Abstract

The health of the global financial system has improved since the October 2009 Global Financial Stability Report (GFSR), as illustrated in our global financial stability map (Figure 1.1).1 However, risks remain elevated due to the still-fragile nature of the recovery and the ongoing repair of balance sheets. Concerns about sovereign risks could also undermine stability gains and take the credit crisis into a new phase, as nations begin to reach the limits of public sector support for the financial system and the real economy.

A. How Has Global Financial Stability Changed?

The health of the global financial system has improved since the October 2009 Global Financial Stability Report (GFSR), as illustrated in our global financial stability map (Figure 1.1).1 However, risks remain elevated due to the still-fragile nature of the recovery and the ongoing repair of balance sheets. Concerns about sovereign risks could also undermine stability gains and take the credit crisis into a new phase, as nations begin to reach the limits of public sector support for the financial system and the real economy.

Figure 1.1.
Figure 1.1.

Global Financial Stability Map

Note: Closer to center signifies less risk, tighter monetary and financial conditions, or reduced risk appetite.

Macroeconomic risks have eased as the economic recovery takes hold, aided by policy stimulus, the turn in the inventory cycle, and improvements in investor confidence. The baseline forecast in the World Economic Outlook (WEO) for global growth in 2010 has been raised significantly since October, following a sharp rebound in production, trade, and a range of leading indicators. The recovery is expected to be multi-speed and fragile, with many advanced economies that are coping with structural challenges recovering more slowly than emerging markets. The improving growth outlook has reduced dangers of deflation, while inflation expectations remain contained as output gaps remain large in many advanced economies. In contrast, the need to address the consequences of the credit bubble has led to sharply higher sovereign risks amid a worsened trajectory of debt burdens (Figure 1.2).

Figure 1.2.
Figure 1.2.

Macroeconomic Risks in the Global Financial Stability Map

(Changes in notches since October 2009 GFSR)

Note: The indicators included in our assessment of macroeconomic risks (see Annex 1.1) are the IMF’s WEO growth projections, G-3 confidence indices, OECD leading indicators, and implied global trade growth (economic activity); mature and emerging market country breakeven inflation rates (inflation/deflation); and advanced country general government deficits and sovereign credit default swap spreads (sovereign credit).

With markets less willing or able to support leverage—be it on bank or government balance sheets—sovereign credit risk premiums have more recently widened across mature economies with fiscal vulnerabilities. Longer-run solvency concerns have, in some cases, telescoped into short-term strains in funding markets that can be transmitted to banking systems and across borders. The management of sovereign credit and financing risks therefore carries important consequences for financial stability in the period ahead (see Section B).

Quantitative- and credit-easing policies, extraordinary liquidity measures, and government-guaranteed funding programs have helped improve the functioning of short-term money markets and allowed a tentative recovery in some securitization markets. As a result, monetary and financial conditions have eased further, as market-based indicators of financial conditions largely reversed the sharp tightening seen earlier in the crisis. This has been accompanied by a decline in market and liquidity risks as asset prices have continued to recover across a range of asset classes (Figure 1.3).

Figure 1.3.
Figure 1.3.

The Crisis Remains in Some Markets as Others Return to Stability

Source: IMF staff estimates.Note: The heat map measures both the level and one-month volatility of the spreads, prices, and total returns of each asset class relative to the average during 2003–06 (i.e., wider spreads, lower prices and total returns, and higher volatility). The deviation is expressed in terms of standard deviations. Dark green signifies a standard deviation under 1, light green signifies 1 to 4 standard deviations, yellow signifies 4 to 9 standard deviations, and magenta signifies greater than 9 standard deviations.MBS = mortgage-backed security; RMBS = residential mortgage-backed security.

Supported by these more benign financial conditions, private sector credit risks have improved. Our estimates of global bank writedowns have declined to $2.3 trillion from $2.8 trillion in the October 2009 GFSR, reducing aggregate banking system capital needs. However, pockets of capital deficiency remain in segments of some countries’ banking systems, especially where exposures to commercial real estate are high. Banks face new challenges due to the slow progress in stabilizing their funding and the likelihood of more stringent future regulation, leading them to reassess business models as well as raise further capital and make their balance sheets less risky. Distress may resurface in banks that have remained dependent on central bank funding and government guarantees (see Section C).

The overall credit recovery will likely be slow, shallow, and uneven. The pace of tightening in bank lending standards has slowed, but credit supply is likely to remain constrained as banks continue to delever. Private credit demand is likely to rebound only weakly as households restore their balance sheets. Ballooning sovereign financing needs may bump up against limited lending capacity, potentially helping to push up interest rates (see Section D) and increasing funding pressures on banks. Policy measures to address supply constraints may therefore still be needed in some economies.

Emerging market risks have continued to ease. Capital is flowing to Asia (excluding Japan) and Latin America, attracted by strong growth prospects, appreciating currencies, and rising asset prices, and pushed by low interest rates in major advanced economies, as risk appetite continues to recover. Rapid improvements in emerging market assets have started to give rise to concerns that capital inflows could lead to inflationary pressure or asset price bubbles. So far there is only limited evidence of stretched valuations—with the exception of some local property markets. However, if current conditions of high external and domestic liquidity and rising credit growth persist, they are conducive to over-stretched valuations arising in the medium term (see Section E).

B. Could Sovereign Risks Extend the Global Credit Crisis?

The crisis has led to a deteriorating trajectory for debt burdens and sharply higher sovereign risks. With markets less willing to support leverage—be it on bank or sovereign balance sheets—and with liquidity being withdrawn as part of policy exits, new financial stability risks have surfaced. Initially, sovereign credit risk premiums increased substantially in the major economies most hit by the crisis. More recently, spreads have widened in some highly indebted economies with underlying vulnerabilities, as longer-run public solvency concerns have telescoped into strains in sovereign funding markets that could have cross-border spillovers. The subsequent transmission of sovereign risks to local banking systems and feedback through the real economy threatens to undermine global financial stability.

The crisis has increased sovereign risks and exposed underlying vulnerabilities. The higher budget deficits resulting from the crisis have pushed up sovereign indebtedness, while lower potential growth has worsened debt dynamics. For example, G-7 sovereign debt levels as a proportion of GDP are nearing 60-year highs (Figure 1.4). Higher debt levels have the potential for spillovers across financial systems, and to impact on financial stability. Some sovereigns have also been vulnerable to refinancing pressures that could telescope medium-term solvency concerns into short-term funding challenges (Figure 1.5).

Figure 1.4.
Figure 1.4.

Sovereign Debt to GDP in the G-7

(In percent)

Source: IMF, Fiscal Affairs Department database.Note: Average using purchasing power parity GDP weights.
Figure 1.5.
Figure 1.5.

Sovereign Risks and Spillover Channels

Table 1.1 shows a range of vulnerability indicators for advanced economies that captures their current fiscal position, reliance on external funding, and banking system linkages to the government sector.2 It features not only economies that had credit booms and subsequent busts, but also those whose underlying vulnerabilities have come into greater focus, and which are perceived as having less flexibility—economically or politically—to address mounting debt burdens.3,4

Table 1.1.

