Financial Risks Rise Amid Uneven Global Economic Recovery

IMF Blog, April 15, 2015

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Financial Risks Rise Amid Uneven Global Economic Recovery

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Bibliographic details

• Authors: Jose-Vinals
• Published: April 15, 2015

Three main messages

• Risks to the global financial system have risen since October and have rotated to parts of the financial system where they are harder to assess and harder to address.
• Advanced economies need to enhance the traction of monetary policies to achieve their goals, while managing undesirable financial side effects of low interest rates.
• To withstand the global crosscurrents of lower oil prices, rising U.S. policy rates, and a stronger dollar, emerging markets must increase the resilience of their financial systems by addressing domestic vulnerabilities.

Context: current risks and their rotation

• Global financial stability risks have risen amid a moderate and uneven global economic recovery—with rates of inflation that are too low in many countries.
• Divergent growth and monetary policies have increased tensions in global financial markets and caused rapid and volatile moves in exchange rates and interest rates over the past six months.
• Risk rotation described:
  • From banks to shadow banks.
  • From solvency risks to market liquidity risks.
  • From advanced economies to emerging markets.
• Legacy factor: weakened and incomplete repair of private sector balance sheets is part of the problem.

Five key challenges to safeguard global financial stability

• Enhance the traction of monetary policies.
• Limit financial excesses from accommodative monetary policies and manage negative effects of prolonged low interest rates.
• Preserve stability in emerging markets facing global cross-currents and domestic vulnerabilities.
• Cope with geopolitical tensions (Russia and Ukraine, the Middle East, parts of Africa) and risks in Greece.
• Strengthen market liquidity and complete financial regulatory reforms.

Challenge 1 — Enhance traction of monetary policies

• The European Central Bank and the Bank of Japan have pursued bold monetary policies to counter renewed disinflationary pressures; quantitative easing programs have lowered financing costs in the euro area, surged equity prices, and depreciated the euro and yen significantly, supporting inflation expectations.
• Monetary actions must be complemented by other policies—“QE plus other policies.”
• Euro area specific:
  • Nonperforming loans now stand at more than 900 billion euros.
  • Need to tackle nonperforming loans to unclog bank lending channels; banks burdened with bad loans lend less.
  • Policymakers should encourage banks to deal with this stock of bad loans and implement more efficient legal and institutional frameworks to speed up the process.
• Japan specific:
  • Effectiveness of QE depends on policies supporting it; steadfast implementation of Abenomics’ second and third arrows—fiscal and structural reforms—is essential.
• United States specific:
  • Baseline of a smooth monetary policy normalization is not guaranteed.
  • Divergences between market participants and policymakers over the expected pace of U.S. monetary tightening suggest markets are taking a more benign view of inflation prospects.
  • Low long-term yields suggest potential for upside surprises in long rates when policy tightening becomes more imminent.
  • Smooth normalization requires the Fed getting the pace of “exit” right and clearly communicating to the public; a rapid decompression of yields could increase volatility with global repercussions.

Challenge 2 — Limit financial excesses and manage low-rate side effects

• Example: weak European mid-sized life insurers could face rising risks of distress.
  • Almost a quarter of insurers would be unable to meet their solvency capital requirements if low interest rates were to persist.
  • Life insurers hold a portfolio of €4.4 trillion in assets in the European Union.
  • High and rising interconnectedness with the wider financial system means weak insurers create a source of potential spillovers.
• This illustrates the rotation of risks from banks to nonbanks.

Challenge 3 — Preserve stability in emerging markets

• Lower commodity prices and lower inflationary pressures are benefiting many emerging economies by providing monetary policy space to combat slowing growth.
• But oil- and commodity-exporters and sectors with heavy borrowing face more substantial risks.
  • Strains in the debt repayment capacity of the energy sector may become more evident in Argentina, Brazil, Nigeria, and South Africa, as well as in countries reliant on oil revenues, such as Nigeria and Venezuela.
  • The sharp dollar appreciation entails additional risks for corporates and countries with large foreign currency debts.
• China-specific risks and priorities:
  • Retrenchment from overinvested industries, coupled with property price declines, could spill over to emerging markets more broadly.
  • Exposures to real estate are almost 20 percent of domestic lending in China.
  • Financial stress among real estate firms could lead to direct cross-border spillovers given the substantial increase in external bond issuance since 2010.
  • Priority: allow an orderly correction of excesses, curtail the riskiest parts of shadow banking.
  • Smooth deleveraging requires mechanisms for effective corporate debt restructuring and the exit of nonviable firms.
• Across emerging markets, enhance financial resilience through micro- and macroprudential measures:
  • Conduct bank stress tests related to foreign currency and commodity price risks.
  • More closely and regularly monitor corporate leverage and unhedged foreign currency exposures, including derivatives positions.

Challenge 4 — Cope with geopolitical tensions and localized risks

• Geopolitical tensions cited: Russia and Ukraine, the Middle East, and parts of Africa.
• Risks in Greece are also highlighted.
• Markets can be illiquid when strained, making management of these challenges more difficult.

Challenge 5 / Cross-cutting issue — Market liquidity and regulatory completion

• Market liquidity may appear sufficient in good times but can dry up rapidly when markets are strained, amplifying price shocks.
• During periods of illiquidity since the crisis, correlation across markets has risen, increasing contagion potential.
• Underlying causes of reduced liquidity include:
  • A shift towards high-frequency electronic trading.
  • Reduced market making.
  • Greater use of benchmarks.
• Policy imperatives:
  • Additional policy measures beyond monetary policy are vital to make a durable exit from the global financial crisis and to safeguard financial stability.
  • Address crisis legacies, increase the traction of monetary policies with complementary reforms, contain financial excesses, strengthen market liquidity, and complete financial regulatory reforms.

José Viñals, April 15, 2015 — Financial crisis management

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