Reaching the ‘Great Normalization’—Overcoming Financial Stability Challenges in Advanced and Emerging Economies

Speech by José Viñals
Financial Counsellor and Director of the Monetary and Capital Markets Department, IMF
Reserve Bank of India, Mumbai
March 10, 2016

As prepared for delivery

Good morning Ladies and Gentlemen,

I am delighted to be with you in Mumbai today. I want to thank Governor Rajan for his kind words and his invitation to speak at the Reserve Bank of India. Tomorrow I will travel to Delhi, where the IMF is co-hosting with the Government of India a conference on “Advancing Asia: Investing for the Future,” in the presence of Prime Minister Modi and IMF Managing Director Christine Lagarde.

Today, I want to talk about global financial stability—an issue that keeps coming back to the forefront of policymaker discussions and news commentaries. In fact, since the start of 2016, financial market developments have given us a renewed cause for concern.

Markets have been extremely volatile, in the context of a sharp increase in risk aversion and flight to safety. To some extent, some increase in volatility was to be expected: after years of policy accommodation, it shouldn’t be surprising that the road to normalization is characterized by a few bumps: some decompression of risk premia and volatility is a normal thing to happen, as we exit exceptional monetary policies and implement reforms to strengthen the global financial sector. But the recent heightened volatility may be signaling deeper concerns.

In fact, the turmoil has been intense and broad based, hitting commodities, equity markets, and banks, with advanced economies being particularly impacted. My sense is that this turmoil partly reflects an element of correction of past excesses in financial valuations. But it also points to a more general reassessment of risks related to global growth and stability. In particular, it is a sign that financial markets are pricing in increasing risks of falling into a scenario of considerably slower nominal growth, as well as diminishing confidence on the ability of policies in advanced economies to keep things on the right track.

Let me mention four main factors that have been driving these risk perceptions:
• Worries about global growth and the inflation outlook;
• Uncertainty about China;
• Falling commodity and oil prices, together with the feeling that they are having a larger-than-expected negative impact on commodity- and oil-exporting countries, and a smaller-than-expected positive impact on many importing countries.
• Concerns about banks in advanced countries.

Higher risks and a triad of pre-existing policy challenges

These factors fall on fertile grounds and exacerbate preoccupations regarding a pre-existing triad of challenges facing policymakers: increasing vulnerabilities in emerging markets, persistent legacies (such as high leverage) from the crisis in advanced economies, and financial market fragilities. Not only do these concerns contribute to high market volatility, but they also point to higher risks of a derailed recovery, at a moment when the global economy is highly vulnerable to adverse shocks.

In light of all of this, are the current policy responses sufficient to manage these challenges and to address the gloom that has enveloped financial markets recently? More needs to be done to achieve what I will call the ‘Great Normalization,’ thus avoiding further market dislocation. I will argue that to succeed policymakers need to adopt urgently more comprehensive and concerted policy action to strengthen growth and manage vulnerabilities. The cost of inaction is high, as markets are signaling their restlessness with the status quo.

Against the background of a disappointing and fragile recovery, global financial stability is far from assured

Let’s look at the macroeconomic picture—the anchor of financial stability—more in detail. As I just emphasized, the recovery remains disappointing and highly vulnerable. The IMF’s forecast for global growth, released in mid-January, amount to a downward revision of 0.2 percentage points for both 2016 and 2017. Yet, growth will be about 3.5 percent, this year and next, expected to rise from 3.1 percent in 2015.

The baseline outlook suggests a continuation of the modest recovery in advanced economies, just over 2 percent in 2016 and 2017, reflecting a combination of weak demand and slow potential growth. Prospects in emerging markets point to growth rising from 4 percent in 2015 to about 4.5 percent this year and next. Still, this is relatively low from a historical perspective.

But it is not all doom and gloom! India is projected to continue growing at a robust pace, supported by lower global commodity prices, policy actions, improved confidence, and reduced external vulnerabilities. Growth reached 7.3 percent last year and is estimated by the IMF at 7.5 percents this year—the fastest growing large economy in the world.

Given the limited positive news, increasing risks to the global economic recovery, and the triad of policy challenges I mentioned, our message continues to be that global financial stability is not yet assured. Let me run through the triad of challenges that policymakers have to face head on, 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 60 percent and commodity prices have fallen by almost 40 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 $3.5 trillion in overborrowing.1

Deteriorating corporate health in key emerging markets runs the risk of deepening the corporate-bank risk nexus, as banks remain the dominant source of financing for the corporate sector in these countries. Not all banks, in fact, have sufficiently strong buffers to absorb adverse shocks. Therefore, a number of emerging markets are increasingly vulnerable to financial stress, economic downturn, and capital outflows.

