The world’s financial system is expected to benefit from continued growth and contained inflation over the coming months, but it will also be subject to downside risks, according to the IMF’s new Global Financial Stability Report (GFSR). The biannual report cautions that higher inflation and further monetary tightening, oil price surges, a larger-than-expected decline in the U.S. housing market, or a disorderly unwinding of global imbalances could lead to market corrections. Market features, such as “crowded trades” and illiquid secondary market conditions for some structured credit products, could amplify a downturn. The report also highlights the rapid rise in household credit in many emerging market countries, noting that household and bank balance sheets could suffer, particularly in the absence of adequate risk management and prudential infrastructure.
Prices retreated and volatility increased in global financial markets in May and June, but the market correction was short lived. Investors appeared to be readjusting their risk positions in response to monetary tightening, rather than reassessing economic fundamentals.
The global economy and international financial markets have been performing well in recent years, mainly because of low interest rates in major countries. In many countries, corporations and financial institutions, marked by strong balance sheets and substantial liquid assets, have been quite profitable. Many emerging market countries have improved their fiscal positions, accumulated reserves, and strengthened public debt structures.
Dealing with downside risks
According to the report, the recent turbulence is a timely reminder for policymakers to strengthen macroeconomic policies and pursue structural reforms to reduce vulnerabilities. In the same vein, market participants should intensify their risk-management efforts, and financial supervisors need to improve market infrastructures to limit the amplification of market corrections. Emerging market countries that rely heavily on external financing should reduce vulnerabilities and pursue reforms that will help them sustain their current growth performance.
There is good reason for policymakers, market participants, and supervisory agencies to be more alert. The GFSR weighs the potential risks:
Growth slowdown. While projections are for continued strong global growth, risks are tilted to the downside, and a lower-than-expected growth outturn could result in a correspondingly negative outcome for financial markets. In particular, a rapid deceleration of house price growth could increase the financial burden of heavily indebted households in many countries, reducing personal consumption and affecting asset markets adversely.
Interest rates and risk premiums. Sustained high rates of global growth have absorbed spare capacity, raising inflationary pressures, with moderate inflation increases in the United States and Europe. The use of higher policy rates to counter such pressures, should they intensify, could increase the downside risks (see chart, this page). Inflation expectations have generally remained within a narrow range in recent years, and, although there has been some increase in long-run inflation expectations in the United States, term premiums have not gone up. However, if the risk premiums for future inflation increase, asset markets could come under pressure. Supply shocks and geopolitical tensions could make investors retract, forcing risk premiums higher and eroding business and consumer confidence. Corporate and sovereign spreads, which are linked to volatility, could widen. A repricing of credit risk could be amplified by illiquid secondary market conditions for some structured products, which have become popular and useful in dispersing credit risk. Risk-management practices by banks’ trading desks and hedge funds should be monitored closely, the report says.
Disorderly dollar adjustment. The market view is that any dollar adjustment is likely to be limited and orderly. Forward bilateral exchange rates indicate that the dollar’s real effective exchange rate is expected to remain relatively stable, with Asian currencies expected to appreciate over the medium term and non-Asian currencies expected to weaken. A gradual and orderly adjustment will depend on a credible policy framework for resolving global imbalances over the medium term. The GFSR notes that, although the depth, liquidity, and breadth of U.S. financial markets have played an important role in attracting capital inflows and thereby financing imbalances, this advantage may diminish over time as foreign holdings of U.S. assets continue to rise and global markets continue to develop. At the same time, there is a broad trend of liberalization of private capital outflows and diversification of official reserves, particularly in Asia, that should help smooth adjustment.
Past tightening episodes suggest that volatility may rise as liquidity is withdrawn.
1includes the U.S monetary base and foreign official holdings at the Federal Reserve Bank of New York, leading 12 months.
2VIX is a measure of the implied volatility of stock index options. Expressed in percentage points, it represents the market’s expectation of annualized volatility over the next 30-day period.
Data: Bloomberg L.P. and IMF staff estimates.
Pressure points in emerging markets. Private capital flows, including foreign direct investment, to emerging markets remained strong in the first half of 2006 despite the recent turbulence. The GFSR projects continued capital flows in the months ahead but notes that their composition has changed because of credit booms and related increases in current account deficits in a number of countries. As a result, debt flows to private sector borrowers have increased, while debt flows to public sector borrowers have declined.
Household credit soars
In many emerging market countries, household credit is growing rapidly, albeit from a low base. This growth is typically beneficial: better access to credit reduces the volatility of household consumption, improves investment opportunities, eases constraints on small businesses, and diversifies household and financial sector assets. When risk management and prudential infrastructure are inadequate, however, rapid credit growth can weaken household balance sheets, contributing to asset price bubbles and creating vulnerabilities for financial systems.
According to the GFSR, household credit in emerging market countries has a range of characteristics:
Improved bank lending and restructured asset portfolios have encouraged household credit growth in emerging market countries.
Note: The circled cluster of countries includes Argentina, Brazil, China, Colombia, India, Indonesia, Peru, Philippines, Romania, Russia, Turkey, and Venezuela.
Data: IMF, September 2006 World Economic Outlook, and staff calculations based on data from country authorities; and CEIC.
Level and growth rate. The average ratio of household credit to GDP in emerging market countries is about 18 percent, with considerable variation among countries (see chart below). Credit growth has been encouraged by the restructuring of banks’ asset portfolios and business models in the wake of the financial crises of the late 1990s. In several Asian and Latin American countries, postcrisis bank lending has been led by household credit rather than corporate credit.
Composition and structure. The average share of housing loans in total household credit is lower in emerging market countries than in mature market countries, reflecting high and volatile interest rates and hindrances such as an inadequate legal framework for enforcing mortgages. Consumer loans are generally extended at fixed rates, whereas housing loans can carry either fixed or floating interest rates. Although longer terms for housing loans are becoming more common, the tradition of short-term loans persists in many countries despite moderate inflation expectations.
Providers. Banks are the largest providers of household credit. Foreign banks have played an important role in the growth of household credit but, in the face of certain restrictions, they have focused on the market for credit cards and personal loans. Government-sponsored lending institutions, particularly in the housing market, are increasingly competing with commercial banks. In many countries, nonbank finance companies and, to a lesser extent, the informal credit sector are often the only available source of household credit.
Sound policies can lower risk
Emerging market household credit has grown during a period of low mature market interest rates and falling emerging market interest rates. If these trends are reversed, weaknesses in household balance sheets could undermine financial sectors, weaken property prices, and slow consumer spending. Excessive mortgage lending could also contribute to the inherent vulnerability of property markets to boom-bust cycles and to cyclicality in the banking system. Policymakers can minimize the risks associated with rapid credit growth by ensuring a sound macroeconomic policy environment, implementing appropriate prudential regulation, and improving the capacity to assess vulnerabilities. A key step is to improve data availability—particularly on the buildup of credit and exchange rate risks in household credit portfolios at all levels.
IMF External Relations Department
Copies of the September 2006 Global Financial Stability Report are available for $54.00 each ($51.00 academic price) from IMF Publications Services. The full text of the latest issue of the Global Financial Stability Report is available on the IMF’s website (www.imf.org).