Fed chair Janet Yellen on television on floor of New York Stock Exchange: U.S. central bank policy has begun to return to normal (photo: Brendan McDermid/Reuters)
GLOBAL FINANCIAL STABILITY REPORT
Easy financial conditions due to low interest rates in advanced economies have meant many economies rely on “liquidity crutches.” The IMF said it is time for financial systems to move beyond this dependence on easy money and transition to an environment of self-sustaining growth.
Areas of progress:
• Monetary policy in the United States has begun to return to normal amid growing signs that the country’s economic recovery is gaining traction.
• Banks in the euro area have improved their capital ratios, and the region is moving from fragmentation to a more robust framework for integration.
• Outflows of capital from emerging markets have remained limited, especially where policymakers are addressing macroeconomic vulnerabilities amid tighter external financial conditions.
Roadwork ahead
The transition to greater stability is far from complete, and the conditions necessary for a stable financial system are not yet fully in place, as evidenced by recent bouts of financial turbulence, according to the IMF.
“In advanced economies, financial markets continue to be supported by extraordinary monetary accommodation and easy liquidity conditions,” said José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department. “These economies will need to reduce their reliance on monetary and liquidity supports if they are to create an environment of self-sustaining growth, marked by increased corporate investment and growing employment.”
Engineering a successful shift from financial markets driven by low interest rates in advanced economies to one driven by self-sustaining growth will require strong actions by policymakers in advanced and emerging market economies.
The smooth path to normal monetary policy
The gradual shift to self-sustaining growth is most advanced in the United States, where the “green shoots” of economic recovery are visible. Yet a number of financial stability risks remain. One is the emergence of vulnerabilities in some pockets of U.S. credit markets, such as high-yield bonds and leveraged loans, where underwriting standards have weakened. The increased activity in these markets—and the possible mispricing of risk—reflect investors’ search for higher returns on their investments and the continuing drive by corporates to take advantage of easy lending conditions.
Other risk factors could amplify the effect of potential shocks. These include sharply reduced market liquidity and the rapid growth of credit-focused mutual funds and exchange traded funds. These investment vehicles are more prone to sudden redemptions from investors than other traditional holders of leveraged loans. The concern is that if investors seek to withdraw massively from investment vehicles focused on relatively illiquid high-yield bonds or leveraged loans, the pressure could lead to fire sales in credit markets and rapid increases in yields.
U.S. policymakers must carefully manage these growing risks to ensure financial stability and avoid global spillovers. Macroprudential policies, for example, can help reduce excessive risk taking by market participants. These actions are essential to help the United States achieve a smooth exit from unconventional monetary policies—which remains the most likely scenario.
Emerging markets face heightened challenges
The favorable tailwinds from easy external financial conditions and strong credit growth have now subsided. Macroeconomic and financial imbalances have built up during the period of extraordinary accommodative monetary policy, as private and public balance sheets have become more indebted.
Countries such as Brazil, Indonesia, India, and Turkey faced increased market pressures over the past year because investors are increasingly looking at these imbalances to differentiate among markets and asset classes. Swift policy actions to enhance the credibility of policy frameworks have helped to alleviate some of these pressures, but more remains to be done.
Viñals said some emerging market companies were particularly vulnerable.
“Higher debt loads and lower debt servicing capacity make corporates more sensitive to tighter external financing conditions and to a potential reversal of capital flows that could trigger a rise in borrowing costs and a drop in earnings,” he noted.
The IMF has conducted an in-depth analysis of emerging market corporate balance sheets, focusing on the share of corporate debt held by weaker, highly leveraged firms, known as “debt at risk”. In a severe and adverse scenario, where borrowing costs escalate and earnings deteriorate significantly, debt at risk could increase by $740 billion, to 35 percent of total corporate debt in the sample.
The impact of any shock could be magnified by a growing “systemic liquidity mismatch.” For example, in some local-currency sovereign bond markets where foreign investors now play a greater role, there is now a stark contrast between the potential scale of capital outflows and the diminished capacity and willingness of international banks to intermediate these flows. This mismatch could magnify the impact of any shock and broaden the impact on asset prices across countries.
Policymakers in emerging markets need to maintain credible macroeconomic policy frameworks and buffers. They also need to take prudential measures to safeguard both banks and nonbanks. This is particularly relevant in China, where the growth in non-bank lending has boosted corporate leverage.
Fixing euro area banks and corporates
Market sentiment toward European sovereigns and banks has improved, particularly in stressed euro area countries. This reflects reforms taken at the national and European levels, and growing confidence that the forthcoming asset quality review and stress tests by the European authorities will further strengthen banks. Yet important challenges remain:
• The restructuring of the debt-burdened euro area corporate sector has been held back by the unfinished repair of bank balance sheets.
• Credit conditions remain difficult in stressed euro area economies. Banks in these countries have been weighed down by a large and growing stock of non-performing loans, resulting in part from an unresolved corporate debt overhang. This burden has been limiting banks’ profitability and capacity to provide credit. Without a flow of new credit, it will be difficult for banks to support the recovery and to help complete the euro area’s transition from financial fragmentation to integration.
Euro area policymakers face a difficult task of accelerating the cleanup of bank and corporate balance sheets without disrupting the recovery in market sentiment. “It is not enough to fix the banks,” Viñals said. “Policymakers also need to finish the job of repairing corporates.”
The Global Financial Stability Report also calls for additional measures to speed up the resolution of nonperforming loans and to improve corporates’ access to credit.
• Policymakers should increase incentives for bank provisioning and write-offs, reform legal frameworks to facilitate timely resolution, and promote a secondary market for nonperforming loans.
• Market regulators could also facilitate the listing of high-yield bonds by smaller corporates, and policymakers should reassess the regulatory impediments to the securitization of loans.
The resulting strengthening of bank and corporate balance sheets should help reinforce the improved optimism in financial markets, and improve the flow of credit to support the recovery.
