Transcript of Global Financial Stability Report Launch of the Analytical Chapters

October 4, 2017






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MR. DONNAN: Good morning from the IMF, here in Washington. I'm Shawn Donnan, the World Trade Editor for the Financial Times. We are here this morning to launch the analytic chapters of the Global Financial Stability Report (GFSR). The main GFSR chapter will be released next week at the Annual Meetings here in Washington, of the International Monetary Fund.

We are looking at two very important subjects today, household debt, and also financial conditions what they tell us about economic growth, and how it may be at risk or not be at risk. Joining me to do this today are, Claudio Raddatz, who is Head of Global Financial Stability Analysis Division at the IMF. Claudio, Welcome.

MR. RADDATZ: Good morning, Shawn.

MR. DONNAN: Also joining me, Nico Valckx, a Senior Economist in the Division, who is our expert on household debt this morning; and Jay Surti, Deputy Chief of the Global Financial Stability Analysis Division, who is also our expert on these kinds of early-warning signs that we can see among financial conditions and their effect on growth.

Again, we are launching chapters two and three of the Global Financial Stability Report; Chapter 1 comes out in full next week.

Claudio why don't you start off by walking us through why it is that you chose to look household debt on the one side, and this question of what financial conditions do they tell us about how growth may be at risk.

MR. RADDATZ: Sure, Shawn. Let me start first from what is the goal of the analytical chapters in the Global Financial Stability Report. The goal is to go beyond the current headlines and identify and provide in-depth analysis about the structural trends in the global financial system, and the likely consequences for financial stability.

They also aim to develop tools that can help policymakers identify risks to financial stability, and take proper actions if needed. So, the two chapters that we are launching today follow this tradition. The first one, as you mentioned, provide some new evidence on the relationship between household debt and economic growth and financial stability. The second one shows how to use financial conditions in order to forecast risks to growth.

So, that is the big picture. Let me tell you a little bit about why is that we are focusing now on household debt. There are several reasons to be interested in household debt, but I would like to highlight the three that are behind our motivation. The first is that the experience from the global financial crisis suggests that rapid expansion in household debt, especially mortgages, can be dangerous. Indeed, some of the countries that were most severely affected by the global financial crisis had seen large expansions in household debt, and house prices.

The second reason, which is also closely related to this one, is that, motivated by this experience, some new research has started focusing on how increases in credit, including household debt, can help predict financial crisis, and future declines in economic activity. What this evidence is starting to suggest is that household debt may play an active role in amplifying shocks to the economy or to the financial system, and it's not just a side show in the story.

The third, and probably most important reason, is that we have seen an increase in household debt in the nearly a decade since the global financial crisis. When we measure household debt to GDP, for instance, we see a broad-based increasing trend across both advanced and emerging market economies. And even those economies where this ratio has declined, as a result of the post-crisis deleveraging process, the levels are still high by pre-crisis historical standards.

So, for these three reasons we thought it was timely and important to have a comprehensive look at household debt and its relationship to financial stability and economic growth using both macroeconomic and microeconomic data, a variety of statistical techniques, and perhaps most importantly a broad sample of countries that can help us identify under what conditions household debt is most likely to yield risks to growth and financial stability, and what can countries do to mitigate those risks. This is precisely what chapter two of the GFSR is doing.

Now, chapter three: why analyzing the relationship between financial conditions and risks to growth? Our main motivation is that we have learned that the financial system and the real economy are closely linked. Some events that take place in the financial system may affect not only financial intermediaries, and market participants, but they may also put growth at risk.

This strongly suggests that information in financial conditions—understood as a broad set of financial indicators that give you a picture of the state of financial system—can be useful to forecast risks to growth. The problem is that finding a way of quantifying these risks associated with the financial system has been difficult.

Policymakers rely on a variety of tools to assess the stability of the financial system, including stress tests, expert judgment, and early warning indicators, that link the state of the financial system to, the probability of a financial crisis or capital shortages in the banking sector. But while they are useful, none of these tools map the state of the financial system to forthcoming risks to growth.

