The global economy is at last shaking off the financial crisis, the IMF (International Monetary Fund) says. Financial markets have rebounded since the lows following the 2008 collapse of the Wall Street investment firm Lehman Brothers - - the result of improving economic conditions and wide-ranging policy actions by central banks and governments, according to the IMF’s update of its Global Financial Stability Report (GFSR). Separately, an IMF working paper warns that the market's ability to absorb Japanese public debt will likely diminish in years ahead as the country's population grows older. The publication coincided with Standard & Poor's Ratings Services threat on Tuesday to downgrade Japan's sovereign debt because of lack of confidence in the new government's ability to push through overdue reforms.

“Notwithstanding the recent sell-off, risk appetite has returned, equity markets have improved, and capital markets have reopened,”José Viñals, Director of the IMF’s Monetary and Capital Markets Department, said at a press conference on Tuesday.

But policymakers still face extraordinary challenges as they seek to unwind the unprecedented fiscal, monetary, and financial support they provided to keep their economies, financial institutions, and markets from collapsing.

The IMF says they  must restore the health of banking systems still saddled with impaired assets and ensure that bank deleveraging does not undermine the nascent recovery by strengthening balance sheets and restructuring weak banks and dissolving insolvent ones to get credit flowing again. They also must make changes in supervision and regulation that lead to a safer and more resilient financial system.

Heavy debt burden

Moreover, the heavy load of debt that governments took on in fighting the economic downturn could elbow out private borrowers and present other complications to recovering global financial markets, the IMF said. Governments accumulated the debt as a result of heavy spending to compensate for sagging private demand and for financial system interventions, such as transferring risky assets to public balance sheets and investing in weakened institutions.

The IMF update outlined three potential issues for financial stability arising from higher fiscal deficits and transferred private risks:

• Public debt issuance “could crowd out private sector credit growth, gradually raising interest rates for private borrowers and putting a drag on the economic recovery.” This would occur especially if private credit demand increased but banks were still constrained in their ability to lend as financial support measures were being withdrawn.
• A rapid increase in interest rates on public debt, which “could have negative effects on a wide variety of financial institutions and the recovery as sovereign debt is repriced.”
• The remote possibility of “a substantial loss in investor confidence in some sovereign issuers.” This is likely to be a country-specific problem, but “there is the risk of wider spillovers to other countries and markets and a negative shock to confidence.”

To reduce public sector risks, the IMF stressed the importance of getting fiscal policy in order over the medium term.

Careful on timing

At the same time, the Fund says policymakers must be mindful of the timing of the withdrawal of their support. If they act too early, recovery could be aborted, while if they are too late, they risk triggering inflation and rekindling asset bubbles - - a fear that is already present in some emerging market economies.

Viñals noted that optimum timing varies from country to country. In those mature economies and some emerging market economies where recoveries are frail, the exits will be somewhat slower than in some emerging economies that are already rebounding more rapidly.

At the same time that policymakers must exit from their extraordinary measures, they must aim at a financial system that balances the need for safety and the need to foster enough innovation and dynamism “to support sustained growth,” the report said.

Policymakers must implement changes quickly—to minimize debilitating uncertainty—but not so fast that proper studies on the impact of the new regulations are not done. Moreover, policymakers across the globe must coordinate implementation of new regulatory frameworks “to avoid an uneven playing field and regulatory arbitrage that could compromise financial stability,”  the IMF said.

Japan

In a working paper (does not necessarily represent the views of the IMF or IMF policy), The Outlook for Financing Japan’s Public Debt, IMF researcher Kiichi Tokuoka, says despite the rapid rise in public debt and large fiscal deficits, Japanese Government Bond (JGB) yields have remained fairly stable. Possible factors include: Japan’s sizeable pool of household savings, presence of large and stable institutional investors, and strong home bias. These factors are likely to persist for some time, but in future, the market’s capacity to absorb debt is likely to diminish, as population aging reduces savings inflows and financial reforms enhance risk appetite. This could in turn strengthen the link between JGB yields and the stock of public debt. In light of these structural changes in the market, fiscal consolidation will be key for maintaining market stability.

Japan's public debt is forecast to exceed 110% of GDP (gross domestic product) in net terms in 2010, and will represent 225% of GDP in gross terms, according to the IMF paper.

The paper says that Japan's savings rate is expected to decline as the population ages, likely decreasing the amount of saving money entering the bond market.

It said that gross public debt could exceed gross households' financial assets in 2015 assuming that the household saving rate stays at 2.2%.

During the 1990s the 10-year Japanese Government Bond (JGB) yields declined steadily from 7% to below 2%, while net public rose from 20% of GDP to 60% of GDP. Since 2000, net public debt has further climbed to 90% of GDP, while long term yields have remained fairly stable at below 2%.

With the general government deficit projected to stay around 10% of GDP in 2010, Japan's public debt is forecast to exceed 110% of GDP (gross domestic product) in net terms in 2010, and will represent 225% of GDP in gross terms, according to the IMF paper.

The paper says JGB yields in future could be more strongly tied to changes in the deficit and debt due to the ongoing structural shifts in the JGB market. At the same time, the gross public financing requirement is likely to remain substantial - - reaching 50% of GDP in 2009 (including rollover of financing bills) and will increase further in line with rising public debt.

Standard & Poor's Ratings Services on Tuesday warned  that it may downgrade Japan's AA government debt rating, signalling that it had lost confidence in the new Democratic Party of Japan-led government capacity to introduce reforms in an economy with the highest debt burden in the industrialized world.