The latest issue of the Global Financial Stability Report put out by the IMF has raised some serious concerns over the rising risk of global financial instability. The IMF report has highlighted that between October 2015 and October 2016 there has been a sharp and perceptible increase in the risks that the global financial system is exposed to. According to the IMF, risks in developed markets have gone up due to a slowdown in growth and systemic risks as is visible in European banking today. On the other hand, emerging markets are facing the brunt of weak oil and commodity prices since a vast majority of EMs are either commodity producers or benefit from higher commodity prices. Emerging markets are also exposed to higher risk of an economic slowdown from China and its concomitant impact on global currencies.
Background to the global financial stability debate…
It may be recollected that in the immediate aftermath of the Fed rate hike in December 2015, global markets across the world lost nearly $14 trillion in market cap. According to the IMF, this was not just a knee-jerk reaction to the US rate hike but was indicative of larger fault lines in the global economic structure that manifested in the form of financial instability and heightened volatility across markets. The IMF goes on to add that although the global markets have recovered their losses since February 2016, the confidence of the global financial system has been badly shaken. Additionally, it has also exposed the fault-lines wherein global markets have displayed a high vulnerability to any signs of hawkishness by the US Federal Reserve.
Key Takeaways from the IMF Global Financial Stability Report
There are a few takeaways from the IMF report. Here are a few that are highlighted…
- To secure financial stability, companies must work harder to bring back growth and inflation. While low inflation may be partly attributed to weak oil and commodity prices, they are also indicative of weak demand.
- Rising debt burden of most nations is another cause for worry. Countries like Japan, China and most European countries have a debt / GDP ratio that is substantially above the 100% mark. That is a recipe for fragility.
- The IMF has also highlighted that the limitations of monetary policy as a tool to propel growth has been consistently exposed in the last few years as countries like Japan and EU have been unable to get growth back on track even with negative interest rates.
- Any disruption in the global economic cycle is likely to have impact across different markets. Currently, global markets like commodities, bonds, equities and derivatives are closely and intricately connected. It will take very little time for shocks to be transmitted across markets.
- According to the IMF, the world economy could lose output to the tune of nearly 3.9% by 2021 as an outcome of financial instability. This will be a huge loss especially when you consider that it will be a loss of nearly $5 trillion of global GDP with far ranging consequences for jobs and output.
- The IMF has laid special emphasis on the vulnerability of banks in the advanced economies. We have seen the crisis at Deutsche Bank due to its exposure to derivatives to the tune of $70 trillion. In the past we seen such a crisis erupting in banks like Citibank, Barclays, RBS, CSFB, UBS and Goldman Sachs among others.
- The immediate challenge, therefore, will be to restore confidence in the banking system, build their capital defences and their liquidity buffers. These can make global vulnerable at short notice and in an interconnected world, such shocks can be transmitted seamlessly across economies and markets.
- The report has also highlighted the inordinate contribution that insurance companies make to global risk. Since AIG in 2008, the systemic risk of insurance companies has only increased.
So what is the strong medicine that IMF recommends?
According to the IMF, reduction of risk in financial markets stability needs to be addressed urgently. It requires the following measures:
- More prudential and innovative ways of monitoring banks and insurance companies is called for. Many of the inherent risks in the current business model are not fully captured by existing risk-management structures. Stress testing is something that needs to be done more frequently and more rigorously for banks and insurers.
- Emerging markets need to improve their resilience to global headwinds. Today the global markets are overly vulnerable to US monetary policy or to China’s currency policy. Unfortunately, the standard response among commodity driven EMs has been to cut down on capital spending and government expenditure. This is not a sustainable scenario as it will eventually fuel social unrest.
- The IMF also underscores that the bellwether economies in the global markets like the US and China have strong externalities. Any monetary or currency action on their part is likely to have larger repercussions. Hence, these economies need to be more transparent in laying out the trajectory of their policy in the larger interest of the global economy.
The IMF report is important because it comes at a time when the global growth complacency is at its highest. For too long cheap money has been used to fuel asset prices. This has resulted in asset inflation across the world instead of making money easily available for productive investments. The sooner the world’s policy makers read these signals and act upon it the better it will be for global markets.