IMF Survey: Government Borrowing Is Rising Risk to World Financial System

IMF News, April 20, 2010

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Publication: IMF Survey online, April 20, 2010.
Core message: While unprecedented government interventions have helped stabilize the global financial system and world economy, the sharp rise in government debt during the economic crisis has created growing sovereign risk that could undermine the recovery and prolong the financial crisis.

Improving economic and financial conditions have helped private bank balance sheets in advanced economies.
The IMF reduced its estimate of writedowns or loan loss provisions banks will have to take for bad loans and securities on their books from $2.8 trillion (last October) to $2.3 trillion.
Banks already have written off about $1.5 trillion of the $2.3 trillion, the IMF estimates.
Credit recovery will be “slow, shallow and uneven,” as heavy government borrowing soaks up available funds and banks remain reluctant to lend.
There is little evidence, at least so far, of bubbles in asset prices in emerging markets, despite strong portfolio flows to Asian and Latin American countries.
Authorities must address how to manage borrowing and spending to minimize sovereign risk.

The global banking system is recovering from severe funding difficulties and lack of confidence experienced two years earlier.
Improvements: expected writedowns reduced; bank capital positions have improved substantially.
Remaining concerns:
- Banks must refinance nearly $5 trillion in debt that will mature in the next three years.
- Liability-side pressures may rise as special government assistance programs are withdrawn and heavy government issuance coincides with bank refinancing needs.
- Problem pockets exist in regional U.S. banks with heavy real estate exposure; Spanish banks with exposure to real estate development loans; and some regional banks in Germany.
- Troubled banks often bid up rates to attract funds, squeezing margins for healthier banks.
- Withdrawal of special government support will further constrain bank lending.

Heavy sovereign borrowing in advanced economies stems from governments taking on bad assets and facing continuing borrowing needs due to slow growth and high unemployment.
Potential transmission channels:
- Government borrowing could crowd out business and household borrowers, retarding recovery.
- Jittery investors could drive down sovereign bond prices in advanced economies; banks—major investors in government debt—could face asset value losses.
- Rising interest rates on public debt could flow through to the private sector, raising borrowing costs for businesses, consumers, and banks.
Quote: “In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured,” José Viñals said; failing to address legacy crisis issues and emerging sovereign risks could “undermine the recovery and extend the financial crisis into a new phase.”

Capital has flowed to countries such as Brazil, China, India, and Indonesia and their partners as investors seek higher returns.
So far there is no evidence that asset prices in these emerging markets have been seriously and unsustainably overvalued.
Expansionary policies could fuel asset price inflation; policymakers must manage the consequences of strong portfolio inflows.
The GFSR includes an analytical chapter exploring capital-flow issues and policy options (released April 13).

Carefully manage budget deficits to ensure fiscal sustainability over the medium term and avoid extending the crisis into a new phase.
Ensure a smooth deleveraging process that results in a vital and sound financial system of the right size that can provide an adequate flow of credit to the private sector.
Employ a wide range of tools, including macro-policy adjustments and prudential measures, to address risks from strong portfolio inflows.
Continue pushing for policies and regulatory reforms to:
- Improve capital and liquidity buffers,
- Enhance risk management,
- Reduce the likelihood and costs of the failure of a system institution,
- Address the issue of too-important-to-fail institutions.

Source: IMF Survey: Government Borrowing Is Rising Risk to World Financial System (IMF Survey online, April 20, 2010).