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IMF: Strong growth is no substitute for financial regulation

Though the global economy is charting a strong path toward recovery, International Monetary Fund economists are warning central bankers and financial regulators to remain vigilant as market risks proliferate with the availability of inexpensive debt.

"This is no time for complacency," Tobias Adrian, financial counselor with the IMF’s department of monetary and capital markets said at an Oct. 11 news conference in Washington, D.C. "Action is required now because vulnerabilities are building."

In its October World Economic Outlook the international organization revised its expectation for global growth slightly upward to 3.6% in 2017 and 3.7% in 2018 from its April report, citing accelerating growth in Europe, Japan, China and the United States.

Debt pile-up

That growth has come on the back of plentiful cheap debt that corporations and governments have piled up, the IMF said, so that asset valuations are high and risk spreads are tight.

Growth may continue for a time as the big central banks remain accommodative in their approach to monetary policy, however, that approach is also "fueling a risk for yield," Adrian said.

Total nonfinancial sector debt, which includes borrowing by governments, nonfinancial companies and households, from banks and bond markets, for the G-20 economies is now $135 trillion or about 235% of aggregate GDP, the IMF said in its Global Financial Stability Report released Oct. 11.

Recent moves by the major central banks to normalize monetary policy are appropriate, Adrian said, even while inflation rates remain below targets in the U.S., Europe and Japan. However, the IMF is recommending the use of macroprudential tools to address the buildup of cheap debt, he said.

Capital liquidity requirements and resolving legacy financial crisis loans continues to make the global banking system more stable and should be retained, the report noted.

China, in particular, must address the issue of the size and complexity of its credit as it strives to meet growth targets, said Matthew Jones, a director with IMF’s department of monetary and capital markets.

A stronger growth outlook is providing a "window of opportunity" for China to address these issues, especially in its shadow banking sector, he said.

Mispricing risks

Not only has the level of debt risen, but asset mispricing could also render economies vulnerable in the event of a sharp shift in interest rates or geopolitical shock.

Market risk premiums — what investors are paid to hold bonds over time have declined, the IMF Global Financial Stability Report noted.

"To reach the average levels from 2000 to 2004, market risk and term premiums would need to rise about 200 basis points for investment-grade bonds and about 450 basis points for high-yield bonds," the report said. "Market risk and term premiums would need to rise about 375 basis points for emerging market bonds."

At the same time, benign market conditions promoted by central bankers' accommodative policies has led to unusually low volatility, the report said.

That, in turn, has elevated valuations across regions and asset classes, Adrian said.

"It’s the low level market volatility together with compression of risk prices, such as credit spreads or interest rate term spreads that’s particularly striking at the moment," he noted.

Quickly rising benchmark rates, or other jolts to the global financial system could result in asset "fire sales" or adverse liquidity and leverage events, the IMF said in its report.

Global regulators should continue to work with financial institutions to ensure they have robust risk management procedures and appropriate capital buffers, the report said.

The report also noted that there had been a lack of progress internationally in derivative regulation. That is especially critical because fund managers use the instruments for financial leverage in their search for yield, "particularly in strategies that target a specified level of price volatility," the report said.

Banking sector vulnerabilities

While global systemically important banks are, overall, doing well, "there are pockets of weakness," Adrian said.

"In 2019, we still expect one-third of banks to have relatively weak returns; half may not even meet their own targets," he said. Those banks represent $17 trillion in assets, Adrian noted.

European banks have had some success in dealing with legacy nonperforming loans, said Peter Dattels, deputy director of IMF monetary and capital markets department. The IMF pegs the latest number for nonperforming loans in the European banking sector at 988 billion, which the fund expects to be reduced to 900 billion by year’s end, he said.

Household debt problems

The need to address high debt loads is of particular concern as households join companies and governments in piling on debt, adding another source of potential stress to a potential downturn, IMF economists said.

Median household debt-to-GDP ratio among developed economies increased to 63% in 2016 from 52% in 2008, while in emerging market economies, it was 21% in 2016, as compared to 15% in 2008, according to the Global Financial Stability Report.

Higher household debt is also associated with a higher risk of a banking crisis, the IMF warned. That risk is more pronounced in advanced economies individuals have greater capability to take on consumer and mortgage debt.

"A simple look at the data shows that increases in household debt peak about three years before the onset of a banking crisis," the reported noted.