won gains.
…at the same time, global financial stability is not assured as policy makers face a triad of challenges
Despite some positive news, our message continues to be that global financial stability is not yet assured. Policymakers need to face, upfront, a triad of policy challenges arising from: increasing vulnerabilities in emerging markets, persistent legacies from the crisis in advanced economies (such as high leverage), and weak systemic market liquidity. These challenges remain, and are a reason why market volatility persists.
Let me address some of these challenges, before turning to the policies needed to achieve the ‘Great Normalization.’
Rising vulnerabilities in emerging markets, . . .
Emerging markets face three important shifts. First, the commodity supercycle has come to an end just as credit booms are peaking in these countries. For example, since June 2014 oil prices have fallen by 70 percent and commodity prices have fallen by almost 45 percent. Why does it matter? It matters because corporates in emerging markets had been building large debt throughout the period of high commodity prices and ample liquidity conditions. We estimate that corporate and bank balance sheets are saddled with up to $3.3 trillion in overborrowing.1 Therefore, emerging markets are increasingly vulnerable to financial stress, economic downturn, and capital outflows.
There are, of course, winners and losers from the fall in oil and commodity prices in emerging markets, depending on whether countries are net commodity exporters or importers. But from a financial stability perspective, about one-quarter of outstanding corporate debt in emerging markets is from companies engaged in the oil and mining sectors. In some of these economies, borrowers are quasi sovereign, and thus represent a contingent liability on the sovereign balance sheet. At the same time, commodity exporting countries have seen corporate revenues fall. This corporate-sovereign nexus can put pressure on credit worthiness, and we have seen ratings for major emerging market sovereigns and state-owned enterprises that have already been downgraded.2
A second shift in emerging markets is a tightening of external financing conditions. Emerging markets have benefited in past years from abundant access to liquidity and strong foreign portfolio inflows. However, normalizing interest rates in the U.S and an appreciating US dollar have tightened access to external finance and increased the burden of dollar-denominated debt. In this context, emerging markets will need to adjust to lower capital inflows, and in some cases, a reversal. Moreover, domestic financial conditions are also tightening, as nonperforming loans (NPLs) are recognized and domestic banks try to contain risks from their corporate exposure.
A third shift is taking place in China. As the second largest economy in the world, China plays an important role in driving global growth and increasingly in global financial markets. Growth in China is holding up even as the economy undergoes an important rebalancing: after all, growth last year was 6.9 percent and is projected at 6.3 percent in 2016. We do not believe that China is facing a hard landing, and recent data continue to bear this view out.
But the country is facing major policy challenges as it transitions to a growth model driven increasingly by consumption and services, rather than public investment and exports. Financial and corporate sector vulnerabilities have been rising—total credit to nonfinancial corporates rose from 124 percent of GDP in 2011 to 163 percent of GDP in mid 2015. These will need to be addressed as the economy is transitioning toward a more market-based financial system that discourages the buildup of new imbalances. The internationalization of the renminbi and greater financial integration with global markets represents an important step forward not only for China but for the international monetary system. This transition may become bumpy at times, but a strong commitment to reform and effective implementation with clear communication are essential.
Many emerging markets can still count on strong policy frameworks and buffers to weather these headwinds. Increased exchange rate flexibility, higher foreign exchange reserves, improved reliance on FDI flows, and domestic currency denominated external financing have enhanced their resilience to external shocks. Yet, not all emerging markets have strong policy buffers and in some cases they are depleting quickly, as the shifts these countries are facing are complex and difficult. This has been reflected in their bumpy ride throughout 2015 and the start of 2016.
. . . legacy issues in advanced economies
One of the reasons why financial markets are increasingly sensitive to developments in emerging and global markets is that advanced economies are still struggling with important legacies from the crisis: a weak and uneven recovery, high levels of debt in the public and the private sectors, low interest rates, and persistently high unemployment. This has been reflected in recent market movements, including falling equity prices and widening credit spreads, particularly for bank financials.
The U.S. is a brighter spot among advanced economies with its higher growth rate. It has made progress in addressing households’ housing-related debt overhang, and moved promptly to restore capital in its banks. Besides, U.S. monetary policy normalization has begun with a successful liftoff in December: the Federal Open Market Committee (FOMC)’s 25 basis point increase in Federal fund rates took place without any major market jitters.
But pockets of financial vulnerabilities have also emerged in the U.S. during a period of prolonged and exceptional monetary ease. Spreads had become overly compressed. The high yield market boomed, with funds supplied increasingly through mutual funds by retail investors searching for yield. Credit risks have become highly concentrated in the high leverage energy sector.
In Europe, there has also been some progress: monetary policy has been eased to counter downward risks to price stability, and this has helped support growth. But Europe still has to tackle important sovereign and banking vulnerabilities, which will be crucial to enhancing the effectiveness of monetary policy. Such effectiveness is currently blunted by crisis legacies. The stock of banks’ NPLs remains high: despite some improvement, it is still over 5.5 percent of banking assets or almost 900 billion euros. High NPLs undermine banks’ ability to lend—even at a time when quantitative easing has clearly helped banks repair their balance sheets by reducing funding costs and by helping to support economic activity. Cleaning up NPLs therefore remains a top priority! Europe also needs to complete its financial architecture—I will come back to this in a little while—to consolidate financial stability; and ultimately it will have to settle political tensions.
In a world where one of the lead economies—the U.S.—is recovering at relatively healthy pace, and others—the EU and Japan—are still struggling, policy normalization has implied diverging monetary policies. This, in turn, creates movements in exchange rate markets, with the appreciation of the US dollar. While a normal development, it generates tensions that warrant careful monitoring and strong macroprudential policy frameworks to contain potential risks.