Sovereign Market and Vulnerability Indicators

(Percent of GDP, unless otherwise indicated)

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Sources: Bank for International Settlements (BIS); Bloomberg, L.P.; IMF, International Financial Statistics, Monetary and Financial Statistics, and World Economic Outlook (WEO) databases; BIS-IMF-OECD-World Bank Joint External Debt Hub; and IMF staff estimates.Note: (p) = projected. CDS = credit default swap; bps = basis points.

As of April 9, 2010.

CDS contracts are denominated in U.S. dollars, except for the Czech Republic, Iceland, and the United States, which are denominated in euros.

Swap spreads are shown here as government yields minus swap yields, the opposite of market convention.

Based on average of long-term foreign currency debt ratings of Fitch, Moody’s, and Standard & Poor’s agencies, rounded down. Outlook is based on the most negative of the three agencies.

Sum of rating actions (excluding credit watches and outlook changes) for long-term foreign currency debt ratings by the Fitch, Moody’s, and Standard & Poor’s agencies.

Based on projections for 2010 from the April 2010 WEO. See Box A1 in the WEO for a summary of the policy assumptions underlying the fiscal projections.

On a national income accounts basis. The structural budget deficit is defined as the actual budget deficit (surplus) minus the effects of cyclical deviations from potential output. Because of the margin of uncertainty that attaches to estimates of cyclical gaps and to tax and expenditure elasticities with respect to national income, indicators of structural budget positions should be interpreted as broad orders of magnitude. Moreover, it is important to note that changes in structural budget balances are not necessarily attributable to policy changes but may reflect the built-in momentum of existing expenditure programs. In the period beyond that for which specific consolidation programs exist, it is assumed that the structural deficit remains unchanged. Calculated as a percentage of projected potential 2010 GDP. Figure for Norway is the nonoil structural deficit as a proportion of mainland potential GDP. For other country-specific details see footnotes of Table B.7. of April 2010 WEO.

As a percentage of projected fiscal year 2010 GDP.

Gross general government debt consists of all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of SDRs, currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable.

Net general government debt is calculated as gross debt minus financial assets corresponding to debt instruments. These financial assets are: monetary gold and SDRs, currency and deposits, debt securities, loans, insurance, pension, and standardized guarantee schemes, and other accounts receivable.

Sum of domestic and international government securities (excluding central bank domestic obligations) with less than one year outstanding maturity as compiled by the BIS, divided by WEO projection for 2010 GDP.

Most recent data for externally held general government debt (from Joint External Debt Hub) divided by 2009 GDP. New Zealand data from Reserve Bank of New Zealand.

As a percentage of projected 2010 GDP.

Includes all claims of depository institutions (excluding the central bank) on general government. U.K. figures are for claims on the public sector. Data are for end-2009 or latest available.

BIS reporting banks’ international claims on the public sector on an immediate borrower basis for third quarter 2009, as a percentage of 2009 GDP.

The crisis has driven up market prices of sovereign risk.

The vulnerabilities outlined in Table 1.1 are being priced in to market assessments of sovereign risk. A cross-sectional regression over 24 countries indicates that higher current account deficits and greater required fiscal adjustment are correlated with higher sovereign credit default swap (CDS) spreads (Figure 1.6).5 In addition, BIS reporting banks’ consolidated cross-border claims on each country’s public sector as a proportion of GDP help to explain spreads, especially for those countries with wider spreads.6

Figure 1.6.
Figure 1.6.

Contributions to Five-Year Sovereign Credit Default Swap Spreads

(In basis points)

Sources: Bank for International Settlements (BIS); and IMF staff estimates. Note: Credit default swap spread (t-stats) =–2.35 (–1.89) current account balance + 4.45 (3.08) required fiscal adjustment + 4.14 (4.93) BIS bank claims. Adjusted R = 0.81, n = 24.

Sovereign risks have come to the fore in the euro zone.

The global financial crisis triggered several phases of unprecedented volatility in European government bond and swap markets (Figure 1.7).7 To chart the evolving nature of risk transmission among euro zone sovereigns, a model of swap spreads was estimated that takes account of joint probabilities of default, global risk aversion, and fiscal fundamentals (Box 1.1).

Figure 1.7.
Figure 1.7.

The Four Stages of the Crisis

(Ten-year sovereign swap spreads, in percent)

Source: Bloomberg L.P.

In the early stages of the crisis, the increase in global risk aversion benefited core sovereigns such as France and Germany, while spreads widened for sovereigns (Figure 1.7) perceived to be more risky. After Lehman’s collapse, the countries that weighed adversely on other sovereigns were those that had financial systems that were hit hard by the financial crisis (Austria, Ireland, and the Netherlands). As sovereigns stepped in with public balance sheets to support banks, there was a general narrowing of swap spreads as fears of systemic crisis subsided and global risk aversion fell. However, more recently, the source of spillovers has shifted to economies with weaker fiscal outlooks and financial strains, with these tensions most evident in Greece.

The recent turmoil in the euro zone also demonstrated how weak fiscal fundamentals coupled with underlying vulnerabilities can manifest themselves as short-term financing strains.

In the presence of outsized deficits and an unsustainable debt trajectory, heavy reliance on external demand for government obligations and large concentrated debt rollover requirements can shorten the timeline for addressing solvency challenges. Unlike local demand sources, nonresident buyers are naturally more attuned to sovereign risk and inclined to step back from further purchases in times of market stress. A debt profile with concentrated maturities also introduces “trigger dates” around which policymakers must navigate. These hurdles can constrain policy options and increase the likelihood of standoffs developing between the government and investors demanding higher risk premiums. Ultimately, an unresolved solvency crisis amid high near-term refinancing needs and political uncertainty could limit access to public debt capital markets.

Explaining Swap Spreads and Measuring Risk Transmission among Euro Zone Sovereigns

What factors most affected swap spreads during the four phases of the crisis (see diagram) and how did sovereign risk transmission evolve during these phases? A model of swap spreads based on measures of sovereign risk, global risk aversion, and country-specific fiscal fundamentals was estimated to shed light on this question (see Annex 1.10 on the IMF GFSR website). The first figure summarizes the results of the model. It shows that during the initial phase of the crisis, the increase in global risk aversion helped lower swap spreads in core sovereigns as investors sought the relative safety of these bonds. However, as the crisis progressed, spreads widened in other sovereigns, driven by worsening fundamentals and spillovers. In recent months, spreads have continued to widen in those countries with the greatest fiscal pressures.

Sovereign risk transmission between two countries was derived from sovereign CDS spreads using the methodology developed by Segoviano (2006). Essentially, this measure represents the probability of distress in one sovereign given the distress in another. In order to determine whether the nature of risk transfer had changed, these joint probabilities of distress were averaged over each of the four phases of the crisis that are defined in the diagram.

During the systemic outbreak phase of the crisis (see first table), the main sources of risk transfer—shown by the sum of the percentage contributions in the last row—were Austria, Ireland, Italy, and the Netherlands. In other words, the euro zone members that faced the greatest concerns regarding their exposures to eastern Europe, domestic financial systems (e.g., Ireland), or general fiscal conditions (in the case of Italy) transmitted the most sovereign risk to other countries.

UC1NF2

Contributions to Swap Spreads by Crisis Phase

(Average of changes in swap spreads in basis points)

Source: IMF staff estimates.

