Global Financial Stability: Beginning To Turn The Corner
IMF Blog, April 9, 2014
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- Authors: Jose-Vinals
- Published: April 9, 2014
Progress
- Global financial stability is improving; "we have begun to turn the corner."
- U.S. economy is gaining strength, setting the stage for the normalization of monetary policy.
- In Europe, better policies have led to substantial improvements in market confidence in both sovereigns and banks.
- In Japan, Abenomics has made a good start as deflationary pressures are abating and confidence for the future is rising.
- Emerging market economies are adjusting policies in the right direction after recent bouts of turmoil.
Challenges
- Need to move beyond liquidity dependence to overcome remaining challenges to global stability.
- Key risks in the United States:
- Can the United States make a smooth exit from unconventional policies? Termed the “Goldilocks exit” — not too hot, not too cold, just right.
- Baseline: normalization has begun; Fed tapering; policy rates expected to start rising by mid-2015.
- Adverse (bumpy exit) scenario: faster rise in policy rates and term premiums, widening credit spreads, and a rise in financial volatility that could spill over to global markets.
- Growing hotspots in the U.S. financial system, particularly in the shadow banking system: strong issuance of high-yield bonds and leveraged loans, weakened underwriting standards, and underpricing of risk.
- High-yield issuance over the past three years is now more than double the amount recorded before the last downturn.
- High yield bond spreads have fallen close to pre-crisis levels.
- Supervisory measures are more intense but have not yet sufficiently restrained some excesses.
- Emerging market vulnerabilities:
- Especially vulnerable to a tightening in the external financial environment after prolonged capital inflows, easy access to international markets, and low interest rates.
- Substantial corporate borrowing in emerging markets could be pressured by rising interest rates, weakening earnings, and depreciating exchange rates under the adverse scenario.
- In the adverse scenario, emerging market corporates owing almost 35 percent of outstanding debt could find it hard to service their obligations.
- China:
- Nonbank financial institutions have become an important source of financing in China, doubling since 2010 to 30 to 40 percent of GDP.
- Non-bank lending diversifies the system but poses risks as savers may not realize higher risks behind nonbank savings products due to the perception of implicit guarantees.
- Challenge: achieve an orderly deleveraging of the shadow banking system and manage the transition to greater market discipline and accurate risk pricing, including removal of implicit guarantees, without triggering systemic stress.
- Euro area:
- Incomplete repair of bank and corporate balance-sheets continues to place a drag on the recovery.
- Fragmentation between periphery and core countries persists; accommodative monetary conditions have not translated into the flow of credit needed, particularly for smaller companies.
- Need to strengthen bank balance sheets through the European comprehensive bank assessment and follow-up, and to tackle the corporate debt overhang.
- Geopolitical risks:
- Spillovers surrounding developments in Ukraine have been limited so far, but geopolitical risks remain elevated and could pose a shock to global markets.
- Market liquidity risk:
- Sizeable inflows into emerging markets over past years could reverse.
- Asset price moves may be amplified by lower market liquidity conditions, with more investors running for the exit than the exit door can accommodate, potentially extending to some segments of developed markets and amplifying market volatility.
Scenarios and dynamics
- Baseline scenario:
- Fed tapering proceeds; "green shoots" of recovery visible; easy money leads to credit which spurs growth.
- Policy rates starting to rise by mid-2015 per baseline.
- Adverse (bumpy) scenario:
- Triggered by growing U.S. concerns about financial stability or higher-than-expected inflation.
- Consequences: faster rise in policy rates and term premiums, widening credit spreads, higher financial volatility, spillovers to global markets.
- Emerging market corporates owing almost 35 percent of outstanding debt could face servicing difficulties.
- Sudden rise in yields could substantially widen credit spreads and exacerbate leverage and default risks.
Policy recommendations
- Overarching message: strong policy actions are needed to shift from “liquidity-driven” to “growth-driven” markets.
- First:
- Get the normalization of US monetary policy right—its timing, execution, and communication.
- Effective macro-prudential policy is key to allow for smooth exit by containing financial stability risks, particularly in the shadow banking system.
- Second:
- Emerging markets should continue to prepare for tightening in global financial conditions by enhancing resilience through strong macro and prudential policies, building policy buffers, and managing corporate financial risks.
- Emerging markets should be ready to ensure orderly market conditions through adequate provisioning of liquidity in the event of turbulence.
- Third:
- Japan needs to complete Abenomics.
- The euro area needs to finish cleaning both bank and corporate balance sheets, start the banking union right, and develop non-bank sources of credit to smaller companies.
- These steps are paramount for confidence and recovery.
- Global cooperation:
- Greater global policy cooperation is needed across monetary policy, financial regulation and supervision, and ensuring orderly market conditions.
José Viñals, April 9, 2014
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