Outlook for Global Stability: A Bumpy Road Ahead
IMF News, April 27, 2018
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- Published: April 27, 2018
Executive summary and main message
- Short-term risks to global financial stability have increased over the past six months — as stock-market volatility has risen, and as investors have grown more concerned about geopolitical tensions, especially over trade policy.
- The odds of a downturn remain elevated, and there’s even a small chance of a global economic contraction over the medium term — that is, over the next three years.
- Main policy challenge: address financial vulnerabilities without undermining growth, and avoid inward-looking policies — particularly on trade — that may damage longer-term prospects for the global economic and financial system.
“Growth at Risk” methodology and key distributional findings
- “Growth at Risk” links current financial and economic conditions to the distribution of future growth outcomes and identifies severely adverse outcomes in the left tail (small probability, 5 percent).
- One-year-ahead conditional distribution:
- In the severely adverse scenario (5th percentile), global growth one year from now will be about 3 percent or less.
- Three-year-ahead distribution:
- The three-year-ahead distribution is notably more skewed toward the left; in the severely adverse scenario global growth is more likely to be negative three years from now.
- Trade-tension scenarios using Growth at Risk:
- Near-term channel: increased uncertainty tightens financial conditions, fattening the left tail of the one-year-ahead distribution.
- Medium-term channel: a reduction in global output shifts the entire three-year-ahead distribution leftward, lowering both central and severely adverse outcomes.
Global financial conditions and vulnerabilities
- Compared to six months earlier, global financial conditions have tightened moderately but remain very accommodative overall in both advanced and emerging economies.
- Offset in market indicators:
- Expected short rates in some markets (notably in the United States) have edged higher.
- Equity-market volatility has increased.
- Investor risk appetite remains strong, as reflected in prices of risky assets.
- Five specific vulnerabilities identified:
- Stretched asset valuations
- Weakening of credit quality
- Vulnerabilities in Emerging Markets and Low-Income Countries
- Bank funding (U.S.-dollar) mismatches
- Greater synchronization of house prices
Stretched asset valuations and market volatility
- Stock-market valuations remain elevated despite the February sell-off; cyclically adjusted price-to-earnings ratios (“CAPE”) have continued to rise in many regions, most notably in the United States.
- Volatility:
- First spike in early February referred to as “the VIX tantrum.”
- Equity volatility currently remains closer to historical averages, reflecting higher uncertainty due to geopolitical and global trade tensions.
Credit quality concerns
- Late-stage credit-cycle dynamics evident in advanced-economy credit markets.
- Leveraged loans:
- Global issuance of leveraged loans reached a record $788 billion last year.
- Covenant quality has continued to decline.
- Lower-rated corporates in the United States and in the Euro area now account for a greater proportion of bonds than they did 10 years ago.
Emerging Markets and Low-Income Countries (LICs)
- Foreign capital flows have remained robust over the last six to 12 months, allowing weaker Emerging Market sovereign issuers to gain market access.
- Non-investment-grade issuance has risen to more than 40 percent of total Emerging Market sovereign issuance over the past year.
- In many Low-Income Countries:
- Public debt vulnerabilities have increased.
- Bond issuance has reached record highs due to easier market access.
- Creditor composition has become less borrower-friendly: share of Paris Club debt declined from 62 percent to 28 percent between 2007 and 2016; external financing provided by commercial and non-Paris-Club creditors has doubled.
- 40 percent of Low-Income Countries are at risk of, or are already in, “debt distress,” based on the IMF’s debt-sustainability assessment.
Bank U.S.-dollar liquidity and funding mismatches
- Most internationally active non-U.S. banks rely on short-term, or wholesale, sources for about 70 percent of their dollar funding.
- Dollar liabilities are not always evenly matched with dollar assets in size or maturity, creating structural U.S.-dollar liquidity mismatches for non-U.S. banks.
- Aggregated liquidity ratios for non-U.S. banks:
- Dollar-liquidity and stable-funding ratios look notably less favorable than similar ratios at the consolidated level.
Synchronization of house prices
- There has been a steady increase in house-price synchronization across countries.
- Greater financial integration increases the role of global factors for house-price valuations, and synchronization tends to increase sharply in the run-up to a crisis — signaling downside risk to real economic activity.
