Friday, April 19, 2013

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.

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