Improved economic fundamentals and stimulative monetary policies in the major financial centers contributed significantly to the global equity market rally and to the reduction in credit spreads of mature and emerging market bonds in 2003. The stronger fundamentals are rooted in firming global economic growth, rising corporate earnings, and strengthening balance sheets in the household, corporate, and banking sectors as the corporate and household sectors continue to build up liquidity and rising asset values buoy net worth.
A number of key emerging market countries have also taken steps to put their public finances on a sounder footing and increase their resilience. Many countries have used the favorable external financing environment to raise funds on international capital markets and improve the structure of their public debt by lengthening maturities and reducing the share of outstanding obligations indexed to foreign currencies and short-term interest rates. In addition, many emerging market countries have benefited from increased demand for their exports and higher commodity prices. The consequent gains in credit quality and low interest rates in the major financial centers contributed to an impressive compression of spreads on emerging market bonds last year (see chart, this page).
The improved outlook for financial stability is not without risks. The report notes that vigilance is needed, not least because of the potentially interconnected nature of these developments. One potential source of vulnerability arises from the impact of exceptionally low interest rates on investor behavior and asset valuations. Monetary stimulus aimed at boosting economic growth can encourage excessive risk taking and boost asset valuations beyond levels justified by fundamental economic improvements. Low short-term interest rates and a steep yield curve in the United States provide powerful incentives to boost leverage by borrowing at short maturities to venture out along the risk spectrum.
In the current low interest rate environment, the report explains, it is desirable to remain alert to the potential for excessively leveraged or concentrated investor positions (see chart, page 108). If asset valuations become rooted in expectations of continued low short-term interest rates, an abrupt move to higher rates could be disruptive. Moreover, rising interest rates would increase debt-service burdens, especially in a number of European countries where debt levels in the corporate sector remain high despite some progress in strengthening balance sheets. A transition to higher interest rates in the major financial centers will eventually need to take place. To facilitate this, the report recommends that policymakers develop forward-looking communication strategies to encourage investors to base their investment decisions on fundamentals.
Spreads on emerging market bonds narrowed sharply as credit quality improved
EMBI=Emerging Markets Bonds Index
Data: Bloomberg L.P.; J.P. Morgan Chase & Co.; Moody’s; Standard & Poor’s; and IMF staff estimates
Another key challenge and a second potential source of risk will be to ensure an orderly reduction in global external imbalances. As the report underscores, the need to attract sizable foreign capital inflows to finance the U.S. external current account deficit poses a potential challenge to the stability of the U.S. dollar and to currency market stability. The possibility that investors may demand an increased risk premium for U.S.-dollar-denominated assets in an environment of a rapid decline of the dollar also raises the risk of broad financial market turbulence. To date, however, portfolio flows into the United States have remained quite strong—notably including official flows into the U.S. treasury market—and the decline of the dollar has so far been orderly. Still, a strong and sustained international cooperative effort will be required to ensure a smooth adjustment of global imbalances over the medium term.
Risk transfer and the insurance industry
Improved prospects for global financial stability also afford a window of opportunity for countries to undertake structural reforms that can bolster financial stability over the longer term. With the April 2004 issue, the report inaugurates a series that analyzes how risk is transferred away from the banking sector to other institutions. The series highlights the regulatory and risk management issues that arise as financial risk intermediation is shifted from the relatively heavily regulated banking sector to other less uniformly regulated parts of the financial sector and beyond.
The first study in this series examines risk transfer in the insurance industry in mature markets. Insurance companies are increasingly taking on credit risk—in part through the use of credit derivatives. The patterns and levels of insurer involvement in credit instruments have, however, varied widely across countries and regions, largely reflecting the structure of local capital markets and regulation. The report observes that the reallocation of credit risk to the insurance sector, together with improvements in risk management in that sector, appears to have enhanced financial stability. Credit instruments, by virtue of their relatively low volatility and stable cash flow, seem to be an appropriate investment for insurers that are seeking to manage long-term liabilities and related market risks.
Short-term U.S. interest rates remain at extraordinarily low levels
1Periods in which the United States was in recession, as defined by the National Bureau of Economic Research (NBER).
Data: Bloomberg L.P.; NBER; and IMF staff estimates
But increased investment by insurers in credit instruments will also need to be accompanied by a continued improvement in risk management and regulatory oversight of the sector. In particular, there is scope to widen the adoption of risk-based capital standards, strengthen supervisory resources, increase information sharing among supervisors, and improve disclosure standards. The current debate on international accounting standards for insurers represents an important step toward promoting standards that accurately reflect an insurer’s financial position.
Key role of institutional investors
Significant progress has been made in recent years in deepening local emerging securities markets; institutional investors, both local and international, have played a key role in this development. Emerging market securities have increasingly attracted investments from pension funds, mutual funds, and insurance companies. The growth of a diverse and stable investor base for emerging markets is likely to dampen market volatility by increasing the stability of capital flows to emerging markets.
To continue to attract and maintain the interest of international institutional investors in their sovereign and corporate securities, emerging market countries will need to enhance their growth potential and make their financial systems more resilient. The report also recommends measures to improve disclosure and transparency standards, including subscription to the IMF’s Special Data Dissemination Standard and regular communication with investors. There is also scope to further deepen domestic financial markets, improve market infrastructure, strengthen clearance and settlement systems, and develop a greater variety of instruments—in particular, bonds of long duration.
The report counsels that such efforts should, in particular, address the needs of domestic institutional investors. To increase the attractiveness of local markets for domestic and international investors, it will also be important to ensure that restrictions on local pension fund managers be designed to encourage the creation of asset portfolios that best match desired risk and return objectives. Restrictions on foreign investments, for example, can work against financial stability when local markets are insufficiently developed to provide the range of instruments that local institutional investors need. Finally, the report also observes that promoting improved risk management by local institutional investors—including, as appropriate, the imposition of risk-based capital adequacy requirements for insurers—can contribute to deeper and more stable domestic emerging markets.
Copies of the April 2004 Global Financial Stability Report are available for $49.00 ($46.00 academic price) from IMF Publication Services. See page 103 for ordering details. The full text of the report is also available on the IMF’s website (http://www.imf.org).