April 18, 2018/IMF
Tobias Adrian, Financial Counsellor
Good morning. As the “World Economic Outlook” noted yesterday, the global economy continues to show broad-based momentum. Today, I will discuss our outlook for financial stability. Since our last “Global Financial Stability Report,” short-term risks to financial stability have increased, and medium-term risks remain elevated. Despite the VIX tantrum in February and the recent volatility in equity markets due to trade-policy tensions, still easy financial conditions continue to support global growth in the short term. But there has been a buildup of medium-term vulnerabilities which have accumulated during years of low interest rates.
Vulnerabilities may make the road ahead bumpy, and could put growth at risk. Our “Growth at Risk” analysis — which links financial conditions to the distribution of future global growth — indicates that, under a severely adverse scenario, growth could be negative three years from now.
This report discusses three main vulnerabilities: stretched valuations across many asset classes; borrowing by emerging markets and low-income countries; and bank dollar liquidity mismatches. I will discuss each of these vulnerabilities, in turn.
The first vulnerability is that valuations of risky assets are stretched, across many markets.
• Some late-stage credit-cycle dynamics are emerging. Corporate bond spreads remain at low levels; issuance of riskier bonds has surged; and leveraged lending hit a record high in 2017.
• A faster-than-expected pickup in inflation might lead to a more rapid withdrawal of monetary accommodation by some central banks. This could trigger a sudden tightening in financial conditions, and a sharp fall in asset prices.
• The resulting turbulence in financial markets could be amplified by liquidity mismatches and increased use of financial leverage.
The second vulnerability is that emerging markets and low-income countries could face a sudden tightening in global financial conditions.
• Such an event could lead to a reduction in capital flows.
• Debt sustainability in low-income countries has deteriorated, and a more complex creditor composition poses challenges for any future debt restructurings.
The third vulnerability is that there is a structural US dollar mismatch among non-US banks—even though banks, overall, have improved their resilience since the global financial crisis.
• The international US-dollar balance sheets of non-US banks rely on short-term or wholesale sources for about 70 percent of their funding.
• This could leave banks exposed to dollar funding problems in the event of strains in markets.
The report also looks at crypto assets.
• Some of the technologies behind crypto assets could make the financial market infrastructure, such as payment systems, more efficient.
• But crypto assets have also been afflicted by fraud, security breaches, and operational failures.
• Their limited size — now around 3 percent of combined G4 central bank balance sheets — currently implies little risk to financial stability. But they could pose greater risks in the future.
This all suggests that policy actions are needed in several spheres.
• Central banks should continue to normalize monetary policy gradually, and they should communicate their decisions clearly.
• Regulators should address financial vulnerabilities by deploying and developing prudential policy tools.
• Emerging markets and low-income countries should strengthen fundamentals and build buffers.
• Policymakers should ensure that the post-crisis regulatory reform agenda is implemented — and they should resist calls for rolling back reforms.
To sum up: The economic recovery has remained resilient despite recent market volatility. But investors and policymakers should not take too much comfort from today’s relatively easy financial conditions. They should remain attuned to the risks associated with rising interest rates, elevated market volatility, and an escalation of trade tensions. The road ahead may well turn out to be bumpy.