Warning Signs as Global Financial Risks Increase
IMF Blog, April 13, 2016
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- Authors: Jose-Vinals
- Published: April 13, 2016
Overview
- Author: José Viñals
- Date: April 13, 2016
- Context: Over the last six months, global financial stability risks increased due to weaker and more uncertain outlook for growth and inflation, falling commodity prices and concerns about China’s economy, and slipping confidence in policy traction.
Recent macroeconomic and market developments
- Markets earlier in the year reacted negatively: global equities plummeted; volatility rose sharply; talk of recession in advanced economies increased; bank equity prices came under renewed pressure.
- By mid-late period referenced, markets improved relative to mid-February lows: equity markets recovered much of their losses, oil prices are higher, and volatility subsided.
- Improvement followed: some better economic news, intensified policy actions by the European Central Bank, a more cautious stance toward raising rates by the U.S. Federal Reserve, and China stepping up efforts to strengthen its policy framework to bolster growth and stabilize the exchange rate.
Major risks identified
- Macroeconomic risks: weaker and more uncertain growth and inflation outlooks; more subdued sentiment.
- Commodity and emerging market pressures: falling commodity prices and concerns about China’s economy placing pressure on emerging markets and advanced economy credit markets.
- Policy traction concerns: doubts about the ability of overburdened monetary policies to offset higher economic and political risks.
Advanced-economy challenges
- Crisis legacy issues remain unaddressed, especially in the banking sector.
- Banks in advanced economies are safer than previously but experienced significant market pressures early in the year.
- Structural profitability challenges persist for many banks.
- Quantified point: These banks account for about 15 percent of bank assets in advanced economies.
- Euro area specific issues: elevated nonperforming loans that need urgent comprehensive strategies; excess bank capacity (too many banks) needs addressing over time.
- Institutional reform recommendation: Europe must complete the banking union and establish a common deposit guarantee scheme.
Emerging-market challenges
- Fallout from commodity price declines has exacerbated corporate and sovereign vulnerabilities.
- After rising indebtedness, emerging economies face slower growth, tighter credit conditions, and volatile capital flows.
- Buffer depletion: many economies used buffers accumulated during boom years; buffers are depleting quickly and some countries are running out of room to maneuver.
- Corporate sector risks: deteriorating corporate health, especially in commodity-exporting countries and commodity-related sectors, increases refinancing pressures and potential spillovers to governments where weaker corporates are state owned.
- Bank resilience: bank buffers are generally adequate in many emerging markets but may be tested by increasing nonperforming loans.
- Policy emphasis: close monitoring of corporate vulnerabilities, swift and transparent recognition and management of nonperforming assets, and strengthening bank resilience.
China: scale and specifics
- China is navigating a transition to slower, more balanced growth and a more market-based financial system; transition remains complex despite progress.
- Corporate-bank nexus is critical: corporate health is declining due to slowing growth and lower profitability.
- Quantified measures:
- “Debt at risk” has increased to 14 percent of the debt of listed Chinese companies, more than tripling since 2010.
- Corporate bank loans potentially at risk in China amount to almost US$1.3 trillion.
- These loans could translate into potential bank losses of approximately 7 percent of GDP.
- Assessment: the magnitude of vulnerabilities is large but manageable given China’s bank and policy buffers and continued strong growth; authorities are putting in place measures to address overindebted corporates.
- Recommended Chinese policy agenda (three items):
1) addressing the corporate debt overhang, 2) strengthening banks, 3) upgrading the supervisory framework to support an increasingly complex financial system.
Potential global scenarios and quantified impacts
- Risk of a pernicious feedback loop: fragile confidence → weaker growth → tighter financial conditions → rising debt burdens → potential economic and financial stagnation.
- Quantified downside scenario: world output could fall by almost 4 percent, relative to the baseline projections, over the next five years (Figure 1). This would be roughly equivalent to forgoing one year of global growth.
- Upside from collective action: tackling the three global challenges could expand world output by up to 1.7 percent, relative to the baseline, over the next five years. That is like securing an additional half a year of global growth.
Policy recommendations and required actions
- Need for a collective approach to policymaking to tackle a triad of global challenges: unaddressed crisis legacy issues in advanced economies, elevated vulnerabilities in emerging markets, and systemic market liquidity risks.
- Deliver a more balanced and potent policy mix beyond overreliance on monetary policy:
- Monetary policy remains crucial but cannot be the only tool.
- Implement well-designed structural reforms.
- Adopt growth-friendly and supportive fiscal policies.
- Strengthen financial policies to further enhance resilience, including completing and implementing the global financial regulatory reform agenda for banks and nonbanks.
- At the global level: complete and implement financial regulatory reforms—including for nonbanks—to bring balance to the policy mix and make policies more potent and effective.
Source: Warning Signs as Global Financial Risks Increase, José Viñals, April 13, 2016.
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