Yields on sovereign debt in the periphery rose sharply as
renewed concerns about economic growth and the health of banks
curtailed market access [Figure 2(Data)].
The 3-year LTROs helped support demand for peripheral sovereign
debt but that positive effect has waned. Private capital
outflows continued to erode the foreign investor base in Italy
and Spain [Figure 3(Data)].
A flight to safe assets led to a collapse of yields on
government bonds in the U.S., Germany, and Switzerland, and
pushed the dollar to a 20 month high against major currencies.
Safe-haven inflows drove Japanese government bond yields to near
historical lows and yen appreciation has created headwinds for
the economic recovery. Within the EU, Sweden and Denmark have
also served as additional safe havens. Growing risk aversion
contributed to weakened confidence in emerging markets (EM),
amid increased concerns about their ability to tackle homegrown
vulnerabilities, especially given their diminished policy room
and a weaker global outlook.
At the end of June, European leaders agreed upon significant
positive steps to address the immediate crisis. The agreement,
if implemented in full, will help break the adverse links
between sovereigns and banks and create a banking union. In
particular, once a single supervisory mechanism for euro area
banks is established—with key decisions to be taken by
end-2012—the European Stability Mechanism (ESM) could have the
possibility to recapitalize banks directly. Moreover, ESM
assistance will not carry seniority status for Spain. After a
short-lived rally, Spanish and Italian bond yields have
deteriorated again amid volatile trading conditions, as market
participants focus on implementation risks and the need for
broader steps toward pan-European risk sharing.
Strains in EU funding markets have intensified and
deleveraging pressures remain elevated.
Notwithstanding the ample liquidity provided by the ECB’s
refinancing operations, funding conditions for many peripheral
banks and firms have deteriorated. Interbank conditions remain
strained, with very limited activity in unsecured term markets,
and liquidity hoarding by core euro area banks. Bank bond
issuance has dropped off precipitously, with little investor
demand even at higher interest rates. Banks in the euro area
periphery have had to turn to the ECB to replace lost funding
support, as cross-border wholesale funding dried up, and deposit
outflows continue.
The
April 2012 GFSR noted that EU banks are under pressure to
cut back assets, due to funding strains and market pressures, as
well as to longer-term structural and regulatory drivers. The
sharp reduction in bank balance sheets in the fourth quarter of
2011 continued, albeit at a slower pace, in the first quarter of
2012. Growth in euro area private sector credit diverged
significantly. While credit has contracted in Greece, Spain,
Portugal and Ireland, it has remained more stable in some core
countries. Survey data on bank lending conditions show that
credit supply remains tight, albeit less so than at the end of
2011, but that demand has also weakened more recently.
Deleveraging is also a concern for many peripheral corporations,
given their historic dependence on bank funding and the risk
that credit downgrades and diminished investor appetite could
drive borrowing costs higher, even for high credit quality
issuers.
Bank downgrades have raised the prospect of higher funding
costs for many banks. Moody’s credit rating agency recently
downgraded 15 European and U.S. banks with large capital markets
operations. The downgrades reflected concerns about diminished
longer-term profitability of these firms due to risks inherent
in their capital markets activities, challenging funding
conditions, and tighter regulatory requirements. The rating
actions also reflected the size and stability of earnings from
non-capital market activities, liquidity buffers, risks from
exposures to Europe, U.S. residential mortgages, commercial real
estate or legacy portfolios, as well as any record of risk
management problems. S&P took similar actions in November 2011.
Measures to stabilize the Spanish banking system have
not yet restored market confidence.
Concerns over the recapitalization needs of the Spanish
banking system have resulted in sharp declines in the equity
market [Figure 4(Data)].
Wholesale funding costs for Spanish banks also returned to late
2011 highs for both covered bonds and unsecured debt.
Investors took little comfort from Spain’s request for
external assistance on June 10 to support its domestic banking
system. While the request for external support does provide a
welcome backstop for restructuring segments of the banking
sector, the initial adverse market response reflected the lack
of a comprehensive program to restructure the banking system and
lack of details about the loan. Some market participants also
expressed concern that the support, in the form of a loan to the
sovereign, could represent a claim that is senior to current
holders of Spanish government debt. The decision at the end-June
summit of EU leaders that financial support could take the form
of direct recapitalization of banks and would not enjoy
preferred creditor status helped to allay some of these
concerns.
A complete set of policies providing a pan-European
solution remains a work in progress.
The measures announced at the European leaders’ summit in
June are steps in the right direction to address the immediate
crisis. Additional steps to cement this progress in the short
term include the following:
- Policymakers must resolve the uncertainty about bank
asset quality and support the strengthening of banks’
balance sheets. Bank capital or funding structures in many
institutions remain weak and insufficient to restore market
confidence. In some cases, bank recapitalizations and
restructurings need to be pursued, including through direct
equity injections from the ESM into weak but viable banks
once the single supervisory mechanism is established.