In contrast, during the latest sovereign risk phase (see second table), Greece, Portugal, and, to a lesser extent, Spain and Italy became the main contributors to inter-sovereign risk transfer, reflecting the shift in market concerns from financial sector vulnerabilities to fiscal vulnerabilities.

Contributions to Euro Area Distress Dependence, October 2008–March 2009

(Percentage point contribution to total distress probability)

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Source: IMF staff estimates.

Weighted average percentage point contribution to all other countries.

Contributions to Euro Area Distress Dependence, October 2009–February 2010

(Percentage point contribution to total distress probability)

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Source: IMF staff estimates.

Weighted average percentage point contribution to all other countries.

Note: This box was prepared by Carlos Caceres, Vincenzo Guzzo, and Miguel Segoviano.

Financial channels can amplify sovereign risks.

Insufficient collateral requirements for sovereign counterparties in the over-the-counter (OTC) swap market can transmit emerging concerns about the credit risk of a sovereign to its counterparties. In contrast to most corporate clients, dealer banks often do not require highly rated sovereign entities to post collateral on swap arrangements.8 Dealers may attempt to create synthetic hedges for this counterparty risk by selling assets that are highly correlated with the sovereign’s credit profile, sometimes using short CDS (so-called “jump-to-default” hedging).

This hedging activity from uncollateralized swap agreements can put heavy pressure on the sovereign CDS market as well as other asset classes. For instance, heavy demand for jump-to-default hedges can quickly push up the price of short-dated CDS protection. With bond dealers also trying to offset some of the sovereign risk in their government bond inventory, many European sovereign CDS curves departed from their normal upward sloping configuration to significant flattening or outright inversion (Figure 1.8). Greece’s sovereign CDS curve inverted in mid-January as the funding crisis accelerated and jump-to-default hedging demand increased; Portugal’s CDS curve inverted two weeks later. These pressures can easily spill over into the domestic bond market and push yields higher.

Figure 1.8.
Figure 1.8.

Sovereign Credit Default Swap Curve Slopes

(Five-year credit minus one-year default swap spread, in basis points)

Source: Bloomberg L.P.

Yet sovereign CDS markets are still sufficiently shallow, especially in one-year tenors, that a large gross notional swap exposure may prompt a dealer to look to other, more liquid asset classes for a potential hedge for its exposure to sovereigns.9 Proxies such as corporate credit, equities, or even currencies are commonly used, putting pressure on other asset classes. If swap arrangements with sovereigns were adequately collateralized, there would be no need for such defensive hedges and there would be less potential for volatility to spread from swaps to other markets.10 However, steps to reduce transmission channels should avoid interfering with efficient market functioning and good risk management practices. Thus, recent proposals to ban “naked” CDS exposures could be counter-productive, as this presupposes that regulators can arrive at a working definition of legitimate and illegitimate uses of these products (see Section F) (Annex 1.2).

Sovereign crises can widen and cross borders as they spread to the banking system.

Due to the close linkages between the public sector and domestic banks, deteriorating sovereign credit risk can quickly spill over to the financial sector (Figure 1.9). On the asset side, an abrupt drop in sovereign debt prices generates losses for banks holding large portfolios of government bonds. On the liability side, bank wholesale funding costs generally rise in concert with sovereign spreads, reflecting the longstanding belief that domestic institutions cannot be less risky than the sovereign. In addition, the perceived value of government guarantees to the banking system will erode when the sovereign comes under stress, thus raising funding costs still higher. Multiple sovereign downgrades could precipitate increased haircuts on government securities or introduce collateral eligibility concerns for central bank or commercial repos.11

Figure 1.9.
Figure 1.9.

Sovereign Risk Spilling over to Local Financial Credit Default Swaps (CDS), October 2009 to February 2010

Sources: Bloomberg L.P.; and IMF staff estimates.

Financial sector linkages can transmit one country’s sovereign credit concerns to other economies. As higher domestic government borrowing in a country crowds out private lending, multinational banks may withdraw from cross-border banking activities. Likewise, other economies that are heavily reliant on international debt borrowing or on banks from countries under significant sovereign stress could be viewed as susceptible to financial sector instability. Figure 1.10 illustrates these linkages by showing how some countries in eastern Europe have proven more sensitive to changes in Western European sovereign credit risk.

Figure 1.10.
Figure 1.10.

Regional Spillovers from Western Europe to Emerging Market Sovereign Credit Default Swaps

Sources: Deutsche Bank; and IMF staff estimates.Note: Sensitivities of sovereign credit default swaps (CDS) captured by regression betas estimated from daily spread changes between October 2009 and February 2010 in joint regression, using the Traxx Main Index and a reweighted SovX-Western Europe index that matches geographic profile of Traxx Main.

Thus, the skillful management of sovereign risks is essential for maintaining financial stability and preventing an unnecessary extension of the crisis.

C. The Banking System: Legacy Problems and New Challenges

The global banking system is coping with the legacy of the crisis and with the prospect of further challenges from the deleveraging process. Improving economic and financial market conditions have reduced expected writedowns and bank capital positions have improved substantially. But some segments of country banking systems remain poorly capitalized and face significant downside risks. Slow progress on stabilizing funding and addressing weak banks could complicate policy exits from extraordinary support measures, and the tail of weak institutions in some countries risks having “zombie banks” that will act as a dead weight on growth. Banks must reassess business models, raise further capital, shrink assets, and make their balance sheets less risky. Policymakers will need to ensure that this next stage of the deleveraging process unfolds smoothly and leads to a safe, competitive, and vital financial system.

Since the October 2009 GFSR, total estimated bank writedowns and loan provisions between 2007 and 2010 have fallen from $2.8 trillion to $2.3 trillion. Of this amount, around two-thirds ($1.5 trillion) had been realized by the end of 2009 (Table 1.2 and Figure 1.11). As explained in that previous GFSR, these estimates are subject to considerable uncertainty and considerable range of error.12 The sources of this uncertainty include the data limitations, measurement errors from consolidation, cross-country variations, changes in accounting standards, and uncertainty associated with our assumptions about exogenous variables. Differences between writedowns projected and realized reflect a number of factors, including the future path of delinquencies, differences in accounting conventions and reporting lags across regions, and the pace of loss recognition. In the current environment of near-zero interest rates, banks also face strong incentives to extend maturities and prevent delinquent loans from being reported as nonperforming.13

Table 1.2.

Estimates of Global Bank Writedowns by Domicile, 2007–10

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Sources: Bank for International Settlements (BIS); Bank of Japan; European Securitzation Forum; Keefe, Bruyette & Woods; U.K. Financial Services Authority; U.S. Federal Reserve; and IMF staff estimates. Note: Domicile of a bank refers to its reporting country on a consolidated basis, which includes branches and subsidiaries outside the reporting country. Bank holdings are as of the October 2009 GFSR. Mark-to-market declines in securities pricing are as of January 2010.

Foreign exposures of regional banking systems are based on BIS data on foreign claims. The same country proportions are assumed for both bank holdings of loans and securities. For each banking system, the proportion of exposure to domestic credit categories is assumed to apply to overall stock of foreign exposure.

Includes Denmark, Norway, Iceland, Sweden, and Switzerland.

Includes Australia, Hong Kong SAR, Japan, New Zealand, and Singapore.

Figure 1.11.
Figure 1.11.

