Journal Issue

Global FinancialS tability ReportWorld markets resilient, but medium-term vulnerabilities building

International Monetary Fund. External Relations Dept.
Published Date:
September 2005
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The global financial system has continued to strengthen and become more resilient, according to the IMF’s latest semiannual Global Financial Stability Report (GFSR). This trend has again been driven by global economic expansion, together with determined corporate restructuring and cost-cutting efforts, which have led to further improvements in corporate balance sheets in most countries. On the basis of expectations of continued global growth and low inflation, and with generally benign financial markets, the report projects that the global system’s resilience will further improve in the short term.

Low bond yields and flat yield curves have continued to encourage investors to move out along the credit risk spectrum in search of yield, further narrowing credit spreads including those in emerging markets. Investors have also been attracted by improving macroeconomic fundamentals in many emerging market countries, which, along with superior long-term risk-adjusted returns, have convinced institutional investors, such as pension funds, to make strategic allocations to this asset class. This, in turn, has had a stabilizing influence on emerging bond markets and has occurred in spite of occasional corrections in mature credit markets and growing political uncertainty in a number of emerging market countries with upcoming elections.

But the benign forces that have helped to underpin global economic growth and buoyant financial markets have also contributed to larger global payments imbalances and debt—particularly household debt. Thus, the recent developments that have reduced risks in the near term have increased potential vulnerabilities for the medium term, including:

Low bond yields, narrow credit spreads, and low risk premiums more generally have increased financial markets’ vulnerability to corrections. These could be triggered if investors’ appetite for risk declines—for example, because of a deterioration in fundamentals. If economic growth were to slow significantly, corporate balance sheets could deteriorate. Nevertheless, the resilience of the global financial system would likely weaken only gradually.

With the credit cycle likely close to its peak, the robust corporate earnings growth of the past few years is likely to slow%. While current indicators are excellent, higher levels of corporate indebtedness—stemming, for example, from more active merger and acquisition activity or higher corporate dividend payments—could weaken credit quality. Indeed, a recent steepening of the U.S. credit curve—that is, an increase in spreads on longer-maturity corporate credits relative to still narrow spreads for shorter maturities—reflected market concerns about a medium-term deterioration. And the flatter yield-curve environment has reduced scope for traditional carry trades—borrowing in a low-yielding market and using the proceeds to invest in a higher-yielding one—which tends to negatively affect financial institutions’ earnings outlook.

The household sector in mature markets, especially the United States, has accumulated record levels of debt%. Asset price increases, mainly in the housing market, have raised households’ net worth, but left the household sector increasingly exposed to the performance of asset markets. Large declines in asset prices would undermine consumer confidence and dampen personal consumption. The credit cycle in the household sector also seems to be peaking across many mature markets. U.K. personal delinquency rates have been on the rise, for example, and U.S. regulatory authorities will need to keep a watchful eye on popular but risky interest-only and negative-authorization mortgages that postpone the debt-service burden into the future.

Growing global imbalances are a serious medium-term issue%. The United States has been able to finance its current account deficit easily this year, with the dollar appreciating and thanks to sufficient private capital inflows. But the danger, the report warns, is that investors’ willingness to continue to finance global imbalances reduces the urgency for policymakers to take the necessary corrective actions. This raises the specter of a “snap back”—a sharp, significant reallocation of investors’ asset holdings away from U.S. dollars—in the future. While the GFSR views the probability of this occurring soon as low, the associated costs and dislocation, if it were to occur, would be large in terms of sharp declines in the U.S. currency and hikes in U.S. interest rates—possibly with disorderly financial markets and likely depressing global economic growth.

Corrections in credit derivatives and collateralized debt obligation markets are a more likely risk than is a sharp, abrupt widening in credit spreads%. These complex instruments are used in relative-value trades and tend to be used by many investors executing similar strategies. They also depend on relatively untested models and default correlation assumptions for their pricing.

Buffers in times of stress

While not seeking to downplay the seriousness of these risks and vulnerabilities, the GFSR argues that they need to be seen in perspective and alongside certain trends that could create “self-stabilizing” forces. Although credit spreads could—and probably will—widen, they are considered likely to do so gradually and moderately. For corporations overall, currently healthy and liquid balance sheets should serve as a “long fuse” that would delay a general credit downturn. Similarly, in mature markets’ household sectors, the accumulated increase in household net worth could buffer the immediate impact of any downturn.

Aside from these more cyclical factors, two trends could also help protect against the medium-term risk of abrupt and indiscriminate reversals of capital flows. First, assets under management by institutional investors have been increasing significantly, in line with demographic changes and pension reforms over the past 15 years or so and, given the potential for further development of institutional investors in many emerging and mature markets, are expected to continue to expand. Because these large institutional investors are generally guided in their asset allocation strategies by long-term fundamentals rather than by day-to-day market noise, they will likely continue to have a stabilizing effect on financial markets. Second, the risk of contagion has been reduced in recent years by greater transparency and disclosure in financial markets, including on the part of emerging market borrowers, as well as increased sophistication of the investor base.

Lines of defense

Policymakers can also take a proactive approach to mitigating medium-term risks, the report points out, through ongoing risk management and market participants’ vigilance in carrying out supervisory activities. National monetary authorities face the challenge of striking the right balance, while maintaining low inflation, between encouraging excessive risk-taking and overly constraining financial markets and dampening economic growth. Here, the report commends the U.S. Federal Reserve’s gradual tightening of monetary policy since mid-2004 and urges its continuation.

Countering the risk of growing global imbalances, however, will require a cooperative, mutually reinforcing response from the national policymakers in the major economies, albeit with each adopting policies appropriate for its particular circumstances. Among the most critical of these needed measures are greater efforts to raise public and private savings rates in the United States; further progress in implementing key structural reforms to raise the trend growth rates in Europe and Japan; and financial sector reforms and further moves to more currency flexibility on the part of many Asian countries, following the recent welcome lead of China and Malaysia. These sorts of mutually reinforcing policy actions would go some way toward upholding current levels of investor, business, and consumer confidence.

FDI flows to emerging markets on the rise

In the first quarter of 2005, FDI flows to emerging markets continued their upward trend, after having fallen in 2002-03.

Data: World Bank.

To guard against the future risk of nonperforming corporate loans, it will be important for national financial supervisors to ensure that lending institutions not relax their credit standards. Equally important, financial supervisors, particularly in the United States and other mature markets, will need to remain vigilant on household indebtedness.

Given the more severe risk of a correction in credit derivatives and collateralized debt obligation markets, financial supervisors must ensure that regulated institutions maintain robust counterparty risk management practices—notably guarding against any spillover effects of market corrections should they occur. In view of the complexity of these instruments and markets, financial regulators may need to upgrade their skills to carry out their functions effectively.

Financial supervisors across countries will also need to understand and anticipate the systemic implications of the evolving trends in global asset allocation, the report cautioned. The influence of private capital flows is likely to continue growing, with emerging market economies becoming increasingly important players in the competition for global capital flows (see chart). Moreover, changes in asset allocation decisions by institutional investors may have important effects on capital flows across asset classes and national borders, as well as on asset prices. For this reason, the report urges national financial authorities to develop and revise regulatory and accounting policies with an eye to preserving the diversity in investment behavior of the various financial market players, as well as the long-term orientation of major institutional investors.

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