“Transitions” are still looming large 

The global financial system continues to face several major transitions along the road towards greater financial stability[1]. Over the past three months, key financial systems have moved further along the right path, but they have yet to arrive at their destinations. For example:

• The process of normalizing monetary policy in the United States has begun. But the trillion-dollar question is whether this transition will be smooth or bumpy.
• As the tide of liquidity ebbs, emerging markets need to step up their financial rebalancing.
• Japan’s transition from deflation to reflation under the policy regime of Abenomics is well underway, but much work lies ahead.
• The Euro Area continues to move from fragmentation to robust integration. While there has been progress in recent months, the picture is still mixed.
• And, due to the continuing regulatory reforms, the global financial system is moving to a better place. It is now safer than before the crisis—but not yet safe enough.

 Financial stability: where are we now?

Despite the recent nervousness in some financial markets, global financial stability has improved since the October 2013 GFSR. However, we remain in a liquidity-driven environment that could create new and expose old underlying vulnerabilities in emerging markets and advanced economies. This is why we need concerted policy efforts to transition to greater stability.

Goldilocks exit from unconventional monetary policy?

The probability of a smooth exit from unconventional monetary policy in the United States has increased since last October. In this “Goldilocks scenario”, a sustained upturn in U.S. economic growth leads to a normalization of monetary policy—without undue financial stability risks. This remains the most likely scenario.

Some positive factors have been at work in recent months. The improvement in communications by the U.S. Federal Reserve has helped convince financial markets that tapering of asset purchases does not imply imminent monetary tightening. This reduction in policy uncertainty has helped spur growth. And there have been signs of green shoots in the real economy, with corporate lending and capital investment picking up.

Nevertheless, financial markets still remain too much dependent on liquidity provided by central banks. Stock markets in the United States have continued to benefit from monetary policy support, as evidenced by the expansion of the Federal Reserve’s balance sheet. And there have been signs of weaker underwriting standards and increased financial leverage in some segments of the U.S. credit market. For example, issuance of “covenant-lite” loans, which impose limited conditions on borrowers, is now well above its pre-crisis level.

Policy recommendations:

• To reduce the risk of a bumpy exit scenario, U.S. policymakers need to strengthen their macroprudential oversight of shadow banking, where pockets of excess leverage may be beginning to emerge.
• Effective communication of the exit strategy and careful calibration of timing will be critical to reducing the risk of excess volatility and of overshooting of interest rates.

Emerging markets need to have their umbrellas ready

Market jitters in recent days have reminded us that emerging economies have yet to complete their adjustment to more volatile external conditions and higher risk premiums.

Emerging market investors largely shrugged off the Federal Reserve’s tapering announcement in December. This muted reaction underscored the improvement in Fed communications and suggested that some portfolio rebalancing had occurred over the summer of 2013.

Emerging market economies remain vulnerable to future increases in U.S. interest rates, although investors are increasingly differentiating among countries based on their financial vulnerabilities and macroeconomic imbalances.

Policy recommendations:

The best thing emerging market economies can do is to prepare for a rainy day by having their umbrellas ready. This requires policymakers to:

• Strengthen buffers by creating room for maneuver for fiscal and monetary policies.
• Address acute financial vulnerabilities by reining in excess corporate leverage and credit.
• Use macroeconomic buffers and appropriate policies to limit risks if instability occurs.
• Strengthen oversight of shadow banking in China and elsewhere. For example, wealth management products, distributed by banks, continue to be a major source of credit growth. Yet these structures may come under pressure as credit conditions tighten in China.

Euro Area: from fragmentation to integration 

In the euro area, confidence is coming back, but is not yet sufficiently strong. It is, therefore, essential that the forthcoming asset quality review (AQR) and stress tests are done well.

This exercise is expected to pave the way for a fully-fledged banking union by reducing uncertainty about the health of European banks. There has been significant progress in recent months. And the ECB is keenly aware of the importance of sound execution and good communication, given the complexity of the exercise.

However, the absence of an effective “common” backstop is likely to slow the pace of financial reintegration, because it leaves the sovereign-bank linkages largely intact. Greater clarity on backstops can reduce the need for their use—by strengthening market confidence and making it easier to raise private capital. It is encouraging that European banks have already made progress in repairing balance sheets in the run-up to the exercise, but further work lies ahead. Corporate balance sheets in stressed economies also remain under strain and further balance sheet repair is required.

These transitions were outlined in the October 2013 Global Financial Stability Report.

Source: IMF