Global Financial Stability is in the ICU

This is a joint note with Prof. Charan Singh, IIM B

The vital signs have emerged but if care is not taken then risks may reappear and global financial crisis could morph deeper into a coma or a more chronic phase, warned the IMF in its latest Global Financial Stability Report released on April 17 at Washington DC. Though the Report opens with the statement that the global financial stability has improved in the last six months, the reading of Chapter 1 gives the perception that vital organs are still infected.

The Report mentions some persistent and old risks which are a legacy of the crisis. These are in the Euro area and mainly in the periphery – small and medium companies are suffering on account of inadequate flow of credit and the corporate sector is facing a large debt overhang. The Report assesses the effects of high corporate leverage on debt servicing and debt repayment capacity over the medium term and concludes that it needs continued vigilance by supervisors. Five years after the start of the crisis, banking systems are still in different stages of balance sheet repair with the Euro area requiring significant adjustments where banks remain weak with low buffers, deteriorating asset quality and poor profitability. The medium term prospects seem bleak. The new risks,  mainly in the US and euro area, are associated with weakening of the underwriting standards of corporate debt; further risk taking by pension funds and insurance companies, in view of ultra-low interest rates; increased borrowings by emerging market corporates in international markets exposing them to foreign currency risks; and finally, eventual unwinding of prolonged monetary easing by the US.  

The emerging markets have been performing well but some deterioration in asset quality has begun to appear in countries like Brazil, India and Mexico. Asset restructuring by the financial institutions in China and India also needs to be carefully assessed, according to the IMF. The emerging markets have also been advised to stay alert to the risks stemming from increased cross-border capital flows. In view of the low interest rates and high risk appetite in advanced countries, there is a possibility that too much money chasing too few emerging market assets, says the IMF. Alas, the recognition of the fact, long advocated by India at the IMF board, that easy monetary policy in advanced countries spills over to the emerging countries and causes asset appreciation is finally being recognized by the IMF. Another related aspect which has been so elegantly articulated in the Report was the need for some emerging countries, in the face of the appreciation pressure from increased inflows, to opt for looser monetary policy than they would otherwise have done for fear of becoming major carry trade destination.

In any war, since the times of Mahabharata, a good army general plans an exit before launching an attack. Well, better late than never, the focus of Chapter 3 titled Do Central Bank Policies since the Crisis carry risks to Financial Stability is mainly on exit policies that central banks need to consider. The chapter, sort of an extension of Chapter 1, discusses the unconventional monetary policies, called MP-plus in the chapter, followed by four major central banks – Fed Reserve, European Central Bank, Bank of Japan and Bank of England. It identifies possible risks to domestic financial stability and to the financial health of banks. The MP-plus has been useful in the short run but has had some side-effects. The Report recognizes that longer the MP-plus remains in place, a number of future risks are likely to increase, including heightened credit risks for banks, delays in balance sheet repairs, difficulties in restarting private interbank funding markets and challenges in exiting from markets in which central banks have intervened.  MP-plus refers to policy measures like prolonged periods of very low interest rates, quantitative easing involving direct purchases of government bonds, indirect credit easing providing long term liquidity to banks and direct credit easing whereby central banks directly intervene in credit markets. These operations have changed the size and composition of the balance sheet of the central banks. The risks in the exit strategy, associated with rising interest rates and sale of assets in the balance sheet of central banks would impact banks, financial institutions, and markets. Hence, the IMF provides advice to policy makers to use macro-prudential toolkit to mitigate risks and strengthen supervision of the financial sector during the exit phase.

The remedial prescriptions in the GFSR would seem familiar to Indians, who firmly believe that precaution is better than cure. While the world is busy in getting rid of the malady, cautious approach of the policy makers in India, including that of the RBI, needs to be recognized. It would have been interesting if the measures initiated during this time by a central bank on the other side of the spectrum, illustratively an emerging market like India, would also have been analysed in GFSR.

Global Fiscal Situation is Not very Grim

Joint note with Prof. Charan Singh, IIM B

The global fiscal situation is improving with the fiscal deficits declining gradually in most advanced economies despite continuation of fiscal risks and difficult path to fiscal sustainability, according to the Fiscal Monitor released by the IMF on April 16, 2013. In the US, overall fiscal tightening is one of the largest in recent decades and is excessive in light of cyclical considerations. Not-withstanding the weak recovery, fiscal adjustment is expected to continue in most advanced economies like France, Netherlands, Italy, UK, Ireland, Portugal and Greece. In higher debt countries like Japan and the US, specific medium-term plans are urgently required to put debt ratios in downward trajectory. The emerging markets are expected to continue with neutral fiscal policies, given their low levels of debts and deficits but many have still to work on restoring policy buffers and address other medium term concerns. India’s fiscal efforts like reduction in subsidies, spending cuts and tax administrative measures are discussed.

