More than seven years after the collapse of Lehman Brothers precipitated the most severe financial crisis since the depression of the 1930s, it may feel as if the debate about financial stability should be over. After all, the wave of European and US bank collapses is over, economies are stuttering back to life, consumer confidence is at least inching out of the trough, the US is poised to begin the normalisation of interest rates, and the UK will eventually follow suit. While it is hardly time to put out the flags in celebration, surely it is time to stow away the most potent weapons of economic fire-fighting?
Not according to José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department at the International Monetary Fund. At a presentation of the IMF’s October 2015 Global Financial Stability Report hosted by the London Business School in November, he explained why the IMF believes a ‘policy upgrade’ is needed to deal with three remaining challenges which could still destabilise the global economy.
First, there are the legacy issues which could undermine the recovery in advanced markets; these include the normalisation of economic policy in the US, the debt overhang in Europe and the need to continue economic stimulus in Europe and Japan.
Second, there are ‘financial market fragilities’, including concern about the liquidity of financial markets. Finally, and perhaps most importantly, there is the concern that some of the travails of advanced economies have been exported to emerging markets and the risk that a downturn there will become the ‘third leg’ of the financial crisis.
The difference between a good and a bad outcome is approximately 3%: that is the potential cost of inaction or reward for action. This is quite significant for the world.
The way in which these challenges are handled could have a significant impact: the IMF’s base expectation is that global growth in 2017 will be 2.8%; with an appropriate policy upgrade, leading to a smooth decompression of risk, growth could be 40 basis points higher, at 3.2%; handled badly, the abrupt decompression could cut growth to just 0.3%. ‘The difference between a good and a bad outcome is approximately 3%: that is the potential cost of inaction or reward for action. This is quite significant for the world,’ said Viñals.
The fragility of financial markets was demonstrated in the ‘taper tantrum’ of 2013, when the prospect that the US would end its Quantitative Easing programme sent bond yields soaring across global markets, repeated in the ‘flash crash’ in 2014, and underlined in the gyrations in global markets, led by the Shanghai stock exchange, when China devalued the yuan.
With a rise in US interest rates once more on the horizon, the risks of disruptive shifts in asset prices in financial markets are increasing. While it is likely that subsequent increases will be gradual, Viñals points to a dislocation in expectations. The US Federal Reserve is signalling that rates could rise to 2.5% by the end of 2017 while the market consensus is for 1.5%, but with a 24% likelihood that they will still be 1% or lower by then if the US recovery stalls.
Richard Portes, Professor of Economics at LBS, told the meeting that liquidity in financial markets, and particularly in bond markets, is already an issue and ‘if we have a market crisis, liquidity always disappears anyway.’ Pointing to suggestions from senior figures in the industry that central banks should act as market makers of last resort if there is a bond market rout, he asked: ‘Should central banks do that anyway?’ and suggested there should be more research on the issue of liquidity in financial markets.
Viñals agreed on the need for further research on these issues, and said that the IMF is devoting some resources to that. He added that the IMF had no institutional view on whether central banks should act as market makers of last resort should liquidity issues arise, but added: ‘On a personal basis, I am closer to those who think that, if push comes to shove, central banks should be there’, although he admitted that was an ‘extraordinarily controversial’ issue, with the Bank of England agreeing and the US Federal Reserve likely to say no.
Portes also doubted whether there are significant bubbles in financial markets, and Viñals concurred, with one qualification: ‘On the sovereign debt side, there is definitely an overvaluation’, originating in US markets but spreading to other regions, as a consequence of Quantitative Easing. ‘Eventually, normalisation will happen: the question is will it be smooth normalisation or disorderly normalisation? We do not know. But we need to put in place macroprudential policies to make sure that both the banking system and the shadow banking system are sufficiently resilient to any adverse scenarios.’
The IMF has its own measure of market resilience, shown by calculating the number of days US mutual funds would take to liquidate corporate bond portfolios in the, admittedly unlikely, event that every investors wanted out at the same time. Five years ago, it would have taken five to seven days; now, it is nearer 60 days. ‘That tells you something about the resilience of market liquidity – it is not that high at the moment,’ said Viñals. That matters, he added, because this measure is effectively a measure of the depth of financial markets – the lower the depth of markets, the greater the risk of volatility. That could make markets more fragile should an unexpected event occur, such as a greater-than-expected tightening from the Federal Reserve or an accident from emerging markets.
