By José Viñals
The three main messages from this Global Financial Stability Report are:
- Risks to the global financial system have risen since October and have rotated to parts of the financial system where they are harder to assess and harder to address.
- Advanced economies need to enhance the traction of monetary policies to achieve their goals, while managing undesirable financial side effects of low interest rates.
- To withstand the global crosscurrents of lower oil prices, rising U.S. policy rates, and a stronger dollar, emerging markets must increase the resilience of their financial systems by addressing domestic vulnerabilities.
Let me now discuss these findings in detail.
Financial stability risks have risen amid a moderate and uneven global economic recovery—with rates of inflation that are too low in many countries. Divergent growth and monetary policies have increased tensions in global financial markets and caused rapid and volatile moves in exchange rates and interest rates over the past six months. In part, this situation results from the legacy of weakened and incomplete repair of private sector balance sheets. Risks are also rotating—away from banks to shadow banks, from solvency to market liquidity risks, and from advanced economies to emerging markets.
In light of this, five key challenges must be met to safeguard global financial stability.
The first is to enhance the traction of monetary policies.
The European Central Bank and the Bank of Japan have pursued bold monetary policies to counter renewed disinflationary pressures. These quantitative easing programs have already shown measurable signs of success: financing costs have fallen in the euro area, equity prices have surged, and the euro and yen have depreciated significantly, helping support inflation expectations.
However, central bank actions must be complemented with other policies; otherwise monetary policies cannot be fully effective in achieving their aims. What is needed is ‘QE plus other policies.’
- In the euro area, it is necessary to tackle nonperforming loans to further unclog bank lending channels. And why is this important? Because banks burdened with bad loans lend less. Nonperforming loans now stand at more than 900 billion euros, despite important achievements in strengthening bank capital in the wake of the ECB’s Comprehensive Assessment and the introduction of the Single Supervisory Mechanism. Policymakers should encourage banks to deal with this stock of bad loans and implement more efficient legal and institutional frameworks to speed up this process.
- In Japan, the effectiveness of QE depends on the policies supporting it. Steadfast implementation of Abenomics’ second and third arrows—namely fiscal and structural reforms—is essential. If these reforms are incomplete, efforts to keep the economy out of deflation and raise growth are less likely to succeed.
- In the United States, the baseline of a smooth monetary policy normalization is not guaranteed. Divergences between market participants and policymakers over the expected pace of U.S. monetary tightening suggest that markets are taking a more benign view of inflation prospects. But low long-term yields also suggest the potential for upside surprises in long rates, when policy tightening becomes more imminent. Smooth normalization of monetary policy will continue to require the Fed getting the pace of “exit” right and clearly communicating to the public. A rapid decompression of yields could increase volatility with global repercussions.
The second challenge is to limit the financial excesses resulting from accommodative monetary policies, and to manage the negative financial impact of a prolonged period of low interest rates. For instance, weak European mid-sized life insurers could face rising risks of distress, with almost a quarter of insurers unable to meet their solvency capital requirements if low interest rates were to persist. With a portfolio of €4.4 trillion in assets in the European Union in the hands of life insurers, and high and rising interconnectedness with the wider financial system, weak insurers create a source of potential spillovers. This is an important illustration of the rotation of risks from banks to nonbanks.
The third challenge is to preserve stability in emerging markets caught in global cross-currents and confronting domestic vulnerabilities. Lower commodity prices and lower inflationary pressures are benefiting many emerging economies, providing monetary policy space to combat slowing growth. However, oil- and commodity-exporters and market sectors that have borrowed heavily face more substantial risks. Strains in the debt repayment capacity of the energy sector may become more evident in Argentina, Brazil, Nigeria, and South Africa, as well as in countries reliant on oil revenues, such as Nigeria and Venezuela. The sharp dollar appreciation entails additional risks for corporates and countries with large foreign currency debts.
In China, retrenchment from overinvested industries, coupled with property price declines, could spill over to emerging markets more broadly. Exposures to real estate are almost 20 percent of domestic lending in China. Financial stress among real estate firms could lead to direct cross-border spillovers, given the substantial increase in external bond issuance since 2010. The overall priority must be to allow an orderly correction of excesses, curtailing the riskiest parts of shadow banking. Smooth deleveraging also requires mechanisms for effective corporate debt restructuring and the exit of nonviable firms.
Across emerging markets more generally, financial resilience can be enhanced through micro- and macroprudential measures. Regulators need to conduct bank stress tests related to foreign currency and commodity price risks, and more closely and regularly monitor corporate leverage and unhedged foreign currency exposures, including derivatives positions.
The fourth challenge is to cope with geopolitical tensions in Russia and Ukraine, the Middle East, and parts of Africa, as well as risks in Greece.
Managing any of these challenges could become more difficult when markets are illiquid. Markets may have sufficient liquidity in good times, but this can dry up rapidly when markets are strained, amplifying the impact of shocks on prices. During periods of illiquidity since the crisis, correlation across markets has risen, increasing the potential for contagion. The underlying causes include a shift towards high-frequency electronic trading, reduced market making, and greater use of benchmarks.
Additional policy measures—beyond monetary policies—are vital to make a durable exit from the global financial crisis and to safeguard financial stability. Crisis legacies need to be addressed. The traction of monetary policies must be increased with complementary reforms and financial excesses need to be contained. Market liquidity needs to be strengthened and financial regulatory reforms must be completed.