Financial Risks Rise, Rotate-IMF Survey
Global financial stability risks have risen since October 2014, and have rotated to parts of the financial system where they are harder to assess and harder to address, according to the International Monetary Fund's latest Global Financial Stability Report.Financial stability risks have risen amid a moderate and uneven global economic recoverywith rates of inflation that are too low in many countries. Divergent growth and monetary policies across countries have increased tensions in global financial markets and caused rapid and volatile moves in exchange rates and interest rates over the past six months, according to the IMF.
In part, this situation results from the legacy of weakened and incomplete repair of private sector balance sheets. Risks are also rotatingaway from banks to shadow banks, from solvency to market liquidity risks, and from advanced economies to emerging markets.
As risks rise and rotate, additional policy measures are required to enhance monetary policy traction and ground financial stability, said JosVils, Financial Counsellor and head of the IMF's Monetary and Capital Markets Department. Prompt action is critical at the global level as well as in specific countries.
In light of these developments, countries must meet five key challenges to safeguard global financial stability.
Need for QE plus policies
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The first challenge relates to enhancing the impact of monetary policy in advanced countries, while managing the undesirable side effects of low interest rates. The European Central Bank and the Bank of Japan have pursued bold monetary policies to counter renewed disinflationary pressures. These so-called quantitative easing programs have already shown measurable signs of success. Financing costs have fallen in the euro area, equity prices have surged, and the euro and yen have depreciated significantly, helping support inflation expectations.
However, officials must complement these actions with other measuresor QE plus policiesotherwise monetary policy cannot be fully effective in achieving their aims.
In the euro area, this requires unclogging the bank lending channel by tackling the 900 billion stock of nonperforming loans. As banks with more bad loans tend to lend less, the high level of nonperforming loans needs to be reduced. If no further actions are taken, bank lending capacity in the euro area could only amount to a meager 1 to 3 percent on average per year. Policymakers should encourage banks to deal with their bad loans and ensure more efficient legal and institutional frameworks to speed up this process.
In Japan, the effectiveness of quantitative easing depends on the steadfast implementation of Abenomics' second and third arrows, namely fiscal and structural reforms. If these reforms are incomplete, efforts to keep the economy out of deflation and raise growth are less likely to succeed.
In the United States, the baseline of a smooth return to normal monetary policy is not guaranteed. The Fed needs to continue getting the pace of exit right and continue communicating clearly to the public. But potential complications could arise given divergences between the market and official views of inflation prospects. A rapid decompression of yields could also increase volatility with global repercussions.
Managing low for long
The second challenge is to limit the financial excesses resulting from interest rates being low for long. For instance, weak European mid-sized life insurers could face rising risks of distress, with almost a quarter of insurers unable to meet their solvency capital requirements in the future, if low interest rates persist. With a portfolio of 4.4 trillion in assets in the European Union in the hands of life insurers, and high and rising interconnectedness with the wider financial system, weak insurers create a source of potential spillovers. This is an important illustration of the rotation of risks from banks to nonbanks.
It is extremely important that these potential solvency problems do not materialize, said Vils. They should be addressed preemptively through appropriate micro- and macroprudential policies.
Emerging markets amid global crosscurrents
The third challenge is to preserve stability in emerging markets caught in global crosscurrents and confronting domestic weaknesses. Lower commodity prices and lower inflationary pressures are benefiting many of these economies. However, oil and commodity exporters, as well as market sectors that have borrowed heavily face more substantial risks. In addition, the sharp dollar appreciation entails additional risks for corporates and countries with large foreign currency debts.
Financial resilience can be enhanced through micro- and macroprudential measures. Regulators need to conduct bank stress tests related to foreign currency and commodity price risks, and more closely monitor corporate leverage and unhedged foreign currency exposures, including derivatives positions.
Unpredictable geopolitical risks
The fourth challenge is to cope with geopolitical tensions in Russia and Ukraine, the Middle East, and parts of Africa, as well as risks in Greece.
Illusion of market liquidity
Finally, managing any of these challenges could become more difficult when markets are illiquid. Markets may have sufficient liquidity in good times, but this can dry up rapidly when markets are strained, amplifying the impact of shocks on prices. During periods of illiquidity since the crisis, correlation across markets has risen, increasing the potential for contagion. The underlying causes include a shift towards high-frequency electronic trading, reduced market making, and greater use of benchmarks.
A broad policy mix to address rising and rotating risks
As risk are rising and rotating, additional policy measuresbeyond monetary policiesare vital to make a durable exit from the global financial crisis and safeguard financial stability.
Policymakers must address the legacies of the crisis. The impact of monetary policy needs to be increased and financial excesses contained. In addition, policymakers need to strengthen market liquidity and complete financial regulatory reforms.
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