April 17, 2017/IMF
Financial stability has continued to improve since the October 2016 Global Financial Stability Report (GFSR). Economic activity has gained momentum, as outlined in the April 2017 World Economic Outlook (WEO), amid broadly accommodative monetary and financial conditions, spurring hopes for reflation.
Longer-term interest rates have risen, helping to boost earnings of banks and insurance companies. Gains in many asset prices reflect a more optimistic outlook.
Equity markets in the United States hit record highs in March on investors’ hopes for tax reform, infrastructure spending, and regulatory rollbacks. Markets outside the United States have also risen steadily over the past six months, driven in part by stronger growth expectations and higher commodity prices. At the same time, risk premiums and volatility have declined.
How strong is the case for such optimism? To realize stronger growth and sustain the improvements in financial conditions, policymakers will need to implement the right mix of policies, including to
(1) invigorate economic risk taking, especially in the United States, through policies that boost potential output, increase corporate investment, and avoid raising financial stability risks; (2) address domestic and external imbalances to enhance resilience in emerging market economies; and (3) respond more proactively to long-standing structural issues in European banking systems.
Policy Uncertainty Is a Key Downside Risk
New threats to financial stability are emerging from elevated political and policy uncertainty around the globe. In the United States, if the anticipated tax reforms and deregulation deliver paths for growth and debt that are less benign than expected, risk premiums and volatility could rise sharply, undermining financial stability.
A shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment.
In Europe, political tensions combined with spillovers from advanced economies. But overall financial stability risks remain elevated because global political and policy uncertainties are opening new channels for negative spillovers. A sudden reversal of market sentiment or a global shift toward inward-looking protectionist policies could reignite capital outflows and hurt growth prospects, testing the resilience of these economies.
Countries with strong international financial and trade links in particular could be challenged by tighter global financial conditions or adverse trade measures.
These risks could exacerbate existing vulnerabilities in the corporate sector and could increase the debt at risk of the weakest firms by $130–$230 billion. A sharp turn away from the current supportive external environment could reinforce risks in countries whose weakest banks are challenged to maintain asset quality and adequately provision for bad loans after long credit booms.
China faces mounting risks to financial stability as credit continues to rise rapidly. China’s bank assets are now more than triple its GDP, and other nonbank financial institutions also have heightened credit exposure.
Many financial institutions continue to be overly dependent on wholesale financing, with sizable assetliability mismatches and elevated liquidity and credit risks. Recent turbulence in money markets illustrates the vulnerabilities that remain in China’s increasingly large, opaque, and interconnected system.