Global Financial Stability Outlook Fabio Natalucci Deputy Director - - PowerPoint PPT Presentation

Global Financial Stability Outlook

Fabio Natalucci

Deputy Director Monetary and Capital Markets Department

International Monetary Fund

1

Financial Stability Risks Could Rise Sharply

Vulnerabilities Continue to Build

• High nonfinancial leverage
• Stretched asset valuations
• EM external borrowing
• Bank exposures & FX funding

Risks Could Rise Sharply

Possible triggers:

• Broader EM pressures
• Escalation of trade tensions
• Political and policy uncertainty
• Faster monetary policy

normalization

Since the April 2018 GFSR

• Global financial conditions have

tightened somewhat, but remain broadly accommodative

• Near-term risks have increased

modestly, while medium-term risks remain elevated

2

MARKET DEVELOPMENTS

3

Financial Conditions Have Diverged Across AEs and EMs

Financial Conditions Indices of Other Advanced and Emerging Market Economies (z-scores over 2010-18)

• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 2015 2016 2017 2018 AE ex. US China EM ex. China

Last GFSR

Tighter conditions

Financial conditions in the US eased, despite policy rate hikes…

Global Growth Forecast Densities (Probability density, 2018:Q3)

…offsetting tighter financial conditions in EMs, and…

4

…supporting near-term growth, while keeping medium-term risks elevated

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

• 1

1 2 3 4 5 6 Near term Medium term 5th percentile Global growth rate (percent) US Financial Conditions Index and Federal Funds Rate (z-scores over 2010-18 and percent)

• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 0.0 0.5 1.0 1.5 2.0 2.5 2015 2016 2017 2018 Federal Funds Rate (lhs) FCI (rhs)

Last GFSR

Tighter conditions

Note: Assessment of financial conditions is based on findings of the Global Financial Stability Report – October 2018

The sharp selloff in US stocks triggered a global stock market correction…

Major Stock Index Performance (index to Jan 1, 2018; YTD change in parentheses)

… leading to a significant fall in equity valuations

12-month Forward Price-to-Earnings Ratio (z-score since 1987; current value in parentheses) 5

Recent Market Movements Have Contributed to Tighter Conditions

• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5 1.0 2012 2013 2014 2015 2016 2017 2018 US (15.3) Europe (11.9) Japan (12.3) EM (10.2) 80 90 100 110 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec US (3.5%) Europe (-8.8%) Japan (-9.3%) EM (-12.2%)

Markets Are Pricing in a Benign Macroeconomic Outlook

6

Policy rate expectations point to gradual rate hikes… … despite relatively benign expectations

• f future inflation

Breakeven Swap Rates, 5Y5Y Forward (Percent) Overnight Indexed Swap (OIS) Forward Rate Curves for Advanced Economies (Percent)

Note: Annual average three-month overnight indexed swap (OIS) rates on forward contracts for tenors from six months to five years. The OIS forward curves are constructed from the USD, EUR, JPY, and GBP, and the average, maximum, and minimum are computed for each tenor across the four jurisdictions.

• 2
• 1

1 2 3 4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 JPY USD EURO

• 1

1 2 3 4 5 6 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 YTD Average Maximum Minimum

In Certain Asset Classes, Valuations Still Increasingly Stretched

Term premiums are low, but mostly fairly priced based

• n fundamentals…

Credit Spreads on US Investment Grade and High Yield Corporate Bonds (Spread over US Treasury in basis points, Yield on GE bond in percent ) 7

…but corporate spreads remain very low, given creditworthiness of borrowers

Deviation from Fitted 10-Year Premium (Percentage points)

• 1.50
• 1.00
• 0.50

0.00 0.50 1.00 1.50 2.00

Deviation from weighted- average fitted value Max-Min of the range 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 500 1000 1500 2000 2500 2006 2009 2012 2015 2018 US IG Spread US HY Spread GE 5-Yr USD Sr. Secured (RHS) % Bps

Intensifying Risks in Leveraged Lending

Leverage Multiple

Global new issuance of leveraged loans has been growing…

Covenant Quality

… as has been the issuance of such loans by highly indebted companies…

8

… with fewer investor protections and lower overall quality

New Issuances of Leverage Loans (Billion of US Dollars)

Note: 2018 data is through Q3 and annualized to estimate full-year 2018 issuance. Note: Leverage multiple is defined as the ratio of total debt-to-earnings before interest, taxes, depreciation and amortization after issuance of the loan. Note: Moody’s Loan Covenant Quality Index score is a year average. Data unavailable from 2008 to 2010. 2018 data is through Q3.

