Financial stability risks have increased substantially

By Deepal V. Perera in Washington DC

The International Monetary Fund (IMF) releasing its Global Financial Stability Report assessing key risks facing the global financial system said that financial stability risks have increased substantially over the past few months.

Weaker growth prospects adversely affect both public and private balance sheets and heighten the challenge of coping with heavy debt burdens across the world.

Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department Jose Viñals presenting the report cautioned that lack of sufficiently decisive policy action to finally address the legacy of the financial crisis has led to the present crisis of confidence at global level.

“This has thrown us back into the danger zone and poses a major threat to the global economy. Yet we believe that while the path to sustained recovery has considerably narrowed, it has not disappeared. It is still possible to make the right decisions that will help restore global financial stability and sustain the recovery. But for this, we need to act now, we need to act boldly and we need to act in a globally coordinated manner. There is a way; now we need the political will,” he said.

He said that since the launch of the previous report, financial stability risks have increased substantially reversing some of the progress that had been made over the previous years, and therefore the world is back in the danger zone.

“As we have moved in to new political phase of the crisis, several shocks have recently buffeted the global financial system, including unequivocal signs of broader global economic slowdown, fresh market turbulence in the euro area and credit down grade of the United States,” he said

Presenting the causes of the confidence crisis the IMF Financial Counsellor said that this has thrown the world into a new crisis of confidence which is being driven by three main factors, namely, weak growth, weak balance sheets and weak politics.

Weaker growth prospectus and larger downside risks to growth have prompted investors to reassess the sustainability of the economic recovery, which appears increasingly fragile.

Secondly, the reduced pace of the economic recovery and incomplete policy actions have stalled progress in balance sheet repair.

This has led to increased concerns about the financial health of sovereigns in advanced economies, banks in Europe and households in the United States.

Commenting on the sovereigns, banks and households, the IMF said that in Europe sovereign risks have spilled to the regions’ banking system, thereby putting funding strains on many banks operating in the euro and depressing their market capitalisation.

“We have quantified the size of these spill-overs on banks in the European Union since the outbreak of the sovereign debt crisis in 2010.

During this period banks have had to withstand an increase in credit risk coming from high spread euro area sovereigns that we estimate amounts to about Euro 200 billion. If we include exposure to banks in high spread euro area countries, the total estimated spill-over increases to Euro 300 billion.”

According to the IMF, this analysis helps explain current levels of market strains, but it does not measure the capital needs of banks, which would require a full assessment of the bank balance sheets and income positions.

It said that because of increased market pressure, banks may be forced to speed up deleveraging curtail credit to the real economy and thus worsen the economic drag, which clearly must be avoided.

Commenting on weak politics, the third factor driving the crisis of confidence, the IMF said that policy makers on both sides of the Atlantic had not yet commanded broad political support for the needed policy actions and markets had begun to question their resolve.

With regard to the risks associated with low interest rates, Viñals said that there was another important issue facing policy makers: Incomplete balance sheet repair in advanced economies coupled with prolonged of low interest rates can pose financial stability risks for both advanced and emerging markets.

Low policy rates are necessary to support economic activity under current conditions. They can also buy time to repair public and private balance sheets. But if time is not well used and these repairs remain incomplete, low rates can pose risks to longer term financial stability by encouraging the build-up of excess leverage, diverting credit creation to the shadow banking system and pushing capital flows toward emerging markets.

In that matter, policy makers in general need to shift their focus from the symptoms of the crisis to dealing once and for all with its underlying causes. The IMF commenting on emerging markets called for balancing of current risks to avoid future crisis. Given the experience in the past rapid credit growth in many emerging markets, often in the context of strong capital inflows, policy makers need to avoid future build-up of financial imbalances where credit growth remains elevated even if capital flows have abated somewhat recently.

In addition to sound macroeconomic policies, macro prudential and capital flow measures can also play a supportive role in addressing these concerns. At the same time, emerging markets face a potential global shock that could lead to a reversal of capital flows and a drop in economic growth.

“Our analysis shows that the impact on emerging market banks could be substantial and thus warrants a further build-up of capital buffers in the banking system,” he added.

See page 4 for the Executive Summary of the IMF’s latest Global Financial Stability Report