The fall in oil and commodity prices in emerging markets results in both winners and losers, 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 risk nexus can put pressure on credit worthiness. We have seen that ratings for several major emerging market sovereigns and state-owned enterprises have already been downgraded.2

India has benefitted from the dramatic fall in global oil prices, seeing a boost to its fiscal revenues, and a positive impact on inflation. However, it faces its own idiosyncratic challenges due to existing weaknesses in corporate and banking balance sheets. Corporate profitability is at a decade-long low, and large corporates are highly leveraged. The stock of banks’ stressed loans—NPLs and restructured assets—is high at 14.1 percent, with public sector banks responsible for most bad loans. Deteriorating corporate and banking sector health can exacerbate risks due to the strong corporate-bank risk nexus. The high levels of stressed loans, and lingering questions about whether banks classify loans properly as NPLs, undermine banks’ ability to lend to corporates.

A second shift in emerging markets is a tightening of financing conditions, both externally and internally. Many 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, to capital outflows. Moreover, domestic financial conditions are also tightening. As NPLs are being recognized, domestic banks try to contain risks from their corporate exposure and are more cautious in lending.

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 is holding up even as the economy undergoes an important rebalancing: after all, growth last year was 6.9 percent and is projected by the Fund at 6.3 percent this year. We do not believe that China is facing a hard landing, and recent data continue to bear this view out.

But there is increased uncertainty about the economy and potential policy missteps, as China tackles domestic and external imbalances. In fact, China confronts a number of critical 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 slightly above 120 percent of GDP in 2011 to more than 160 percent of GDP in mid 2015.

These vulnerabilities will need to be addressed promptly as the economy moves toward a more market-based financial system, including for the exchange rate. In this context, the internationalization of the renminbi and greater financial integration with global markets represent 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 policy implementation with clear communication are essential.

Many emerging markets can still count on improved and resilient policy frameworks and buffers to weather these headwinds. Increased exchange rate flexibility, higher foreign exchange reserves, more stable FDI flows, and domestic currency denominated external financing have enhanced emerging markets’ resilience to external shocks.

India is a good example in this regard. It bolstered its domestic policy frameworks to tame inflation and to foster better growth prospects—including, importantly, via the adoption of inflation targeting under the apt guidance of Governor Rajan; greater exchange rate flexibility; and the commitment to fiscal consolidation. The recently announced budget is a testament to the latter. It has also been taking important steps to attract stable, non-debt creating capital flows, particularly FDI.

Yet, not all emerging markets have strong policy buffers. In some cases, buffers are depleting quickly, as these countries are facing complex and difficult shifts. In addition, rapid credit growth and a worsening credit cycle may combine with the multiple shocks to the real economy from weak domestic growth, lower commodity prices, and at times prolonged domestic currency depreciation. This poses a risk to earnings and capital buffers in emerging economy banks as NPLs and provisions rise.

These increasing vulnerabilities explain emerging markets’ bumpy ride throughout 2015 and the start of 2016, and show that buffers should not lead to complacency. Despite better growth prospects, even higher-buffer countries like India do face the risk of potential capital flow reversals and should, hence, guard against the buildup of domestic vulnerabilities.

. . . legacy issues in advanced economies

One of the reasons why financial markets are increasingly sensitive to developments in emerging markets is the significant role they play in contributing to global growth. Another reason is that many advanced economies are still struggling with important legacies from the crisis: modest 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 financial market movements, including by falling equity prices and widening credit spreads, particularly for banks.

The U.S. is a brighter spot among advanced economies with its robust domestic demand, supported by still easy financial conditions, and strengthening housing and labor markets. The country has made progress in addressing households’ housing-related debt overhang, and moved promptly to restore capital in its banks. Besides, monetary policy normalization has begun with a successful liftoff by the Federal Reserve in December. But, the economy is facing increasing headwinds owing to dollar appreciation and cuts in equipment investment in the mining sector—notably in energy. Inflation expectations are also easing, prompting market expectations of a slower monetary policy normalization.

Furthermore, pockets of financial vulnerabilities have emerged in the U.S. as a result of a period of prolonged and exceptional monetary ease. Spreads have been overly compressed. The high yield market has boomed, until recently, 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 been some progress: the banking union continues to advance while 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 also 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 reduction, 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 helped banks repair their balance sheets. With negative interest rates becoming more prevalent, and affecting banks net interest margins, cleaning up NPLs remains a top priority! Another priority is dealing appropriately with the corporate debt overhang remaining in certain non-core European countries. Europe also needs to complete its financial architecture to consolidate financial stability; and ultimately it will have to settle political tensions.

