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Global Financial Stability Report - Sept 2011

Category: World of Business


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Global Financial Stability Report - Sept 2011


 

Last Updated Sunday September 18 2011/IMF

 

 

 

A Report by the Monetary and Capital Markets Department on Market Developments and Issues

 

June 17, 2011:  Since the publication of the April 2011 Global Financial Stability Report (GFSR), financial risks have risen for three reasons. First, while a multi-speed global recovery remains the base case, downside risks to this baseline have increased. Second, concern about debt sustainability and support for adjustment efforts in Europe’s periphery is leading to market pressures and worries about potential contagion. Political risks are also raising questions about medium term fiscal adjustment in a few advanced countries, notably, the United States and Japan. Third, notwithstanding some recent pullback in risk appetite, the prolonged period of low interest rates may push investors into riskier assets in a “search for yield.” This trend has the potential to build financial imbalances for the future, particularly in some emerging markets. Against these tensions, deep-seated challenges remain. Although there has been progress, improvements in financial system robustness have been insufficient so far. Markets may lose patience and become disorderly if political developments derail momentum on fiscal consolidation and financial repair and reform. Given these risks, policymakers need to accelerate actions to address long-standing financial vulnerabilities as outlined in the GFSR, before the window of opportunity to do so closes.

 

Markets Pricing a Mid-Cycle Slowdown

The base case of a multi-speed economic recovery remains intact, as outlined in the WEO Update. A key contributing factor to the improved financial stability outlook of the April GFSR has been the global economic recovery, which has helped strengthen private and banking sector balance sheets. However, negative surprises in recent economic data are causing investors to rethink the pace and strength of the recovery (Figure 1).

 

In the United States, downward growth concerns, in part on the back of renewed weakness in housing markets, have pushed real U.S. Treasury yields lower and have started to exert pressure on risk assets. More broadly with investors beginning to shift from equities to bonds, global stock markets have retreated since peaking at end-April. Commodity prices have fallen and remain highly volatile as net long positions in commodities futures markets have been pared.

 

 

 

 

Concerns about debt sustainability and support for adjustment efforts in the euro area periphery have intensified . . .

Market doubts about debt sustainability and support for adjustment programs in the smaller countries of the European periphery have resurfaced. Credit default swap spreads have risen to new highs in Greece amid concerns over the degree of political resolve that will be needed to implement adjustment and secure needed funding. This, in turn, has renewed the market’s focus on the potential for transmission of shocks from sovereigns to banks as banking systems in core European countries still have large exposures to peripheral countries (Figure 2). In a serious market event, a shock could be transmitted beyond the euro zone via both cross-border exposures and a general retraction of risk appetite.

 

 

 

 

. . . while the outlook for sovereign risk in some larger economies has worsened.

Negative sovereign ratings actions have spread beyond Greece, Ireland, and Portugal further into other euro area countries (Figure 3). This reflects concerns that it will be difficult to reach the political consensus necessary for fiscal consolidation and structural reforms. Market concerns are also rising about the fiscal path in the United States, given little evident progress in breaking the political stalemate over how to carry out needed fiscal consolidation. In the near term, markets have focused on a potential failure to raise the debt ceiling, which the U.S. authorities have estimated will become binding at the beginning of August, absent action. The risk of a temporary default has pushed U.S. short-term CDS spreads above those of some countries rated below the United States’s AAA rating. Even that rating has come under question following S&P’s issuance of a negative outlook in April. In Japan, ratings agencies have downgraded the sovereign outlook on concerns about the government’s ability to achieve deficit reduction.

 

 

 

 

Prolonged zero interest rates promote risk-taking, including a “search for yield”

Low interest rates in advanced economies are promoting pockets of re-leveraging by lowering the “all-in” cost of debt capital for corporate borrowers. This is encouraging investors to use financial leverage to generate sufficiently attractive returns on equity. Although credit spreads are still higher than before the crisis, ultra-low short-term interest rates mean that the cost of debt is now lower, both for floating-rate and fixed-rate debt. This lower cost of borrowing renders debt servicing ratios more favorable, even at higher debt loads, thereby enabling companies to operate with more financial leverage (Figure 4).