So, we thought that having a tool that does that would be really valuable for policymakers as a useful addition to their toolbox. It would allow them to conduct financial surveillance, and also could be used to evaluate policy options. For instance, this tool would tell us what are the odds of having a recession in one quarter, one year, or even further ahead in the future, given the current state of the financial system. You could also ask hypothetical questions such as what would be the consequences of the movement in financial variables for the odds of a recession.

So, we think that this tool would be valuable for policymakers, and that's why we devoted chapter three to develop it.

MR. DONNAN: The kind of crystal ball that every policymaker wishes they had in their office. Just before we go any further, I just want to point out that we are ready to answer your questions live. So, if you have any questions please email them to and through the magic of technology they’ll get to me. It's a rare opportunity to throw your questions at these experts.

Nico, let's build on this idea. The whole idea that since the crisis, household debt has risen across both advanced and emerging economies goes against what I remember reading at the time, or shortly after the crisis, about the great deleveraging that was going on. So, what are you seeing out there? You’ve spent the last few months of your life looking into this issue.

MR. VALCKX: Yes. Well, we see a short decline in the household debt-to-GDP ratio in a number of advanced economies. The ones that were most severely affected by the financial crisis—the U.S., U.K., some European countries, the Baltics—we document that in the chapter. But that was fairly short-lived. Since a couple of years, the trend of household debt to GDP—the measure that we use throughout the chapter to assess the developments in household debt, has picked up again.

MR. DONNAN: But that's advanced economies?

MR. VALCKX: That has been the case in advanced economies.

MR. DONNAN: You are also seeing something similar in emerging economies?

MR. VALCKX: In emerging market economies we do not see much of a decline; no decline at all in fact. We just see a gradual increase, in some cases a more rapid increase in the household debt-to-GDP ratio. What that reflects is more of a financial development type of situation, or a development related to the fact that in those countries, usually the levels are much lower. They start very low out with 10 percent household debt-to-GDP ratios, whereas in advanced economies typically the level is about 50, 60 percent of GDP.

MR. DONNAN: And what's the composition of this debt? Are we talking about mortgages, are we talking about credit cards?

MR. VALCKX: All of that. We talk about the global composite measure of household debts, that includes mortgage and non-mortgage debts, that's everything basically. It's consumer loans, car loans, student loans. Any loan from a bank or other type of lender is accounted for in those figures.

We've done that comprehensively. We've looked at 80 countries, about 40 advanced economies, and 40 emerging markets and low-income countries from across the globe, so as to get a fairly comprehensive picture of what is happening to the state of household debts.

MR. DONNAN: So, how worried should we be? I mean you are talking about households around the world loading up on debt, that doesn’t sound good.

MR. VALCKX: Well, yes and no. I mean we do a statistical analysis to sort out what is the relationship with economic growth, consumption, and employment on the one hand, and with the probability of entering into a banking crisis on the other hand. We control for a number of factors and overall what we find is that in the short term, households debt can be a boon or a boost to economic growth, and to employment and to consumption, but those effects are typically reversed in a couple of years further down the line.

The reasons for that being several. One has to do with the effect of leverage: households take up debt become more indebted, face higher debt service burdens, and then if something goes wrong, a negative shock hits their income and they may not be able to pay the higher payments on the debts. Then they need to scale back consumption, and that translates into macroeconomic negative effects in a couple of years afterwards.

That also tells us something about expectations formation. Often we've have seen studies documenting that households have sometimes short-term expectations. Not only households, but also in the real estate sector, we see that right before a crisis, real estate agents were pricing out further increases in house prices even though the trend was already declining. This tells us that households may not discount all future possible risks, and neglect downside risks.

MR. DONNAN: I want to come back to you Nico, but first let me go to Jay.


MR. DONNAN: Jay, in Chapter 3 you are talking about assembling a kind of canary in the coal mine, a crystal ball, whatever you want to call it, but something that really allows policymakers to have an early warning system in terms drawing signals out of the financial system and what that means for growth in their economies. So, what does the kind of crystal ball tell you now? Talking about household debt, if you look at the signals in the financial system, how worried should we be?

