By José Viñals

It would be unfair for any assessment of global economic and financial stability not to acknowledge that tremendous progress has been made in repairing and strengthening the financial system since the onset of the global crisis.

Still, the key message from the IMF’s October 2010 Global Financial Stability Report (GFSR) is clear. Progress toward global financial stability has suffered a setback over the past six months—the financial system remains the Achilles’ heel of the economic recovery.

Our outlook envisages a gradual improvement in financial stability as the ongoing economic recovery continues, and as policies that aim to strengthen the financial system are fully implemented. But the outlook is subject to considerable downside risks linked to financial system fragilities and weak sovereign balance sheets.

I think the most important thing is that confidence has not yet been fully restored —although it has improved in recent months, particularly after very decisive policy actions were taken in Europe in May and later on in July. This explains why financial markets remain sensitive to negative surprises and can so quickly shift back to crisis mode.

But what is at the heart of this lack of confidence?

The first issue concerns lingering financial system fragilities that stemmed from the crisis. Specifically, without further balance sheet repair and reform, financial systems remain susceptible to funding disruptions that could endanger the economic recovery and weaken government budgets. The euro area is the most vulnerable to these problems. Banks there have a lot of debt to refinance because of their heavy reliance on wholesale funding, a large portion of which matures in the next two years. Their sovereign exposures, legacy asset problems, as well as weak business models leave their funding highly sensitive to confidence shocks and increase the size of capital buffers they need to ensure open access to funding markets. In the United States, concerns about household balance sheets and real estate markets continue to cloud the outlook for loan quality in the banking sector.

Second, elevated sovereign risks exacerbate financial sector vulnerabilities. Financial markets continue to focus on not only high public debt burdens, but also the exposure of national financial systems to sovereign debt, and fewer resources are available to support the economic recovery and financial stability. Encouragingly, governments have begun to develop and, in some cases implement, plans to reduce budget deficits and debt levels over the medium term. However, sovereign debt is expected to remain at unprecedented levels for many years. And, if there were to be another big decline in growth, we see a risk that debt levels could rise even further. These medium-term debt sustainability concerns can lead to short-term sovereign funding difficulties, and sharply higher funding costs, especially as many advanced economy governments have both sizeable rollover needs and large deficits.

The recent experience in Europe illustrates the danger that these weaknesses—in both sovereign and financial balance sheets—if not addressed, could easily reignite asset sell-off pressures and cause highly damaging spillovers between countries and financial centers.

So what are the policy priorities?

For the advanced economies, I think action is needed on four fronts:

  • The first of these is the need for further progress on the regulatory reform front. As I wrote about this a couple of days ago, I won’t dwell on the issue here. Suffice to say, these reforms need to be stepped up if we are to move toward a much safer financial system.
  • Second, policymakers should tackle the problem of high public debt and sovereign balance sheets risks by putting in place ambitious and credible medium-term strategies to lower fiscal deficits and reverse the rise in debt levels. These should take into account country-specific circumstances, and be accompanied where necessary by growth-enhancing structural reforms. Contingent liabilities must be managed and reduced in the medium term, including by ensuring that significant public or private financial enterprises do not enjoy implicit taxpayer support. Market discipline needs to be brought back.
  • Third, they should address the remaining vulnerabilities in the banking system and they should resolve and restructure weak banks in order to provide their national banking systems with enough capital and liquidity to be able to support the economic recovery. Also, a key message from the GFSR is that capital buffers for some European banks should be increased to reduce vulnerabilities to renewed funding stress and to protect against downside risks.
  • Fourth, central banks and governments should remain open to providing financial support, if and when needed, given the risks to the outlook. Exit strategies should also be contingent on adequate progress on the stability front. The sooner the financial system stabilizes, the sooner policy support can be unwound.

For emerging market policymakers, the main challenge will be to tackle the macroeconomic and financial challenges of sizable, and potentially volatile, capital inflows. Targeted use of prudential tools—like loan-to-value ratios—can help to reduce pressures on credit markets, in combination with flexible use of macroeconomic policies. Measures should also focus on continuing to develop local capital markets, as well as reinforcing regulatory and supervisory frameworks to help ensure that local financial systems are able to absorb, and safely and efficiently intermediate higher capital flows.

Persevering with such wide-ranging reforms may well seem daunting, especially several years into our efforts. But there is a long road ahead of us. And only with concerted action at the national level and collaboration at the global level can we keep the economic recovery firmly on track.