100 200 300 400 500 600 700 800 900 US Issuers Non-US Issuers 2.0 2.5 3.0 3.5 4.0 4.5 10 20 30 40 50 60 70 80 90 07 08 09 10 11 12 13 14 15 16 17 18 Covenant-lite percent of new issuance (left scale) Moody's Loan Covenant Quality Index score (right scale)

Highe gher r Scor core e Equals s Weake ker r Covena enant nts

Portfolio Flows to EMs Have Been Under Pressure

9 EM Portfolio Flows by Investor Type (US$ bn, 3-month rolling sum)

EM portfolio flows have declined, driven by a reversal in retail fund flows Some moderation in EM portfolio flows is expected due to ongoing US monetary policy normalization

Baseline: Estimated Cumulative Impact of External Factors on Portfolio Flows to EMs (US$ bn)

• 120
• 90
• 60
• 30

30 60 90 120 150 2013 2014 2015 2016 2017 2018

Renminbi devaluation U.S. election Taper tantrum

Institutional flows

Retail flows

EM Sell-off

Total flows

• 140
• 120
• 100
• 80
• 60
• 40
• 20

20 2017Q4 2018Q2 2018Q4 2019Q2 2019Q4 Risk aversion (assumed to stay at 2018:Q3 level) Fed balance sheet (from Federal Reserve) Fed rates (consistent with WEO) Estimates through 2018Q3 Baseline Outlook

• 50

50 100 150 200 250 300 350 400

China Poland Chile Malaysia Peru Kazakhstan Philippines Colombia Hungary Russia Indonesia Mexico Brazil South Africa Turkey Egypt Nigeria Ukraine Argentina Lebanon

Investors Have So Far Differentiated Among EMs

10

Lower-rated EMs have seen larger widening in external debt spreads… … but outsized FX currency moves have been limited to a few countries

USD Government Bond Spreads (changes since end-March; basis points)

A BBB BB B

EM and AE Currencies against the USD (index, 3/30/18=100)

Note: Letters refer to foreign currency long-term sovereign credit ratings, as assigned by at least two out of the three major credit rating agencies Note: “High spread EMs” include Argentina, Brazil, South Africa, and Turkey; “Oil exporters” include Colombia, Kazakhstan, Mexico, and Russia.

65 70 75 80 85 90 95 100 105 Apr May Jun Jul Aug Sep Oct Nov Dec Advanced economies Oil exporters All EMs High spread EMs

Depreciation against the dollar

EM Policy Responses to Market Pressures Have Varied

EM policy responses have included policy rate hikes…

Changes in Actual and Expected Policy Rates (changes from 3/30/18 to 11/07/18; basis points)

…and foreign exchange market interventions

11

• 75
• 50
• 25

25 50 Oct-14 Jul-15 Apr-16 Jan-17 Oct-17 Jul-18 Latin America EM Asia CEEMEA 14 EMs excluding China Reserves Operations (US$ bn)

Note: In Argentina, the monetary regime was changed on October 1.

• 150
• 100
• 50

50 100 150 200 250 300 350 Brazil China Malaysia Poland Colombia Thailand Chile Romania India Hungary Philippines South Africa Indonesia Mexico Turkey Russia Argentina Change in forward policy rate for end-2019 Change in actual policy rate

1125 1682 3275

Frontier Markets Face Challenging External Borrowing Conditions

12 Frontier Market International Bond Issuance and Spread (US$ bn and bps) Frontier Issuers’ International Bond Redemptions (US$ bn) Low-income Countries Face Debt Challenges (percent share of all LICs)

More low-income countries are at risk of distress External borrowing conditions have deteriorated Some countries have large rollover needs over the medium term

