October 9, 2013
Primary challenge is normalization of U.S. monetary policy
Emerging markets must prepare for likely external shocks
Euro area corporate debt overhang must be addressed comprehensively
Policymakers need to carefully navigate a series of important transitions facing the global financial system, according to the IMF's latest Global Financial Stability Report. A failure to implement effective policies and reforms could potentially derail a smooth transition to greater financial stability.
The IMF's analysis outlined five transitions with global impact:
- The expected unwinding of accommodative monetary policy in the United States;
- A move to a more balanced and sustainable financial sector in emerging economies;
- The drive to bolster weak banks and corporates in the euro area;
- Efforts to reinvigorate Japan's economy through "Abenomics"; and
- The strengthening of global financial regulation.
The road to normal monetary policy
The primary challenge for policymakers is to manage the current side effects-and the eventual withdrawal-of easy money policies such as low interest rates and bond buying by the U.S. central bank.
Given the prospect of higher interest rates and greater volatility, investors will naturally adjust their portfolios by reducing their fixed income holdings. But there is a risk that by selling too much too fast, long-term interest rates could rise more sharply than presently anticipated.
"There may be bumps in the road to monetary normalization," said Jose Viñals, Financial Counsellor and head of the IMF's Monetary and Capital Markets Department. "The question is whether the bumps will make the trip merely uncomfortable, or whether some of them are likely to lead to accidents."
One of the challenges is the sheer magnitude of the likely portfolio adjustment. The IMF estimates that, since 2009, cumulative U.S. mutual fund inflows into fixed income have exceeded their historical trend by more than $5 trillion. This has raised the risk of large withdrawals in the event of monetary tightening.
Another challenge is the "weak links" in the U.S. shadow banking system, such as mortgage real estate investment trusts. Like the structured investment vehicles and the conduits that mushroomed before the crisis, mortgage real estate investment trusts are highly leveraged and susceptible to funding runs. They could be forced to sell their asset holdings quickly, causing disruption in the mortgage-backed securities market, which could spread to broader asset markets.
Engineering a smooth transition to normal monetary policy will require a clear and well-timed communication strategy by the U.S. central bank to minimize interest rate volatility. It will also require effective strategy execution, according to the IMF. Increased oversight of the overall risks in the shadow banking system and more transparency will be essential to preserve financial stability.
Emerging market risks
Many emerging market economies are increasingly sensitive to changes in easy money policies in advanced economies. This is because foreign investors have crowded into local markets and may withdraw. The IMF estimates that, since 2008, cumulative foreign inflows into local bond markets have exceeded their long-term structural trend by about $470 billion. This amounts to more than 5 percent of advanced economy GDP.
While foreign investors play a bigger role in local debt markets, market liquidity has deteriorated in recent years. This makes local interest rates more sensitive to changes in investor sentiment. At the same time, corporate balance sheets have weakened, financial vulnerabilities are rising, and economic growth is slowing.
Emerging economies need to facilitate an orderly adjustment in their financial markets. If they are faced with significant capital outflows, policy buffers may have to be used wisely. In addition, policymakers need to address domestic vulnerabilities by strengthening macro-financial frameworks and buffers.
Cutting the Gordian knot in the euro area
In the euro area, policy actions at the regional and national levels have helped reduce funding pressures on sovereigns and banks. However, continuing financial fragmentation has increased bank lending rates in stressed euro area economies.
The Global Financial Stability Report also shows that a significant share of the corporate debt in stressed economies is now owed by companies with weak debt servicing capacity. This debt overhang can affect the banking system through losses on corporate loans.
"Some banks will need to increase provisioning against these expected losses," said Viñals. "This could absorb a large portion of future bank profits and, in some cases, could even eat into capital."
The IMF estimates that, even if financial fragmentation were reversed over the medium-term, a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal, and Spain.
How can policymakers bolster weak banks and corporates? First, the corporate debt overhang needs to be addressed. This may involve debt cleanups, improvements to bankruptcy frameworks, or special asset management companies to restructure loans.
Second, the planned balance sheet assessment and stress tests by the European authorities are a golden opportunity to conduct a thorough and transparent review of bank asset quality and to identify capital shortfalls. But credible backstops need to be put in place before the exercise is concluded to offset any identified shortfalls.
Japan needs to implement a complete policy package under the "Abenomics" framework. A failure to enact the planned fiscal and structural reforms could re-ignite deflation and could intensify financial stability risks.