In the months since the March 2003Global Financial Stability Report was issued, the world economy has made further progress in addressing the lingering effects of the bursting of the equity price bubble. Facilitated by interest rates that approached post–World War II lows, household and corporate balance sheets have continued to improve gradually, and corporate default levels have declined. Faced with the prospect of a protracted period of low short-term interest rates and armed with ample liquidity, investors sought higher yields and ventured out along the risk spectrum. In response, emerging market economies increased their issuance of new bonds in the first half of 2003, and corporate issuance rebounded as borrowers extended the maturity of their obligations and took steps to manage their liabilities.
Bond yields rebound from postwar lows
More robust conditions
Since mid-June, mature markets have seen a rebound in their government bond yields, and the rally in equity markets that began in March continued in the third quarter (see charts). Bond yields could rise further, the report observes, if there are convincing signs of a strong economic recovery and an increased supply of government securities. The U.S. Federal Reserve has indicated that the Fed funds rate will be kept low for a sustained period, which would likely further steepen the U.S. treasury yield curve. Given the historically high correlation among government bond markets, yield curves in other major financial centers can be expected to do likewise. Ultimately, a combination of a steep yield curve and stronger growth would contribute to more robust global financial conditions.
The transition period, however, would entail risks that need to be carefully managed. More recently, price volatility has risen due to the unwinding of “carry trades” and the hedging of the holdings of mortgagebacked securities. Volatility, however, should not necessarily be of concern to policymakers unless it reaches a point where it triggers financial instability. Potential amplifying factors include dynamic hedging techniques, rigid risk limits, weak corporate governance, lack of transparency by market participants, benchmarking, and index tracking.
Against this background, theGlobal Financial Stability Report underscores the importance of achieving the appropriate balance between market discipline and regulation. It urges authorities in major market financial centers to persist in reforms to strengthen market foundations while calling on regulators to monitor market innovations. Corporate governance also needs to be strengthened further to restore investor confidence. And, given the increased participation of insurance companies in financial markets and their correspondingly important role in systemic stability, the report calls for improvements in the regulation and supervision of insurance companies.
The report also warns that continued lackluster corporate profitability and weak economic growth could pose another serious risk. The report cautions that lower-than-expected earnings growth in the second half of 2003 could lead to an equity market sell-off, as the recent rally was built on an inflow of funds from low-yielding alternatives and encouraged by expectations of better earnings. If a renewed equity decline were substantial, it could undo some of the financial improvements to date and thereby weaken the global financial sector. Nevertheless, recent corporate earnings reports suggest that the probability of this happening, while not negligible, is low.
Emerging market financing
Although the external financing climate for emerging market economies has improved, the report notes that public sector debt in these countries remains high, and there is no room for complacency by borrowers. The report urges countries to take advantage of enhanced market access to press ahead with the implementation of sound policies and improve the structure of their liabilities, including by extending maturities and reducing their dependence on dollar-linked debt. The report also welcomes the use of collective action clauses in recent bond covenants.
Equity market rally continues during third quater
Changes in the composition of the investor base for emerging market assets have increased the volatility of overall capital flows, and the report expresses concerns about the persistence of boom-bust cycles for such flows. While some volatility of capital flows is inevitable, sound economic policies and increased transparency could help to make flows more stable.
There is also much that emerging market economies could do to shield themselves from the effects of volatility. These steps should include strengthening asset and liability management, adopting exchange rate arrangements appropriate to the degree of capital account openness, strengthening domestic financial institutions, enhancing supervision and regulation, and developing local securities markets. Such selfinsurance efforts might also be complemented, in some cases, by increased holdings of international reserves. The potential volatility of external flows, particularly private debt flows, makes it especially important that emerging market economies continue to deepen their reform efforts and broaden the investor base for emerging market securities.
Copies ofGlobal Financial Stability Report, September 2003, are available for $49.00 ($46.00 for academics) each from IMF Publication Services. Please see page 263 for ordering details. The report is also available on the IMF’s website (www.imf.org).