MR. SURTI: Shawn, let me continue where Claudio left off. What Chapter 3 of the GFSR does is to present a new tool that uses the information contained in financial conditions to foresee, to assess, the risk to growth. Now, if you think about the run-up to the Global Financial Crisis, this was preceded by a period of seeming calm in financial markets. There was abundant credit, market volatility was low, and interest rates were low, cost of financing was quite low, and what this period did was it bred significant risks for the real economy, eventually.

And this is because financial vulnerabilities—be it leverage or mismatches in the maturities of assets and liabilities of corporates, households, and financial institutions. These vulnerabilities tend to increase significantly during such conditions, and once they are elevated, they tend to greatly amplify the negative impact of shocks on economic activity.

So, all of this strongly suggests to us that if we can somehow use the information in financial conditions when we look at the outlook and risks for growth, then we can get richer answers which can then better inform policy.

So, that's what this chapter contributes to. It develops new techniques and tries to extract this information from financial conditions and illustrates the potential of doing so by applying the model to a set of major advanced and emerging market economies—some of the largest in the world.

So, what did we find in terms of broadly-applicable findings? When you look at certain segments of financial information—what I'll call the price of risk—this includes asset prices and returns, risk sentiment of investors, which generally drives volatility in financial markets, and also spreads, that is the cost at which ordinary people, corporates, firms, can get funding.

MR. DONNAN: The risk premium.

MR. SURTI: The risk premium. A rise in any of these or a fall in asset returns tends to signal imminent risk of a large macroeconomic downturn within a year, or maybe even earlier. On the other hand, if people are loading up on debt, or if the pace of credit growth is rising, this usually tends to signal a higher likelihood of a downturn in the medium term, maybe two or three years out. But these are not just qualitative insights. The model we develop in Chapter 3 also helps us actually quantify some of these risks.

Let me just quickly illustrate the application of this model to the global economy. Now, over the last quarter century or so, global growth has averaged about 3½ percent. If you were to look at the likelihood of this growth falling below 1 percent, a level which is significantly lower, then the likelihood is about 5.8 percent, on average. If you were to look at the constellation of financial conditions I mentioned in the first quarter of 2008, feed it into this model, that likelihood of growth falling below 1 percent one year out—just after Lehman Brothers—would rise to around 20 percent.

MR. DONNAN: Why don't we go back, Nico, to you and this question? When I think of debt and the global economy, I think of the two largest economies: the U.S., and China. We often think about the power of the U.S. consumer, and that gets into household debt on one side; and then we think of the rising power of the Chinese consumer on the other side. Why don't we start with that rising power in terms of China? Now, I think you've got a box in Chapter 2 that I found fascinating. It is about the changing situation in China, where household debt, as a percentage of GDP, has gone from roughly 18 percent in 2007, to around 38 percent in 2016.

MR. VALCKX: That is correct.

MR. DONNAN: What's behind that, and should we be worried?

MR. VALCKX: Well, what's happening in China is exemplary for emerging markets in general. It's the rapid increase from very low levels to higher and higher levels. Part of that is a normal economic development story. As a country develops, financial markets become bigger, deeper, more efficient, and that allows for more finance in the economy and for households to take on debt. We also document in another box, as a separate analysis, that in the long run, more household debt in per capita terms, is good for growth up to a certain point, after which there may be too much finance. So, developmentally it's a good thing.

Now, the other thing is that China is a specific case because they had a housing policy in place, where households were given houses. So, you see a very large stock of households still owning their own house.

MR. DONNAN: That's an amazing figure you've got in there—90 percent of Chinese households own property.

MR. VALCKX: Exactly. But that is a legacy issue. That's no longer the case. The Chinese authorities stopped this policy in the late-1990s, and since then households that are in their 20s, 30s, 40s they need to buy their houses at market prices. That explains the rising household debt, together with the rising house price. This explains why we see more of a vulnerability developing in terms of debt-service burden and higher debt relative to these households’ incomes.

