A Bumpy Road Ahead for the Global Financial System

IMF Blog, April 18, 2018

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Author: Tobias Adrian
Date: April 18, 2018
The current economic environment remains favorable, but short-term risks to global financial stability have increased in the past six months, as a result of a spike in stock-market volatility in February and continuing investor concerns about rising geopolitical and trade tensions.
Given current financial conditions, risks to financial stability and growth are high over the medium-term; there is even a small chance of a global economic contraction over the medium-term.
The global financial stability assessment in the latest Global Financial Stability Report (GFSR) uses the “Growth-at-Risk” approach that links financial conditions to the distribution of future economic growth.
Larger imbalances mean that any shock to the economic or financial system would trigger a more painful adjustment. Examples include:
- A faster-than-anticipated increase in US inflation could cause the Federal Reserve and other central banks to withdraw monetary accommodation more quickly than is currently expected, and that could shake financial markets.
- A wider escalation of protectionist measures would take a toll on financial markets as well as growth.
- A sudden decline in asset prices could expose vulnerabilities in the financial system.

The report identifies three areas of vulnerability:
- Weakening credit quality.
- External debt-related vulnerabilities in emerging markets and low-income countries.
- Dollar liquidity mismatches among banks outside the United States.

Weakening credit quality:
- Global issuance of leveraged loans—made to riskier companies and those with high debt loads—rose to a record $788 billion last year.
- Lower rated US and euro-area companies account for a growing proportion of corporate bonds.

External debt in emerging-market and low-income countries:
- Foreign capital flows have remained robust in recent years, with more emerging and low-income economies benefitting from favorable external financing conditions.
- As the global liquidity tide recedes, flows to emerging markets could decline by as much as $60 billion a year, equal to about a quarter of annual totals in 2010-17.
- More than 40 percent of low-income countries are at a high risk of debt distress.

US dollar liquidity mismatches among non-US banks:
- Internationally active non-US 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 terms of size or maturity, leaving banks exposed to dollar funding problems in the event of a sudden tightening in financial conditions and strains in markets.

Some underlying technologies could make financial market infrastructures, such as payment systems, more efficient.
Crypto assets have been afflicted by fraud, security breaches, operational failures, and have been associated with illicit activities.
The limited size of crypto assets suggests they currently pose little risk to financial stability, but risks could grow if their use became more widespread without appropriate safeguards.

Policymakers should take advantage of today’s favorable environment to adopt safeguards against looming financial risks.
Specific recommendations:
- Central banks should continue to gradually withdraw monetary accommodation, where appropriate, while communicating their decisions clearly.
- Regulators should address financial vulnerabilities by deploying and developing regulatory and financial policy tools.
- Policymakers should ensure that the post-crisis regulatory reform agenda is completed — and they should resist calls for rolling back reforms.
- Emerging markets and low-income countries should build reserves and fiscal buffers against external risks.

The global economic recovery has so far been resilient to pronounced swings in financial markets, but investors and policy makers should remain attuned to risks associated with rising interest rates, elevated market volatility, and increasing protectionism.
The road ahead may well be bumpy.
For an explanation of the new “Growth at Risk” model, click here .
To listen to Podcast click here.

Source: A Bumpy Road Ahead for the Global Financial System — Tobias Adrian, April 18, 2018

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