Russian
Global
Financial Stability Report
GFSR Market Update
Financial System Stabilized, but Exit, Reform, and Fiscal Challenges
Lie Ahead
January 26, 2010
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Systemic risks have continued to
subside as economic fundamentals have improved and substantial public
support remains in place. Despite improvements, financial stability remains
fragile in many advanced countries and some hard-hit emerging market
countries. A top priority is to improve the health of these banking systems
so as to ensure the credit channel is normalized. The transfer of financial
risks to sovereign balance sheets and the higher public debt levels also add
to financial stability risks and complicate the exit process. Capital
inflows into some emerging market countries are beginning to raise concerns
about asset price and exchange rate pressures. Policymakers in these
countries may need to exit earlier from their supportive policies to contain
financial stability risks. For all countries, the goal is to exit from the
extraordinary public interventions to a global financial system that is
safer, but retains the dynamism needed to support sustainable growth.
Financial markets have recovered strongly
since their troughs, spurred on by improving economic fundamentals and
sustained policy support (see the World Economic Outlook Update,
January 2010). Risk appetite has returned, equity markets have improved, and
capital markets have re-opened. As a result, prices across a wide range of
assets have rebounded sharply off their historic lows, as the worst fears of
investors about a collapse in economic and financial activity have not
materialized (Figure 1).
These favorable developments have
resulted in an overall reduction in systemic risks. Overall credit and
market risks have fallen, reflecting a more favorable economic outlook and a
reduction in macroeconomic risks, together with support from accommodative
monetary and financial conditions. Emerging market risks have also fallen.
Prevailing easier monetary and financial conditions, while helpful, also
point to future challenges that will need to be managed carefully.
Even with overall improvement, however, the repair of the
financial system is far from complete, and financial stability remains
fragile. There are still pressing challenges from the crisis. At the same
time, new risks are emerging as a result of the extraordinary support
provided by the policy measures that have been implemented. Indeed,
unprecedented policy support has come at the cost of a significant increase
of risk to sovereign balance sheets and a consequent increase in sovereign
debt burdens that raise risks for financial stability in the future.
Simultaneously, some major emerging market economies already have rebounded
strongly, raising initial concerns about upward pressure on both asset
prices and exchange rates. As a result, the timing, sequencing, and
execution of exits to a newly reformed financial system will require
policymakers’ deft handling.
Banks and Credit
The first major challenge is to restore the health of the
banking system and of credit provision more generally. For this it is
necessary that the deleveraging process under way in the banking system
remains orderly and does not require such large adjustments that they
undermine the recovery. The process of absorbing the credit losses is still
under way, supported by ongoing capital raising. Our estimates of expected
writedowns will be updated in the April 2010 GFSR; the recovery in
securities prices on banks’ balance sheets suggests the estimate would be
somewhat lower than estimated previously if recalculated at the present time.
Looking forward, even though some bank capital has been
raised, substantial additional capital may be needed to support the recovery
of credit and sustain economic growth under expected new Basel capital
adequacy standards, which appear to be converging to the markets’ norms that
were the basis of the October 2009 GFSR’s calculations of remaining capital
needs.
Credit losses arising from commercial real estate
exposures are expected to increase substantially (Figure 2). The
expected writedowns are concentrated in countries that experienced the
largest run-ups in prices and subsequent corrections and are in line with
our previous estimates.
Banks not only face the task of raising more capital, but
also need to address potential funding shortfalls. As noted in the October
2009 GFSR, there is a wall of maturities looming ahead through 2011–13. This
bunching of financing needs is a legacy of shortening maturities during the
crisis. A future retrenchment in confidence therefore could severely weaken
banks’ ability to roll over this debt.
A more imminent concern is the withdrawal of special
central bank liquidity facilities and government guarantees for bank debt.
While the use of both types of programs has fallen as money and funding
markets have stabilized, some banks remain more dependent than others on
such support. Unless the weaknesses in these banks are addressed in
conjunction with the withdrawal of funding support measures, there is the
risk of renewed bank distress and overall loss of confidence that could have
systemic implications.
Bank credit growth has yet to recover in mature markets,
despite the recent improvement in the economic outlook (Figure 3).
Bank lending officer surveys show that lending conditions continue to
tighten in the euro area and the United States, though the extent of
tightening has moderated substantially. Although credit supply factors play
a role, presently weak credit demand appears to be the main factor in
constraining overall lending activity.
Bank credit growth is continuing to contract as the credit
cycle turns. Even though the cycle trough is approaching, the prospects for
a strong rebound are highly uncertain. Nonbank sources of credit such as
corporate bond issuance have picked up strongly, but in many cases are not
large enough to offset the decline in bank lending and have, for the most
part, been used for refinancing outstanding debt. The improving economic
outlook will bolster both the demand for credit and banks’ willingness to
lend, but as banks continue to deal with capital and funding challenges,
their capacity to lend may become a more binding constraint. Uncertainty
about the future regulatory framework may also weigh on bank lending
decisions.
A combination of continued bank writedowns, funding and
capital pressures, and weak credit growth are expected to limit future bank
profitability. This highlights the need for more decisive steps to promote
bank restructuring in order to ensure that banks have sufficient margins to
weather future shocks and to generate additional capital buffers.
