By José Viñals
Global financial stability is improving—we have begun to turn the corner.
But it is too early to declare victory as there is a need to move beyond liquidity dependence—the central theme of our report—to overcome the remaining challenges to global stability.
We have made substantial strides over the past few years, and this is now paying dividends. As Olivier Blanchard discussed at yesterday’s press conference of the World Economic Outlook, the U.S. economy is gaining strength, setting the stage for the normalization of monetary policy.
In Europe, better policies have led to substantial improvements in market confidence in both sovereigns and banks.
In Japan, Abenomics has made a good start as deflationary pressures are abating and confidence for the future is rising. And emerging market economies, having gone through several recent bouts of turmoil, are adjusting policies in the right direction.
But financial stability also faces new challenges even as the legacy of the crisis recedes. Let me outline the key challenges.
Can the United States make a smooth exit from unconventional policies? I call this the “Goldilocks exit” – not too hot, not too cold, just right. This is our baseline, and most likely outcome. After a turbulent start, the normalization of monetary policy has begun. Improved communications is smoothing market adjustment, while “green shoots” of economic recovery are increasingly visible —easy money is leading to credit and the latter is spurring growth.
The Fed is now taking its foot off the accelerator gradually through a smooth tapering path. Our baseline is for the Fed to begin lightly touching the brakes with policy rates starting to rise by mid-2015, all the while keeping the car driving smoothly down the road to growth and recovery.
But a bumpy exit—though not our baseline—is possible. This adverse scenario could be produced by growing concerns in the United States about financial stability risks, or higher-than-expected inflation. The result would likely be a faster rise in policy rates and term premiums, widening credit spreads, and a rise in financial volatility that could spill over to global markets.
Though not a new story, we continue to track growing hotspots in the U.S. financial system. Many of these are in the shadow banking system, such as strong issuance of high-yield bonds and leveraged loans, weakened underwriting standards, and underpricing of risk. For instance, high-yield issuance over the past three years is now more than double the amount recorded before the last downturn while high yield bond spreads have fallen close to pre-crisis levels. Supervisory measures, while now more intense, have not yet sufficiently restrained some of these excesses. So a sudden rise in yields could lead to a substantial widening of credit spreads and add to concerns about leverage and future defaults.
Emerging markets are especially vulnerable to a tightening in the external financial environment, after a prolonged period of capital inflows, easy access to international markets, and low interest rates.
This has induced substantial amounts of borrowing, particularly by emerging market companies. But rising interest rates, weakening earnings, and depreciating exchange rates could put substantial pressure on emerging market corporate balance sheets under our adverse scenario. Indeed, in this scenario, emerging market corporates owing almost 35 percent of outstanding debt could find it hard to service their obligations. While the situation varies widely across countries, those economies under recent pressure owing to macroeconomic imbalances also share some vulnerabilities in their corporate sectors.
In China, achieving an orderly deleveraging of the shadow banking system is a key challenge. Nonbank financial institutions have become an important source of financing in China, doubling since 2010 to 30 to 40 percent of GDP.
This non-bank lending, though a sign of the system becoming more diversified, is also prone to risks as savers may not realize the higher risks that lie behind the more attractive rates of return offered by nonbank savings products due to the perception of implicit guarantees.
The challenge for policymakers is to manage the transition to a financial sector in which market discipline plays a larger role and prices more accurately reflect risks—including through the removal of implicit guarantees—without triggering systemic stress.
In the euro area, the incomplete repair of bank and corporate balance-sheets continues to place a drag on the recovery. Fragmentation between periphery and core countries persists, as accommodative monetary conditions have not translated into the flow of credit needed to support a stronger recovery, particularly for smaller companies. Thus, further efforts must be made to strengthen bank balance sheets, through the European comprehensive bank assessment and follow-up, and to tackle the corporate debt overhang.
While so far spillovers surrounding developments in Ukraine have been limited, geopolitical risks remain elevated and could pose a shock to global markets.
Finally, failure to adequately address any of the challenges that I mentioned could have a significant impact on global stability. The sizeable inflows into emerging markets over the past number of years could reverse. Assets price moves may be amplified by the lower market liquidity conditions, with more investors running for the exit than the exit door can accommodate. This rush for the exit could extend to some segments of developed markets straining market liquidity and amplifying market volatility.
The key message is that strong policy actions are needed to definitely turn the corner from the Great Financial Crisis and engineer a successful shift from “liquidity-driven” to “growth-driven” markets.
o First, is to get the normalization of US monetary policy right—its timing, execution, and communication. Effective macro-prudential policy is key to allow for smooth exit by containing financial stability risks, particularly in the shadow banking system.
o Second, emerging markets need to continue to prepare for tightening in global financial conditions by enhancing resilience through strong macro and prudential policies, building policy buffers, and managing corporate financial risks. They should also stand ready to ensure orderly market conditions through adequate provisioning of liquidity in the event of turbulence.
o Third, while Japan needs to complete Abenomics, the euro area needs to finish cleaning both bank and corporate balance sheets, start the banking union right, and develop non-bank sources of credit to smaller companies. This is paramount for confidence and recovery.
But, beyond national actions, we need greater global policy cooperation as we are all in this together. This extends to monetary policy, financial regulation and supervision, and ensuring orderly market conditions.