Concerns about debt sustainability and support for
adjustment efforts in the euro area periphery have intensified .
. .
Market doubts about debt sustainability and support for
adjustment programs in the smaller countries of the European
periphery have resurfaced. Credit default swap spreads have
risen to new highs in Greece amid concerns over the degree of
political resolve that will be needed to implement adjustment
and secure needed funding. This, in turn, has renewed the
market’s focus on the potential for transmission of shocks from
sovereigns to banks as banking systems in core European
countries still have large exposures to peripheral countries
(Figure 2). In a serious market event, a shock could be
transmitted beyond the euro zone via both cross-border exposures
and a general retraction of risk appetite.
. . . while the outlook for sovereign risk in some
larger economies has worsened.
Negative sovereign ratings actions have spread beyond Greece,
Ireland, and Portugal further into other euro area countries
(Figure 3). This reflects concerns that it will be difficult to
reach the political consensus necessary for fiscal consolidation
and structural reforms. Market concerns are also rising about
the fiscal path in the United States, given little evident
progress in breaking the political stalemate over how to carry
out needed fiscal consolidation. In the near term, markets have
focused on a potential failure to raise the debt ceiling, which
the U.S. authorities have estimated will become binding at the
beginning of August, absent action. The risk of a temporary
default has pushed U.S. short-term CDS spreads above those of
some countries rated below the United States’s AAA rating. Even
that rating has come under question following S&P’s issuance of
a negative outlook in April. In Japan, ratings agencies have
downgraded the sovereign outlook on concerns about the
government’s ability to achieve deficit reduction.
Prolonged zero interest rates promote risk-taking,
including a “search for yield”
Low interest rates in advanced economies are promoting
pockets of re-leveraging by lowering the “all-in” cost of debt
capital for corporate borrowers. This is encouraging investors
to use financial leverage to generate sufficiently attractive
returns on equity. Although credit spreads are still higher than
before the crisis, ultra-low short-term interest rates mean that
the cost of debt is now lower, both for floating-rate and
fixed-rate debt. This lower cost of borrowing renders debt
servicing ratios more favorable, even at higher debt loads,
thereby enabling companies to operate with more financial
leverage (Figure 4).
As leveraged loan prices recover (after the deep discounts of
2008–2009) and yields fall, investors are increasingly turning
to financial engineering to achieve double-digit returns. Both
new and refinanced private equity transactions suggest that
related corporate balance sheets are quickly approaching
pre-crisis leverage multiples. Though the aggregate amount of
financial leverage provided remains far less than before the
crisis, high-yield corporate bond and leveraged loan investors
have recently been borrowing at higher earnings multiples, not
much below 2007 levels.
Notwithstanding recent market jitters, the “search for yield”
is also spurring flows into emerging markets, notably corporate
debt markets. These inflows, although volatile, are often
magnifying already ample domestic liquidity. These conditions,
if they continue, risk stretching valuations and raising worries
that some countries could be re-leveraging too quickly. Flows
into mutual funds for emerging market debt have been strong
(behind only high-yield and commodities funds as a percent of
total outstanding amounts). Even record amounts of EM corporate
bond issuance cannot keep up with demand, and investor due
diligence is waning. At nearly $65 billion, external EM
corporate debt issuance in the first quarter of 2011 was the
highest in three years, and markets expect record issuance for
the full year (Figure 5). Emerging market corporate bonds are
increasingly seen as substitutes for U.S. corporate high-yield
bonds—offering similar market capitalization, lower leverage,
and higher returns for the same credit ratings, thus making such
bonds attractive to a wider investor base. Although this may
represent a healthy development to the extent that some
previously credit-constrained companies now have access to
capital, the risk is that if the trend continues, too much
capital may be moving too quickly to emerging markets. This
raises the risk of a mispricing of credit and/or a sudden
reversal, if adverse events lead to a rapid retraction in risk
appetite.