Emerging Market Inflows
While bank flows to emerging markets have yet to recover,
the rebound in portfolio inflows has supported a rally in emerging market
assets, particularly equities, and to a lesser extent real estate. Concerns
have been raised that these inflows can lead to asset price bubbles and put
upward pressure on exchange rates. This can complicate the implementation of
monetary and exchange rate policies, especially in those countries with less
flexible exchange rate regimes.
These inflows are being driven by a variety of factors.
The initial surge in inflows in the second quarter of last year appears to
have been the result of push factors, that is, changes in the desires of
investors (Figure 4). There was a sharp renewal in risk appetite that
benefited all risky assets. Investors shifted from safe havens in search of
yield, given low interest rates in advanced countries. This can be seen from
the decline of the dollar and treasury bond prices, and outflows from money
market funds. But since the second quarter, inflows have been sustained by
pull factors, namely the better growth prospects for emerging markets,
particularly in Asia and Latin America. Expectations of exchange rate
appreciation in these regions also have encouraged new inflows.
The rise in asset prices cannot yet be considered
excessive and widespread, although there are some countries and markets
where pressures have increased significantly. Property price inflation is
within historical norms, with a few localized exceptions.
Further, outside of China, credit growth in many emerging
markets has yet to recover appreciably (Figure 5). This suggests that
leverage is not yet a key driver of the rise in asset prices. That said,
policymakers cannot afford to be complacent about inflows and asset
inflation. As recoveries take hold, the liquidity generated by inflows could
fuel an excessive expansion in credit and unsustainable asset price
increases.
Sovereigns Under Pressure
Financial market participants are increasingly focusing on
fiscal stability issues among advanced economies. Concerns over
sustainability and political uncertainties have led to a widening of credit
default swap spreads for the United Kingdom and Japan in recent weeks (Figure
6). Other European issuers, most notably Greece, have come under more
pronounced pressure after their ratings were downgraded or as uncertainty
has persisted over their fiscal imbalances and consolidation plans (Figure
7).
Our projections of the net supply of public sector debt
show a substantial increase in issuance relative to the long-run average
over the next two to three years. This increase in deficits and public debt
imposes some important challenges for policymakers and risks for financial
stability.
At a minimum, there is a risk that the public debt
issuance in the coming years could crowd out private sector credit growth,
gradually raising interest rates for private borrowers and putting a drag on
the economic recovery. This could occur as private demand for credit
recovers and as banks are still constrained in their ability to extend
credit, particularly as financial support measures are being unwound. A more
serious risk is from a rapid increase in interest rates on public debt. Such
a rapid run-up in rates and a steepening of the yield curve could have
negative effects on a wide variety of financial institutions and on the
recovery as sovereign debt is repriced. Finally, there is the risk of a
substantial loss in investor confidence in some sovereign issuers, with
negative implications for economic growth and credit performance in the
affected countries. While this may be a localized problem, there is the risk
of wider spillovers to other countries and markets and a negative shock to
confidence.
Policy Priorities
Policymakers now face a difficult balancing act in judging
the timing, pace, and sequencing of exit policies, both from the monetary
and financial policies, as well as starting implementation of a medium term
strategy for fiscal consolidation and debt reduction. Withdrawing policy
support prematurely would leaves the financial system vulnerable to a
re-intensification of pressures (such as in countries with weak recoveries
and remaining financial vulnerabilities), while belated withdrawal could
potentially ignite inflationary pressures and sow the seeds for future
crises (such as in countries with risks of financial excesses and
overheating).
In the near term, policies should be focused on securing
financial stability, which remains fragile, to ensure that the recovery is
maintained and that there is no recurrence of the negative feedback between
the real economy and the financial sector. In those economies where
financial vulnerabilities persist, efforts should continue to clean up bank
balance sheets, ensure smooth rollover of funding, and restructure weak
banks.
In those emerging market countries that are recovering
rapidly, the policy priorities remain to address capital inflows through
macroeconomic policies, including through greater exchange rate flexibility,
and prudential measures.
Over the medium term, policies should be aimed at
entrenching financial stability, which will underpin strong, sustained and
balanced global growth. Public sector risks will need to be reduced through
credible fiscal consolidation, while risks emanating from private financial
activities should be addressed by the adoption of a new regulatory framework.
The Financial System of the Future
Overall, the exit from the extraordinary support measures
implemented in the crisis must be to a financial system that is safer as
well as sufficiently dynamic and innovative to support sustainable growth.
Achieving this correct balance between safety and dynamism will not be easy.
Several aspects of implementation require special
attention. Policymakers should be mindful of the costs associated with
uncertainty about future regulation, as this may hinder financial
institutions’ plans regarding their business lines and credit provision. But
they should also avoid the risks associated with too-rapid deployment of new
regulations without proper overall impact studies. It also continues to be
vitally important that differences in international implementation of the
new regulatory framework are minimized to avoid an uneven playing field and
regulatory arbitrage that could compromise financial stability.
For regulatory reform to be successful, micro- and
macro-prudential regulations will have to complement one another and help to
effectively mitigate systemic risks. Only then can the financial system
properly do its job—to intermediate flows from savers to borrowers in ways
that enhance sustainable economic growth and financial stability.
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