By Tobias Adrian

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The world’s financial system has become safer and more stable since our last assessment six months ago. Economic activity has gained momentum. The outlook has improved and hopes for reflation have risen. Monetary and financial conditions remain highly accommodative. And investor optimism over the new policies under discussion in the United States has boosted asset prices. These are some of the conclusions of the IMF’s latest Global Financial Stability Report

But it’s important for governments in the United States, Europe, China and elsewhere to follow through on investor expectations by adopting the right mix of policies. This means preventing fiscal imbalances, resisting calls for higher trade barriers, and maintaining global cooperation on regulations needed to make the financial system safer.

 

The right policy mix

In the United States, policy makers should ensure that measures to overhaul the tax system encourage companies to invest in new machines, computers and equipment—rather than engage in financial risk taking. Emerging markets should focus on strengthening the health of corporates and the banking system. And in Europe, policy makers should tackle the structural causes of weak bank profitability.

Let’s take a closer look at the challenges in each region.

In the United States, discussions of corporate tax reform, infrastructure spending, and reductions in regulatory burdens have boosted business and investor confidence. This could herald a much needed rebound in investment, which has languished for more than 15 years.

Many firms that have the capacity to increase capital spending have instead focused on financial risk taking, such as the acquisition of financial assets and using debt to pay out shareholders. On the other hand, firms in sectors accounting for almost half of U.S. investment—namely energy, utilities, and real estate—are already highly levered. This means that expanding investment, even with tax relief, could increase already elevated debt levels.

Why is this a problem?

A sharp rise in interest rates—for example, owing to larger budget deficits—could push corporate debt servicing capacity to its weakest level since the global financial crisis. Under such a scenario, companies with some $4 trillion of assets may find servicing their debt challenging. This is almost a quarter of the assets we analyze.

Integrated global economy

This more than just a concern for the United States. In an integrated global economy, events in advanced economies have repercussions for the rest of the world. That is why U.S. policy proposals should aim to spur economic growth while avoiding imbalances that could have negative consequences for the rest of the world. That means preemptively addressing areas where risk taking appears excessive and helping to ensure healthy corporate balance sheets.

For emerging markets, the risk is that a sudden reversal of market sentiment could prompt capital outflows and hurt growth prospects—as could a global shift toward protectionism. 

How vulnerable are emerging markets under such a scenario? We estimate that debt held by the weakest firms could rise by as much as $230 billion. In turn, banks in some countries would need to rebuild their buffers of capital and provisions. Those are the banks that are already experiencing a decline in asset quality after a long credit boom.

To protect their economies, emerging market policy makers should improve corporate-restructuring mechanisms, monitor corporate vulnerabilities, and ensure banks maintain healthy buffers.

Credit growth in China

China is a key contributor to global growth but also has notable vulnerabilities. Credit in relation to China’s economy has more than doubled in less than a decade, to more than 200 percent. Credit booms this big can be dangerous. The longer they last, the more dangerous they become.

The Chinese authorities continue to adjust policies to limit the growth of the banking and shadow banking systems. But more needs to be done to slow credit growth. The authorities’ progress and success is essential for global financial stability.

European banks

In Europe, policymakers have strengthened the banking system by instituting higher capital requirements, more robust regulation and enhanced supervision. Over the past six months, bank equity prices have risen as yield curves steepened, and the economic recovery has firmed.

But the story shouldn’t end there. A cyclical recovery is unlikely to fully resolve the profitability challenge that many banks in Europe face. Weak profitability limits their ability to retain capital, making it harder for them to weather shocks and increasing risks to financial stability.

In the Global Financial Stability Report, we examine European banks representing $35 trillion in assets. We divide them into three groups—global, Europe-focused, and domestic.

Domestic banks face the greatest challenges, with almost three-quarters of them having very weak returns in 2016. For many, “overbanking” is a problem. This term encompasses weak banks with low capital buffers, too many banks with a regional focus and narrow mandate, or too many branches with low efficiency.

To overcome such structural impediments, policy makers in Europe should take steps to promote bank consolidation and branch rationalization, reform bank business models, and address nonperforming loans.

Regulatory reform

We have outlined domestic measures that would strengthen financial stability. At the global level, successful completion of the regulatory reform agenda is vital, and relies on continued multilateral cooperation and coordination. Completing the reform agenda will ensure that the global financial system is safe and can continue to promote economic activity and growth.

Getting the policy mix right will provide a firm foundation for the global financial system and cement recent improvements in the outlook for growth and financial stability. Policy makers in the U.S., Europe, China and emerging markets all have their roles to play.