Assessing Global Financial Stability
IMF News, October 27, 2017
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- Authors: Tobias Adrian
- Published: October 27, 2017
Current assessment of risks to global financial stability
- Global growth projected to rise to 3.6 percent in 2017 and 3.7 percent in 2018; global growth rate was 3.2 percent in 2016.
- Near-term financial stability risks are lower, driven by a decline in macroeconomic and emerging market risks.
- Core of the global financial system is stronger: systemically important banks and insurers are raising capital and liquidity and adapting business models.
- Portfolio inflows to emerging market economies are on track to reach $285 billion in 2017, more than twice the total over the past two years.
- Supportive monetary and financial conditions and buoyant financial markets have helped foster growth and repair balance sheets.
- Market and liquidity risks remain elevated and medium-term vulnerabilities are rising; monetary accommodation remains necessary and markets expect prolonged accommodative policy before full “normalization.”
Five key vulnerabilities identified
- Market risk and search for yield
- Size of fixed-income investment-grade assets has more than doubled to some $45 trillion.
- The share that yields more than 4 percent has fallen to 5 percent, compared to 80 percent in 2007.
- If compensation reverted to 2000–2004 average levels, investment grade bond spreads would need to rise by about 200 basis points, and high-yield bond spreads by 450 basis points.
- Low volatility and the “volatility paradox”
- Extremely low volatility across asset classes may encourage investor complacency and mask risks from corporate leverage and other shocks.
- Cheap financing has led to lower model-based default probabilities and facilitated a build-up in corporate leverage.
- Potential shocks include geopolitical risks, upside inflation surprises, a “snapback” in long-term interest rates, and downside economic risks.
- Rising debt levels in G20 economies
- Leverage (gross debt to GDP) is now higher than prior to the financial crisis.
- About 80 percent of the $60 trillion increase in debt since 2006 has been in sovereign and nonfinancial corporate exposures.
- China and the United States each account for about one-third of the total increase.
- Debt service burdens have increased in several major economies, including Australia, Canada, and China, and the household sector in Korea.
- Increased external borrowing in emerging market and low-income countries
- Risk premiums compressed for emerging market borrowers, reaching multi-year lows and driving higher issuance.
- Africa has been a main beneficiary.
- Greater reliance on foreign borrowing may become a vulnerability if global risk premiums decompress, particularly for low-income countries; debt servicing share of revenues is expected to rise significantly.
- Risks from China’s credit expansion
- Size, complexity, and pace of expansion of credit—particularly shadow credit—point to elevated risks to financial stability.
- Authorities have introduced measures to contain shadow credit growth but face a delicate balance because tightening could impact bank credit capacity and economic growth.
Conceptual framework: linking financial stability risks to macroeconomic performance
- Two definitions of risk to financial stability:
- Likelihood of a disruption in the capacity of the financial system to perform its functions, especially providing credit to the economy; vulnerabilities include high leverage, funding mismatches, interconnectedness, and opacity.
- Dynamic/procyclical definition where vulnerabilities build endogenously during strong economic periods and low price of risk, increasing the likelihood of sharp downward adjustments in financial conditions and growth.
- Financial conditions measure the price of risk and vulnerabilities; they are useful for predicting the conditional distribution of future GDP growth.
- Nonlinear amplification channels beyond traditional credit effects include investor runs, fire sales, contagion, and occasionally binding collateral constraints.
- The “volatility paradox”: easy financing masks problems and leads to increases in debt, which can precipitate sharp increases in volatility when conditions tighten.
- Tradeoff for policymakers between resilience and level of activity in normal times.
Estimating Growth-at-Risk — empirical approach and key findings
- Growth-at-Risk is defined as the value-at-risk of future GDP as a function of financial conditions; computed at horizons of one quarter, one year, and three years ahead.
- Calculations done for 21 major economies (11 advanced and 10 emerging market).
- Financial condition measures include term spreads, credit spreads, equity and house prices, indicators of financial sector strength, borrower credit, global conditions (commodity prices, exchange rates), and the VIX.
- Key empirical findings:
- Financial conditions are powerful forecasters for downside risks to GDP growth over one to four quarters.
- Tighter financial conditions predict increased downside risks to GDP growth in most advanced economies and more uncertain growth in several emerging markets.