- Countries must also deliver on their previously agreed
policy commitments to strengthen public finances and enact
sweeping structural reforms.
The recent initiatives are steps in the right direction that
will need to be complemented, as envisaged, by more progress
toward a full-fledged banking union and deeper fiscal
integration. By setting in motion a process toward a unified
supervisory framework, the European summit put in place the
first building block of a banking union. But other necessary
elements, including a pan-European deposit insurance guarantee
scheme and bank resolution mechanism with common backstops, need
to be added. In the shorter run, timely implementation,
including through the ratification of the ESM by all members,
will be essential. In addition, these steps would usefully be
complemented by plans for fiscal integration, as anticipated in
the report of the “Four Presidents” submitted to the summit.
Supportive monetary and liquidity policies remain crucial as
well. The recent interest cut by the ECB is welcome, but there
is room to further ease monetary policy. The LTROs have helped
to bring down the cost of secured and unsecured interbank
lending for many European banks, but alone are not sufficient to
restore investor confidence or provide a lasting solution. If
economic conditions continue to deteriorate, unconventional
measures could be used. This means giving consideration to
non-standard measures, such as a re-activation of the Securities
Markets Program (SMP), additional LTROs with suitable collateral
requirements, or the introduction of some form of quantitative
easing. New ECB collateral rules have played an important role
in easing liquidity constraints, and any new tightening of
collateral rules should be avoided.
Risks to global financial stability are also present
in the United States.
Outside of Europe, the U.S. fiscal cliff —the convergence of
tax cuts expiring and automatic spending cuts kicking in at
year-end—has received increased focus in recent weeks. If no
policy action is taken, the fiscal cliff could result in a
fiscal tightening equivalent to more than 4 percent of GDP (see
the accompanying
Fiscal Monitor Update).
As year-end approaches and uncertainty increases, another
bout of political brinksmanship —similar to that seen in August
2011 in discussions of the U.S. debt ceiling—could trigger
increased market volatility. A complicating factor is that the
debt ceiling could be hit around the same time as the fiscal
cliff. During the last debt ceiling episode, rates on near-term
money market instruments increased, repo transaction volumes
fell, the Treasury bond curve steepened, and sovereign credit
default swap (CDS) spreads inverted. Although the debt ceiling
was ultimately raised, S&P lowered its sovereign credit rating
on the United States from AAA to AA+. They continue to maintain
a negative outlook, citing deterioration in the US fiscal
outlook and the lack of political consensus over its resolution.
Most markets, however, are not yet pricing in enhanced fiscal
risks. U.S. CDS spreads have picked up, but remain at low
levels.
The market consensus is that the bulk of fiscal tightening
will be deferred until later and that the debt ceiling will be
raised in time to avert a default. However, there is clearly the
potential for a significant adverse market reaction should
market participants reassess the likelihood of a fiscal cliff,
given its potentially severe effects on the U.S. economy. The
federal debt ceiling should also be raised well ahead of the
deadline (most likely falling into early 2013) to mitigate risks
of financial market disruptions and a loss in consumer and
business confidence. Meanwhile, a lack of progress on a credible
consolidation plan risks triggering additional sovereign credit
rating downgrades. Further downgrades could increase term premia,
leading to a loss in liquidity, and—given the widespread role
that Treasuries play in the pricing and collateralization of
other assets—have a destabilizing impact on broader markets and
global market sentiment.
Emerging markets have not escaped contagion, and are
also dealing with home-grown vulnerabilities.
Emerging markets are facing extraordinary uncertainty about
external conditions impinging on their economic performance.
Earlier this year, policymakers across several EM economies were
still worried about large-scale capital inflows and excessive
appreciation of their currencies. Such fears have given way to
concerns about overly rapid depreciation and increased
volatility, as currencies like the Brazilian real or the Indian
rupee depreciated by between 15 and 25 percent in less than one
quarter.
Equity markets in EMs rebounded strongly during the first two
months of 2012, but have since reversed much of these gains [Figure
5(Data)].
Compared to equity flows, there have been minimal bond flows out
of local markets. Indeed, many foreign bond investors have opted
to hedge currency risk selectively rather than withdraw from
markets. This dynamic has helped to put a floor on bond prices
during periods of heightened global risk aversion. However, if
sizable bond outflows were to materialize, bond yields could
spike and destabilize domestic markets. In that case, countries
may have to rely more on exchange rate flexibility, draw more
intensely on foreign exchange reserves or undertake other policy
measures to counter disorderly market conditions.