Now, if everything goes fine, this is a good story. But, as we have seen throughout the financial crisis and across our sample of countries, things may not always be rosy. There may be downturns and recessions, and then you will still have to be able to service a debt one way or another. If you cannot, that creates vulnerability; and there we see, possibly a couple of years ahead, a vulnerability increasing.

Now, specifically for China, I wouldn't say that the risks are very high, given the overall debt level is at 40 percent. That's still at the lower level relative to our sample. We've done some analysis where we've looked at which level does that become risky, in general, for growth; and we see that developing more towards a higher household debt to GDP level.

MR. DONNAN: I want to follow-up with a question on the U.S., but we've also got a question sent online by Sandro Pozzi from Spain’s El Pais who asks which countries among advanced economies have seen the biggest increase in household debt?

MR. VALCKX: We document that in our chapter in a bit more detail. We name a couple of countries and we do a case study in a Box 2.3, specifically for the U.S. and Canada. These are two countries that come to mind for their high level of household debt to GDP, in general. But they're also quite different in a sense. They follow a similar pattern up to the global financial crisis with household debt-to-GDP ratios rising from around 55 or 60 percent to 80 percent; and to 100 percent in the U.S. But then you see diverging developments. While the U.S. households had to delever, Canadian households further increased their debt level to GDP from 80 to 100 percent of GDP.

So, you see, broadly speaking, there are rising levels of household debt across advanced economies, but with some nuances and differences, even like for U.S. and Canada.

MR. DONNAN: So, Sandro Pozzi asks a question that's always on the mind of journalist when we're here at the IMF. Does any of that out there in advanced economies look dangerous?

MR. VALCKX: It's a question you have to approach with a certain nuance. We do in our chapters some more detailed analysis. If you look broadly at the question, an increase in household debt in the future may pose certain risks; but there's a lot that policymakers can do, and there's a number of factors that can attenuate the risks. In the blog that we published today and that related to Chapter 2, we document that on the policy side, actually three to five years out, household debt risk can be mitigated quite well by adopting a number of policies.

MR. DONNAN: Would you name some of those policies?

MR. VALCKX: Indeed. Those include good financial regulation, having a reporting system, like a credit bureau or transparency on loans available; good protection for households in terms of financial literacy, so that households know how much they borrow; that they do not over borrow; that you're educated about the choices; but also some macro policy considerations come to mind. The dependence on external financing, for example, is one. If you price your loans in a foreign currency - that is riskier—also for household debt—and that is one factor that interacts significantly with the effects of household debt on GDP.

MR. DONNAN: And that's something we saw during the crisis with the U.K., with homeowner having their mortgages denominated in euros or in Europe, in Swiss francs. Claudio, you want to jump in?

MR. RADDATZ: Yes, if I may, I would like to add to Nico’s answer. As he correctly put it, the main message that we have in the chapter is that while, on average, increases in household debt signal some risks to economic activity in the medium term, there is a lot of variation across countries on how these risks actually map, and this variation is associated with several factors: with the initial level of household debt, and with all the institutional and country characteristics that Nico mentioned. So therefore, a full assessment of the risks that are posed by increasing household debt in a specific country has to take into consideration all these elements. That is an important message from the Chapter. We should keep it in mind. So, (we need) a broad perspective, to evaluate the risks rather than just a simple mechanical analysis.

MR. DONNAN: So, what you're telling us is we've seen an increase since the crisis, but you shouldn't necessarily be worried about that yet, at this point. I think you make a point, Nico, just to come back to that question of when we get worried. In the chapter, you talk about the increase in household debt being good for growth and then three to five years down the track, things get a little more complicated. I'm wondering are we three to five years down the track?

MR. VALCKX: Well, as Claudio mentioned, it's an analysis that you have to approach with having in mind exactly how much growth there is in each country. There is no perfect synchronization. Not all the countries grow at the same rate; but, in general, we do find, for example, that a 5 percent increase in household debt over a three-year period can have a negative effect on GDP of -1.25 percent three or four years out.

