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Weak Spots in Global Financial System Could Amplify Shocks

Tobias Adrian, Fabio Natalucci

April 10, 2019

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In the United States, the ratio of corporate debt to GDP is at record-high levels. In several European countries, banks are overloaded with government bonds. In China, bank profitability is declining, and capital levels remain low at small and medium-size lenders.

Vulnerabilities like these are on the rise across advanced and emerging market economies, according to the IMF’s latest Global Financial Stability Report. They aren’t all setting off alarm bells just yet. But if they continue to build, especially with still-easy financial conditions, they could amplify shocks to the global economy, raising the odds of a severe economic downturn a few years down the road.

With the right mix of policies, countries can sustain growth while keeping vulnerabilities in check.

This poses a dilemma for policymakers seeking to counter a slowing global economy, as discussed in the World Economic Outlook. By taking a patient approach to monetary policy, central banks can accommodate growing downside risks to the economy. But if financial conditions remain easy for too long, vulnerabilities will continue to build, and the odds of a sharp drop in economic growth at some later point will be higher.

The good news: short-term risks to global financial stability are still low by historical standards, though they are slightly higher than we found in our October 2018 Global Financial Stability Report . In the medium term, however, risks remain elevated. But with the right mix of policies, countries can sustain growth while keeping vulnerabilities in check.

Why do we worry about financial vulnerabilities? Because they can amplify the impact of sudden shocks—such as a sharper-than-anticipated economic slowdown, an unexpected shift in monetary policy, or an escalation of trade tensions. Higher vulnerabilities give rise to greater financial stability risks.

The latest Global Financial Stability Report introduces a way to quantify vulnerabilities in the financial system, so policymakers can monitor them in real time and take preventive steps if needed to mitigate risks. The framework encompasses six sectors: corporates, households, governments, banks, insurance companies, and other financial institutions—some of which are what we call “shadow banks.”

The framework tracks both the level and the pace of change along a variety of vulnerabilities, including leverage and mismatches in the maturity and liquidity of assets and liabilities, as well as currency exposures. These vulnerabilities are tracked at regional and global levels, aggregating across 29 systemically important countries.

Here are some of the most serious vulnerabilities:

Advanced economies. Corporate debt and financial risk-taking have increased, and the creditworthiness of borrowers has deteriorated. The stock of bonds with BBB ratings has quadrupled, and the stock of speculative-grade credits has almost doubled in the United States and the euro area since the crisis. A sharp tightening of financial conditions or a severe downturn could make it harder for indebted firms to repay their loans and force them to cut back on investment or employment. So-called leveraged loans to highly indebted borrowers are an area of particular concern, as we explained in an earlier blog and discuss further in the current GFSR.

Fortunately, there are ways to address such vulnerabilities:

In some circumstances, countries with strong economies and inflation at or above target can also consider using monetary policy to “lean against the wind.” With the right combination of policies, countries can keep their economies humming while also limiting risks to financial stability.

 

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