Risks rotating to emerging markets: IMF report

Stability has improved due to a strengthening in the macro-financial environment in advanced economies, the report says “as the recovery has broadened, confidence in monetary policies has firmed, and deflation risks have abated somewhat in the euro area.”

At the same time, risks are rotating toward emerging markets, amid greater market liquidity risks, the report says, as “several key economies face substantial domestic imbalances and lower growth.” It points to higher leverage in the private sector in many economies, and rising foreign currency exposures, as particular vulnerabilities. In addition, banks in the emerging markets have thinner capital cushions, and non-performing loans are set to rise “as corporate earnings and asset quality deteriorate,” the IMF report says.

Several emerging market sovereigns “are at greater risk of losing investment-grade ratings in the medium term,” the report says, citing lower commodity prices and overall weak economic growth.

Policymakers are facing three main challenges in terms of financial stability, the IMF report says: emerging market vulnerabilities; high debt levels in advanced economies, and remaining gaps in the euro area financial system architecture; and weak systemic market liquidity.

“The relatively weak baseline for both financial stability and the economic outlook leaves risks tilted to the downside,” the IMF report says. “Thus, ensuring successful normalization of financial and monetary conditions and a smooth handover to higher growth requires further policy efforts to tackle pressing challenges.”

The report says that these policies should include: clear, consistent communication from the U.S. Federal Reserve on the U.S. interest rate picture; more progress in strengthening the financial architecture of Europe; rebalancing and gradual deleveraging in China; addressing both cyclical and structural challenges in emerging markets to discourage the buildup of excessive leverage and foreign indebtedness; safeguarding against market illiquidity and strengthening market structures; and ensuring the soundness and health of banks and other long-term savings players, such as insurers and pension funds.

“With bold and upgraded financial policy actions detailed in the report, policymakers can help deliver a stronger path for growth and financial stability, while avoiding downside risks,” the report says. “Such an upside scenario would benefit the world economy and raise global output 0.4 percent above the baseline by 2018.”

Absent policy efforts, global asset market disruptions could occur, the report warns. “Without the implementation of policies to ensure successful normalization, potential adverse shocks or policy missteps could trigger an abrupt rise in market risk premiums and a rapid erosion of policy confidence,” the report says. “Shocks may originate in advanced or emerging markets and, combined with unaddressed system vulnerabilities, could lead to a global asset market disruption and a sudden drying up of market liquidity in many asset classes.”

This sort of situation would, in turn, have negative repercussions on financial stability, and could harm the economic recovery and weaken confidence in medium-term growth, raising credit risks, and leading to higher corporate default rates, possibly an adverse feedback loop between corporate and sovereign risks. In such a scenario, “aggregate global output could be as much as 2.4% lower by 2017, relative to the baseline,” the report warns.