EM managers urged to strengthen economic fundamentals against short-term risks to global financial stability

Though the current economic environment remains favourable, short-term risks to global financial stability have increased in the past six months as a result of a spike in stock-market volatility in February and continuing investor concerns about rising geopolitical and trade tensions, according to an IMFblog published Wednesday, April 18, 2018.

The author of the article titled: “A Bumpy Road Ahead for the Global Financial System”, noted that looking ahead, the odds of a downturn remain elevated, and there’s even a small chance of a global economic contraction over the medium-term.

He specifically urged policy makers to take advantage of the current favourable economic climate and take steps to reduce the risks, including emerging market economic managers strengthening economic fundamentals and buffers against external shocks.

He noted that the global economic recovery has so far been resilient to the pronounced swings in financial markets—but investors and policy makers shouldn’t take too much comfort from that fact. They should remain attuned to the risks associated with rising interest rates, elevated market volatility, and increasing protectionism. The road ahead may well be bumpy.

“Policy makers should take advantage of this favourable environment to take steps that will reduce the risks. For emerging-market economies, this means strengthening economic fundamentals and buffers against external shocks; for advanced economies, it means deploying and developing their regulatory and financial policy tools and following through on plans to strengthen financial institutions,” the author noted.

The article cited the global financial stability assessment contained in the latest Global Financial Stability Report (GFSR), which is based on the new “Growth-at-Risk” approach that links financial conditions to the distribution of future economic growth, stating that given current financial conditions, risks to financial stability and growth are high over the medium-term.

“This reflects the fact that recent years of low interest rates—needed to support economic growth—have provided an environment in which vulnerabilities have been building. These vulnerabilities could exacerbate the next economic downturn and could also make the road ahead bumpy.”

The article explained how today’s financial vulnerabilities make the road bumpy, stating that larger imbalances mean that any shock to the economic or financial system would trigger a more painful adjustment.

It states that a faster-than-anticipated increase in US inflation could cause the Federal Reserve and other central banks to withdraw monetary accommodation more quickly than is currently expected, and that could shake financial markets, and that a wider escalation of protectionist measures is another risk, which would take a toll on financial markets as well as growth.

“In either case, a sudden decline in asset prices could expose vulnerabilities in the financial system,” the author noted.

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The GFSR indeed identified three areas of vulnerability, including weakening credit quality; external debt-related vulnerabilities in emerging markets and low-income countries, and dollar liquidity mismatches among banks outside the United States.

For example, on weaker credit quality, it states that increasingly, less creditworthy companies are able to borrow in financial markets, that global issuance of so-called leveraged loans—made to riskier companies and those with high debt loads—rose to a record $788 billion last year.

Separately, the GFSR looked at the rise of crypto assets. Some of the technologies behind these assets could make financial market infrastructure, such as payment systems, more efficient. But they have also been afflicted by fraud, security breaches, and operational failures—and have been associated with illicit activities. While the limited size of crypto assets suggests they currently pose little risk to financial stability, risks could grow if their use became more widespread without appropriate safeguards.

The author, therefore, canvassed the following policy options for policymakers, saying that they should take advantage of today’s favourable environment to adopt safeguards against looming financial risks: Central banks should continue to gradually withdraw monetary accommodation, where appropriate, while communicating their decisions clearly; and regulators should address financial vulnerabilities by deploying and developing regulatory and financial policy tools.

Other options are: Policymakers should ensure that the post-crisis regulatory reform agenda is completed — and they should resist calls for rolling back reforms; and emerging markets and low-income countries should build reserves and fiscal buffers against external risks.