A year after the subprime market crisis erupted in the United States, triggering financial market turmoil around the world, global financial markets continue to be fragile and systemic risks remain elevated, the IMf siad in its latest assessment.
“Credit quality across many loan classes has begun to deteriorate with declining house prices and slowing economic growth. Although banks have succeeded in raising additional capital, balance sheets are under renewed stress and bank equity prices have fallen sharply,” the IMF’s Global Financial Stability Report (GFSR) Market Update, released on July 28, said.
The Update notes that banks have been fairly successful in raising equity so far, amounting to about three-fourths of the writedowns to date, adding that IMF analysts had little reason to change earlier estimates of $945 billion of aggregate potential losses from the crisis published in April (see chart). However, the renewed stress has made raising additional capital more difficult and increased the likelihood of a negative interaction between banking system adjustment and the real economy, the report added.
“At the same time, policy trade-offs between inflation, growth, and financial stability are becoming increasingly difficult. The resilience of emerging markets to the global turmoil is being tested as external financing conditions tighten and policymakers face rising inflation,” it added.
Slowing global growth
The update was released 11 days after the IMF published its latest forecast for the world economy—now clouded by the impact of high energy prices and anxieties about rising inflation.
The IMF expects global growth to slow significantly from 5 percent in 2007 to 4.1 percent in 2008 and 3.9 percent in 2009. Updated forecasts in the IMF’s World Economic Outlook (WEO) also raised inflation projections, particularly for emerging markets and developing countries.
The IMF’s market assessment said that as banks seek to deleverage and economize on capital, assets are being sold and lending conditions are tightening, which will result in slower credit growth in the United States and euro area.
Banking system adjustment
Banks have generally been successful in raising capital, but losses have thus far exceeded capital raised.
Citation: 37, 8; 10.5089/9781451967906.023.A002
Source: Bloomberg L.P.
With inflation risks on the rise, the scope for monetary policy to be supportive of financial stability has become more constrained. In the first quarter of 2008, total U.S. private sector borrowing growth fell to 5.2 percent—a level last seen after the 2001 recession. With continuing pressures on banks to deleverage, this growth might slow further. One positive development has been the continuing resilience of investment-grade bond issuance, although high-yield and structured credit markets remain effectively shut.
Emerging markets remain relatively resilient to the credit turmoil thus far. However, as the crisis remains protracted, external funding conditions are tightening, and some emerging markets are coming under increased scrutiny, especially regarding their policies to address rising inflationary pressures.
The progression of the crisis has underscored the importance of moving forward with needed reforms, the report said.
Growing U.S. problems
The report stressed the need to stem the decline in the U.S. housing market to help both households and financial institutions recover. “At the moment, a bottom for the housing market is not visible,” the IMF report said. But it also noted that recent developments in affordability may provide support for house prices to stabilize.
House prices are softening in a number of European economies, prompting concerns over future loan losses in the mortgage, construction, and commercial property areas.
Uncertainty about their future losses and capital needs have prompted a sharp decline in the share prices of the U.S. housing government-sponsored enterprises (GSEs). The wide investor base in GSE debt (both domestic and foreign) and the current reliance of U.S. mortgage lending on agency securitization meant that systemic consequences would have arisen if confidence in GSE debt had seriously come into question. The recently passed legislation will support the GSEs and create an independent regulator. “The policy challenge is now to find a clear and permanent solution,” the report said.
At a press briefing, Jaime Caruana, Director of the IMF’s Monetary and Capital Markets Department, said that extraordinary steps by central banks in mature markets had succeeded in capping systemic risk. “However, in the context of the deleveraging process and uncertainty about asset valuations, credit risks remain elevated, indicating that further raising of capital may be needed in a number of financial institutions,” Caruana stated.
“In this phase of the crisis, the nature of resolution strategies and the extent of government support have come into sharper focus. Financial market disruptions will still need to be dealt with on a case-by-case basis and there is no ironclad rulebook as to how to handle such instances in today’s more global environment. Prompt and transparent government responses, however, will go a long way to relieving the uncertainties.”