That challenge of economic adjustment is particularly acute among emerging markets, which have been the engine of global growth during the financial crisis. That was fuelled partly by a build-up of debt, particularly at bank and corporate level, which now poses a significant risk of dislocation. While many emerging economies have built up their resilience since the financial crisis through initiatives like moving to flexible exchange rates, increasing reserves and reducing their reliance on foreign investment and borrowings, in some countries there is still an issue – the IMF highlights China, Turkey and Brazil in particular – of significant over-borrowing. China’s ‘credit gap’, defined as the deviation from its long-term borrowing trend, is the largest of all emerging economies.
That is significant given that China has become crucial to the global economy and also faces its own challenges, as it seeks to rebalance its economy from investment to consumption, manufacturing to services and export to domestic demand, without derailing its economic growth. So far, the slowdown in its growth has been relatively modest, and market expectations are that this will remain the case. But other factors, including rising corporate debt and China’s efforts to move to a more market-based system, suggest increasing risks.
Lucrezia Reichlin, Professor of Economics at London Business School, raised the prospect that China’s economy has actually come to maturity and may be getting to what has been called the ‘middle income trap’, given China’s demographics, including the ageing population.
‘There is a risk that China will converge to a rate of growth around 4% rather than 6.8% quite soon. Then the adjustment in leverage could be quite severe,’ although neither the IMF’s projections, nor her own, are that pessimistic.
Viñals said he did not think a sharp fall in growth over the short run was an issue, as the Chinese authorities have enough buffers to prevent growth slowing too much. However, ‘if it were to happen rapidly over the next few years, I think that would be a big problem for China and for the rest of the world.’
Viñals and Reichlin agreed that shadow banking is a significant issue in China. Viñals estimates it is between 30% and 40% of the financial system but added: ‘It is very unclear what the relationship is between shadow banks and banks. More broadly it is unclear what the lending practices are.’ He added that the IMF is starting analysing this area.
Corporate debt has risen sharply across emerging markets – from $4 trillion in 2004 to more than $18 trillion in 2014, according to the IMF’s statistics. This trend has been particularly pronounced in China, with a rise in corporate debt as a proportion of GDP of 25% in the last seven years alone. Viñals pointed out that, despite this rise in private sector debt, non-performing loans are still relatively low, at around 2%. There is, however, evidence that borrowers are getting shakier – the IMF calculates that around 25% of corporate borrowers have a weak debt-servicing capacity. ‘The issue for China is to ensure that the banking sector is sufficiently strong to absorb an increase in non-performing loans,’ said Viñals.
But the issue is not confined to China. Across emerging markets, following the financial crisis, corporate leverage has been increasing while corporate profits have been falling. Yet Viñals stressed that the spread at which this debt has been issued has fallen continuously, ‘in principle this ought to reflect lower corporate risk, yet at the same time the debt-servicing capacity of the emerging market corporates was deteriorating.’
The IMF’s analysis suggests that the key reasons for this dichotomy were high rawmaterial prices and loose monetary conditions. ‘The question is what happens when the cycle turns—when raw material prices are lower for an extended period, as they are likely to be, and when there is a tightening of global financial conditions, following action by the Fed. That is likely to be a much more demanding environment for corporates in emerging markets.’
Two key risks for emerging market corporate debt are foreign exchange and commodity exposure. The IMF estimates that around a third of emerging market corporate debt is in foreign currencies; although in some countries it is much higher. In Turkey, for example, it is 50%. But the IMF does not know how much of this debt is hedged – something which Viñals says ‘is a big issue.’ Commodity producing companies also account for a sizable proportion of emerging market corporate debt – 40% in Brazil, whose economy is heavily commodity-dependent and 30% overall, in the IMF’s sample.
These twin risks are particularly significant because of the banking sector’s exposure to corporate lending – for example in Turkey, 65% of the bank’s loan book is corporate, or around 50% across emerging markets as a whole. ‘If corporates get into trouble, banks better have buffers that are strong enough to cope,’ said Viñals.
Both Portes and Reichlin expressed concern about the level of debt still burdening the European economy, both at government or corporate level. ‘Public debt is an issue which is not well understood,’ said Reichlin. As for corporate non-performing loans, she pointed out that, seven years after the crisis, Italy is still talking about the creation of a ‘bad bank’ - something which is proving very controversial. And Portes added that dealing with non-performing loans can be hampered by rules over state aid. Italy, for example, has been constrained from dealing with its €300 billion overhang of non-performing loans because of competition rules being enforced by the European Commission. Viñals said that decisively addressing non-performing loans in European banks is most important while reducing European public debt is a ‘marathon not a sprint.’
The same is true for the process of ensuring an orderly recovery from the financial crisis for the global economy. ‘It calls for policies which will enhance confidence, both in advanced but particularly in emerging markets, which build resilience, particularly in emerging markets, and use policy buffers wisely.’
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