For the first time since the October 2008 Global Financial Stability Report, risks to global financial stability have increased (Figures 1.2 and 1.3), signaling a partial reversal in progress made over the past three years. The pace of the economic recovery has slowed, stalling progress in balance sheet repair in many advanced economies. Sovereign stress in the euro area has spilled over to banking systems, pushing up credit and market risks. Low interest rates could lead to excesses as the “search for yield” exacerbates the turn in the credit cycle, especially in emerging markets. Recent market turmoil suggests that investors are losing patience with the lack of momentum on financial repair and reform (Box 1.1). Policymakers need to accelerate actions to address longstanding financial weaknesses to ensure stability.

Global Stability Assessment

For the first time since the October 2008 Global Financial Stability Report, risks to global financial stability have increased (Figures 1.2 and 1.3), signaling a partial reversal in progress made over the past three years. The pace of the economic recovery has slowed, stalling progress in balance sheet repair in many advanced economies. Sovereign stress in the euro area has spilled over to banking systems, pushing up credit and market risks. Low interest rates could lead to excesses as the “search for yield” exacerbates the turn in the credit cycle, especially in emerging markets. Recent market turmoil suggests that investors are losing patience with the lack of momentum on financial repair and reform (Box 1.1). Policymakers need to accelerate actions to address longstanding financial weaknesses to ensure stability.

Figure 1.2.
Figure 1.2.

Global Financial Stabillity Map

Source: IMF staff estimates.Note: Away from center signifies higher risks, easier monetary and financial conditions, or higher risk appetite.
Figure 1.3.
Figure 1.3.

Global Financial Stability Map: Assessment of Risks and Conditions

(In notch changes since the April 2011 GFSR)

Source: IMF staff estimates.Note: Changes in risks and conditions are based on a range of indicators, complemented with IMF staff judgment (see the April 2010 GFSR, especially Annex 1.1, and Dattels and others, 2010, for a description of the methodology underlying the Global Financial Stability Map). Overall notch changes are the simple average of notch changes in individual indicators. The number next to each legend indicates the number of individual indicators within each subcategory of risks and conditions. For lending standards, positive values represent slower pace of tightening or faster easing.

Overall macroeconomic risks have increased, reflecting a significant rise in sovereign vulnerabilities in advanced economies. The World Economic Outlook (WEO) baseline has shifted downward since April 2011, as the recovery appears more fragile. Weaker growth prospects and higher downside risks have contributed to concerns about debt sustainability, especially in the euro area periphery. Downgrades in sovereign ratings have spread beyond Greece, Ireland, and Portugal into the larger countries of the European periphery. Elsewhere, political risks to achieving medium-term fiscal adjustment have risen in a few advanced economies, notably the United States and Japan. Many sovereigns are vulnerable across multiple dimensions, raising market concerns about debt sustainability.

Market and liquidity risks have risen, partly as a result of increased macroeconomic and sovereign risks. Higher volatility and rising yields on government bonds issued by countries on the periphery of the euro area are threatening a loss of investor confidence, weakening the investor base, and further driving up funding costs. As a result, public debt has become more difficult to finance, while higher sovereign risk premiums are disrupting bank funding markets. These concerns are eroding confidence in broader markets (Figure 1.4), reflected in a two-notch contraction in risk appetite since the April 2011 Global Financial Stability Report (GFSR).

Figure 1.4.
Figure 1.4.

Asset Price Performance since the April 2011 GFSR

(In percent; VIX in percentage points; VIX and sovereign CDS are inverted)

Sources: Bloomberg L.P.; and IMF staff estimates.Note: CDS = credit default swap; VIX = implied volatility index on S&P 500 index options; and EM = emerging market.

Credit risks have risen as sovereign strains have spilled over to the banking system in the euro area. This GFSR assesses the impact of the rise in sovereign credit risk on the financial system and its negative implications for funding markets and for the flow of credit to the real economy.

Monetary and financial conditions remain unchanged from the April 2011 GFSR. This GFSR cautions that low interest rates, although necessary under current conditions, can carry longer-term financial stability risks. With balance sheet repair still incomplete in many advanced economies, and notwithstanding the overall pullback in risk appetite, the search for yield is pushing some market segments to become vulnerable and overleveraged, contributing to future risks.