 

 

As leveraged loan prices recover (after the deep discounts of 2008–2009) and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains far less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.

 

Notwithstanding recent market jitters, the “search for yield” is also spurring flows into emerging markets, notably corporate debt markets. These inflows, although volatile, are often magnifying already ample domestic liquidity. These conditions, if they continue, risk stretching valuations and raising worries that some countries could be re-leveraging too quickly. Flows into mutual funds for emerging market debt have been strong (behind only high-yield and commodities funds as a percent of total outstanding amounts). Even record amounts of EM corporate bond issuance cannot keep up with demand, and investor due diligence is waning. At nearly $65 billion, external EM corporate debt issuance in the first quarter of 2011 was the highest in three years, and markets expect record issuance for the full year (Figure 5). Emerging market corporate bonds are increasingly seen as substitutes for U.S. corporate high-yield bonds—offering similar market capitalization, lower leverage, and higher returns for the same credit ratings, thus making such bonds attractive to a wider investor base. Although this may represent a healthy development to the extent that some previously credit-constrained companies now have access to capital, the risk is that if the trend continues, too much capital may be moving too quickly to emerging markets. This raises the risk of a mispricing of credit and/or a sudden reversal, if adverse events lead to a rapid retraction in risk appetite.

 

 

Although there is little evidence for generalized asset price overvaluation in emerging markets, one area of recent concern has been the real estate sector in fast-growing emerging Asian economies, and possibly a few countries in other EM regions. The pace of property price increases in Asia may be easing (with the possible exception of Hong Kong SAR) on the back of aggressive macroprudential and administrative measures, together with some moderation in economic growth. However, if there were to be a sharp slowdown in growth, this could trigger a large correction in property prices, given their still elevated levels in several markets.

 

Market concerns about property prices center on China. In order to slow inflation, the central bank has tightened financial policies and hiked policy rates. Should such measures result in an unexpectedly sharp slowdown, the impact on property prices may be even higher. This is in part due to a recent history of strong investment in real estate, including by local authorities as part of the stimulus measures undertaken in response to the global crisis.

 

Policymakers Must Strive for Rapid Progress on Financial System Robustness

Deep-seated financial challenges remain, even if vulnerabilities are masked by highly accommodative monetary and liquidity conditions. The current window of opportunity to prepare the financial and economic system against potential systemic shocks, importantly by providing clarity on euro area-wide solutions to strains in the periphery, could close unexpectedly. It could be closed by market developments if a sudden pickup in risk aversion (caused, perhaps, by unrelated factors) leads market participants to narrow their tolerance for incomplete policy solutions. It could also be closed by political developments, either because adjustment programs lose political support in debtor countries, or because populaces in creditor countries lose patience in continuing to finance those programs.

 

Thus, a more robust financial system, notably in Europe, is needed to gird against shocks. This will require a coordinated and cross-border policy response. Though there has been progress on banking system repair, the pace is too slow. First, funding challenges for banks remain. Bank bond yields have risen and some banks in peripheral European countries remain heavily dependent on the European Central Bank (ECB) for liquidity support. In some countries, banks are vulnerable to a further tightening in funding conditions and will need to step up the pace at which they roll over maturing funding.

 

Second, some banks have not yet sufficiently de-risked their balance sheets, leaving a large measure of uncertainty about asset quality given holdings of legacy assets and significant real estate exposures. Third, the pace of recapitalization needs to be accelerated in order to provide cushions against asset losses or shocks to liquidity (Figure 6). The forthcoming stress tests from the European Banking Authority will represent an important opportunity for updating the assessment of risks in the European banking system and for addressing the weak tail of banks flagged in the April GFSR. It will be critical that, where potential capital gaps are found to exist, plans are seen to be in place to fill them expeditiously, together with the resolution of nonviable banks.

