By José Viñals, Financial Counselor and Director of the IMF’s Monetary and Capital Markets Department
Policymakers’ decisive actions since our last report in October have increased global financial stability by reducing acute risks.
- In the euro area, policymakers averted a financial cliff.
- In the United States, the worst fears of the fiscal cliff had been averted, while balance sheet repair and continued monetary easing have supported financial markets and the recovery.
- In Japan, new policy initiatives have caught the imagination of global markets that Japan may finally leave its deflation valley.
But our latest Global Financial Stability Report concludes that improved financial markets and gains in financial stability will not be sustained — and new risks are likely to emerge — unless policymakers address key underlying vulnerabilities.
There are two types: “Old risks”, which are the legacy of the crisis, and “new risks” coming from the easy monetary policies put in place to fight the crisis.
First, the euro area still needs to be fixed.
- Despite the substantial improvements in market conditions, credit is not adequately flowing in the euro area periphery.
- The corporate sector in periphery countries is also facing a sizeable debt overhang, which they built up before the crisis.
- The report identifies a weak tail of companies that need to reduce their debt over time. The required debt reduction by these companies accounts for a fifth of the total debt of periphery corporates in our sample. This poses a challenge to their economies and financial stability.
Second, we need healthy banks to support economic recovery. But five years after the start of the crisis, banking systems around the world are still in different stages of repair.
- We find that the process is largely completed in the United States, but remains unfinished in Europe
- Many banks in euro area periphery countries still need to make further progress in strengthening their balance sheets. And important banks in the core are still too dependent on wholesale funding markets.
- At the same time, the global financial regulatory reform agenda is incomplete, creating regulatory uncertainty. This leaves banks less willing to lend.
The easy monetary policies in advanced economies have been essential to support the economy. But their use over a prolonged period may cause side effects, such as excessive risk taking and leverage, and asset bubbles.
Do we see evidence that those risks are growing?
- In the United States, corporate debt underwriting standards are weakening rapidly—even though corporate fundamentals are strong, and leverage is in line with typical historical patterns. Also, continued low interest rates are leading some pension funds and insurance companies to take further risks to close their widening funding gaps.
- Second, easy money in advanced economies is spilling over to emerging markets. Borrowing on international markets by corporations in emerging economies has been growing at a record pace, exposing them to foreign currency risks and rising leverage. This makes emerging economies more sensitive to volatile capital flows.
- Third, the eventual unwinding of prolonged monetary easing in the United States could expose these vulnerabilities and destabilize credit markets. Put simply, we are in uncharted territory.
A key message of this report is that addressing the old risks is essential to leave the crisis behind. But it also reduces the need for continued accommodative monetary policies. This will prevent the new risks from growing and from becoming systemic.
What needs to be done?
Policymakers need to fix the euro area. This calls for stronger policies to reduce financial fragmentation to help unblock the flow of credit to the economy and increase the resilience of the currency union.
- Policymakers can achieve this by completing the banking sector repair and by moving steadfastly towards full-fledged banking union.
- Furthermore, the flow of credit to solvent small and medium-sized enterprises needs to be improved.
- And private debt overhangs need to be addressed to complement the clean-up of bank balance sheets.
We also need to see renewed political commitment at the national and global levels to complete and implement the regulatory reform agenda. This is critical to minimize regulatory uncertainty and arbitrage, and to reduce financial fragmentation.
At the same time, policymakers must address new risks.
In the United States, policymakers need to keep banks safe. As for non-banks, they must be vigilant and proactive by restraining too rapid increases in leverage and by encouraging prudent underwriting standards. All this requires appropriate microprudential and macroprudential policies.
Emerging market economies must keep the guard up against deteriorating bank asset quality and disruptive short-term capital flows. At the same time, prudential policies should be deployed to ensure adequate buffers in the financial system and to prevent the excessive build-up of leverage and asset price bubbles.
Recent policy actions have bought precious time to address underlying financial vulnerabilities. We all know what needs to be done. There is no time to waste. Get it done!