Realized and Expected Writedowns or Loss Provisions for Banks by Region

(In billions of U.S. dollars unless indicated)

Source: IMF staff estimates.1 Includes Denmark, Iceland, Norway, Sweden, and Switzerland.2 Includes Australia, Hong Kong SAR, Japan, New Zealand, and Singapore.

Expected writedowns from loans have declined with the improved economic outlook, but further deterioration lies ahead.

For U.S. banks, estimated loan writedowns and provisions for 2007–10 were revised down by $66 billion to $588 billion after growth turned positive and house prices stabilized in the second half of 2009 (Table 1.2). Nevertheless, serious mortgage delinquencies and foreclosures continue to rise, as unemployment persists at a high level and almost one-quarter of mortgage borrowers have negative housing equity. Loan charge-off rates are expected to peak between 2009 and 2011 depending on the asset class (Figure 1.12).

Figure 1.12.
Figure 1.12.

U.S. Bank Loan Charge-Off Rates

(In percent of total loans)

Sources: Federal Reserve; and IMF staff estimates.

For euro area banks, improvements in GDP growth and unemployment forecasts have brought down estimated total loan writedowns and provisions by $38 billion to $442 billion since the October 2009 GFSR. Total loan loss provisions are now expected to have peaked at 1 percent in 2009 and decline to 0.7 percent this year. Corporates in the euro area proved more resilient than expected as they adjusted their capital expansion/working capital requirements, and reduced labor costs through the use of flexible working arrangements. Larger corporates also issued record amounts of debt in capital markets.

For U.K. banks, estimated loan loss provisions have been revised down by $99 billion to $398 billion, reflecting improvements in expected losses on residential mortgages. The projected mortgage loss provision rate for the first half of 2009 (1.9 percent) is significantly below that projected in the October 2009 GFSR (2.7 percent). However, commercial real estate has deteriorated more rapidly than anticipated with peak-to-trough price declines of more than 40 percent now expected, notwithstanding some signs of a recent uptick in prices in some segments.14

Financial healing and market normalization have led to a substantial improvement in securities prices, further pushing down overall writedown estimates.

Estimated global securities writedowns in banks have dropped by $287 billion to $629 billion as a result of improvements in market pricing of liquidity and risk premia across the range of corporate, consumer, and real estate securities held by banks (Figure 1.13). The largest reduction in writedowns is in corporate securities, while improvements in real-estate-related securities were more uneven. For example, in the United States, prices of (private label) residential mortgage-backed securities (RMBS) remain under pressure. In Europe, top-rated U.K. RMBS prices recovered strongly in the latter half of 2009, but Spanish RMBS markets reflect the weak housing market.

Figure 1.13.
Figure 1.13.

Global Securities Prices

(Rebased, 2007:Q3 = 100)

Sources: Barclays Capital; European Securitization Forum; Markit; and IMF staff estimates.Note: ABS = asset-backed security; CMBS = commercial mortgage-backed security.

In aggregate, bank capital positions have improved substantially …

Capital ratios of aggregate banking systems have improved substantially since the October 2009 GFSR (Table 1.3). Banks have continued to raise private capital, and in some cases a pick-up in earnings in 2009 has helped to bolster capital. Projected write-downs are mostly covered by earnings for the aggregate banking system.

Table 1.3.

Aggregate Bank Writedowns and Capital

(In billions of U.S. dollars, unless otherwise shown)

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Source: IMF staff estimates.Note: Capital-raising includes government injections net of repayments. Capital ratios reflect those repayments. Figures in parentheses reflect percentage point changes since end-2008. All figures are under local accounting conventions and regulatory regimes, making direct comparisons between countries/regions impossible. GSE = government-sponsored enterprise. Tier 1 = Tier 1 capital; RWA = risk-weighted assets.

Denmark, Iceland, Norway, Sweden, and Switzerland.

Reported writedowns do not include estimated writedowns on loans for 2009.

…but some segments of country banking systems remain poorly capitalized and face significant downside risks.

The aggregate picture masks considerable differentiation within segments of banking systems, and there are still pockets where capital is strained; where risks of further asset deterioration are high; and/or which suffer from chronically weak profitability.

In the United States, real estate exposures still represent a significant downside risk. The regional banks with heavy exposure to real estate need to raise capital (Table 1.4).15 Some 12 institutions have commercial real estate (CRE) exposure in excess of four times tangible common equity.16 In addition, the mortgage government-sponsored enterprises (GSEs) already received $128 billion of capital from the Treasury as of end-2009 and analysts’ estimates of total capital likely to be needed stretch up to $300 billion, highlighting that in the United States a substantial proportion of mortgage credit risk and capital shortfall has been transferred to the government by placing the GSEs under conservatorship.17

Table 1.4.

United States: Bank Writedowns and Capital

(In billions of U.S. dollars, unless otherwise shown)

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Source: IMF staff estimates.Note: RWA = risk-weighted assets.

Other banks include consumer, small (between $10 billion and $100 billion in assets), foreign and other banks (including those with less than $10 billion in assets).

Drain on capital =–(net pre-provision earnings–writedowns–taxes–dividends). Gross drain aggregates only those banks with a capital drain.

Further pressure on real estate markets may lie ahead. The “shadow housing inventory” continues to rise as lenders retain ownership of foreclosed property and forbear on seriously delinquent borrowers (as shown by the rising gap between 90-day+ delinquencies and foreclosure starts in Figure 1.14). The ending of foreclosure moratoria, house purchase tax incentives, and the Federal Reserve’s agency MBS purchases could trigger another drop in housing prices.18 In addition, a mortgage principal modification program (or the passage of so-called “cramdown” legislation) would precipitate significant additional losses on both first- and second-lien loans, prompting further RMBS downgrades.19

Figure 1.14.
Figure 1.14.

U.S. Mortgage Market

(In percent of total mortgage loans, seasonally adjusted)

Source: Mortgage Bankers Association.

Concerns in real estate lending also present a challenge in some euro area economies. In Spain, the most vulnerable loans are to property developers, as nonperforming loans and repossessions of troubled real assets have increased sharply over the last two years. Problem assets comprised of nonperforming loans and repossessions are projected to rise further, although reserves and earnings provide substantial cushions against potential losses. Overall, our conclusion is that, in Spain, a small gross drain on capital is expected in both commercial and savings banks under the baseline, despite severe economic deterioration. Under our adverse scenario, the gross drain on capital could reach €5 billion and €17 billion at commercial and savings banks, respectively (see Table 1.5 and Annex 1.3). These estimates are subject to considerable uncertainty and are relatively small in relation to both overall banking system capital and, importantly, the funds set aside under the resolution and recapitalization program set up by the government under the Fund for the Orderly Restructuring of Banks (FROB) of €99 billion. So far, three restructuring plans have been approved under the FROB involving a total of eight savings banks. The existing FROB scheme is currently scheduled to expire by June 2010. It is therefore important that the comprehensive resolution and restructuring processes financed through the FROB be under way before that date.

Table 1.5.

Spain: Bank Writedowns and Capital

(In billions of euros, unless otherwise shown)

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Source: IMF staff estimates.Note: RWA = risk-weighted assets; for details refer to Annex 1.3.

Latest available official data.

Includes potential losses from nonperforming loans, repossessed real assets, and securities.

Net drain = –(net pre-provision earnings–writedowns). A negative sign denotes capital surplus.