 

Emerging market policymakers need to guard against overheating and a buildup of financial imbalances amid strong credit growth and rising inflation, exacerbated by capital inflows in some countries. Corporate leverage is also rising and weaker firms are increasingly accessing capital markets. This could make corporate balance sheets more vulnerable to external shocks. With strong domestic demand pressures, especially in emerging Asia and Latin America, macroeconomic measures are needed to avoid overheating, an accumulation of financial risks, and an undermining of policy credibility. Macroprudential tools and, in some cases, a limited use of capital controls, can play a supportive role in managing capital flows and their effects.

 

However, they cannot substitute for appropriate macroeconomic policies.

 

In sum, policymakers must act now to make the financial system more robust:

  • Downside risks have again risen to the fore, including that the global economic recovery may be more fragile than had been thought, so time to address existing vulnerabilities may be running out.
  • At the same time, the room for maneuver to counter shocks has been reduced, especially via traditional fiscal and monetary policy levers.
  • Thus, it will be critical to make the financial system strong enough to withstand potential major shocks, thereby enabling it to support ongoing recovery. The key priorities are, first, to make the current financial system more robust, especially to clean up from the legacy of the crisis in advanced countries. Second, the financial reform agenda must be completed as expeditiously as possible.

 

Finally, policymakers must chart a path that supports recovery without allowing a buildup of excessive risks in the future. This is likely to prove particularly challenging in those emerging markets where policymakers face rising inflation pressures and a buildup of financial imbalances. This requires a tightening of macroeconomic policies and use of macroprudential measures.

 

 

Previous Reports

 


April 2011:  Despite ongoing economic recovery and improvements in global financial stability, structural weaknesses and vulnerabilities remain in some important financial systems. The April 2011 Global Financial Stability Report highlights how risks have changed over the past six months, traces the sources and channels of financial distress with an emphasis on sovereign risk, notes the pressures arising from capital inflows in emerging economies, and discusses policy proposals under consideration to mend the global financial system.

 

October 2010:  The global financial system is still in a period of significant uncertainty and remains the Achilles' heel of the economic recovery. Although the ongoing recovery is expected to result in a gradual strengthening of balance sheets, progress toward financial stability has experienced a setback since the April 2010 GFSR. The current report highlights how risks have changed over the last six months, traces the sources and channels of financial distress with an emphasis on sovereign risk, and provides a discussion of policy proposals under consideration to mend the global financial system.

 

April 2010:  Risks to global financial stability have eased as the economic recovery has gained steam. But policies are needed to reduce sovereign vulnerabilities, ensure a smooth deleveraging process, and complete the regulatory agenda. The report examines systemic risk and the redesign of financial regulation; the role of central counterparties in making over-the-counter derivatives safer; and the effects of the expansion of global liquidity on receiving economies.

 

October 2009:  This GFSR chronicles the evolution of the path toward reestablishing sound credit intermediation and the near-term risks that could interrupt its restoration, including the rising burden of sovereign financing. The report addresses how to restart securitization markets and the pitfalls if done improperly. The effectiveness of unconventional public sector interventions and the principles for disengagement are discussed. The report also discusses the design of medium-term policies that aim to reshape the financial system to make it more resilient and stable.

 

April 2009:  The global financial system remains under severe stress as the crisis broadens to include households, corporations, and the banking sectors in both advanced and emerging market countries. In normal times, the Global Financial Stability Report aims to prevent crises by highlighting policies that may mitigate systemic risks, thereby contributing to financial stability and sustained economic growth. In the current crisis, the report traces the sources and channels of financial distress and provides policy advice on mitigating its effects on economic activity, stemming contagion, and mending the global financial system.

 

October 2008:  With financial markets worldwide facing growing turmoil, internationally coherent and decisive policy measures will be required to restore confidence in the global financial system. The process of restoring an orderly system will be challenging, as a significant deleveraging is both necessary and inevitable. It is against this challenging and still evolving backdrop that the October 2008 Global Financial Stability Report frames recent events to suggest potential policy measures that could help address the current circumstances.

 

April 2008:  The events of the past six months have demonstrated the fragility of the global financial system and raised fundamental questions about the effectiveness of the response by private and public sector institutions. The report assesses the vulnerabilities that the system is facing and offers tentative conclusions and policy lessons. The report reflects information available up to March 21, 2008.