Although there is little evidence for generalized asset price
overvaluation in emerging markets, one area of recent concern
has been the real estate sector in fast-growing emerging Asian
economies, and possibly a few countries in other EM regions. The
pace of property price increases in Asia may be easing (with the
possible exception of Hong Kong SAR) on the back of aggressive
macroprudential and administrative measures, together with some
moderation in economic growth. However, if there were to be a
sharp slowdown in growth, this could trigger a large correction
in property prices, given their still elevated levels in several
markets.
Market concerns about property prices center on China. In
order to slow inflation, the central bank has tightened
financial policies and hiked policy rates. Should such measures
result in an unexpectedly sharp slowdown, the impact on property
prices may be even higher. This is in part due to a recent
history of strong investment in real estate, including by local
authorities as part of the stimulus measures undertaken in
response to the global crisis.
Policymakers Must Strive for Rapid Progress on
Financial System Robustness
Deep-seated financial challenges remain, even if
vulnerabilities are masked by highly accommodative monetary and
liquidity conditions. The current window of opportunity to
prepare the financial and economic system against potential
systemic shocks, importantly by providing clarity on euro
area-wide solutions to strains in the periphery, could close
unexpectedly. It could be closed by market developments if a
sudden pickup in risk aversion (caused, perhaps, by unrelated
factors) leads market participants to narrow their tolerance for
incomplete policy solutions. It could also be closed by
political developments, either because adjustment programs lose
political support in debtor countries, or because populaces in
creditor countries lose patience in continuing to finance those
programs.
Thus, a more robust financial system, notably in Europe, is
needed to gird against shocks. This will require a coordinated
and cross-border policy response. Though there has been progress
on banking system repair, the pace is too slow. First, funding
challenges for banks remain. Bank bond yields have risen and
some banks in peripheral European countries remain heavily
dependent on the European Central Bank (ECB) for liquidity
support. In some countries, banks are vulnerable to a further
tightening in funding conditions and will need to step up the
pace at which they roll over maturing funding.
Second, some banks have not yet sufficiently de-risked their
balance sheets, leaving a large measure of uncertainty about
asset quality given holdings of legacy assets and significant
real estate exposures. Third, the pace of recapitalization needs
to be accelerated in order to provide cushions against asset
losses or shocks to liquidity (Figure 6). The forthcoming stress
tests from the European Banking Authority will represent an
important opportunity for updating the assessment of risks in
the European banking system and for addressing the weak tail of
banks flagged in the April GFSR. It will be critical that, where
potential capital gaps are found to exist, plans are seen to be
in place to fill them expeditiously, together with the
resolution of nonviable banks.
Emerging market policymakers need to guard against
overheating and a buildup of financial imbalances amid strong
credit growth and rising inflation, exacerbated by capital
inflows in some countries. Corporate leverage is also rising and
weaker firms are increasingly accessing capital markets. This
could make corporate balance sheets more vulnerable to external
shocks. With strong domestic demand pressures, especially in
emerging Asia and Latin America, macroeconomic measures are
needed to avoid overheating, an accumulation of financial risks,
and an undermining of policy credibility. Macroprudential tools
and, in some cases, a limited use of capital controls, can play
a supportive role in managing capital flows and their effects.
However, they cannot substitute for appropriate macroeconomic
policies.
In sum, policymakers must act now to make the financial
system more robust:
- Downside risks have again risen to the fore, including
that the global economic recovery may be more fragile than
had been thought, so time to address existing
vulnerabilities may be running out.
- At the same time, the room for maneuver to counter
shocks has been reduced, especially via traditional fiscal
and monetary policy levers.
- Thus, it will be critical to make the financial system
strong enough to withstand potential major shocks, thereby
enabling it to support ongoing recovery. The key priorities
are, first, to make the current financial system more
robust, especially to clean up from the legacy of the crisis
in advanced countries. Second, the financial reform agenda
must be completed as expeditiously as possible.
Finally, policymakers must chart a path that supports
recovery without allowing a buildup of excessive risks in the
future. This is likely to prove particularly challenging in
those emerging markets where policymakers face rising inflation
pressures and a buildup of financial imbalances. This requires a
tightening of macroeconomic policies and use of macroprudential
measures.