Global financial stability risks have risen “modestly” in the near term, but “remain elevated” in the medium term, according to the International Monetary Fund’s Global Financial Stability Report, released today (October 10).
The IMF reports the near-term risks are largely driven by a combination of emerging economy country-specific factors, tightening financial conditions and trade tensions. The “persistent financial vulnerabilities” associated with high debt levels and asset valuations kept the medium-term outlook unchanged since the April 2018 report.
In the past six months, US interest rates have been normalising, and a stronger US dollar coupled with intensified trade tensions have prompted portfolio outflows, increased borrowing costs and depressed local currencies in emerging economies, the IMF reports. Emerging market equity prices have been suppressed and debt spreads have widened.
“Robust global risk appetite has so far masked the challenges emerging markets may face should global financial conditions suddenly tighten sharply,” the report says.
Overall, banks have strengthened their balance sheets, retained higher levels of capital and are more liquid since the global financial crisis. However, the report points out a number of concerns.
In the eurozone, Japan and the UK in aggregate, the market value of banks’ capital is less than the amounts recorded on their balance sheets.
The IMF says: “If market valuations are used to calculate capital ratios – in place of the balance sheet value of capital used in the regulatory ratios – a number of banks would have a market-adjusted capitalisation of less than 3%, the minimum level in the Basel III framework.”
The report warns, if global financial markets’ conditions continue to tighten, banks will be exposed “financial vulnerabilities”. The ratio of total non-financial sector debt to GDP in systemically important areas is at an all-time high of 250%.
This echoes the concerns of the Bank of England about the global leveraged loan market. The BoE’s financial policy committee meeting statement, published on October 9, says the market is “larger than, and growing as quickly as, the US subprime mortgage market” was before the finical crisis.
In the report, the IMF says financial conditions in the eurozone have remained “relatively easy” due to the accommodative monetary policies and robust global risk appetite.
The European Central Bank’s plan to end quantitative easing by the end of 2018 but push back rate hikes encouraged investors to extend the expected timing of a rate increase. As a result, German long-term yields have fallen.
Italian policy uncertainty has reintroduced a focus on the “bank-sovereign nexus”. Fiscal uncertainty could damage confidence in Italy’s financial markets, the IMF warns.
Escalating concerns over a no-deal Brexit with the European Union have driven sterling volatility to a five-month high.
The anxiety over the negotiations could cause “contractual and operational” risks for financial institutions in both jurisdictions. Contractual risks arise from challenges in maintaining cross-border derivatives contracts.
“Ensuring the continuity of contracts is one of the most pressing issues,” the IMF report says, echoing recent warnings by the BoE.
The operational challenges are associated with the regulatory environment through the transition period. Uncertainties over changes in licensing requirements, risk management and recruitment may adversely affect financial market confidence.
China’s financial conditions remained “broadly stable” as monetary policy loosening has held back external pressures so far. However, Chinese equity markets have been damaged by rising trade tensions. The renminbi has fallen 7% against the dollar since mid-June.
“Should market participants start pricing in the possibility of protracted trade tensions, financial conditions could tighten significantly, increasing the tail risk to global growth and financial stability,” the report says.
China’s efforts to “de-risk and deleverage” its financial system have conjured “pockets of stress” in corporate bonds markets and tightened liquidity. The efforts have led to tighter credit conditions for weaker borrowers.
Despite monetary policy tightening, the IMF says, financial conditions in the US have eased. The strong risk appetite and tax reforms are reflected in low volatility and inflated asset prices “well beyond pre-crisis levels”, notwithstanding trade tensions.
“US equity prices now appear modestly higher than their model-based values, based on alternative measures of S&P 500 earnings expectations as well as proxies for both the risk-free rate and the equity risk premium components of the discount factor,” the report says.
The IMF concludes that regulatory gaps prevail in a number of areas, including macro-prudential frameworks, systemic risk monitoring, and cross-border co-operation.
It advises regulators that they “must avoid complacency”. Risks tend to arise in times of good financial conditions, such as the current environment of low interest rates and volatility. During this period supervisors must remain “vigilant” on risks developing in new areas.