Once again, this depends a lot on specific countries and what is their dependence on external finance; their foreign exchange rate regime; whether they have a credit bureau; or they have good financial regulation in place; how is the income inequality, that's another factor that plays a role. So, a lot of factors that can be influenced, and a lot of policies that can also influence the buildup in household debt.

In fact, we also have an analysis that looks at a specific set of policies—namely macroprudential policies—which are now coming in vogue among policymakers that are able to curb household debt increases very significantly.

MR. DONNAN: Jay, we've only got a few minutes left, but I want to come back to you and, again, this model that you got. I interrupted you slightly. You were talking about asset prices, and the kind of the broad realm of asset prices as one of the factors you were looking at. Just walk us through what some of the other financial conditions that you're looking at.

MR. SURTI: Sure. So, in our model, financial conditions are maybe organized into three blocks. We've discussed what I called the price of risk earlier. What we find in the chapter, is that this is particularly useful in signaling threats to growth at relatively short horizons.

There's another block which is related to leverage. Leverage, broadly within the economy, not just within financial institutions but, also, household debt, which Nico's chapter looks at, and corporate debt, which we've looked at in past editions of the GFSR.

Now, leverage is particularly useful because it complements asset prices. It tends to signal risks that are not imminent but may develop over a period of time, if people are loading up on debt. It may make it difficult for them to keep on consuming, to keep on investing, if they get faced with shocks from the asset market.

Then there's a third block which is developments that affect financial conditions that come in primarily from the global environment. Global risk sentiment as captured by indexes like the VIX or the MOVE—signals how much money global investors are willing to put into other financial markets—for example. Commodity prices are particularly important in countries which export or import commodities. Similarly, exchange rates of countries carry information about a whole host of things that are happening outside and which are relevant to growth in the domestic economy.

So, three blocks: the price of risk; the external conditions, and leverage.

MR. DONNAN: Claudio, we've got a minute left, which gives us ample time for you to wrap with one broad message. These are two fascinating chapters, containing a lot of information for people to chew on as we go into the IMF Annual Meetings next week. But, just quickly, the broad message that you want to send.

MR. RADDATZ: Well, I think that the chapters that we are releasing today have valuable lessons for policymakers. So, I would like to highlight a few of them in closing.

So, in Chapter 2, as we have discussed, we find that the risks that are coming, or maybe associated, with increases in household debt vary from country to country; and this variation depends on a country's initial level of debt and institutions, as well. So, what is the message that we should get from here? First is that, in the medium term, there is plenty of things that countries can do in order to reduce and mitigate the risks that may arise from increases in household debt; and we have discussed some of the options.

Second is that in the short run, policymakers in countries that are experiencing increases in household debt may need to take a broad perspective in order to evaluate the risks that these developments pose to future growth. Again, we have discussed this in terms of what is the initial level of debt; what is the stance of their country in terms of all these institutional dimensions that we discussed, including the potential long-term benefits of financial inclusion, before deciding whether further action is needed.

The third message is that if you decide that policy action is needed, our analysis shows that there are plenty of macroprudential policies that you can use to reduce the growth of household debt.

Moving to Chapter 3, the main message we would like to convey is very clear. Our results show that financial conditions can give powerful signals about risks to future growth, and we think that this strongly suggests that this would be a very useful tool for policymakers’ surveillance tool box. Policymakers may want to further customize this tool to carefully calibrate it to specific conditions in their countries keep updating it to keep track of developments in their financial systems, but this tool would be a nice complement to other surveillance approaches, and it could be used also to further guide and evaluate policy options in the future. So, I think that is the main message from Chapter 3.

MR. DONNAN: Super. So, all the finance ministers landing in town next week should look in their swag bag for this new tool. Gentlemen, thank you so much for your time and thank you so much for joining us online. From the IMF here in Washington, I'm Shawn Donnan. Thanks for watching.

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