- As policy tightens in the United States and elsewhere, a widespread decline in house prices could pose risks to financial stability.
China-specific analysis and vulnerabilities
- China’s authorities have taken important steps to reduce financial-system risks, including tightening the regulatory framework; these efforts have slowed the buildup of bank vulnerabilities but risks remain elevated.
- Interconnectedness of banks and nonbank financial institutions:
- Investment vehicles are both large (at about 100 percent of GDP) and opaque.
- On the asset side: these vehicles are largely invested in illiquid corporate debt and provide leverage to banks and other financial vehicles.
- On the liability side: about half of investment vehicles’ funding is sold to investors as high-yielding alternatives to bank deposits.
- This creates significant maturity and liquidity mismatches; investment vehicles borrow from banks and other funds, exposing banks as investors, creditors, guarantors, borrowers, and managers.
- Small and medium-sized banks and insurers are heavily exposed through on-balance-sheet holdings of these products.
- Bond-market characteristics and liquidity risks:
- Trading volumes have been falling, particularly for credit and rates bonds, even as the market continues to grow.
- NCD trading has risen sharply, while trading activity for bonds with a residual maturity greater than one year has declined — suggesting front-end liquidity concentration.
- Repo vs. spot dynamics:
- Spot trading volumes are closely correlated with repo volumes, particularly for riskier bonds.
- Repo volumes are many multiples of spot volumes; repo activity may reflect leveraged carry-trade activity rather than pure market-making.
- If safe bonds can only be financed through repos and not easily sold in stressed markets, liquidity depends on counterparties’ balance-sheet capacity and appetite for counterparty risk, making collective deleveraging harder.
- Yield-curve flattening or inversion occurs fairly frequently because only the front end of the curve is liquid during deleveraging episodes.
- Investment funds and implicit guarantees:
- Investment funds have become a critical part of the bond-market investor base, largely allocating to credit bonds and short-term bank funding instruments while being less active in rates-bonds markets.
- Many investment vehicles benefit from implicit guarantees from sponsors and are structured as fixed-yield products that do not face mark-to-market pressures.
- If reforms unwind implicit guarantees and increase mark-to-market (NAV) pricing, investors would become more risk-sensitive and would likely shift toward safer assets, promoting market deepening but potentially reducing short-term net demand for riskier corporate bonds and weighing on credit growth.
China policy actions and recommended reforms
- Actions taken by China’s authorities:
- Introducing asset-management reforms, strengthening liquidity buffers, and cracking down on nonbank regulatory arbitrage — including through the use of the macroprudential policy assessment (MPA) tool.
- Strengthening central coordination and policymaking by increasing the powers of the PBOC and by unifying the banking and insurance regulators.
- Announcing improved financial-system data collection.
- Key recommendations from the Fund’s FSAP for securities markets and asset-management sector:
- Strengthen the legal framework and data disclosure for Wealth Management Products and other investment vehicles.
- Prohibit promises of “expected yields” and other similar debt-like features of Wealth Management Products.
- Address regulatory arbitrage between banking, insurance, and securities businesses — through enhanced functional supervision.
- Guidance on implementation:
- New asset-management rules set to take effect this year are a promising blueprint and should be gradually phased in to allow time to address data gaps and strengthen buffers.
- Effective implementation will be critical: reforms should be carefully calibrated and properly sequenced, and credit growth should be allowed to decelerate as necessary for financial stability and sustainable medium-term growth.
Policy implications and concluding points
- With elevated financial vulnerabilities, any shock to the financial system is likely to cause more extensive damage and require more significant adjustment.
- Even though U.S. monetary-policy normalization has been smooth so far, markets remain vulnerable to an unexpected policy tightening; a higher-than-expected inflation reading could trigger faster-than-expected tightening and tighter financial conditions.
- Policymakers should:
- Address vulnerabilities across stretched asset valuations, credit quality, EM and LIC debt exposures, bank dollar funding mismatches, and house-price synchronization.
- Avoid inward-looking trade policies that could increase near-term uncertainty and shift medium-term growth distributions leftward.
- Implement and sequence financial reforms (notably asset-management reforms) to remove implicit guarantees and strengthen market functioning while managing the growth-stability trade-off.
Speech by Tobias Adrian at the Sixth Joint Conference, People’s Bank of China and IMF, April 27, 2018. IMFC Communications Department.