For the world’s financial markets, 2006 is unlikely to be a stellar year like 2005, according to the IMF’s Global Financial Stability Report (GFSR). The global financial system has been consistently flexible and resilient since 2004, but headwinds may be building. The report expects cyclical challenges in the coming months—especially risks stemming from higher interest rates and higher inflation, a deterioration in the credit quality of various debtors, and a sudden unwinding of global imbalances. For these reasons, the report urges governments to pursue sound macroeconomic policies, particularly prudent fiscal policy, flexible exchange rates, and active debt management programs.
Former U.S. Federal Reserve Chair Alan Greenspan recently pointed out that increasingly complex financial instruments have made the financial system “far more flexible, efficient, and, hence, resilient” than it was 25 years ago. Globalization and financial innovations have advanced, allowing credit to be channeled more efficiently, resulting in a wider dispersion of risk. Improved fundamentals in emerging market economies, particularly fiscal consolidation and rules-based fiscal and monetary policies, have increased the resilience of the global financial system to shocks. But the GFSR stresses that this “brave new world” of modern capital markets comes with its own risks and challenges.
Will the global financial system be able to withstand the likely deterioration in cyclical conditions? The GFSR says yes, although higher interest rates and the turning of the credit cycle are expected to present particular challenges to financial markets and institutions.
High interest rates and high inflation. Inflation expectations in financial markets are still well anchored, and only mild and mixed movements in short-term interest rates are expected in the year ahead. However, if inflation expectations increase significantly for a sustained period—because of further oil price hikes, for example—short- and long-term interest rates could rise. This, in turn, could lead to an economic slowdown with negative consequences for corporate earnings and credit quality, and credit spreads could widen substantially. At present, the report considers sharply higher interest rates a remote risk, but one that bears watching.
Turning of the credit cycle. The credit cycle refers to fluctuations in the financial health or balance sheet quality of the corporate sector that affect firms’ access to, and cost of, credit. Changes in average corporate credit quality cause credit spreads to fluctuate, which can also affect the household sector and other borrowers on capital markets. The turning of the credit cycle is not expected to pose major problems for the corporate sector as a whole, since overall balance sheets remain healthy. In advanced economies, household balance sheets have also improved since 2001, benefiting from the rise in house prices and the recovery of international equity markets.
Deterioration in credit quality. Since the second quarter of 2005, corporate bond spreads have started to widen—an early sign of a turning of the credit cycle (see chart, below). Rating agency upgrades are expected to decline relative to downgrades. Default rates are expected to rise moderately, and banks have begun to tighten lending standards. While a number of corporations have begun to releverage their balance sheets, corporate sectors in many countries have strong financial positions and an improved ability to service debt. Overall, the report argues, healthy corporate sector balance sheets and still-low default rates should provide firm anchors to credit markets, enabling self-correcting forces to operate and markets to stabilize.
Sudden unwinding of global imbalances. A “disorderly” unwinding of global payments imbalances could have broad and severe consequences for financial stability. Global imbalances have continued to widen. The U.S. current account deficit has risen to about 6.5 percent of GDP, while current account surpluses, particularly in Asia and the oil-exporting countries, have widened commensurately. Deep, flexible, and sophisticated U.S. financial markets offer a wide range of assets to meet different needs and enjoy high trend growth. The GFSR sees growth and interest rate differentials as likely to narrow, which may moderate foreign accumulation of U.S. assets, weaken the dollar, and push bond yields upward.
Signaling a change
Corporate spreads have widened since mid-2005, indicating a turning of the credit cycle.
Data: Merrill Lynch.
Emerging markets prosper
Emerging market bond spreads are trending to record-low levels, thanks to improved fundamentals and external financial conditions.
Data: JPMorgan Chase & Co. and Merrill Lynch.
Such cyclical challenges are expected to be easily weathered, thanks to the absence of a systemic underpricing of risks, healthy corporate balance sheets, strong banking sectors, and sophisticated credit derivative and structured credit markets. Because of the benign economic and financial environment, risk premiums have been low. There is no evidence of a systemic underpricing of risks, but as cyclical conditions become less favorable, volatility—and, ultimately, risk premiums—could increase. Banks in many countries have strong capital bases, good profitability, and improved asset quality, as evidenced by low nonperforming loan ratios. But if cyclical conditions become less favorable, banks’ balance sheets will be affected. Sudden and negative developments, such as a major terrorist attack or an avian flu pandemic, could seriously disrupt global financial markets, especially the payment clearing and settlement system.
Wider dispersion of risk
The sophistication and resilience of the global financial system is partly due to the recent explosion in credit derivative and structured credit products, which have dispersed credit risk to a broader and more diverse group of investors. This increases the shock-absorbing capacity of the system, contributing to stability. The less stringent reporting requirements among nonbank participants in these markets, however, are a source of concern. There is insufficient information, the GFSR argues, about who holds risk outside the banking system and in what amount. The growing complexity of these instruments holds the potential for mispricing and sudden swings in investor sentiment.
Untested structured markets. Rapidly growing market liquidity and infrastructure of credit derivative markets have not yet been tested by a severe downturn. Complexity of instruments means that valuation models may be inaccurate, and the lack of information means that it is difficult to ascertain concentrations of risk. There is concern, although no supporting evidence, that these markets have simply shifted credit concentrations elsewhere in the financial system. Future credit losses are likely to be more broadly distributed, removing a general policy concern for a particular sector. Still, the report recommends that a more liquid secondary market be developed in a number of market segments to make credit derivative and structured credit markets more complete and to enhance financial stability.
Continuing to develop and deepen capital markets. Supervisors and regulators are encouraged to measure, monitor, and manage risk through increased dialogue with market participants and public officials; promote an increasingly diversified investor base in structured markets; and strengthen the institutional, legal, and regulatory infrastructures to attract investors and ensure the flow of capital within and between markets. Best practices could be applied to building emerging capital markets. The report urges policymakers to support the development of such markets, including risk transfer markets.
Emerging markets continue to thrive
Low global interest rates, better fiscal performance, higher creditworthiness, and lower spreads have enabled emerging markets to improve debt management and diversify their investor bases (see chart, this page). Macroeconomic performance, especially in Asia, has also improved significantly since the 1997–98 crisis—allowing many countries to enhance fiscal performance and build healthy balance of payments positions.
In light of these strong fundamentals, contagion from adverse shocks in individual countries is likely to be limited. Likewise, efforts by emerging market countries to manage economic performance and to structure debt should cushion them against any moderate deterioration in external financing conditions. An investor base that is growing more diverse and seeing an increasing number of strategic and long-term investors should give the emerging market asset class greater stability.
There are areas of concern, however. While major emerging sovereign debt markets are becoming less vulnerable to external risks, countries with weak fiscal positions, large debt burdens, and wide current account deficits need to be especially alert to potential pressure arising from a less favorable structural environment. To reduce future vulnerabilities, these countries need to build on their recent successes, focusing on sound macroeconomic policies, structural reforms, strong public debt management, local capital market development, and measures to broaden the investor base.
IMF External Relations Department