Russian
Global
Financial Stability Report
GFSR Market Update
Financial Stability Set Back as Sovereign Risks Materialize
July 7, 2010
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Despite generally improved
economic conditions and a long period of healing after the failure of Lehman
Brothers, progress toward global financial stability has recently
experienced a setback. Sovereign risks in parts of the euro area have
materialized and spread to the financial sector there, threatening to spill
over to other regions and re-establish an adverse feedback loop with the
economy. Further decisive follow-up is needed to the significant national
and supranational policy responses that have been taken in order to
strengthen confidence in the financial system and ensure continuation of the
economic recovery.
Although the global economic recovery remains intact,
progress toward financial stability experienced a setback in late April and
early May. Spillovers between sovereigns and the banking system increased
market and liquidity risks. Banks again have become less willing to lend to
one another, except at the shortest maturities, especially to banks in euro
area countries perceived to be facing greater policy challenges. Moreover,
financial asset price volatility increased and investor risk appetite
declined. Such financial risks have raised the chances of re-establishing an
adverse feedback loop to the economy, though to date there is little
evidence of this.
The most acute market strains have since receded somewhat
over the last month or so, but market confidence remains fragile.
Traditional safe haven assets like U.S. treasuries, German bunds, and gold
have gained in value. Riskier assets such as mature and emerging market
equity prices reversed much of the gains posted earlier in the year and have
recently made only a tentative recovery. Commodity prices dropped back to
the levels of last fall. And while volatility has declined somewhat
recently, it remains higher than prior to the retrenchment.(Figure 1).
Sovereign Risks Intensify
The market dynamics stem from the continuing intense
pressures on some sovereign debt markets (Figure 2). These pressures in part
reflect an ongoing reassessment of sovereign credit risk in the euro area.
The creation of the euro resulted in the disappearance of intra-area
exchange rate risk and an expectation of fiscal and macroeconomic
convergence among the euro member countries. This was reflected in a
significant narrowing of regional sovereign spreads until very recently. On
the heels of Greece’s fiscal troubles, investors are now re-pricing these
risks across the region. This highlights the need for policymakers to
continue to pursue credible fiscal consolidation plans and strengthen
economic governance in the euro area.
The announcement of the European Financial Stability
Facility and the program by the European Central Bank (ECB) to buy
securities helped to ease some of the more severe euro area bond market
pressures. After the announcement of the securities purchase program in
early May, spreads over German sovereign bonds on Greek, Portuguese, and
Irish debt narrowed. Recently, however, the effect has been wearing off, and
market liquidity in this debt has remained poor.1
In contrast, the spreads for Spanish and Italian bonds have continued to
increase and are now at wider levels than at the beginning of the year. More
recently, some differentiation in sovereign credit has also emerged between
Germany, which has benefited from safe haven flows, and Belgium, Austria,
and France.
In part, the public bond market pressures reflect
significant rollover needs. Those countries in the euro area currently
experiencing significantly widened spreads to German bunds need to refinance
about €300 billion in debt maturing in the third and fourth quarters of this
year (Figure 3). In doing so they will face competition from the very large
rollover needs of the United States, United Kingdom, Japan, and other euro
area countries amounting to a total of about $4 trillion maturing in the
third and fourth quarters.
Spillovers to Banks
The financial stability implications of rising sovereign
risks have been significant, reflecting the existing exposure of European
banks to sovereign debt. Recent co-movements of European bank credit default
swap (CDS) spreads with sovereign CDS spreads have intensified since our
estimates in the April 2010 GFSR (Figure 4). This reflects the substantial
holdings of sovereign debt by banks, but also the increasing risks of
adverse feedback loops between the sovereign and the financial sector and
the potential impact on government balance sheets, in case weak banks need
support.
With the heightened uncertainty about the health of some
banks, average bank CDS spreads are increasing in the United Kingdom, United
States, and euro area (Figure 5). In part, the pressure on banks has been
exacerbated by the legacy of unfinished cleansing of bank balance sheets
over the last three years—a process that has been slower in the euro area
than in the United Kingdom and United States—which has resulted in remaining
pockets of vulnerability, overcapacity, and poor profitability for at least
some types of banks. Moreover, lack of detail about the types of bank
regulation or levies that will be introduced and the timetable for their
implementation are adding to investor uncertainty.
Cross-border bank exposures provide the means for the
spillover of sovereign risks to banks and their further spread to other
banking systems in the region and beyond. Although such relationships have
diversification benefits in good times, they represent channels for
contagion in stressful conditions.