In a world where economic recovery remains uneven across advanced economies, monetary policies are expected to remain different. While the U.S. is likely to proceed with a gradual normalization of policy, although at a slower pace than previously envisaged, the euro area and Japan are expected to continue, or even deepen, their monetary accommodation, including through negative interest rates. This creates movements in foreign exchange markets, with the appreciation of the US dollar, which warrant careful monitoring and strong macroeconomic and prudential policy frameworks to contain risks in potentially affected countries.

. . . and weak systemic market liquidity

Another powerful challenge confronting policymakers is financial market fragilities in the context of weak systemic market liquidity.

At a time when risk premiums are expected to decompress, and have started doing so, 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 bonds are being increasingly held by mutual funds, which own almost 30 percent of the market. 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?

The turbulence in financial markets that we have seen since the beginning of this year partly reflects the difficulties in addressing these challenges and their implications. The choices for policy makers are clear:
• Stay on a weak baseline of mediocre growth, asynchronous monetary policies, and heightened vulnerabilities that keep risks titled to the downside.
• Or, upgrade policies to achieve a ‘Great Normalization,’ marked by stronger and sustained growth, converging monetary policies, and reduced vulnerabilities.
• The stakes are high because the weak baseline leaves us exposed to significant downside risks, which could lead to ‘Global Market Disruption,’ and an unwelcome further 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.

Calling for More Comprehensive, Collective, and Urgent Policy Action

On policy, I want to emphasize that there has been some progress and that the ‘Great Normalization,’ while still quite far, is not unreachable. But I also want to underscore that to avoid mounting risks it is essential to put in place more comprehensive and concerted action to help leverage individual country policies and to make the international monetary system more stable and, hence, supportive of growth. All of this is now more urgent. Not acting promptly and falling into the downside scenario of ‘Global Market Disruption’ will be costly in terms of global growth.

To avoid this adverse scenario and move instead toward the ‘Great Normalization’ will require resolute policy action in 2016 going well beyond monetary and financial reforms. It should encompass fiscal and structural policies to reduce over reliance on monetary policy. In particular, commodity exporters with fiscal buffers should use them to smooth the adjustment to lower commodity prices. Furthermore, across advanced and emerging economies, well-designed structural reforms remain critical to lift potential output.

Actions speak louder than words. Where are we so far? On monetary policy, there remains uncertainty about the path of U.S. monetary policy normalization, as signaled by the divergence between the Fed’s stated intentions and market expectations—which, as already mentioned, reflect a much slower pace of policy rate increases.

Euro area banks need to strengthen their balance sheets further by comprehensively tackling NPLs and the corporate debt overhang; this will ultimately also enhance the effectiveness of monetary policy.

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, and keeping inflation under control, while maintaining healthy sovereign balance sheets will remain crucial. So it will be advancing structural reforms to put growth steadily on a higher trajectory.

In China, clarity and communication on policies will be essential to achieve a successful transition toward more balanced, sustained growth; a more market-oriented economy; and closer integration into the world financial system. Similarly, deleveraging the Chinese corporate sector will require great care and will have to go hand in hand with the strengthening of banks.

With regard to India, the country is in a better position than many other emerging markets. As we noted in the recent Article IV Consultation, the economy has been on a recovery path and sentiment is on an upsurge. But vulnerabilities in corporate financial positions and in public bank asset quality could pose risks to economic recovery and weigh on financial stability if left unaddressed. So, to sustain this robust economic growth in the future, in addition to keeping inflation under control and continuing to deliver on fiscal consolidation, priority should be given to redoubling the efforts to clean up the public sector banks’ balance sheets and to tackle the corporate debt overhang. Policy commitment to address long-standing supply bottlenecks, especially in the mining and power sectors, as well as further land, labor, and product market reforms, would also help strengthen India’s economy and support stronger, sustained economic growth.

At the global level, the financial regulatory reform agenda should be completed and implemented. As part of this, the resilience of market liquidity should be reinforced by putting in place adequate policies and oversight of asset management and financial market structures. That is, turning shadow banking into a stable source of market-based finance. This is crucial to safeguarding global financial stability and supporting global growth.

Finally, collective effort should also focus urgently on further enhancing the global financial safety net and strengthening oversight to better manage the risks associated with capital flows. In particular, there may be a need to consider new financing mechanisms to address the risks faced by commodity exporters and emerging markets with strong fundamentals but high vulnerability to spillovers.

All in all, 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 policymakers do their homework.

Thank you

1 See figure 1.7, panel 2 on page 10 of the October 2015 GFSR. Overborrowing has risen to $3.5 trillion as of 2015Q2, from $3.3 trillion in 2014Q4.


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.



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