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The global economy is in a vulnerable state - IMF

Publishing Date : 11 November, 2019

Author : TLHABO KGOSIEMANG

The pace of global economic activity remains weak, and financial markets expect rates to stay lower for longer than anticipated in early 2019. Financial conditions have eased even more, helping contain downside risks and support the global economy in the near term.


But loose financial conditions come at a cost: they encourage investors to take more chances in a quest for higher returns, so risks to financial stability and growth remain high in the medium term. According to International Monetary Fund IMF, elevated vulnerabilities in the corporate and non-bank financial sectors could amplify the impact of a shock, such as an intensification of trade tensions or a no-deal Brexit, posing a threat to economic growth.


This situation poses a dilemma for policymakers. On the other hand, they may want to keep financial conditions easy to counter deterioration in the economic outlook. On the other hand, they must guard against a further build-up of vulnerabilities. IMF report stresses that some policy recommendations, including deploying and developing, as needed, new macro prudential tools for non-bank financial firms.


Since the last edition of Global Financial Stability Report GFSR in April, global financial markets have been buffeted by the twists and turns of trade tensions and significant policy uncertainty. A deterioration in business sentiment, weakening economic activity, and intensifying downside risks to the outlook, according to the report, have prompted central banks across the globe, including the European Central Bank and the Federal Reserve, to ease policy.


The report says investors have interpreted central bank actions and communications as a turning point in the monetary policy cycle. About 70 per cent of economies, weighted by Gross Domestic Product GDP, have adopted a more accommodative monetary stance. The shift has been accompanied by a sharp decline in longer-term yields; in some major economies, interest rates are deeply negative. Remarkably, the amount of governments and corporate bonds with negative yields has increased to about 15 Trillion US Dollars.


Further, the report indicate that the result is even easier financial solutions but also a continued build-up of financial vulnerabilities, particularly in the corporate sector and among non-bank financial institutions. It says corporations in eight major economies are taking on more debt, and their ability to service it is weakening. ‘’We look at the potential impact of a material economic slowdown- one that is as half as severe as the global financial crisis of 2007-08.


Our conclusion is sobering: debt owed by firms unable to cover interest expenses with earnings, which we call corporate debt-at-risk, could rise to 19 Trillion. That is almost 40 per cent of total corporate debt in the economies we studied, which include the United States, China, and some European economies’’.


According to the report, among non-bank financial institutions, vulnerabilities have risen since April and are now elevated in 80 per cent of economies, by GDP, with systematically important financial sectors- a level similar to the height of the global financial crisis. Very low rates have prompted institutional investors like insurance companies, pension funds, and asset managers to reach for yield and take on risker and less liquid securities to generate targeted returns. For example, pension funds have increased their exposure to alternative asset classes like private equity and real estate.


What are the possible consequences? Similarities in portfolios of investment funds could amplify a market sell-off, and illiquid investments by pension funds could constrain their traditional stabilizing role in markets. In addition, the report says, cross-border investments by life insurers could provoke spill overs across markets.


Further, it noted that external debt is rising among emerging and frontier economies as they attract capital flows from advanced economies, where interest rates are lower. Median external debt has risen to 160 per cent of exports from 100 per cent in 2008 among emerging market economies. A sharp tightening in financial conditions and higher borrowing costs would make it harder for them to service their debts. Adding to that, the report underlined that stretched asset valuations in some markets are also contributing to financial stability risks.


Equity markets appear to be overvalued in the United States and Japan. In major bond markets, credit spread- the compensation investors demand to bear credit risk- also seem to be too compressed relative to fundamentals. A sharp, sudden tightening in financial conditions, as indicated in the report, could unmask these vulnerabilities and put pressure on asset price valuations. So, what should policy-makers do to tackle these risks?


What tools can be deployed or developed to address the specific vulnerabilities identified in this report? Corporate debt-at-risk: stricter supervisory and macro prudential oversight, including targeted stress testing of banks and prudential tools for highly levered firms, while for institutional investors, there is a need for strengthened oversight and enhanced disclosures, including steeped-up efforts to mitigate leverages and other balance-sheet mismatches.


Emerging and frontier markets: prudent sovereign-debt management practices and frameworks. With financial conditions still easy so late in the cycle, and with vulnerabilities building, policymakers should act quickly to avoid putting growth at risk in the medium term, this is according to the report. Uncertainty may reign today- but sound policy decisions, adopted soon, could help avoid the most dangerous outcomes, the report concluded.

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