IMF Global Financial Stability Report

Global markets have been subjected to the twists and turns of trade tensions and have been kept off balance by continuing policy uncertainty. Against the backdrop of deteriorating business sentiment, weakening economic activity, and intensifying downside risks, many central banks have adopted an easier stance on monetary policy. About 70 percent of the world’s economies, weighted by GDP, have done so.

Investors have interpreted the central bank actions as a turning point in the monetary policy cycle. The shift has been accompanied by a sharp decline in long-term yields. In some major economies, interest rates are deeply negative.

Remarkably, the amount of government and corporate bonds with negative yields has increased to about $15 trillion. Moreover, markets expect about one-fifth of government bonds will have negative yields for at least three years.

With rates staying lower for longer, financial conditions have eased, helping contain downside risks and support global growth, for now. But loose financial conditions have encouraged investors to take more risks in a quest to achieve their return targets. Valuations appear stretched in some important markets, including equity and credit markets, in both emerging and frontier, as well as advanced economies.

As a result of easier financial conditions and stretched asset valuations, vulnerabilities have continued to intensify, putting growth at risk in the medium term. Let me draw your attention in particular to our assessment of global vulnerabilities, summarized in the radar chart. The gray shading in that chart shows where vulnerabilities now stand. As you can see, there has been a notable increase in vulnerabilities in the section marked “Other Non-bank Financials.”

Vulnerabilities among non-bank financials, which include asset managers, structured finance vehicles, and finance companies, are now elevated in 80 percent of economies, as measured by GDP. This is similar to what we have seen at the height of the global financial crisis. The search for yield among institutional investors, such as insurance companies, asset managers, and pension funds, has led them to take on riskier and less-liquid securities. These exposures may act as amplifiers to shocks.

In addition, corporations are taking on more debt, and their ability to service that debt is weakening. In the event of a material economic slowdown, the prospects would be sobering. Debt owed by firms unable to cover interest expenses with earnings, which we refer to as corporate debt at risk, could rise to $19 trillion in a scenario that is just half as severe as the global financial crisis. That is almost 40 percent of total corporate debt in the eight economies that we studied, which include the United States, Japan, China, and some European countries, could be addressed in such a downside scenario.

Among emerging and frontier economies, external debt is increasing, as they attract capital flows from advanced economies, where interest rates are lower. External debt has risen to 160 percent of exports on average, up from 100 percent in 2008. A sharp tightening of financial conditions and higher borrowing costs would make it more difficult for them to service their debts. Overall, resilience of the banking sector has improved, thanks to stricter regulations and supervision since the global financial crisis.

However, there are still pockets of weak institutions. Negative yields and flatter yield curves have reduced expectations about bank profitability, and the market capitalization of some banks has fallen to low levels. Among banks outside the United States, US dollar funding liquidity remains a source of vulnerability that could amplify the impact of a tightening in funding conditions and could create spillovers to countries that receive cross-border dollar loans.

Policymakers need to take urgent action to mitigate financial stability risks. They should deploy and develop, as needed, new macroprudential tools for non-bank financial firms to mitigate vulnerabilities, highlighted in this report. They should address corporate vulnerabilities with stricter supervisory and macroprudential oversight, including the creation of targeted stress-testing of banks and the development of prudential tools for highly levered firms, which can help restrain debt at risk.

They should tackle risks among institutional investors through strengthened oversight and disclosures. Emerging and frontier economies should implement prudent sovereign debt management practices and frameworks.

Greater multilateral cooperation is needed in several areas. Policymakers should complete and implement the global regulatory reform agenda. They should ensure that there is no rollback of regulatory reforms. In addition, policymakers should foster the further development of sustainable finance, an approach to investment that takes environmental, social, and governance factors into account. To help promote awareness of climate threats and other risks to the financial system, policymakers should encourage better corporate disclosures and adequate standardization.

To sum up, with financial conditions still easy, and with vulnerabilities building, policymakers should act now to reduce the vulnerabilities that could exacerbate the next economic downturn.

Source / More : IMF

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