Should Barbados be concerned about financial instability?
Short-term risks to global financial stability have abated since the April 2016 Global Financial Stability Report (GFSR). Commodity prices have risen from their lows earlier in the year, and ongoing adjustments in emerging markets have supported a recovery in capital flows.
Immediate concerns over a slowdown in China have eased on the back of policy measures to shore up growth. In advanced economies, weaker growth was mitigated by the prospect of further monetary accommodation, which supported asset prices and spurred some recovery in risk appetites.
Despite lower short-term risks, medium-term risks are building. The continued slowdown in global growth has prompted financial markets to expect an extended period of low inflation and low interest rates and an even longer delay in normalising monetary policy.
The political climate is unsettled in many countries. A lack of income growth and a rise in inequality have opened the door for populist, inward-looking policies.
These developments make it even harder to tackle legacy problems, further expose economies and markets to shocks, and raise the risk of a gradual slide into economic and financial stagnation In such a state, financial institutions struggle to sustain healthy balance sheets, which weakens economic growth and financial stability.
Financial institutions in advanced economies face a number of cyclical and structural challenges and need to adapt to this new era of low growth and low interest rates, as well as to an evolving market and regulatory environment.
These are significant challenges that affect large parts of the financial system, and if unaddressed could undermine financial soundness.
Emerging markets are also adapting to an environment of lower global growth, lower commodity prices, and reduced global trade. The current favourable external environment, including low interest rates and the global search for investment opportunities, presents an opportunity for overly indebted firms to restructure their balance sheets.
Corporate leverage in many of these markets may be peaking, since firms have slashed investment in the wake of commodity price declines and slowing demand. The challenge for many emerging market economies is to achieve a smooth deleveraging of weakened corporate balance sheets.
Approximately 11 per cent of corporate debt (over $400 billion) is held by firms with weak repayment capacity. Indebtedness declines only gradually under our baseline scenario, as high debt levels and excess capacity make it difficult to grow out of the problem, leaving them sensitive to downside external or domestic developments.
Policymakers need a more potent and balanced policy mix to deliver a stronger path for growth and financial stability. Financial markets have benefited from renewed risk appetite in the wake of unprecedented central bank actions.
Although monetary accommodation is still needed to support the recovery, a more comprehensive set of policies would ease mounting burdens on central banks.
Some monetary policies, such as negative interest rates, are reaching the limits of their effectiveness, and the medium term side effects of low rates are rising for banks and other financial institutions.
There is an urgent need to implement fiscal and structural policies to bolster confidence and raise global growth, and deploy macro prudential policies to strengthen the foundations of the global financial system.
This could help to avoid slipping into a state of financial and economic stagnation. A financial stagnation and protectionist scenario could result in a loss of world output by about eight per cent through 2021.
Taken from the International Monetary Fund’s most recent Global Financial Stability Report.