      The process of fiscal consolidation is reflected in the performance of many advanced countries but debt levels continue to be high (Table). The Fiscal Monitor has an interesting discussion on various options to reduce the value of debt – high inflation, restructuring, privatization of government assets, structural reforms, and fiscal adjustment. The foremost of the options is to set out and implement a clear and credible plan to bring debt ratios down over the medium term; an absence of such a plan in the US and Japan are a matter of concern.

   In the US, though fiscal cliff has been averted, durable solutions are still awaited. However, he WEO released two hours before the Fiscal Monitor, questions the impact of debt on economic growth, in the current context of deficient global aggregate demand. Box 1.2 titled Public Sector Overhang and Private Sector Performance offers mixed results on the effect of debt on growth. Debt overhang is generally believed to have growth retarding implications on the economy through various channels like reduced public and private investment. In literature, debt ‘overhang threshold” levels are discussed which give broadly similar results. In contrast, recent studies to understand debt restructuring channels and its distributional effects across different sectors of the economy indicate a reverse result. 

   In an informative box 4, titled Potential Sources of Contingent Liabilities in Emerging Market Economies, two specific examples of China and India are discussed.  In the case of China, the focus is local government financing vehicles financing local infrastructure.  In the case of India, the discussion pertains to the deteriorating quality of credit. Credit growth in Indian economy remained consistently high, with growing concentration on infrastructure in the post crisis years. But with slowing down of the economy, public sector banks seem vulnerable to losses from delayed infrastructure projects as well as dented profits of large companies that account for bulk of bank loans.  Gross non-performing assets in public banks reached 3.3 % of advances in 2012. RBI has taken steps to tighten the reporting requirement in parity with increased capital standards of BASEL III.  Yet there is a fear of rise in contingent liabilities due to India’s state owned enterprises and the large public-private partnership programs.

    Fiscal Monitor has an Appendix titled Reforming Energy Subsidies, summarising another IMF paper (Energy Subsidy Reform: Lessons and Implications; forthcoming) that examines 176 countries. The appendix discusses reforms based on insights from 22 case studies and observes that energy subsidies have wide-ranging economic consequences. Though aimed at protecting consumers, subsidies aggravate fiscal imbalances and exacerbate macroeconomic imbalances. By diluting incentives to reduce domestic energy consumption, incomplete pass-through of increasing international energy prices to domestic consumers worsens the balance of payments further. Subsidies are distorting in the long run and lead to inequitable distribution. Globally, energy subsidies are pervasive and impose substantial fiscal costs on the exchequer. Institutional reforms that depoliticize energy pricing, introduction of automatic pricing and phased price increases coupled with measures to protect the poor is recommended.

In India, recent energy price reforms in 2012, are addressing some of the distortions that had arisen in petroleum pricing.  This needs to be extended to pricing of other sources of energy like Natural gas and electricity and other petroleum using sectors like fertilizers.

Table - Select Fiscal Indicators(Per cent of GDP)

 (Source: Fiscal Monitor)

	2012				2013
	Overall Balance	Revenue	Expenditure	Gross Debt	Overall Balance	Revenue	Expenditure	Gross Debt
USA	–8.5	31.8	40.2	106.5	–6.5	32.9	39.5	108.1
Japan	-10.2	31.1	41.3	237.9	-9.8	31.6	41.4	245.4
France	–4.6	52.0	56.6	90.3	–3.7	52.9	56.6	92.7
Italy	–3.0	47.7	50.7	127.0	–2.6	48.2	50.8	130.6
Germany	0.2	45.2	45.0	82.0	–0.3	44.4	44.7	80.4
Brazil	–2.8	37.2	40.0	68.5	–1.2	37.0	38.2	67.2
Russia	0.4	37.0	36.6	10.9	–0.3	36.2	36.5	10.4
India	–8.3	19.2	27.5	66.8	–8.3	19.5	27.8	66.4
China	–2.2	22.6	24.8	22.8	–2.1	22.1	24.2	21.3
South Africa	–4.8	27.9	32.7	42.3	–4.8	27.8	32.6	42.7
Indonesia	–1.3	17.8	19.1	24.0	–2.8	17.6	20.5	23.6
Turkey	–1.5	34.7	36.1	36.4	–2.2	35.6	37.8	35.5