- The inverse relationship between tighter financial conditions and forecasts of global growth holds across distributional points (median, 95th, and 5th percentiles).
- Estimated impact of financial conditions is largest for the 5th percentile; effects on median or upper percentiles are quite small—indicating important asymmetries and pronounced effects in advanced economies.
- External conditions (including commodity prices) significantly impact downside risk for emerging market economies; rising commodity prices benefit exporters but increase downturn risk for commodity-importers.
- Over medium term (two to three years), the price of risk does not significantly affect the shape of the conditional growth distribution, but higher leverage has significant predictive power at longer horizons.
- Conclusion: price of risk and external conditions signal near-term downside risks; leverage signals risks at longer horizons.
Model simulations and scenario results
- Global growth has averaged about 3½ percent in the last 25 years; probability of it being below one percent has averaged 5.8 percent.
- Changes in financial conditions observed in Q1 2008 pulled up the probability of global growth falling below one percent in Q1 2009 to as high as 20 percent.
- A tightening of financial conditions half the size of the financial crisis example:
- If U.S. spreads rose to five times their historic average, or the VIX rose to twice its historic average, the probability of global growth falling below one percent would rise to 35 percent at the current juncture.
- Open economy structural model simulations:
- When asset prices are low (risk premiums have risen), growth in the next period declines and declines more with larger increases in risk premiums.
- Effects of higher credit-to-GDP ratios on next-period growth are striking; moderate changes broaden the conditional density, while larger changes substantially increase downside risk and can generate crises (decline in output of more than three percent).
- Macroprudential policy simulations:
- Without a tax on borrower leverage, probability of a recession driven by a financial crisis is 1.3 percent.
- If an optimal state-contingent debt tax or loan-to-value limit were implemented, the probability of a recession would fall to 0.5 percent.
- A simple rule approximating the optimal tax based on risk premiums moderates sharp reductions in output and other variables, implying welfare gains.
Policy recommendations and implications
- Policymakers should continue providing appropriate monetary policy support for the recovery while containing underlying financial vulnerabilities.
- Financial regulators should deploy macroprudential policies to curb leverage and stability risks.
- Specific recommendations:
- Major central banks should ensure a smooth normalization of monetary policy.
- Supervisors need increased focus on business models of major banks.
- Emerging market countries should use benign financing conditions to address imbalances, leverage, and external debt.
- Global regulatory reform framework must be completed and fully implemented; global cooperation is essential.
- Macroprudential tools and monetary policy roles:
- Macroprudential policies (e.g., limits on debt-service-to-income ratios, loan-to-value ratios, countercyclical capital buffers) can be targeted and less costly when vulnerabilities are narrow; they build resilience and mitigate systemic tail risks.
- Monetary policy can affect financial conditions broadly and reach across jurisdictions, but using it to lean against vulnerabilities may conflict with price stability mandates and incur broader costs.
- Growth-at-Risk measures can help integrate financial stability risks into monetary policy decision-making by quantifying risks to growth in comparable metrics.
- Recommended policy actions when vulnerabilities are building:
- Tighten macroprudential policies (e.g., borrower debt taxes, higher bank-capital requirements) to increase the price of risk or reduce credit growth before leverage reaches levels that signal substantial downside risks.
- Consider raising monetary policy to tighten broader financial conditions where appropriate, recognizing tradeoffs with price stability and communication challenges.
Future work and extensions
- Ongoing work to estimate Growth-at-Risk conditional on financial conditions and vulnerabilities (e.g., excess private nonfinancial credit) to assess whether effects differ when vulnerabilities are high versus low.
- Preliminary results for advanced economies suggest a steeper tradeoff when credit is high, implying policy actions may be warranted when vulnerabilities are building.
- Country-specific, tailored FCIs and models could complement existing surveillance tools, enabling regular estimation of Growth-at-Risk and scenario analysis (one quarter, one year, or further ahead).
- Research agenda includes assessing the effectiveness and complementarity of monetary policy and macroprudential tools in leaning against building vulnerabilities and how Growth-at-Risk measures can inform these debates.
Assessing Global Financial Stability — By Tobias Adrian, IMF Financial Counsellor, October 27, 2017