Global Financial Stability Report: Markets poised for recovery, but uncertainty clouds outlook
Household balance sheets in the United States appear to have stabilized, U.S. corporate balance sheets have strengthened somewhat, and mature market financial institutions appear to be less hesitant to take on risk. Accommodative monetary policies in the major economies have helped institutional and retail investors build up sizable cash positions. Indeed, a partial mobilization of these cash positions in the fourth quarter of 2002 helped fuel a short-lived stock market rally, led to a narrowing of credit spreads on mature and emerging market bonds, and contributed to an increase in flows to emerging market borrowers.
Normally, a gradual strengthening of balance sheets in mature markets suggests the potential for a rebound in the real economy and financial markets once investor sentiment turns and the large pool of risk capital waiting on the sidelines is reallocated to risk taking. This potential, however, is currently being overshadowed by uncertainty about the course of the war in Iraq and its repercussions for growth and stability. Markets appear to have priced in a short and decisive war, but any adverse departure from this scenario would weaken confidence further. Even with a reasonably short and decisive military conflict, however, uncertainty may persist for some time, owing to the potential for continued geopolitical instability and tangible threats of terrorism. In addition, fundamental imbalances from the bubble period remain, despite recent progress.
Prolonged uncertainty associated with geopolitical conditions could, the Global Financial Stability Report cautions, extend the period in which cash is sidelined and strengthen the head wind against global economic recovery.
In mature markets …
The major financial markets have made some progress in correcting past excesses, but more needs to be done. The mature markets have benefited from the apparent stabilization of U.S. household sector balance sheets and the gradual improvement in the balance sheets of U.S. corporations (reflected in a sharp increase in the ratio of broad liquid assets to short-term debt).
In addition, large internationally active banks have remained reasonably well capitalized and liquid and are not now likely to pose systemic risks. But a deteriorating global economy or further revelations of hidden corporate losses could pose problems for these banks. Most European banks appear to be well supported by the underlying earning power in their home markets. German wholesale banks, however, need to bolster their financial condition, and Japan’s banking system has deteriorated in an environment of continued deflation and limited corporate restructuring, despite recent efforts to raise capital. Corporate and financial sector restructuring in Japan continues to be urgently needed.
The report advises paying increased attention to a number of matters, notably insurance companies, pension funds, exchange rates, and financial sector risks. It notes that some European insurance companies have been substantially weakened because of declines in equity and corporate bond prices (see chart, this page). Problems are particularly acute in the United Kingdom, Germany, the Netherlands, and Switzerland, where life insurance companies have reduced their equity holdings into declining markets to preserve their capital strength. And Japan’s life insurance companies have been under intense pressure for some time.
Corporate defined-benefit pensions in the United States, the United Kingdom, the Netherlands, and Japan appear to be experiencing sizable funding gaps. Such gaps are likely to exist elsewhere in Europe as well. Until equity and corporate bond markets recover, these funding gaps are expected to weigh on corporate profitability and contribute to market uncertainty in estimating future earnings.
Equity markets moved sideways on lower-than-expected corporate earnings
Data: Bloomberg L.P.
The U.S. dollar has weakened against major currencies, but its decline to date has been orderly and generally welcome, given the large U.S. external deficit. Still, a precipitous fall in the dollar cannot be ruled out, and the report cautions that this could have potentially destabilizing consequences, given substantial foreign holdings of U.S. financial assets.
Sovereign spreads in emerging markets differ by region
Emerging Markets Bond Index Plus.
Data: J.P. Morgan Chase
Accommodative monetary policies and the accumulation of cash balances have helped improve balance sheets, and the sizable cash holdings can be deployed as uncertainties abate and investor sentiment improves. Yet this situation, too, calls for caution. Financial institutions have invested substantially in long-term U.S. treasury and agency securities and funded their investments with low-cost, short-term money. As most of these positions appear to be unhedged, some investors could face sizable losses when growth prospects improve and interest rates rise. Further heightening the risk is investor accumulation of large amounts of mortgage-backed securities, which, because of their embedded prepayment option, are more sensitive to interest rate changes than conventional bonds.
… and in emerging markets
The feast-or-famine dynamic of emerging market financing reasserted itself in 2002, as countries at the low end of the credit-rating spectrum—especially in Latin America—faced difficult access to capital markets and high funding costs (see chart, this page). An easing of global financial market conditions in the fourth quarter led to a reopening of capital markets to many, but not all, issuers.
In 2002, investor decisions were largely influenced by the sustainability of policies in individual countries, which contributed to considerable tiering by credit quality. For example, concern that a new administration in Brazil might not sustain existing policies contributed to mounting investor anxiety and rising credit spreads in the run-up to elections there. Initial cabinet appointments and the new government’s policy pronouncements helped ease these fears, and investor sentiment toward Brazil subsequently improved markedly. Domestic borrowing costs remain high, however, and the bond spreads have not yet fallen to a level that permits renewed sovereign access to the primary market.
