Transitions to Financial Stability: A Bumpy Ride
IMF Blog, October 9, 2013
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- Authors: Jose-Vinals
- Published: October 9, 2013
Overview
- The global financial system faces several major transitions along the road to greater financial stability. These transitions are accompanied by substantial risks.
- Five transitions highlighted:
- Transition in the United States from prolonged monetary accommodation towards a normalization of monetary conditions.
- Emerging markets’ transition to more volatile external conditions and higher risk premiums.
- Euro area movement to a stronger union and stronger financial systems, with close links between corporate and banking sectors.
- Japan’s move towards the new policy regime of Abenomics.
- Global transition to a safer financial system requiring completion of regulatory reforms.
U.S. monetary transition and global impact
- Findings and risks:
- The transition to monetary normalization in the United States will be unprecedented and complex.
- Long-term interest rates could overshoot.
- Since May, there has been a sharp rise in bond yields and volatility.
- Lower market liquidity and over-extended allocations to bonds could amplify risks.
- Higher interest rates may reveal weak links in the shadow banking system, exacerbating market and liquidity strains.
- Example: mortgage real estate investment trusts are highly leveraged and susceptible to funding runs; forced asset sales could disrupt the mortgage-backed securities market and spread to broader asset markets.
- Policy recommendations:
- A clear and well-timed communication strategy by the U.S. Federal Reserve to minimize interest rate volatility.
- Effective execution aligned with economic developments.
- Increased macro-prudential oversight and transparency in the shadow banking system to preserve financial stability and allow the Fed to focus on a smooth exit.
Emerging markets
- Key facts and vulnerabilities:
- Since the Lehman crisis, bond inflows into emerging markets have risen by more than one trillion dollars.
- This inflow is well above its long-term trend by almost half a trillion dollars, boosting emerging market corporate borrowing to record levels.
- Events since May point to new financial stability concerns.
- Foreign investors play a bigger role in local debt markets.
- Market liquidity has deteriorated in recent years, making local interest rates more sensitive to changes in investor sentiment.
- Corporate balance sheets have weakened, financial vulnerabilities are rising, and economic growth is slowing.
- These factors expose emerging markets to more severe market stress.
- Policy recommendations:
- If significant capital outflows occur, take steps to ensure orderly market conditions and facilitate smooth portfolio adjustments.
- Address domestic vulnerabilities and enhance policy credibility to keep emerging markets resilient.
Euro area
- Findings on corporate debt and banks:
- Policy actions have reduced funding pressures on weaker sovereigns and banks, but credit remains hampered by financial fragmentation.
- A significant share of corporate debt in stressed economies is owed by companies with weak debt servicing capacity — termed a debt overhang.
- Even if financial fragmentation were reversed, a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal, and Spain.
- The debt overhang affects banks through losses on corporate loans; some banks will need to increase provisioning against expected losses, potentially absorbing a large portion of future bank profits and, in some cases, capital.
- Policy recommendations and actions:
- Address the corporate debt overhang comprehensively — options may include debt clean-ups, improvements to bankruptcy frameworks, or special asset management companies to restructure loans.
- Conduct a thorough and transparent review of bank asset quality via planned balance sheet assessment and stress tests by European authorities.
- Put credible backstops in place before the exercise is concluded to offset identified shortfalls if private funds are insufficient.
- Bolster bank balance sheets in tandem with adequate progress towards banking union.
Japan
- Findings and risks:
- Japan is scaling-up monetary stimulus under the Abenomics framework while the U.S. is considering monetary normalization.
- Policymakers in Japan need to ensure that the policy package is implemented completely.
- A failure to enact the planned fiscal and structural reforms could reignite deflation and intensify financial stability risks.
- Policy recommendation:
- Implement the full set of planned fiscal and structural reforms to reduce risks and support stability.
Moving towards a safer financial system
- Findings:
- Progress has been made on regulatory reform, but work remains.
- Need to complete the regulatory reform agenda, consistently implement new rules across countries, and enhance supervision.
- The system is not yet sufficiently safe; much work remains to be done.
- Overall assessment:
- If the outlined policy challenges are properly managed, the transition towards greater financial stability should be successful and provide a more robust platform for economic growth.
- Policymakers need to steer carefully to navigate the bumps in the road ahead to arrive safely at the destination.
Source: Transitions to Financial Stability: A Bumpy Ride, José Viñals, October 9, 2013
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