Market participants are also concerned about slowing domestic
growth, which could erode bank profitability and pose some risks
to financial stability, for instance in Brazil, China, and
India. The uncertainty about asset valuations and economic
growth has put pressure on bank stocks in recent months. Demand
for credit has fallen in a number of countries, even where
government-supported credit has been available.
There are noticeable differences across regions.
Central and Eastern Europe are the most exposed to the euro
area and could suffer disproportionately from an accelerated
withdrawal of bank funding or portfolio capital. Asia appears
better shielded from the euro area crisis, reflecting limited
direct financial linkages and strong foreign exchange buffers.
Nonetheless, conditions in regional dollar funding markets have
tightened since mid-March and rising global uncertainty and
weaker external demand are causing headwinds for
export-dependent economies such as the Republic of Korea. Growth
in China has also slowed, weighing on markets across Asia, as
well as on global commodity prices. India is a rising concern,
with the rupee recently weakening to new record lows, as the
need to finance large fiscal and current account deficits is
pressuring markets, though financial restrictions have
facilitated the financing of the fiscal deficit. In Brazil, the
central bank has cut the policy rate to a record low to
counteract a sharp deceleration in the real economy. Some of the
regulatory measures taken in 2011 to slow capital inflows and
the growth in consumer credit have also been reversed.
EM policymakers face challenges as well.
Many EM countries still have room for monetary easing to
respond to large adverse domestic or external shocks, while
fiscal stimulus remains a second line of defense for a number of
countries in case of a major shock to growth (see the
Fiscal Monitor Update). Inflation is generally within target
ranges, suggesting scope for further cuts in interest rates
should large shocks materialize. Many EM countries with policy
room to respond to shocks would still benefit from further
rebuilding of policy buffers at this stage, given strong
commodity prices and still-favorable liquidity conditions. In
contrast, a large policy-induced credit stimulus could be less
effective, and certainly less desirable, than in 2008/9.
Relative to other EMs, large economies such as Brazil, China,
and India have benefited from strong credit growth in recent
years, and are at the late stages of the credit cycle. Expanding
credit significantly at the current juncture would heighten
asset quality concerns and potentially undermine GDP growth and
financial stability in the years ahead.
For policymakers, the current constellation of conditions
poses significant challenges. Persistent fears of sharp downside
shocks have kept accommodative policy conditions in place in
many EM countries, which over time could generate new imbalances
and threats to financial stability. Low interest rates create an
incentive to accumulate debt, while boosting asset prices. In a
few large emerging economies (India, Russia, Turkey), fiscal
space is being rebuilt more slowly than is desirable (see
Fiscal Monitor Update). Financial policies may be less
conservative than would be appropriate in EMs at an advanced
stage of the credit cycle. If and when a large downside shock
ultimately materializes, these combined vulnerabilities could
quickly come to the fore, putting financial stability to a
serious test.
The regulatory reform agenda is now focused on
rulemaking and implementation, but progress has been uneven.
The focus of the regulatory reform agenda has shifted from
development of standards to rulemaking and implementation. A few
G-20 countries (India, Japan, Saudi Arabia) have already
announced final rules for implementation of Basel III from early
2013, but the majority are still in the drafting or consulting
stage. The EU has moved closer to a final rule with the European
Council agreeing on a compromise Capital Requirements Directive
IV (CRD IV) package. The U.S. authorities issued a final rule
introducing capital standards closely aligned with Basel 2.5 as
of January 2013, and published for consultation the rules for
incorporating Basel III capital standards into their regulatory
framework.
Other elements of the reform agenda are still evolving, and
implementation has been patchy. On over-the-counter (OTC)
derivatives, all jurisdictions and markets need to aggressively
push ahead to achieve full implementation of market changes in
as many areas as possible, by the end-2012 deadline set by the
G-20 leaders. Specifically, moving all standardized derivatives
trading to exchanges or electronic trading platforms, where
appropriate, and clearing them through central counter parties (CCPs).
With rising concerns that CCPs could become the new global
systemically important financial institutions, there is now
greater urgency for developing and agreeing on resolution
arrangements for them. Progress on developing resolution
frameworks more broadly has been slow, with many jurisdictions
still lacking the necessary statutory resolution tools. Legal
reforms to align national resolution regimes with the Financial
Stability Board’s Key Attributes of Effective Resolution Regimes
are under way in many jurisdictions. The European Commission’s
recent draft directive establishing a framework for the recovery
and resolution of credit institutions and investment firms is an
important step forward. That said, the euro area still needs to
make further progress toward establishing an integrated
supervision, crisis management and resolution framework.