Gross drain aggregates only those banks with a drain on capital.

While the overall health of German banks has improved since the peak of the crisis, banks may still face substantial writedowns on both their loan books and securities holdings, and the pace of realization has been uneven across the different categories of banks. Among main banking categories, Landesbanken have the highest loan writedown rate.20 Commercial banks, Landesbanken, and other banks still hold relatively large amounts of structured products, which results in particularly high writedown rates on their overall securities holdings. Strong capital positions at end-2009 and advanced writedown realization by commercial banks ensure their adequate capitalization (Table 1.6 and Annex 1.4). In contrast, Landesbanken, other banks, and, to a lesser degree also savings banks, are yet to incur a substantial part of total estimated writedowns and are projected to have a net drain on capital. Raising additional capital could prove particularly difficult for the Landesbanken, many of which remain structurally unprofitable and thus vulnerable to further distress. The impending withdrawal of the government’s support measures could intensify these vulnerabilities, stressing the need for expedited consolidation and recapitalization in this sector.

Table 1.6.

Germany: Bank Writedowns and Capital

(In billions of U.S. dollars, unless otherwise shown)

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Source: IMF staff estimates.Note: Foreign exchange rate assumed at 1 euro =1.4 U.S. dollars; RWA = riskweighted assets; for details refer to Annex 1.4.

Other banks include credit cooperatives.

Tier 1 capital levels for 2009 are estimated.

A negative sign denotes a write-up.

Net drain on capital = –(net pre-provision earnings–writedowns–taxes–dividends). A negative sign denotes capital surplus.

Central and eastern European banking systems should be able to absorb the near-term peak in nonperforming loans, but are very vulnerable to weaker economic growth.

All banking systems remain susceptible to downside economic scenarios and this is especially so in central and eastern Europe (CEE). Nonperforming loan (NPL) ratios appear likely to peak during 2010 in the region (see Box 1.2), and banks appear sufficiently capitalized to absorb the baseline increase. However, another acceleration in NPL formation, were a weaker economic scenario to unfold, would leave banks significantly weakened and ill-prepared to absorb losses. As experience from previous crises shows, NPL ratios typically remain elevated for several years after the onset of a crisis, and coverage ratios of loss provisions to NPLs have already fallen to an average of about 65 percent in the CEE region, from pre-crisis levels of about 90 percent.21

While banks are still coping with legacy problems, they now face significant challenges ahead, suggesting the deleveraging process is far from over.

Deleveraging has so far been driven mainly from the asset side as deteriorating assets have hit both earnings and capital. Going forward, however, it is likely to be influenced more by pressures on the funding or liability side of bank balance sheets, and as new regulatory rules act to reduce leverage and raise capital and liquidity buffers.

The new regulatory proposals—enhanced Basel II and proposed revisions to the capital adequacy frame-work—point in the direction in which banks must adjust. The proposals will greatly improve the quality of the capital base, strengthen its ability to absorb losses, and reduce reliance on hybrid forms of capital. The quantitative impact study that will help calibrate the new rules is ongoing and final rules are to be published before end-2010, with a view to implementation by 2012. The outcome seems likely to be significant pressure for increases in the quality of capital, a further de-risking of balance sheets, and reductions in leverage. Once known—and possibly earlier—markets will re-rate banks on their perceived ability to achieve the new standards. Prudent bank management should therefore continue to build buffers of high-quality capital now in anticipation of the more demanding standards.

Nonperforming Loans in Central and Eastern Europe: Is This Time Different?

At what levels and when could nonperforming loan ratios be expected to peak in central and eastern Europe, based on experience from previous economic downturns?

Nonperforming loans (NPLs) have increased substantially in the central and eastern Europe (CEE) region since the onset of the global financial crisis.

This box presents a top-down framework for assessing the deterioration in bank asset quality and analyzing NPLs under different scenarios, based on historical experience in emerging markets.1

The estimation sample consists of annual data between 1994 and 2008 for Asian and Latin American economies, as well as South Africa and Turkey.2

The data reveal that emerging market NPL ratios tend to rise rapidly in a crisis, and remain more than twice as high as before the initial shock for more than four years (first figure). The technical details on the data and the estimations are given in Annex 1.6 on the IMF’s GFSR website.

UC1NF3

Historical Dynamics of Emerging Market Nonperforming Loan Ratios around Large Increases in Year t

Source: IMF staff estimates.Note: Average of indices for Argentina, Chile, Colombia, Dominican Republic, Indonesia, Malaysia, Philippines, Turkey, and Uruguay.

Nonperforming loans in the CEE region have developed largely in line with patterns observed in previous emerging market downturns.

Simulations for the CEE region starting in 2008 indicate that bank asset quality has developed largely as would be expected based on historical experience in emerging markets, considering the size of the GDP shocks that hit the CEE region.3 The model-based projections fairly accurately predict the increase in NPL ratios across subregions in the CEE region during 2009, with the largest increase predicted in the Baltic countries and the smallest in the CE-3 countries (second figure).4 However, the model simulations envisage sharp currency depreciations in response to the large negative GDP shocks that have hit most countries in the CEE region. This explains why the model overpredicts the increase in NPL ratios, especially in the Baltic countries, as CEE exchange rates have successfully been stabilized on the back of international policy coordination and financial backstops.5

UC1NF4

Simulated Average Nonperforming Loan Ratios

(In percent)

Source: IMF staff estimates.Note: CE-3 = Czech Republic, Hungary, and Poland; CIS = Russia and Ukraine; SEE = Bulgaria, Croatia, and Romania.

Simulations suggest that NPL ratios will peak during 2010 in most CEE countries under the WEO baseline scenario for GDP growth.

The simulations indicate that most of the increase in NPL ratios occurred during 2009, but suggest that bank asset quality will improve only gradually in 2011 for most countries, even if GDP growth recovers during 2010 as projected in the World Economic Outlook (WEO). In the Commonwealth of Independent States (CIS), the simulations suggest a decline in the NPL ratio by the end of 2010 on the back of a more vigorous projected economic recovery. However, loans that have been restructured may turn up in the official NPL statistics with a delay, when interest rates are normalized and rolling over of NPLs becomes more costly in terms of interest revenue forgone, which could mean that reported asset quality in the CIS may also continue to deteriorate in 2010.

In a weaker growth scenario, NPL ratios would continue to increase substantially in 2010.

In an adverse scenario where GDP is 4 percentage points lower than the WEO baseline in 2010 and 2 percentage points lower in 2011, the simulations indicate that NPL ratios would increase by around one-third during 2010 in all subregions except the CIS, and would remain elevated in 2011.

