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News : Global Economy Last Updated: Apr 18, 2013 - 9:43 AM

IMF warns central banks of risks of stoking asset price bubbles
By Finfacts Team
Apr 18, 2013 - 7:46 AM

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Roundtable discussion on The Evolving Role of Fiscal Policy with moderator Maria Bartiromo, (l) CNBC anchor and panelists: Christine Lagarde (2nd l), managing director IMF; Sharan Burrow (3rd l), general secretary, International Trade Union Confederation; Agustin Carstens (3rd r), governor, Bank of Mexico; Laura D’Andrea Tyson (2nd r), professor of economics, University of California, Berkeley and Axel A. Weber (r), chairman, UBS and former president Bundesbank, April 17, 2013 at the IMF headquarters in Washington, DC

The global financial system is far more stable than it was six months ago, but a number of challenges remain. The International Monetary Fund’s latest Global Financial Stability Report (GFSR) says that recent rallies in financial markets will not be sustained, and new risks are likely to emerge, unless policymakers address key vulnerabilities. The Fund warns central banks of the risks of stoking asset price bubbles just weeks after the Bank of Japan announced that it would double the money supply to end two decades of deflation.

The report [pdf] focuses on two persistent old risks, which are the legacy of the crisis.

In spite of the recent improvements in market conditions, credit is not adequately flowing in the euro area periphery.

  • Small and medium-sized companies, which are the backbone of employment, are particularly affected by the increased cost and limited supply of bank credit.
  • The periphery corporate sector is also facing a large debt overhang, which was built up before the crisis. The report identifies a weak tail of listed companies in the periphery that need to reduce their debt over time. The required debt reduction by these companies accounts for a fifth of the total debt of listed periphery corporates analysed in the GFSR. This poses a challenge to their economies and financial stability.

Bank balance sheet repair has not been completed and progress has been uneven, according to the IMF. Banking systems around the world are in different stages of repair.

The report shows that the process is largely completed in the United States, but not so in Europe. Many banks in the euro area periphery countries still need to make further progress in strengthening their balance sheets. And important banks in the core countries are still too dependent on wholesale funding markets. Furthermore, the global financial reform agenda is incomplete, prolonging regulatory uncertainty. This leaves banks less willing to lend.

“Addressing the old risks is essential to leave the crisis behind, but it also reduces the need for continued accommodative monetary policies. This will prevent new risks from growing and becoming systemic,” said José Viñals, financial counsellor and head of the IMF’s Monetary and Capital Markets Department, which produced the report.

New risks

The report also identifies new risks linked to easy monetary policies that were put in place to fight the crisis. These policies have been essential to support the economy. But their use over a prolonged period may create side effects, such as excessive risk taking and leverage, and asset bubbles.

The IMF said there are signs of new risks in the United Sates. US corporate fundamentals are strong, and leverage is in line with typical historical patterns. But corporate debt underwriting standards are weakening rapidly. In addition, continued low interest rates are prompting some pension funds and insurance companies to take further risks to close their widening funding gaps.

Also, easy money in advanced economies is spilling over to emerging markets. Borrowing on international markets by emerging market corporates has been growing at a record pace, exposing them to foreign currency risks and rising leverage. This makes emerging markets more sensitive to volatile capital flows.

Above all, the eventual unwinding of prolonged monetary easing in the United States could expose these vulnerabilities and destabilize credit markets.

Policy recommendations

The report calls for stronger policies to reduce financial fragmentation in the euro area, in order to help unblock the flow of credit to the economy and increase the resilience of the currency union.

Policymakers can achieve this by completing the banking sector repair and by moving steadfastly towards full-fledged banking union. Also, the flow of credit to solvent small and medium-sized enterprises needs to be improved. And private debt overhangs need to be addressed to complement the clean-up of bank balance sheets.

The IMF also called for renewed political commitment at the global and national level to complete and implement the financial regulatory reform agenda. Without greater urgency toward international cooperation and comprehensive bank restructuring, weak bank balance sheets will continue to weigh on the recovery and pose ongoing risks to global stability, according to the IMF.

Policymakers must also address new risks:

In the United States, policymakers need to keep banks safe. As for nonbanks, they must be vigilant and proactive by restraining too rapid increases in leverage and by encoura