Uncertainty about bank exposures to sovereign debt of the
countries facing policy challenges has led to significant interbank funding
strains. Increased counterparty concerns have caused longer-term
LIBOR-overnight index swap (OIS) spreads to widen again. To alleviate these
funding strains, the ECB and the U.S. Federal Reserve reintroduced some
flexibility into their liquidity operations. The ECB suspended its
collateral requirements on Greek sovereign debt and reactivated some of its
long-term operations, while the Federal Reserve reinstated its foreign
exchange swap lines. Despite these efforts to improve the functioning of the
interbank market, euro area banks are still hoarding liquidity and putting
those funds in the ECB’s deposit facility (Figure 6).2
Within the interbank market, the demand for short-term
dollar funding is high. For example, money market funds in the United States
have been decreasing their exposure to European financials, reducing dollar
funding sources for European institutions. The central bank foreign exchange
swap lines, reinstated to bolster the market, have helped underpin
confidence, although they have rarely been used.
Banks are also confronted by significant funding pressures
coming from maturing bonds. As was emphasized in the April 2010 GFSR, banks
face a wall of maturities in the next few years, especially in the euro
area, and the recent turbulence has at least temporarily dampened the
primary market for financial institutions’ bond issuance (Figure 7).
Threats to the Recovery
While the current transmission of sovereign risks has been
primarily financial in nature, the possibility of adverse feedback loops to
the economy has risen. As noted in the July 2010 World Economic Outlook
Update, downside risks to the recovery have risen sharply. Bank funding
pressures may accelerate the ongoing deleveraging process. It is too early
to tell if actual bank lending growth will worsen in the euro area, after
recently stabilizing at barely positive year-on-year rates. Early
indications suggest that euro area banks’ lending standards have somewhat
reversed their downward trend, tightening again (Figure 8).
In addition to the potential adverse impact on bank
lending, the recent market turbulence and widening in credit spreads has
corresponded with a collapse in nonfinancial corporate bond issuance in May.
In spite of a recent rebound in June, issuance from European firms was
especially anemic, and smaller than in the period surrounding the Lehman
bankruptcy. If these tighter conditions continue, they could begin to have a
significant impact on the availability of credit to corporates.
Exits from Extraordinary Policies Delayed in Some
Countries
Potential downside economic risks and the strains in
interbank and sovereign markets have complicated exits from the
extraordinary fiscal, monetary, and financial policies initiated some months
ago. For the major central banks, especially the ECB, markets now anticipate
a lengthening of the “extended period” of very-accommodative monetary
policy. In fact, the ECB has not only reinstated some of its extraordinary
operations for liquidity provision, but it has also announced a program to
purchase sovereign debt.
Emerging Market Financing Conditions Tighten
Emerging markets are being affected by the heightened
risks in the euro area through the reduction in broad risk appetite, which
has led to tighter financing conditions. Portfolio flows to emerging markets
have partially reversed, after a significant run-up for almost a year
between March 2009 and April 2010, and asset price valuations have declined.
Moreover, emerging market sovereigns and corporate bond and equity issuance
also stalled in May, although some regions are less affected than others and
it may be mostly temporary (Figure 9). Asian issuance, for instance, has not
deteriorated dramatically.
Not surprisingly, the spillovers from mature Europe are being
felt most in emerging Europe, where direct linkages are the greatest. The
equity markets of Romania and Hungary and those of emerging Europe as a
region were the hardest hit compared to other emerging market countries and
regions (Figure 10). Mature European banks are most exposed to emerging
Europe. These exposures suggest that some emerging markets may experience a
renewed credit squeeze if funding strains cause European banks to withdraw
their cross-border credit flows.
Earlier concerns about Asian real estate markets are
diminishing as prudential measures appear to be taking hold. The growth of
real estate transaction values has eased and the share of real estate loans
in new bank lending is also falling (Figure 11), although further monitoring
of developments is warranted.
Exchange Rate Risks Rising
The depreciation of the euro has the benefit of partially
offsetting the adverse impact on growth in the euro area of heightened
sovereign and bank risks. But the confluence of sovereign credit, banking
sector, and macroeconomic risks has also increased the potential for a
disorderly adjustment in exchange rates. The euro has come under significant
downward pressure, now approaching what a medium-term fundamental analysis
would suggest as an appropriate multilateral level. At the same time, market
volatility has been rising.
Policy Priorities
Policy action is needed on several fronts to bolster
confidence and continue to stabilize financial markets,
The root of the problem—sovereign risk—must be addressed.
This applies in particular to the euro area countries that are under intense
market pressure. They must make further credible progress on fiscal
deficits, together with better strategies for public debt management. Due to
funding pressures, these countries already had to embark on immediate fiscal
consolidation—and they have already made significant progress in this
direction. More generally, fiscal adjustment should be part of medium-term
consolidation plans. These plans need to be credible in order to avoid
adverse market reaction from forcing yet further front-loaded fiscal
adjustment. Market participants see announced fiscal consolidation plans as
a necessary but not sufficient condition to achieve debt sustainability, as
they remain concerned that governments may have difficulty generating enough
nominal growth in a disinflationary environment. Thus there is a need to
combine the announcement of credible fiscal consolidation plans with
structural measures aimed at supporting potential growth. Solid movements in
this direction are already under discussion in a number of euro area
countries.