Note: This box was prepared by Kristian Hartelius.1 The approach taken is to estimate coefficients for the relationship between GDP growth, exchange rate movements, and the ratio of NPLs to total loans for economies outside the CEE region, and then project NPL ratios for the CEE region based on those coefficients. The approach has the advantage of overcoming data limitations in NPL time series for the CEE region, which are often too short to capture full credit cycles. The approach cannot be expected to deliver very precise country-level forecasts, but can serve as a useful complement to country-specific, bottom-up stress tests.2 The economies included in the estimation sample are Argentina, Chile, Colombia, the Dominican Republic, Indonesia, Malaysia, Mexico, Peru, the Philippines, South Africa, Taiwan Province of China, Thailand, Turkey, Uruguay, and Venezuela.3 Although foreign bank ownership and foreign currency lending reached extreme levels in the CEE region in the runup to the current crisis, they were also important elements in many emerging market crises in the past two decades, which enables the model to explain the European data relatively well.4 The group labeled Baltics comprises Estonia, Latvia, and Lithuania. The group labeled CE-3 comprises the Czech Republic, Hungary, and Poland. The group labeled SEE comprises Bulgaria, Croatia, and Romania, and the group labeled CIS comprises Russia and Ukraine. There is considerable variation in NPL ratios within these groupings, as detailed in Table 24 of the Statistical Appendix.5 As noted in Annex 1.6, the model predictions fit the Baltic data better, when controlling for actual exchange rate developments.

Few banks can expect retained earnings alone to lift them to the new capital standards …

Some banks are confident that they will be able to raise prices to maintain their recent high returns on equity, but history suggests they may struggle to do so. To assess this, U.S. bank lending rates were regressed on a number of macroeconomic and structural variables.22 The results suggest that the wide margins and pricing power banks have enjoyed in recent quarters is likely to dissipate as the yield curve flattens (Figure 1.15).

Figure 1.15.
Figure 1.15.

Banks’ Pricing Power—Actual and Forecast

(In percent)

Sources: Federal Reserve; Federal Deposit Insurance Corporation; and IMF staff estimates.

For the few banks that have significant capital markets operations, investment banking revenues are unlikely to provide the bonanza they did in 2009, as interest rates and exceptional liquidity conditions normalize and competition returns. Some corporate issuance in 2009 was precautionary to take advantage of low historical rates, and is unlikely to be repeated. The decline is unlikely to be fully offset by a rise in mergers and acquisition activity. At the same time, the move to central counterparty clearing of many contracts that were previously traded over the counter (at relatively wide spreads) could put downward pressure on one important revenue stream for the larger banks.

…and funding pressures are set to mount, pushing up costs.

The April 2009 GFSR cautioned that large banks generally needed to extend the maturity of their debt. However, they have seemingly been deterred by the historically high spreads at which they would issue, and the availability of ample, cheap central bank funding. The wall of refunding needs is now bearing down on banks even more than before, with nearly $5 trillion in bank debt due to mature in the coming 36 months (Figure 1.16). This will coincide with heavy government issuance and follow the removal of central bank emergency measures. In addition, banks will have to refinance securities they structured and pledged as collateral at various central bank liquidity facilities that are ending.

Figure 1.16.
Figure 1.16.

Bank Debt Rollover by Maturity Date

(In billions of U.S. dollars)

Source: Moody’s.

Banks must move further to reduce their reliance on wholesale markets, particularly short-term funding, as part of the deleveraging process. The investor base for bank funding instruments has been permanently impaired as structured investment vehicles (SIVs) and conduits have collapsed, and banks are significantly less willing to fund one another unsecured. Central banks have provided a substitute with their liquidity facilities, but extraordinary support is set to be scaled back over time. This could put pressure on spreads, and particularly in those markets where the large retained securities portion of bank assets highlights the continuing disruption of mortgage securitization markets (Figure 1.17). However, a significant portion of these securities are being funded through the Bank of England and European Central Bank facilities. In contrast, the U.S. Federal Reserve has purchased securities outright—largely through the quantitative-easing program—and has thus assisted banks through a more durable asset transfer process (see Annex 1.8 on the IMF’s GFSR website).

Figure 1.17.
Figure 1.17.

Government-Guaranteed Bank Debt and Retained Securitization

(As percent of national banking system deposits)

Sources: Autonomous Research; European Central Bank; and IMF staff estimates.

If banks fail to shrink their assets to reduce their need for funding or do not issue sufficient longer-term wholesale funding, they will inevitably be competing for the limited supply of deposit funding (Autonomous Research, 2009).

Indeed, there are already signs that deposit funding is becoming more expensive. The funding spread—the difference between the LIBOR market and what banks pay for deposits—is already heavily negative in the United States and United Kingdom. Even in the euro area, where the funding spread has typically been a positive 175 basis points in normal times, it has now turned negative (Figure 1.18). As a result, even though spreads on assets have widened further in recent months, bank top-line profitability is under pressure in all these regions.23

Figure 1.18.
Figure 1.18.

Euro Area Banking Profitability

(In basis points, on volume-weighted new business, excluding overdrafts)

Sources: Autonomous Research; and IMF staff estimates.Notes: Funding spread = three-month Euribor less volume-weighted average of rates paid on new deposits to households and corporates. Asset spread = interest income on volume-weighted average of rates paid on new lending to households and corporates, less three-month Euribor.

Slow progress on stabilizing funding and addressing weak banks could complicate policy exits from extraordinary support measures.

The planned exit from extraordinary liquidity measures may be complicated by the need for banks generally to extend the maturity of their liabilities and by the presence of a tail of weak banks in the system. Although LIBOR-overnight index swap (OIS) spreads have narrowed, there are ample other signs that money markets have yet to return to normal functioning. The contributions of LIBOR and EURIBOR panel banks to their respective benchmarks remain more dispersed than before the crisis; credit lines for medium-sized banks, and banks that required substantial public support, have generally not yet been reinstated; and turnover in the repo market for any collateral other than higher-rated sovereign paper remains low.

Although substantially improved, there are lingering signs that some institutions remain dependent on central bank liquidity facilities. National central bank data (Figure 1.19) indicate that a number of euro area banks have increased their reliance on European Central Bank (ECB) funding over recent quarters, suggesting their demand is to meet genuine funding needs rather than simply to finance attractive carry trades. Some widening of both financial and sovereign CDS spreads is likely as the withdrawal of extraordinary ECB measures draws nearer. In the United States, borrowing at the Federal Reserve’s discount window has fallen steadily but remains well above pre-crisis levels.24

Figure 1.19.
Figure 1.19.

Net European Central Bank (ECB) Liquidity Provision and Credit Default Swap (CDS) Spreads

(Changes December 31, 2006–October 31, 2009)

Sources: Bloomberg L.P.; and euro area national central banks.Note: Changes in net liquidity provisions are expressed as a percent of bank total assets, while the squares reflect the change in sovereign credit default swap (CDS) spreads between December 1, 2006, and October 31, 2009.

What does this mean for financial policies?

The consequence of these deleveraging forces will be to highlight the extent of overcapacity in the financial system as costs rise, push up competition for stable funding sources, and intensify pressure on weak business models (Figure 1.20). Thus, policy will need to ensure that this next stage of the deleveraging process unfolds smoothly and ends in a safe, vital, and more competitive financial system. This will include addressing too-important-to-fail institutions in order to ensure fair pricing power throughout the financial system and to guard against rising concentration as the size of financial systems shrinks (see Annex 1.5).

Figure 1.20.
Figure 1.20.

Bank Credit to the Private Sector

(In percent of nominal GDP)

Sources: Haver Analytics; and IMF staff estimates.Note: Dotted lines are estimates. Year of credit peak in parentheses.