 

September 2007:  Since the April 2007 Global Financial Stability Report (GFSR), global financial stability has endured an important test. Credit and market risks have risen and markets have become more volatile. Markets are recognizing the extent to which credit discipline has deteriorated in recent years — most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets.

 

April 2007:  This particular issue draws, in part, on a series of discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, credit rating agencies, and academic researchers, as well as regulatory and other public authorities in major financial centers and countries. Contributions from Craig Martin and Kevin Roth (Association for Financial Professionals) in the conducting of a survey are gratefully acknowledged. The report reflects information available up to February 6, 2007.

 

September 2006:  This particular issue draws, in part, on a series of discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, credit rating agencies, and academic researchers, as well as regulatory and other public authorities in major financial centers and countries. The report reflects information available up to July 14, 2006.

 

April 2006:  This particular issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies, as well as regulatory authorities and academic researchers in many major financial centers and countries. The report reflects information available up to February 10, 2006

 

September 2005:  This particular issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies, as well as regulatory authorities and academic researchers in many financial centers and countries. The report reflects information available up to July 22, 2005.

 

April 2005:  This particular issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies, as well as regulatory authorities and academic researchers in many financial centers and countries. The report reflects information available up to February 16, 2005.

 

September 2004:  This issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies in Canada, Colombia, France, Germany, Hong Kong SAR, Italy, Japan, Mexico, the Netherlands, Poland, Singapore, Switzerland, the United Kingdom, and the United States. The report reflects information available up to July 30, 2004

 

April 2004:  This issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies in Brazil, Chile, China, Colombia, France, Germany, Hong Kong SAR, Hungary, Japan, Korea, Mexico, Poland, Russia, Singapore, South Africa, Thailand, the United Kingdom, and the United States. The report reflects mostly information available up to March 8, 2004

 

September 2003:  This issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies in Brazil, Chile, China, Hong Kong SAR, Hungary, Poland, Russia, Singapore, South Africa, and Thailand, as well as the major financial centers. The report reflects mostly information available up to August 4.

 

March 2003:  This issue of the Global Financial Stability Report marks the beginning of a new semiannual frequency for the publication. This issue draws, in part, on a series of informal discussions with commercial and investment banks, securities firms, asset management companies, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies in Brazil, Chile, China, Hong Kong SAR, Hungary, Japan, Poland, Russia, Singapore, Thailand, the United Kingdom, and the United States. The report reflects mostly information available up to February 28, 2003.

 

December 2002:  This is the fourth issue of the Global Financial Stability Report, a quarterly publication launched in March 2002 to provide a regular assessment of global financial markets and to identify potential systemic weaknesses that could lead to crises. This report reflects mostly information available up to November 4, 2002.

 

June 2002:  This is the second issue of the Global Financial Stability Report. This particular issue draws, in part, on a series of informal discussions with commerical investment banks, securities firms, asset management companies, insurance companies, pension funds, stock and futures exchanges, and credit rating agencies in China, Germany, Hong Kong SAR, Hungary, Italy, Japan, Poland, Singapore, Switzerland, Thailand, the United Kingdom, and the United States. The report reflects mostly information available up to May 10, 2002.

 

September 2002:  This is the third issue of the Global Financial Stability Report, a quarterly publication launched in March 2002 to provide a regular assessment of global financial markets and to identify potential systemic weaknesses that could lead to crises. By calling attention to potential fault lines in the global financial system, the report seeks to play a role in preventing crises before they erupt, thereby contributing to global financial stability and to the prospertity of the IMF's member countries.

 

March 2002:  Reviews recent developments in global financial markets and explores the potential market impact of financial imbalances and continued credit quality deterioration. It also focuses on the expansion of credit risk transfer mechanisms -- such as credit derivatives and collateralized debt obligations -- as a means for distributing credit risks. The report concludes with two essays: one on Early Warning System models and another on alternative funding instruments for emerging market countries.

 

 

Source: IMF

 



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