In the financial sphere, in addition to the strong actions
already undertaken, market confidence would greatly benefit from the
following measures:
• Make the €440 billion European Financial Stability
Facility fully operational, now that the difficult task of establishing it
has been accomplished.
• Continue to provide ECB liquidity support for secondary
bond markets. Markets are not yet convinced of the central bank’s commitment
to scaling up purchases if necessary to prevent a further deterioration in
market functioning.
• Pursue greater transparency and credible stress testing
of European banks. A key issue now is uncertainty about individual bank
exposures, including to sovereign debt, which argues for improved disclosure
by European banks. The publication of the results of the ongoing stress
tests and the extension of stress tests to many more banks by the Committee
of European Banking Supervisors is a very important step. At the same time,
bank-by-bank disclosures of the stress test results at the national level
will need to be complemented by a plan that specifies how capital-deficient
institutions would be handled. Bank reporting and disclosure standards, in
general, need to be improved, particularly for banks that are not publicly
traded and for those not producing quarterly reports.
• Implement credible solutions to deal with weak banks.
These banks are exacerbating the current strains in funding markets, and a
more comprehensive mechanism for resolving, restructuring, or recapitalizing
institutions is needed. For this purpose, existing or new public mechanisms
at the national level should be activated without delay. Where needed,
supranational arrangements should be applied to address banking problems.
Forceful pursuit of the above policy measures will be
necessary to underpin market confidence, reduce concerns regarding sovereign
debt and banking system health, and support the euro area economic recovery.
Equally important is for policymakers to avoid policy
missteps. Uncoordinated and one-off measures to halt trading in certain
markets only serve to move risks to other markets or jurisdictions and
increase uncertainty about what types of measures are coming next.
Elsewhere in many advanced economies the emphasis should
be on underpinning medium-term fiscal consolidation. As discussed in the
July 2010 World Economic Outlook Update, credible strategies to lower fiscal
deficits over the medium and long run are of utmost importance. These
countries also need to simultaneously put forth structural policies raise
potential economic growth so as to ease the pressures for consolidation and
deal with age-related entitlement spending. Similarly, backstops provided by
central banks, including quantitative easing or explicit support for credit
and bond markets, will continue to be necessary for the time being.
With the decline of capital inflows, emerging market
countries face the uncertainty of whether the instability in the euro area
causes investors to broadly pull back from foreign markets, or whether flows
to emerging markets will resume as investors look for alternatives to more
volatile advanced country markets. These countries are faced with the
likelihood of greater volatility around an upward trend in their capital
inflows. They thus need to augment their macroeconomic and prudential
policies to reduce their vulnerability to a sudden stop or an excessive
buildup of credit or asset prices. In addition to sound macroeconomic
policies and well-defined prudential policies, structural measures aimed at
developing financial systems in emerging market countries are also
important. Improvements in financial infrastructure can help provide
resilience in the face of volatile flows.
Regulatory reform efforts aimed at making the global
financial system safer need to continue in an expeditious fashion. The
basics of such reforms—to the quality and quantity of capital and more
liquidity—need to be finalized and an appropriate timetable for
implementation established. The current level of uncertainty surrounding the
final set of reforms is making it difficult for banks to take business
decisions about various activities and constraining their willingness to
lend. Greater clarity on the details and timing of intended regulatory
reforms is thus required. Moreover, the implementation schedule will need to
take into account the current health of the financial institutions and the
status of the economic recovery to support trend growth and enhance
stability. A crucial complement to regulatory reform is strong supervision.
This applies in the steady state, but even more so during the transition
period when there may be variances in the implementation of the new rules
between jurisdictions. Adherence to strong supervisory principles can help
contain the risk of regulatory arbitrage.
In sum, recent global stability gains are threatened by a
confluence of sovereign and banking risks in the euro area that, without
continued and concerted attention, could spill over to other regions. Rapid
implementation of the important and appropriate decisions taken by the euro
area governmental authorities will be a key component in calming financial
markets. Further credible and swift action is needed to stabilize financial
institutions. Consolidation of financial stability will be important to keep
the economic recovery on track.
1 So far, the ECB has
purchased approximately net €59 billion in government debt from the
secondary market.
2 Some of the buildup of
deposits at the ECB occurred in anticipation of the expiration of the
one-year long-term refinancing operation on June 30, and there has been some
decline in the holdings since.
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