The viability of weaker segments of banking systems is likely to come into question given new regulations, deleveraging forces, and the withdrawal of extraordinary central bank support facilities. In a number of countries, a significant part of the banking system lacks a viable business model, or suffers from chronic unprofitability. In the case of the European Union, the need for rationalization of the sector can be seen in the striking variability of banking returns (Figure 1.21). The German system, for example, suffers from weak overall profitability, and a large tail of unprofitable banks—primarily the nation’s Landesbanken. Moreover, care will be needed to ensure that too-important-to-fail institutions in all jurisdictions do not use the funding advantages their systemic importance gives them to consolidate their positions even further.

Figure 1.21.
Figure 1.21.

Bank Return on Equity and Percentage of Unprofitable Banks, 2008

(In percent)

Sources: Bankscope; EU Banking Supervision; Federal Deposit Insurance Corporation; and IMF staff estimates.Note: Size of circle corresponds to relative size of bank loan stock at end-2008. Return on equity is as defined by the Banking Supervision Committee (BSC) of the European System of Central Banks in each of its reports. Some countries were reporting under national accounting standards in the earlier BSC reports. For the United States and Japan, return on equity is net income divided by total equity according to Federal Deposit Insurance Corporation and Bankscope data, respectively.

If excess banking capacity is maintained, the costs are felt across the whole economy and are not just limited to support costs faced by taxpayers. Weak banks normally compete aggressively for deposits (on the back of risk-insensitive and underpriced deposit insurance), wholesale funding, and scarce lending opportunities, so squeezing margins for the whole system. Unless tightly constrained, institutions that are either government-owned, or have explicit or implicit government backing, have also demonstrated in many cases a tendency to invest in risky assets of which they have little experience—some of the German Landesbanken being only the latest examples—so adding to systemic risks and the likelihood of future bailouts.

Japan presents a telling example of the challenges banks face in a crowded sector amid low growth and muted or negative inflation. The exceedingly low nominal rates leave banks increasingly pressed to maintain profitability. Over the past 20 years, the average return on bank assets has been negative, partly owing to the disposal of nonperforming loans after the bubble burst. Low returns on assets make it hard for banks to rely on loan revenues to absorb credit losses, and volatility in the values of equity holdings leads to large fluctuations in bank profits (Figure 1.22). Tangible equity at the largest banks is low, and is likely to be put under further pressure by the latest Basel proposals. Options for improving profitability—taking greater market risks, offshore expansion, higher lending margins, or balance sheet shrinkage—all have their difficulties, both economically and politically. Thus, improving profitability is a critical challenge for Japanese banks.

Figure 1.22.
Figure 1.22.

Banking System Profitability Indicators

(In percent, average over 2001–08)

Sources: Bankscope; and IMF staff estimates.Note: Different industry structures and accounting conventions make comparison across countries/regions difficult.

D. Risks to the Recovery in Credit

The credit recovery will be slow, shallow, and uneven. Credit supply remains constrained as banks continue to repair balance sheets. Notwithstanding the weak recovery in private credit demand, ballooning sovereign needs may bump up against supply. Policy measures to address capacity constraints, along with the management of fiscal risks, should help to relieve pressures on the supply and demand for credit.

Credit availability is likely to remain limited …

Two years ago, the GFSR described the possibility that credit growth might drop to near zero in the major economic areas affected by the crisis, as has now happened. For example, in the United States, real credit growth has fallen sharply when compared with past recessions (Figure 1.23).25

Figure 1.23.
Figure 1.23.

Real Nonfinancial Private Sector Credit Growth in the United States

(In percent, year-on-year)

Sources: Haver Analytics; National Bureau of Economic Research; and IMF staff estimates.Note: This figure compares recent real nonfinancial private sector credit growth to that in past recessions, from 1970 to 2001. Past recession dates are from the National Bureau of Economic Research. For this figure, the end of the recent recession is assumed to be 2009:Q3, the first quarter of positive growth.

The last few rounds of bank lending surveys, however, have indicated that lending conditions are tightening at a slower pace, and in some sectors have already begun to register an outright easing. Figure 1.24 indicates that credit growth has lagged lending conditions by around four quarters, suggesting that the worst of the credit contraction may be over. Nevertheless, as discussed in Section C, it is likely that bank credit will continue to be weak as balance sheets remain under strain and funding pressures increase. Banks’ reluctance to lend is evident in still-elevated borrowing costs and strict lending terms (for example, stringent covenants and short maturities) in some sectors.

Figure 1.24.
Figure 1.24.

Average Lending Conditions and Growth in the Euro Area, United Kingdom, and United States

Sources: Haver Analytics; central bank lending surveys; and IMF staff estimates.

Companies have increasingly drawn on nonbank sources of credit in recent quarters as banks have tightened credit supply (Figure 1.25).26 However, nonbank credit has only provided a partial substitute for bank lending and total credit growth has fallen. In general, in addition to households, small and mediumsized enterprises (SMEs) tend to be largely reliant on bank lending and so still face credit constraints. Furthermore, the supply of credit that has been available from central banks during the crisis is set to wane this year.27 Central bank commitments imply under $400 billion of securities purchases in the euro area, United Kingdom, and United States, in total, compared with around $1.9 trillion in 2009. So even though we expect nonbank capacity to increase over the next two years, as economies start to recover, total credit supply, including bank lending, is set to recover slowly (Figure 1.26).

Figure 1.25.
Figure 1.25.

Contributions to Growth in Credit to the Nonfinancial Private Sector

(In percent, year-on-year)

Sources: Haver Analytics; and IMF staff estimates.
Figure 1.26.
Figure 1.26.

Nonfinancial Private Sector Credit Growth

(In percent, year-on-year)

Sources: Haver Analytics; and IMF staff estimates.Note: The dotted lines show projected credit growth. If credit demand is estimated to exceed capacity, after meeting sovereign borrowing needs, then credit is assumed to be constrained by available capacity, including the impact of government and central bank policies.

… and sovereign needs are set to dominate credit demand …

Sovereign issuance surged in 2009 to record levels in all three regions as crisis-related interventions and fiscal stimulus packages led to an unprecedented increase in government borrowing requirements (Figure 1.27). Government borrowing will remain elevated over the next two years, with projected financing needs for both the euro area and the United Kingdom well above previous expectations in the October 2009 GFSR. Burgeoning public sector demand risks crowding out private sector credit if funds are diverted to public sector securities. In addition, as discussed in Section B, a rise in sovereign risk premia could raise private sector borrowing costs.

Figure 1.27.
Figure 1.27.

Total Net Borrowing Needs of the Sovereign Sector

(In percent of GDP)

Sources: National authorities; and IMF staff estimates.

Notwithstanding these risks, private sector demand growth is likely to remain subdued as households and corporates restore balance sheets. The need for private sector deleveraging varies across region and sector (Figure 1.28). For instance, in the United States, households are at the beginning of the deleveraging process, while nonfinancial companies have less of a need to reduce leverage. By contrast, in the euro area and the United Kingdom, nonfinancial corporate debt as a share of GDP is much higher, having experienced a rapid run-up during the pre-crisis period. This, together with the increase in household leverage, means that the United Kingdom’s nonfinancial private sector debt, at over 200 percent of GDP, is one of the highest among mature economies.28

Figure 1.28.
Figure 1.28.

Credit to GDP

(In percent)

Source: IMF staff estimates.Note: Dashed lines represent forecasts.

… which is likely to result in financing gaps.