2 4 6 8 10 12 14 16 18 2019 2020 2021 2022 2023 2024 Africa Latin America Asia Europe Middle East 0% 10% 20% 30% 40% 50% 60% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 In debt distress High risk of debt distress 250 300 350 400 450 500 550 2 4 6 8 10 12

May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Frontier spread (bps, right scale)

FINANCIAL VULNERABILITIES

13

Non-financial Sector Debt Vulnerabilities Continue to Rise

14 Leverage Heatmap: 2018 (percentile ranks; pooled sample, 2000 or earliest available to 2018) REGIONS

Non-financial sector leverage has increased since the global financial crisis and is high in some regions, while banking sector leverage has broadly improved

S E C T O R S

Note: the heatmap is based on the data for 29 jurisdictions with systemically important financial sectors.

United States Euro area Other AEs China Other EMs Corporates Households Sovereigns Banks Insurers Asset managers

< 20% 20-40% 40-60% 60-80% > 80%

Banks’ Exposure to Opaque and Illiquid Assets a Concern

15

... but these holdings are still large relative to capital of some G-SIBs.

Note: the vertical axis shows the estimated loss (in percent) on Level 2 and Level 3 assets that would result in a 1 percentage point reduction in each bank’s leverage ratio.

Exposure to Level 2 and Level 3 Asset, 2018 (percent) 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 North America Euro area Other Europe Asia and Pacific

Level 2 and Level 3 assets to Basel III Tier 1 capital (times)

1 2 3 4 5 6 7 8 9 10 2014 2015 2016 2017 2018

Other Europe Asia and Pacific North America Euro area

G-SIB Holdings of Level 2 and Level 3 Assets (Multiple of Basel III Tier 1 capital)

G-SIB holdings of illiquid assets have fallen …

EM Vulnerabilities Need to Be Carefully Monitored

16

Emerging Markets: Key Risks and Vulnerabilities

Vulnerabilities Risks Buffers

Faster monetary policy normal- ization in advanced economies

• Strong U.S. dollar
• Rising interest rates

Political risks

• Trade tensions
• Policy uncertainty

Contagion

• High leverage
• Large external financing needs
• Short-term foreign currency debt
• Flighty investors
• Trade exposures
• Sound policy frameworks
• Foreign exchange reserves
• Fiscal buffers
• Deep and liquid local markets
• Strong local investor base

30 50 70 90 110 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 75th 90th Median

High Public and External Debt Are Key Vulnerabilities for EMs

17

Global Financial Crisis 90 140 190 240 290 340 390 440 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 75th 90th Median 20 40 60 80 100 120 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 10th 25th Median

Government Debt to GDP Reserves to ARA Metric 1/ External Debt to Exports

Public debt and external debt ratios have increased across many EMs since the global financial crisis, while FX reserve ratios have remained close to the pre-crisis levels

Notes: all ratios in percent. Red shades show the weakest percentiles of all EMEs for each vulnerability metric. 1/ The ARA metric reflects potential balance-of-payment FX liquidity needs in adverse circumstances and is used to assess adequacy of FX reserves against potential FX liquidity drains (see IMF Policy Paper, 2015 “Assessing Reserve Adequacy-Specific Proposals.”)

China: Deleveraging and De-risking Progress

18

Regulatory tightening has slowed the buildup of risks in financial sector…

Investment Products and Small-to-Medium Bank Claims on Financial Institutions (Three-month change, trillions of renminbi) Corporate Defaults and Corporate Bond Spreads (Billions of renminbi, basis points)

… and led to tighter credit conditions for weaker borrowers…

Leverage at Nonfinancial Traded Companies (Top 100 Chinese firms by assets)

… but the deleveraging process is far from complete.

Note: Leverage is measured as the ratio of liabilities to common equity.

