By José Viñals
Today global financial stability is not yet assured and downside risks prevail. Our recommendation is for an urgent upgrade in policies, to avoid downside risks and to achieve our upside scenario of “successful normalization” of monetary and financial conditions. This will secure financial stability and strengthen the economic recovery.
Let me first provide you with our overall assessment for financial stability. How has it changed since our April Global Financial Stability Report? Here I have some good news. Financial stability has improved in advanced economies, as the economic recovery has broadened and solidified. The Federal Reserve has indicated that monetary policy lift-off is close in the United States as the economic preconditions are nearly in place. In the euro area the policies of the European Central Bank have gained traction and credit conditions are improving.
However, as flagged in this and our April 2015 report, risks have rotated toward emerging economies. Although many of these countries have enhanced their policy frameworks and resilience to external shocks, several face substantial domestic imbalances. Growth is slowing for the fifth year in a row, as the commodity super cycle and unprecedented credit booms have come to an end. This is of special relevance given the large share of emerging markets in the world economy, as well as the role that global markets play in transmitting shocks to other emerging markets and spillovers to advanced economies, featured in this summer’s financial turmoil.
Policymakers therefore confront a triad of challenges
First, are emerging market vulnerabilities. Corporate and bank balance sheets are currently stretched: we estimate there is up to three trillion dollars in overborrowing in emerging markets. Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality. China, in particular, faces a delicate balance of transitioning to more consumption-driven growth without activity slowing too much, while reducing high debt levels through an orderly deleveraging, and moving toward a more market-based system. This is a challenging set of objectives.
Second, crisis legacies in advanced economies need to be addressed to consolidate financial stability and to reduce headwinds to growth. In the euro area, tackling sovereign and banking vulnerabilities, as well as filling gaps in the financial architecture remains critical. In the United States, embarking on the most-telegraphed, although unprecedented, process of increasing the policy rates for the first time in nine years is going to be an important transition for global markets.
The third challenge is how global financial markets respond under strain. We have learned that markets can amplify shocks and act as a source of volatility and contagion when market liquidity is low. Indeed this report finds that market liquidity has become less resilient.
This is all the more important given extraordinarily accommodative monetary policies that have contributed to compressing risk premia across a range of asset markets. In fact, risk premia could decompress in a disorderly way causing a vicious cycle of fire sales, redemptions, and more volatility.
Leverage in investment funds also has the potential to amplify shocks. Our analysis found $1.5 trillion dollars in embedded leverage in bond funds through derivatives.
These diverse challenges call for an urgent policy upgrade. What we want to achieve is a successful normalization of financial conditions and monetary policies together with a sustained economic recovery. But policy missteps and/or adverse shocks could result in prolonged global market turmoil that would ultimately stall the economic recovery, and result in what I call a “failed normalization.” The difference between these two scenarios is quite stark, amounting to nearly three percent of global output by 2017.
So what urgent policies are called for?
Monetary policies in key advanced economies must remain accommodative and responsive. Both the euro area and Japan will need to continue to counter downward price pressures. Amid more uncertainty in the global economy, the United States should wait to raise policy rates until there are further signs of inflation rising steadily, with continued strength in the labor market. The pace of subsequent policy rate increases should be gradual and well communicated.
Euro area policymakers cannot rely on the European Central Bank alone, but must strive to complete the banking union to move financial stability onto firmer ground. It also needs to advance the capital markets union. Further strengthening of euro area banks by comprehensively tackling nonperforming loans and the corporate debt overhang will enhance the effectiveness of monetary policy, bolster market confidence, and improve the outlook. Resolving nonperforming loans in euro area banks could deliver about three percent of loans in new lending capacity. This amounts to around €600 billion euros.
Rebalancing and deleveraging in China will require great care. The Chinese authorities face unprecedented policy challenges in making the transition to a new growth model and a more market-based financial system. Deleveraging the corporate sector and enhancing market discipline will inevitably entail some corporate defaults, exits of nonviable firms, as well as write-offs on nonperforming loans, thus requiring a further strengthening of banks. Yet, moving decisively will ultimately prove less costly than trying to grow out of the problem.
Building resilience and maintaining confidence in emerging markets will be crucial. Emerging markets need to get ahead of the credit cycle. With slower growth and rising corporate leverage, immediate prudential attention is needed to ensure the resilience of both corporates and banks. Furthermore, maintaining sovereign investment-grade status through appropriate measures is crucial. Managing any outbreaks in financial contagion will require nimble and judicious use of available policy buffers.
Safeguarding against market illiquidity and strengthening financial market structures are priorities. Oversight of liquidity in the asset-management industry should be enhanced to avoid risk of fire sales and a rush for redemptions.
A collective effort to deliver a policy upgrade is needed urgently to face up to rising challenges in an uncertain world, to ensure financial stability and better growth prospects. Three percent of global output is at stake.