IMF Global Financial Stability Report: Vulnerabilities, Legacies, and Policy Challenges

Global Financial Stability Report

Vulnerabilities, Legacies, and Policy Challenges

October 2015

Disclaimer: As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

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Risks Rotating to Emerging Markets

Financial stability has improved in advanced economies since April, but risks continue to rotate toward emerging markets. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity. Although many emerging market economies have enhanced their policy frameworks and resilience to external shocks, several key economies face substantial domestic imbalances and lower growth. Recent market developments such as slumping commodity prices, China’s bursting equity bubble and pressure on exchange rates underscore these challenges. The prospect of the U.S. Federal Reserve gradually raising interest rates points to an unprecedented adjustment in the global financial system as financial conditions and risk premiums “normalize” from historically low levels alongside rising policy rates and a modest cyclical recovery.
Chapter 2 examines in detail the factors that influence levels of liquidity in securities markets, as well as the implications of low liquidity. Currently, market liquidity is being supported by benign cyclical conditions. Although it is too early to assess the impact of recent regulatory changes on market liquidity, changes in market structure, such as larger holdings of corporate bonds by mutual funds, appear to have increased the fragility of liquidity.
Chapter 3 studies the growing level of corporate debt in emerging markets, which quadrupled between 2003 and 2014. The report finds that global drivers have played an increasing role in leverage growth, issuance, and spreads. Moreover, higher leverage has been associated with, on average, rising foreign currency exposures. It also finds that despite weaker balance sheets, firms have managed to issue bonds at better terms as a result of favorable financial conditions

Executive Summary and Preface

Chapter 1: Three Scenarios for Financial Stability
Financial stability has improved in advanced economies since April, but risks continue to rotate toward emerging markets. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity. Although many emerging market economies have enhanced their policy frameworks and resilience to external shocks, several key economies face substantial domestic imbalances and lower growth. Recent market developments such as slumping commodity prices, China’s bursting equity bubble and pressure on exchange rates underscore these challenges. The prospect of the U.S. Federal Reserve gradually raising interest rates points to an unprecedented adjustment in the global financial system as financial conditions and risk premiums “normalize” from historically low levels alongside rising policy rates and a modest cyclical recovery.

Boxes
Chart Chart	Data	1.1 China’s Equity Market
Chart Chart	Data	1.2 Compression of Global Risk Premiums and Market Abnormalities
Chart Chart	Data Data	1.3 Banking in Europe: The Impact of Nonperforming Loans
Tables
		1.1 Three Scenarios for Financial Stability
		1.2 Why Is Resilient Liquidity Important?
Figures
Chart	Data	1.1 Global Financial Stability Map: Risks and Conditions
Chart	Data	1.2 Global Financial Stability Map: Components of Risks and Conditions
Chart	Data	1.3 Inflation, Monetary Policy, and Policy Rate Normalization
Chart	Data	1.4 Economic Risk Taking Remains Weak in Advanced Economies
Chart	Data	1.5 Locus of Risks Shifting toward Emerging Markets
Chart		1.6 Triad of Global Policy Challenges
Chart	Data	1.7 The Credit Cycle
Chart	Data	1.8 Credit Growth, Corporate Leverage, and New Nonperforming Bank Loans
Chart	Data	1.9 Emerging Market Companies: Exposure to Dollar Strength and Commodity Prices
Chart	Data	1.10 Banking System Average Regulatory Tier 1 Ratio
Chart	Data	1.11 Bank Capital and Asset Changes
Chart	Data	1.12 Chinese Banks: Asset Quality Challenges
Chart	Data	1.13 Evolution of Bank Funding
Chart	Data	1.14 Chinese Exchange Rate Movements and Effect on Emerging Market Currencies
Chart	Data	1.15 Greece: Developments
Chart	Data	1.16 Bank Profitability and Balance Sheet Strength
Chart	Data	1.17 Potential Amplifiers of Market Stress
Chart	Data	1.18 Large United States and European Regulated Bond Investment Funds with Derivatives-Embedded Leverage
Chart		1.19 Systemic Implications of a Liquidity Shock
Chart	Data	1.20 Effect of a Global Asset Market Disruption
Chart	Data	1.21 Emerging Market Local Currency Bond Yields
Chart	Data	1.22 Corporate Debt Burden Market in Disruption Scenario
Chart	Data	1.23 Lower Ratings Would Lock in Higher Borrowing Costs
Chart	Data	1.24 Selected Quasi-Sovereign Company Ownership and Debt
Annex Figures
Chart		1.2.1 Global Asset Market Disruption Scenario: Simulated Peak Effects
Chart		1.2.2 Global Asset Market Disruption Scenario: Aggregated Simulated Paths
Chart		1.2.3 Successful Normalization Scenario: Aggregated Simulated Paths
Chart		1.2.4 Successful Normalization Scenario: Simulated Peak Effects

Chapter 2: Market Liquidity—Resilient or Fleeting?
Chapter 2 of the October 2015 Global Financial Stability Report examines the determinants of market liquidity and of its resilience. Only some markets show obvious signs of worsening market liquidity, although dynamics diverge across bond classes. The current levels of market liquidity are being sustained by benign cyclical conditions and accommodative monetary policy. At the same time, some structural developments may be eroding its resilience. Policymakers should have a policy strategy in hand to cope with episodes of dry ups of market liquidity. A smooth normalization of monetary policy in advanced economies and the continuation of market infrastructure reforms to ensure more efficient and transparent capital markets are important to avoid disruptions of market liquidity in advanced and emerging market economies.