• 4
• 2

2 4 6 8 2015 16 17 18

Investment products Bank intrafinancial sector claims

4.0 4.5 5.0 5.5 6.0 6.5 2010 2011 2012 2013 2014 2015 2016 2017 2018:Q1 2018:Q2

5 10 15 20 25 30 35 40 45 200 250 300 350 400 450 500 2014 2015 2016 2017 2018

Annual defaulted bonds (billions of renminbi, right scale) 2018 pace (billions of renminbi, annualized, right scale) Yield spread of AA- bonds to five-year government bonds (basis points, left scale)

Liquidity Risk in the Chinese Bond Market

19

Trading turnover fluctuates more than in other countries…

Annual Growth in 3-Month Average Bond Trading Volumes, by Country and Bond Type (Percent) Rolling 60-day Sum of Daily Bond Trading to Outstanding Total and One-Month SHIBOR interbank Rate

… and volumes tend to fall when interbank rates rise.

Repo Borrowing Outstanding and Trading Volumes (Trillions of Renminbi)

Trading volumes decline poses risks given growing short-term borrowing

• 100
• 50

50 100 150 200 250 300 2013 2014 2015 2016 2017 2018 US government China government US corporate China corporate 0.0 0.2 0.4 0.6 0.8 1.0 2 4 6 8 10 12

60-day bond turnover ratio (right scale) Interbank yield (left scale) >1.5x standard deviation 60-day move in bond yields

2 4 6 8 10 12 Total short-term borrowing Average daily trading volume

Japanese Banks Cross-Currency Funding

20

Japanese banks are reliant on cross- currency funding via swaps…

US Dollar Cross-Currency Funding Ratio (Net cross-currency derivatives as percent of total assets) Cross-Currency Basis Swaps (Spread on three-month swaps, basis points)

Dollar funding conditions remain relatively tight

Supply of Foreign Exchange Derivatives to Japanese Financial Institutions (Billions of US dollars)

... while supply is shifting from banks to nontraditional financial institutions

Note: Data as of October 2018 Global Financial Stability Report 51% 59% 61% 75% 70% 65% 68% 71% 49% 41% 39% 25% 30% 35% 32% 29%

200 400 600 800 1,000 1,200 1,400 Non-Japanese, non- traditional lenders Non-Japanese banks

• 20
• 10

10 20 30 40 50

2000 2002 2004 2006 2008 2010 2012 2014 2016

Non-US banks CAN CHE DEU FRA GBR JPN

• 90
• 80
• 70
• 60
• 50
• 40
• 30
• 20
• 10

10 20 2013 2014 2015 2016 2017 2018 JPY EUR GBP

FINANCIAL STABILITY RISKS

21

The Outlook for EMs Remains Challenging

22

Adverse scenario assumptions:

• US corporate bond spreads widen

by 100 bps

• US 10-years bond yields fall 30 bps
• The US dollar rises 5 percent

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

• 1.5
• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 Baseline Scenario

5th percentile

A deterioration in the global risk appetite could lead to larger portfolio outflows from EMs

Portfolio flows in percent of EM GDP Baseline and Adverse Scenarios: Near-Term Debt Portfolio Flows Forecast Densities

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

• 1.5

0.5 2.5 4.5 6.5 Baseline Trade scenario

1.5 ppts

An Escalation of Trade Tensions Could Raise Financial Stability Risks

23

Near Term Medium Term WEO/GFSR Trade Tensions Scenario: Growth Forecast Densities

Global GDP growth rate (percent) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

• 1.5

0.5 2.5 4.5 6.5 Baseline Trade scenario with persistent financial conditions shock Global GDP growth rate (percent)

An Increase in Policy Uncertainty Could Trigger A Risk-off Sentiment

25

Markets remain concerned about fiscal policy uncertainty in Italy… …and redenomination risk

Italian Sovereign Spreads and Bank Equities Italy Redenomination Risk (CDS spread difference between ISDA ’03 and ‘14 definitions, bps) 20 40 60 80 100 120 2016 2017 2018 Italy France Spain French presidential elections Italian general elections 0.5 0.6 0.7 0.8 0.9 100 150 200 250 300 350 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

10-year Bond Spread

• ver Bunds (bps, LHS)

Italian Banks Price-to- Book (RHS)

Large Financial Sector Exposure to the Sovereign is a Concern

25

… and these risks are not limited to banking institutions

Insurers’ Exposure to Southern European Sovereigns, 2017Q4 (Percent of capital)

… but risks from growing “sovereign-bank” nexus are rising…

Banking System Exposure to Domestic Governments, 2018 (Percent of assets)