Financial markets continued to differentiate by perceived credit quality. Some Latin American countries faced high yield spreads, while Asian and Eastern European borrowers benefited from near record-low credit spreads. Asian markets, except for the Philippines, are supported by strong growth and other macroeconomic fundamentals, regional liquidity, and a solid investor base. Similarly, Eastern European countries attracted investor interest in anticipation of further credit upgrades stemming in part from their progress toward European Union accession. Investor confidence in Russia has continued to improve as a result of its strong fiscal position and growth performance, both of which have been aided by high oil prices.
Major emerging markets have also recorded a mixed performance in their banking sectors in recent years. Financial health indicators improved significantly in Europe’s emerging markets, helped by considerable bank restructuring efforts and the entry of foreign banks in several of these countries. Asian banking sectors showed similar improvement, but progress has been slower and weaknesses have been persistent in some countries, mainly because of lagging bank and corporate restructuring. In contrast, banks in some Latin American countries remain distressed, with long-standing weaknesses aggravated by recent economic and financial turmoil. In other Latin American countries, banks have achieved stronger financial results, reflecting more favorable initial conditions and better economic performance.
Boosting market confidence
As financial markets and the real economy continue to work off the excesses of the bubble years, policies must stay focused on bolstering consumer, business, and investor confidence. Improved market confidence would allow financial conditions to strengthen gradually and support investment, which would in turn underpin recovery in both financial markets and the real economy. Subject to geopolitical developments, confidence can best be enhanced, the report states, through continued sound macroeconomic policies and a flexible response to renewed signs of an economic downturn.
Both mature and emerging market countries need to take specific measures to address weaknesses and spur recovery. They should include the following steps.
Macroeconomic measures. The major economies’ current accommodative monetary policies are appropriate and have facilitated a gradual improvement in the financial conditions of key sectors and a buildup in the liquidity positions of households and financial intermediaries. Specifically in Europe, the steepening of the yield curve would help financial intermediaries improve their earning power and ability to digest losses in various segments of their businesses. The report calls for more decisive action in Japan to reverse years of economic decline and falling prices.
Corporate and financial sector reforms. Japan urgently needs to renew corporate and financial sector reforms to allow its financial institutions to improve their earnings. Many Japanese financial institutions must address their loan-loss provisions more resolutely and their high cost base more generally, as well as strengthen their capital positions. In Germany, a better capitalization of small and medium-sized companies would help reduce the large loan-loss provisions on the balance sheets of financial institutions. More important, a number of financial institutions must improve their earning power and reduce bloated cost bases through consolidation. In Japan and, to a lesser extent, Germany, the general legal and regulatory framework needs to be adapted to support these restructuring efforts.
Insurance and pension funds. To foster a more stable insurance market in the mature economies, regulators must intensify efforts to encourage sounder asset-risk management at the micro level and to realign incentives, including regulatory rules for solvency and liquidity.
With regard to weaknesses in the funding of corporate pensions, falling equity prices underscore the need to address the long-standing mismatch between pension assets (typically tilted toward equity investments) and pension liabilities (whose behavior typically mimics that of a bond). For many large U.S. corporations, for example, the ratio of pension assets to market capitalization is more than 2 to 1; this illustrates a still-high degree of leveraging in the U.S. corporate sector, where companies are responsible for their pension obligations. A number of issues in pension accounting also warrant attention, notably using realistic actuarial assumptions to measure funding adequacy. Caution should be exercised, however, to avoid an immediate large drain on company earnings that could trigger a self-reinforcing decline in equity markets.
Corporate governance, accounting, auditing, and other investment banking practices. Improvements are under way in the United States and other countries, but the reforms must be sustained. Investors need to be reassured that they face a level playing field and will have access to full and accurate information on the health of publicly traded firms.
Unwinding of cash buildups. The recent buildup of cash balances requires vigilant risk management by private market participants to ensure that the mobilization of these balances and the unwinding of positions now encouraged by the steep yield curve occur in an orderly way. A speedy return of market confidence and risk appetite would expose a significant amount of unhedged long positions in the markets for long-term government securities, creating a potential for large losses. National supervisors should ensure that the risk positions of financial institutions in their jurisdictions—and those of their hedging counterparties, irrespective of location and business sector—are well managed.
Emerging market access and self-insurance. The feast-or-famine dynamic in emerging market financing and persistent credit tiering underscore the need for sound and sustainable macroeconomic policies to facilitate access to capital at reasonable cost. This need is all the more compelling now, as many sovereign borrowers continue to face unfriendly external financial conditions.
Many emerging markets are also taking additional measures to self-insure against volatile capital flows and asset prices. Most prominent is the effort to develop local securities and derivatives markets. These markets—especially local bond markets—have grown substantially over the past five years, but they have not yet developed enough to provide full insurance against the closure of banking or international markets.
The report encourages emerging markets to continue their development efforts, noting that they could eventually provide an alternative source of financing and help act as a buffer against changing global financial conditions. It also suggests a focus, in particular, on steps to strengthen market infrastructure, develop benchmarks and local institutional investors, and improve corporate governance and transparency.
Copies of Global Financial Stability Report, March 2003 are available for $49.00 each ($46.00 academic rate) from IMF Publication Services. See page 93 for ordering information. The full text is also available on the IMF’s website (http://www.imf.org).