. . . and weak systemic market liquidity
Another powerful challenge confronting policymakers is weak systemic market liquidity. Generally an ethereal concept for many, I am sure that fleeting liquidity is something that you, market practitioners, are extremely familiar with. And I take particular pride in emphasizing that we, at the IMF, have been at the forefront for some time now in pointing out this challenge.
In a world where the risk premiums are expected to decompress, this can unfold in an orderly or disorderly way. In the latter case, it could cause a vicious circle of firesales, redemption, and more volatility. Moreover, adjusting to new equilibria in markets and the wider economy poses an even greater challenge, given what appears to be brittle market structures and market fragilities concentrated in credit intermediation channels. Those vulnerabilities could materialize quickly as financial conditions normalize.
Tensions in market liquidity could exacerbate pressure on credit markets. The high yield bond market provides a good example. U.S. high yield securities are being increasingly held by mutual funds: 15 percent of the total high yield market was owned by mutual funds in 2006; this share reached almost 30 percent in 2015. This could be a problem, if the mutual funds that hold those bonds suffer from substantial liquidity mismatches on their balance sheets. They promise daily liquidity to investors but hold assets that are increasingly illiquid, because high yield debt issuers have seen their leverage rise over the year, and are more likely to fall in distress.3
Highly indebted and fragile corporates could also suffer from funding stress, if credit risks in the high yield bond market rise and liquidity wanes. This could result in higher corporate defaults, amplifying bank chargeoffs and leading to an increasing number of credit rating downgrades.
What does this mean for global financial stability?
I would argue that the turbulence in financial markets that we have seen in the opening weeks of this year partly reflects the difficulties in addressing these challenges and their implications. The choices for policy makers are clear. We can:
- Stay on a weak baseline that you might call the ‘Great Distortion’ of mediocre growth, asynchronous monetary policies, heightened vulnerabilities in some advanced economies and emerging markets that keep risks titled to the downside, and elevated market liquidity risks.
- Or, we can upgrade policies to achieve a ‘Great Normalization,’ marked by stronger and sustained growth, converging monetary policies, and reduced vulnerabilities as we leave behind the ‘Great Distortion.’
- The stakes are high because the weak baseline leaves us exposed to significant downside risks, which if they all materialize could lead to ‘Global Market Disruption,’ and an unwelcome rise in volatility and tightening of financial conditions. If this is prolonged, it could result in weaker growth, stalled monetary policy normalization, disorderly deleveraging in emerging markets, and amplified market liquidity risks.
Completing the policy upgrade
In terms of where we stand on policy, I want to emphasize that there has been progress, and that the ‘Great Normalization,’ while still quite far, is not unreachable. But I also want to underscore that to avoid the materialization of downside risks, the policy upgrade that we have recommended for some time remains essential, and is now more urgent. In short, not achieving a policy upgrade and falling into the downside scenario of ‘Global Market Disruption’ will be costly: by our calculations, three percent of global output by 2017!4
Escaping the ‘Great Distortion’ will require resolute policy action in 2016. The policy upgrade we are referring to at the IMF goes well beyond monetary and financial reforms. It encompasses fiscal and structural policies, and our policy recommendations on those issues are covered in our Fiscal Monitor and World Economic Outlook publications.
Actions speak louder than words. Where are we so far? On the monetary policy front, a lot has been achieved, even though there remains uncertainty about the path of U.S. monetary policy normalization. Expectations of successful normalization in the U.S. have decreased, as reflected in the divergence between the Fed’s stated intentions and market expectations. For instance, markets are pricing in an 80 percent chance that rates will be below the FOMC median projection by the end of next year, and an almost 30 percent probability of rates remaining at low levels (1 percent or less).5
But monetary policy should not be “the only game in town”. Euro area banks need to strengthen their balance sheets further by comprehensively tackling NPLs and the corporate debt overhang; this will ultimately enhance the effectiveness of monetary policy. In addition, policymakers must complete the banking union, so as to move financial stability onto firmer grounds. An essential step remains establishing a common deposit guarantee scheme. Equally important, we need a greater focus on system-wide financial stability. Who is really in charge?
Coming back to emerging markets, navigating what promises to be uncharted waters in 2016 will not be easy, especially in those countries with reduced policy buffers. In this context, strengthening surveillance over balance sheet risks, building resilience of both corporates and banks, while maintaining healthy sovereign balance sheets will remain crucial. In China, in particular, clarity and communication on policies will be essential to the country’s smooth integration into the world economy. Similarly, deleveraging the Chinese corporate sector will require great care and will have to go hand in hand with the strengthening of banks. Last but not least, at the global level, market liquidity should be reinforced by putting in place adequate policies and oversight of asset management and financial market structures.
A long and testing to-do list, I am afraid, which policymakers will need to address also amid rising geopolitical risks. But the ‘Great Normalization’ can be within reach if this to-do list is urgently completed.
1 See figure 1.7, panel 2 on page 10 of the October 2015 GFSR.
2 Brazil and Russia lost their investment grade rating in 2015, with state-owned enterprises like Petrobras and Gazprom also downgraded to junk.
3 The share of distressed bonds in the high yield category has risen significantly from about 1 percent in 2013 to 7 percent at the end of 2015. One extreme example of the risks was Third Avenue, the fund that had to close late in 2015.
4 See Annex 1.2, page 39 of the October 2015 GFSR
5 Implied probabilities based on swaptions on U.S. interest rates.