Speech by IMF's José Viñals: Reaching the ‘Great Normalization’—Overcoming Financial Stability Challenges in Advanced and Emerging Economies
IMF News, March 10, 2016
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Bibliographic details
- Published: March 10, 2016
Introduction and context
- Occasion and location: Reserve Bank of India, Mumbai; as prepared for delivery.
- Date: March 10, 2016.
- Central message: Global financial stability is not yet assured; policymakers must pursue a “Great Normalization” involving stronger growth, converging monetary policies, and reduced vulnerabilities to avoid a downside “Global Market Disruption.”
Macroeconomic outlook (anchor of financial stability)
- IMF global growth forecast (mid-January): downward revision of 0.2 percentage points for both 2016 and 2017.
- Global growth projections:
- 3.5 percent this year and next (2016 and 2017).
- 3.1 percent in 2015.
- Advanced economies: modest recovery, just over 2 percent in 2016 and 2017.
- Emerging markets: growth rising from 4 percent in 2015 to about 4.5 percent in 2016 and 2017.
- India:
- Growth reached 7.3 percent last year (2015).
- Estimated by the IMF at 7.5 percents this year (2016) — noted as the fastest growing large economy in the world.
- China:
- Growth last year: 6.9 percent.
- Projected by the Fund at 6.3 percent this year.
- 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.
Key drivers of heightened market risk perceptions
- Four main factors driving risk perceptions:
- Worries about global growth and the inflation outlook.
- Uncertainty about China.
- Falling commodity and oil prices with asymmetric effects on exporters and importers.
- Concerns about banks in advanced countries.
The triad of pre-existing policy challenges
- Summary: Increasing vulnerabilities in emerging markets; persistent legacies in advanced economies; and financial market fragilities (weak systemic liquidity).
Rising vulnerabilities in emerging markets
- Commodity and credit shifts:
- Since June 2014, oil prices have fallen by 60 percent and commodity prices have fallen by almost 40 percent.
- Corporate and bank balance sheets estimate: up to $3.5 trillion in overborrowing (as of 2015Q2).
- Sector concentration and sovereign contingent liabilities:
- About one-quarter of outstanding corporate debt in emerging markets is from companies engaged in the oil and mining sectors.
- Some borrowers are quasi sovereign, representing contingent liabilities on sovereign balance sheets; several major emerging market sovereigns and state-owned enterprises were downgraded in 2015.
- Financial tightening and external risks:
- Normalizing U.S. interest rates and an appreciating US dollar tighten access to external finance and increase the burden of dollar-denominated debt.
- Expectation of lower capital inflows, and in some cases capital outflows.
- India-specific vulnerabilities:
- Corporate profitability at a decade-long low; large corporates highly leveraged.
- Stock of banks’ stressed loans—NPLs and restructured assets—at 14.1 percent, with public sector banks responsible for most bad loans.
- High stressed loans and questions about NPL classification undermine banks’ lending capacity.
- Emerging-market resilience factors:
- Improved policy frameworks: increased exchange rate flexibility, higher foreign exchange reserves, more stable FDI flows, domestic currency–denominated external financing.
- Caveat: buffers should not lead to complacency; higher-buffer countries still face risks of capital flow reversals and domestic vulnerability buildup.
Legacy issues in advanced economies
- Common legacies: modest recovery, high public and private debt, low interest rates, persistently high unemployment.
- United States:
- Robust domestic demand; Fed liftoff in December; progress restoring bank capital; but facing dollar appreciation and cuts in equipment investment in mining/energy.
- Monetary policy normalization underway but with easing inflation expectations and market expectations of slower normalization.
- Pockets of vulnerability: overly compressed spreads; high-yield market boom; credit risks concentrated in high-leverage energy sector.
- Europe:
- Progress on banking union and eased monetary policy, but important sovereign and banking vulnerabilities persist.
- Stock of banks’ NPLs: still over 5.5 percent of banking assets or almost 900 billion euros.
- Negative interest rates affect net interest margins; cleaning up NPLs and addressing corporate debt overhang in non-core countries remain priorities.
Weak systemic market liquidity
- Risk of orderly vs. disorderly decompression of risk premia; disorderly adjustment could produce firesales, redemptions, and amplified volatility.
- Vulnerabilities concentrated in credit intermediation channels and market structures.
- High-yield bond market example:
- Mutual funds own almost 30 percent of the U.S. high yield market.
- Liquidity mismatch risk: funds promise daily liquidity but hold increasingly illiquid, higher-leverage assets.
- Share of distressed bonds in the high yield category: risen from about 1 percent in 2013 to 7 percent at the end of 2015.
- Example of stress: Third Avenue fund closure late in 2015.
- Potential amplification: funding stress in highly indebted corporates could spur defaults, bank chargeoffs, and rating downgrades.
Policy choices and scenario risks
- Policy choice framing:
- Option 1: Stay on weak baseline — mediocre growth, asynchronous monetary policies, heightened vulnerabilities, tilted downside risks.
- Option 2: Upgrade policies toward a “Great Normalization” — stronger sustained growth, converging monetary policies, reduced vulnerabilities.
- Risk of inaction:
- “Global Market Disruption” with further volatility, tighter financial conditions, weaker growth, stalled monetary normalization, disorderly deleveraging in emerging markets, and amplified market liquidity risks.
Recommended policy actions (comprehensive, collective, urgent)
- General prescriptions for 2016 and beyond:
- Adopt more comprehensive and concerted policy action combining monetary, fiscal, structural, and financial regulatory measures.
- Use fiscal buffers in commodity exporters to smooth adjustment to lower commodity prices.
- Implement well-designed structural reforms across advanced and emerging economies to lift potential output and reduce over-reliance on monetary policy.
- Monetary and financial measures:
- Clarify and communicate monetary policy paths to reduce uncertainty (noting divergence between Fed intentions and market expectations).
- Euro area banks: comprehensively tackle NPLs and corporate debt overhang to strengthen balance sheets and enhance monetary policy effectiveness.
- Emerging-market priorities:
- Strengthen surveillance over balance sheet risks; build resilience of corporates and banks; keep inflation under control; maintain healthy sovereign balance sheets.
- Advance structural reforms to support a higher growth trajectory.
- China-specific:
- Emphasize clarity and communication on policies to manage the transition to more balanced, sustained growth and a more market-oriented financial system.
- Pursue deleveraging of the Chinese corporate sector in tandem with bank strengthening.
- India-specific recommendations:
- Continue inflation control and fiscal consolidation.
- Prioritize cleaning up public sector bank balance sheets and tackling the corporate debt overhang.
- Address long-standing supply bottlenecks in mining and power; advance land, labor, and product market reforms to support sustained growth.
- Global financial system reforms:
- Complete and implement the financial regulatory reform agenda.
- Reinforce resilience of market liquidity through policies and oversight of asset management and financial market structures, turning shadow banking into a stable source of market-based finance.
- Enhance the global financial safety net and strengthen oversight of capital flow–related risks.
- Consider new financing mechanisms to address risks faced by commodity exporters and vulnerable emerging markets with strong fundamentals.
Concluding assessment
- The Great Normalization is feasible but requires urgent, resolute, and coordinated policy action across monetary, fiscal, structural, and regulatory domains.
- Failure to act promptly risks costly global market disruption and weaker global growth.
Speech by José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department, IMF; Reserve Bank of India, Mumbai; March 10, 2016.