Boxes
		2.1 How Can Market Liquidity Be Low Despite Abundant Central Bank Liquidity?
Chart Chart	Data	2.2 Electronic Trading and Market Liquidity
Chart Chart		2.3 Structural Drivers of the Resilience of Market Liquidity
Chart		2.4 Market Liquidity and Bank Stress Testing
Tables
		2.1 Liquidity Measures
		2.2 Determinants of Low-Liquidity Regime Probability in the U.S. Corporate Bond Market
		2.3 Determinants of Low-Liquidity Regime in the Foreign Exchange and European Sovereign Bond Markets
		2.4 Bond Returns and Liquidity Risk
		2.5 Summary of Findings and Policy Implications
Figures
Chart		2.1 Drivers of Liquidity and Liquidity Resilence
Chart	Data	2.2 Trends in Bond Marktets—Market Liquidity Level
Chart	Data	2.3 Bond Market Liquidity—Bifurcation and Price Impact of Large Transactions
Chart	Data	2.4 Trends in Market Making
Chart		2.5 Dealers’ Balance Sheet Space
Chart		2.6 Central Bank Collateral Policies
Chart		2.7 Regulation and Market Liquidity: Two Examples
Chart		2.8 Fed Purchases and Mortgage-Backed Securities Liquidity
Chart		2.9 Main Drivers of Market Liquidity
Chart		2.10 Financial Sector Bond Holdings
Chart	Data	2.11 Probability of Liquidity Regimes
Chart	Data	2.12 Liquidity Spillovers and Market Stress

Chapter 3: Corporate Leverage in Emerging Markets—A Concern?
Chapter 3 of the October 2015 Global Financial Stability Report studies the growing level of corporate debt in emerging markets, which quadrupled between 2004 and 2014. The chapter finds that global drivers have played an increasing role in leverage growth, bond issuance, and corporate spreads. Higher leverage has been associated with, on average, rising foreign currency exposures. The chapter also finds that despite weaker balance sheets, firms have managed to issue bonds at better terms as a result of favorable financial conditions. The greater role of global factors during a period when they have been exceptionally favorable suggests that emerging markets must prepare for the implications of global financial tightening.

Boxes
Chart	Data	3.1 Shadow Rates
		3.2 Corporate Foreign Exchange Rate Exposures
Chart	Data	3.3 Corporate Leverage in China
		3.4 Firm Capital Structure, the Business Cycle, and Monetary Policy
Chart		3.5 The Shift from Bank to Bond Financing of Emerging Market Corporate Debt
Chart		3.6 Taper Tantrum: Did Firm-Level Factors Matter?
Tables
		3.1 Worsening Emerging Market Firm-Level and Macroeconomic Fundamentals
Figures
Chart	Data	3.1 Emerging Market Economies: Evolving Capital Structure
Chart	Data	3.2 Emerging Market Economies: Selected Leverage Ratios
Chart	Data	3.3 Emerging Market Economies: Changing Composition of Corporate Debt
Chart	Data	3.4 Domestic Banks: Ratio of Total Corporate Loans to Total Loans in 2014
Chart	Data	3.5 Emerging Market Economies: Corporate Leverage by Selected Regions and Sectors
Chart		3.6 Foreign Exchange Exposures in Emerging Market Economies (Listed Firms)
Chart		3.7 Change in Foreign Exchange Exposures and Corporate Leverage, by Sector
Chart	Data	3.8 Corporate Liabilities and Solvency
Chart		3.9 Key Determinants of Emerging Market Economies' Corporate Leverage
Chart	Data	3.10 Leverage, Cash Holdings, and Corporate Investment
Chart	Data	3.11 Bond Issuance by Regions and Sectors
Chart	Data	3.12 Bond Issuance: Currency Composition
Chart	Data	3.13 Deteriorating Firm-Specific Fundamentals for Bond-Issuing Firms
Chart	Data	3.14 Bond Issuance: Yields and Maturity
Chart		3.15 Factors Influencing the Probability of Bond Issuance
Chart		3.16 Factors Influencing Bond Maturity
Chart	Data	3.17 Emerging Market Economies: Secondary Market Corporate Spreads
Chart		3.18 Emerging Market Economies: Effects of Domestic and Global Factors on Corporate Spreads

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