Updating the analysis of credit demand and capacity in the October 2009 GFSR suggests that ex ante financing gaps will remain in place for all three regions in 2010 (Table 1.7).29 There is some uncertainty around our estimates for both credit demand and capacity, so the size of the financing gap, which is the difference between these two estimates, is approximate. Nevertheless, the work is useful in highlighting the relative size of the ex ante financing gaps. As in the October 2009 GFSR, the analysis suggests that the United Kingdom could have the largest gap (around 9 percent of GDP over 2010–11) as weak bank capacity struggles to keep up with surging sovereign issuance. We expect smaller financing gaps in the euro area in 2010 (around 2 percent of GDP), and a similar gap in the United States in 2010, which is closed by remaining central bank commitments to purchase securities.30

Table 1.7.

Projections of Credit Capacity for and Demand from the Nonfinancial Sector

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Source: IMF staff estimates.Note: Amount is in billions of local currency units rounded to the nearest ten. Growth is in percent.

This includes committed purchases of debt issued by both public and private sectors, which is considered to be extra credit capacity provided by central banks and governments for the whole nonfinancial sector.

At face value, ex ante financing gaps imply that ex post either borrowing needs to be scaled back to equalize the lower supply, or that market interest rates will need to rise. Any increases in interest rates, however, are unlikely to be uniform, and certain sectors, such as SMEs and less creditworthy borrowers, may face higher borrowing costs. In particular, given the surge in public sector borrowing and expected deleveraging by the banking sector, upward pressure on interest rates is likely to result.

Policy action could help to relieve these pressures. For example, the authorities should carefully assess the implications of their policy actions and exit strategies, as well as their timing, on the quantity of credit available to support the economic recovery. The implementation of measures to manage fiscal risks and limit rises in public sector credit demand, along with policies to address weaknesses in the banking system—such as strengthening securitization markets, as discussed in the October 2009 GFSR—should also be considered. There is the possibility that central bank support measures, including purchases of securities, may still be needed in some cases to offset the retrenchment in credit capacity.

E. Assessing Capital Flows and Bubble Risks in the Post-Crisis Environment31

Prospects for strong growth, appreciating currencies, and rising asset prices are pulling capital flows into Asia-Pacific (excluding Japan) and Latin American countries, while push factors—particularly low interest rates in major advanced economies—are also key. Against this backdrop, this section assesses the drivers of recent portfolio capital flows, and both the near- and medium-term prospects of systemic asset price bubbles forming. It finds no evidence of systematic bubbles in advanced and emerging market economies and across asset classes in the near term. However, if the current environment of low interest rates, abundant liquidity, and capital flows persists, history suggests that bubbles could form in the medium term. Moreover, vigilance is warranted given that it is notoriously difficult to identify such financial imbalances ex ante.32

Last year saw a welcome recovery in portfolio capital flows toward emerging markets and other advanced economies. “Pull factors” such as relative growth differentials, appreciating currencies, and rising asset prices are driving the resurgence. The flows have been targeted to countries perceived by investors to have better cyclical and structural growth prospects, like Brazil, China, India, and Indonesia, as well as their trading and financial partners, including commodity exporters.

However, “push factors,” such as low interest rates in major advanced economies and much-improved funding market conditions, are also key drivers of capital flows.33 Low policy rates have encouraged investors to shift their precautionary cash holdings into riskier assets. For example, U.S. money market mutual fund assets have fallen by over half a trillion dollars since March 2009, as central bank policy and operations helped to put downward pressure on broader money market interest rates and risk premiums (Figure 1.29).

Figure 1.29.
Figure 1.29.

Low Short-Term Interest Rates Are Driving Investors Out of Cash

Sources: Bloomberg L.P.; and Investment Company Institute. Note: OIS = overnight indexed swap.

When taken together, these push and pull factors may create a conducive environment for future asset price appreciation, and this, in turn, has heightened concerns about asset price bubbles forming. The surge in portfolio inflows also raises concerns about vulnerabilities to sudden stops, once global monetary and liquidity conditions are tightened or if risk appetite were to diminish.

Although portfolio flows were strong in 2009, other capital flows, which include cross-border bank lending, and direct investments have not recovered to the same extent. This reflects the persistent deleveraging by mature market banks and the still-added tepid desire by firms for cross-border mergers and acquisitions and green field development. For example, the nonportfolio, non-FDI (foreign direct investment) category of the capital accounts of Brazil, Korea, and Russia remained negative in the data available for 2009, and FDI remains subdued in Korea and Russia.34

Further flows could emerge as the crisis has led investors to reconsider the balance of risk and return in emerging and other advanced economies.

The crisis has altered perceptions about risk and return in mature relative to emerging markets. Perceptions of sovereign credit risks have moved in favor of emerging markets and some other advanced economies, primarily due to unfavorable debt dynamics in the major advanced economies and southern Europe (see Section B). In contrast, the average credit rating of issuers in JPMorgan’s Emerging Market Bond Index improved to the lowest investment grade rating during the crisis, reflecting upgrades to some emerging market sovereigns, notably Brazil. Additionally, emerging market equities continued to register higher volatility-adjusted returns than developed markets during and after the fall of 2008 (Figure 1.30).

Figure 1.30.
Figure 1.30.

Emerging Market Returns Better on a Volatility-Adjusted Basis

(In percent)

Sources: Bloomberg L.P.; MSCI Barra; and IMF staff estimates.Note: Volatility-adjusted returns = three-year rolling log returns/three-year historical standard deviation of returns.

The favorable performance of emerging market assets relative to mature market assets has prompted growing interest by global investors in raising their asset allocations to emerging markets and other advanced economies. For example, retail investors and hedge funds are adding to their emerging market portfolios in the near term, facilitated by the increasing development of exchange-traded funds (ETFs) targeting emerging markets broadly and countries like Brazil and China.35 In debt markets, the outstanding stock of emerging market debt has grown to over $7 trillion, compared to under $2 trillion in the mid- to late 1990s, and benchmark bond indices are garnering greater acceptance by institutional investors.36

However, recent surveys indicate that institutional investors’ home bias has only changed in a gradual fashion over the years.37 Some estimate that emerging market equities account for just 5 to 9 percent of global equity exposures, far lower than their share of global market capitalization of 12 percent, and the 27 percent share implied by a GDP-weighted global equity index.38 Nevertheless, even small shifts in portfolio allocations could translate into significant capital inflows to emerging markets and other advanced economies. They also could add to market volatility and test an individual market’s capacity to absorb inflows, especially if flows are concentrated in particular asset classes or in a short period of time.

Portfolio flows have rebounded strongly …

Strong portfolio equity flows into emerging markets and other advanced economies in 2009 primarily reflect a recovery trade from the deep retrenchment in 2008 as shown by the green bars in Figure 1.31. However, Latin America was the only region where 2009 inflows exceeded 2008 outflows by a wide margin as shown by the higher ratio of net flows. In general, regions viewed as having lower growth prospects and structural challenges are receiving smaller inflows. For example, equity funds with exposure to Europe, the Middle East, and Africa recovered less than one-half of the outflows in 2008, and funds continued to flow out of major advanced economy equity funds. Within these broad regions, however, some countries have experienced a rapid surge in portfolio inflows; for example, Brazil was responsible for a large portion of flows to Latin America.

Figure 1.31.