In the Global Financial Stability Report the IMF examines the evolution of financial markets since the recent financial crisis and points to the buildup of downside risks in various segments of the financial market.
The IMF report indicates that in recent time the level of downside risks reached historical highs in several systemically important countries, such as the US or China. In particular, there was an increase in downside risks associated with the price overvaluation on asset markets, the high levels of corporate and government debt, as well as the market of leveraged loans. At the same time, the level of downside risks may continue to build up if global financial conditions remain accommodative — among others, due to investors’ search for yield.
The report also presents an assessment of the structural vulnerabilities in the global financial system. The authors focus in particular on the debt of the corporate sector in developed economies, the linkages between the financial sector and the government bond market in the Eurozone, and downside risks to the housing market.
Incorrect asset valuation is one of the key risks that has built up in the financial markets in recent years, in an environment of low interest rates. The report authors point out that asset prices in some of the major financial markets seem to significantly exceed their fundamental values. Moreover, given the monetary policy currently pursued by the world’s major central banks, the upward trend is expected to continue.
The IMF estimates that share prices on the stock markets in the Eurozone, Brazil and India are approximately 5 per cent above the fundamental value. However, in Japan and China the overvaluation of prices is even more significant — in Japan the prices on the stock market are almost 25 per cent above the level justified by the fundamentals, and in the case of China the overvaluation reaches 10-15 per cent.
The prices of residential real estate are also overvalued. The IMF utilizes a new measure of downside risks to future house price growth — house prices at risk — and warns against a growing risk of significant declines in housing prices in the United States and China.
The risks resulting from the overvaluation of asset prices may materialize in the event of a sudden tightening of financial conditions. The latter could be triggered by political events — especially Brexit, prolonged tensions in trade, unexpected changes in the monetary policy stance of major central banks — as well as a sharper-than-expected slowdown in global GDP growth.
Although the IMF points to a very high level corporate sector debt (in developed countries), it also emphasizes the relative resilience of non-financial companies in the conditions of economic slowdown and market volatility.
Moreover, the leveraged loan market constitutes another source of risk. This is mainly due to the fact that leveraged loans are increasingly being used to finance various forms of financial risk-taking, such as mergers and acquisitions. Borrowers in these markets are more dependent on the capital markets for refinancing, which leaves them more vulnerable to liquidity distress and potential defaults. In addition, non-bank financial institutions are starting to play an increasingly important role in the leveraged loan market, which may increase the risk of market shock spillovers.
On the other hand, recent new fiscal challenges in Italy have rekindled worries about the links between public debt and the financial sector in the euro zone. Banks in some Eurozone countries have become more vulnerable due to their large exposures to government bonds combined with the dependence on the sovereign credit ratings.
The stress tests conducted by the IMF indicate that despite the improvement in capital ratios and reduction in the level of impaired loans in euro area banks, a sudden increase in sovereign debt yields may cause significant losses in the banks’ bond portfolios.
At the same time, insurance companies in the Eurozone are potentially even more vulnerable to a sharp increase in the yields of government bonds than banks. This is because insurers hold more than 15 per cent of the Eurozone countries’ bonds — which is just a little less than banks — as well as almost 25 per cent of the Eurozone bank bonds. Moreover, the exposure of insurance companies to BBB-rated sovereign bonds grew from 5 per cent in 2008 to 20 per cent in 2017.
According to the IMF, the downside risks to financial stability associated with public debt may also be reflected in a slowdown in the rate of economic growth. During a crisis, the incomes of companies and households are falling, which reduces their debt-servicing capacity. This, in turn, could increase the level of non-performing loans in the banks’ balance sheets, and reduce tax revenues.
As a result, the IMF recommends that the economic policies of the governments should be focused on preventing a sharper economic slowdown and on maintaining the resilience of the financial system, which in particular relates to the adoption of an appropriate monetary policy stance — one that takes into account the risks to financial stability in the short- and medium-term.
The views expressed in this article are the private views of the author and are not an expression of the official position of the NBP.