Note: Based on the latest available data in 2018. The size of the circles is proportional to the banking systems’ exposure to their domestic government (relative to assets)

Bank balance sheet weaknesses are gradually being addressed…

Italian Banks: Non-Performing Loans (Percent of total bank loans)

0.0 4.0 8.0 12.0 16.0 20.0

2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 2010Q2 2011Q1 2011Q4 2012Q3 2013Q2 2014Q1 2014Q4 2015Q3 2016Q2 2017Q1 2017Q4 ITA PRT JPN BEL ESP USA GRC KOR CHE IRL DEU GBR FRA 2 4 6 8 10 12 14 100 200 300 400 500 600 Domestic sovereign CDS spread (basis points) Asia and Pacific Euro area North America Other Europe 50 100 150 200 250 300 ITA ESP PRT GRC Domestic Cross-border

Brexit – Financial Stability Considerations

Recommendations

• Financial institutions should

step up their preparations

• Authorities should continue to

work with private parties to reduce risks of disruption

• Authorities should provide more

clarity on their intention to mitigate cliff-edge risks

Medium-Term Challenges

• Market liquidity could be

fragmented raising cost of funding

• Onshore and offshore markets:

Trading venues could be duplicated

• Challenges of risk management

because institutions could become more complex

Short-Term Risks

• Contractual Risks: Unexpected

changes to the legal framework governing financial services (e.g., derivative and insurance contracts)

• Operational risks: Uncertainties

regarding regulatory environment in which financial institutions will

• perate during the transition

26

A DECADE AFTER THE CRISIS: ARE WE SAFER?

27

Regulatory Reform Agenda Is Yet to be Completed and Fully Implemented

28

Quality of Regulation and Supervision Macroprudential Authorities’ Powers

Percent of banking assets Compliant Largely compliant Materially noncompliant Capital Liquidity

Percent of countries, 2017 Compel Comply or explain Recommend None

New Risks Need to Be Actively Monitored

29

… and the assets of nonbank financial institutions have increased

Bank and Other Financial Institutions’ Assets (percent of GDP) 80 100 120 140 160 180 200 220 240 OFIs Banks

The systemic importance of central counterparties has grown…

CCPs and Other Counterparties in Derivatives Clearing (share of different counterparties, percent ) 10 20 30 40 50 60 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Central counterparties Banks and securities firms Hedge funds Other residual financial institutions Insurance and special purpose vehicles

Note: the remaining two categories, “reporting dealers” and “nonfinancial institutions”, are not shown in the chart

Need to Actively Develop and Apply Macroprudential Tools

30

Availability of Macroprudential Tools for Addressing Key Vulnerabilities

Note: Colors depict number of countries reporting at least one macroprudential tool: White shading means policy tools are unavailable or not reported. “Others” includes prudential tools such as risk management requirements, reporting duties, and, less frequently fiscal measures. The tale covers 29 economies with systemically important financial sectors.

< 20% 20-40% 40-60% 60-80% > 80%

Vulnerabilities

AE EM AE EM AE EM AE EM AE EM AE EM Leverage

14.00 6.00 16.00 5.00 21.00 7.00 13.00 1.00 12.00 4.00 2.00 1.00

Liquidity Mismatch

0.00 0.00 0.00 0.00 21.00 7.00 3.00 2.00 15.00 3.00 0.00 1.00

Maturity Mismatch

1.00 0.00 5.00 2.00 0.00 0.00 0.00 0.00 0.00 1.00 0.00 0.00

FX Mismatch

0.00 5.00 0.00 3.00 7.00 6.00 13.00 2.00 0.00 0.00 0.00 0.00

Valuation Misalignment

0.00 0.00 0.00 0.00 0.00 0.00 12.00 1.00 12.00 1.00 0.00 0.00

Interconnectedness

1.00 1.00 0.00 0.00 22.00 7.00 13.00 2.00 13.00 2.00 0.00 1.00

Others

2.00 0.00 2.00 1.00 0.00 0.00 0.00 0.00 13.00 3.00 0.00 0.00

Corporates Households Banks Non-Bank Financials Insurers Pension Funds Asset Managers