Emerging markets risks have increased. Rapid domestic credit growth, balance sheet releveraging, and rising asset prices may ultimately lead to deteriorating bank asset quality in emerging markets as the credit cycle matures. At the same time, emerging markets remain vulnerable to external shocks. The analysis in this report reveals that a sudden stop of capital flows coupled with a rise in funding costs and a fall in global growth could strain capitalization in emerging market banks.

Deep-seated challenges remain, and rapid progress is needed to increase financial system robustness. The economic and financial context for fiscal adjustment and reducing bank risks is daunting. First, most advanced economies are facing a combination of relatively low inflation and subdued real growth. This limits the scope for growing the denominator of the debt-to-GDP ratio and highlights the importance of structural measures to raise potential growth rates. Second, in many countries, the peak in sovereign debt burdens coincides with that of private debt burdens (Table 1.1). The consequence is likely to be a prolonged period of economy-wide deleveraging. Third, bank balance sheets are more extended, and though some repair has occurred, they remain highly leveraged and vulnerable to both economic and funding shocks. Fourth, cross-border dimensions increase the vulnerability of global financial stability to shocks, making the system more fragile and subject to contagion risks. Fifth, and perhaps most crucially, the policy tools available in most advanced economies are geared to combating temporary liquidity shocks rather than tackling concerns about solvency. The result is that balance sheets have not been “cured,” and the financial system remains highly vulnerable to sovereign risks. As discussed in the final section of this chapter, financial stability requires addressing these underlying vulnerabilities, mitigating the risks of contagion and spillovers, raising the capital buffers in banks, and completing the financial reform agenda.

Table 1.1.

Indebtedness and Leverage in Selected Advanced Economies1

(Percent of 2011 GDP except as noted)

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Sources: Bank for International Settlements (BIS); Bloomberg, L.P.; EU Consolidated Banking Data; U.S. Federal Deposit Insurance Corporation; IMF, International Financial Statistics, Monetary and Financial Statistics, and World Economic Outlook databases; BIS-IMF-OECD-World Bank Joint External Debt Hub (JEDH); and IMF staff estimates.

Cells shaded in red indicate a value in the top 25 percent of a pooled sample of all countries shown in the table from 1990 through 2009 (or longest sample available). Green shading indicates values in the bottom 50 percent, and yellow in the 50th to 75th percentile. The sample for bank leverage data starts in 2008 only.

World Economic Outlook projections for 2011

Net general government debt is calculated as gross debt minus financial assets corresponding to debt instruments.

Most recent data divided by annual GDP (projected for 2011). Nonfinancial corporates’ gross debt includes intercompany loans and trade credit, and these can differ significantly across countries

Household net debt is calculated using financial assets and liabilities from a country’s flow of funds data.

Leverage is defined as the ratio of tangible assets to tangible common equity for domestic banks.

Calculated from assets and liabilities reported in a country’s international investment position.

Most recent data for externally held general government debt (from JEDH) divided by 2011 GDP from WEO. Note that debt data from the JEDH are not comparable to WEO debt data when they are at market value.

Sovereign Vulnerabilities and Contagion Risks

Sovereign balance sheets remain fragile in a number of advanced economies despite steps toward fiscal consolidation. The lack of sufficient political support for medium-term fiscal adjustment and growth-enhancing reforms worsens funding pressures for sovereigns amidst a softer growth outlook. These pressures increase the risk that the debt dynamics of vulnerable sovereigns will slide into a spiral of deterioration in the absence of a coherent policy framework and adequate backstops to prevent the spread of contagion.

The spillover of sovereign risks to the banking sector has put funding strains on many banks operating in the euro area and depressed their market capitalization. Analysis quantifies the substantial impact that the spillovers from highspread euro area sovereigns have had on the European banking systems and that help explain current levels of market stress.1These effects are amplified through the network of highly interconnected and leveraged financial institutions. The impact of these spillovers has been greatest on the most exposed banks in high-spread euro area countries. The disruption to funding markets could spread further, which would increase deleveraging pressures on banks and reduce credit growth in the most affected economies, reigniting a negative feedback loop with the real economy.

Credible efforts are required to strengthen the resilience of the financial system. Appropriate fiscal action, combined with bank balance sheet repair and adequate levels of capital, can help break the link between sovereign risk and banks. Weak banks need to be restructured and where necessary resolved. If private capital is not available and national public balance sheets have no spare capacity, EU-wide public backstops for banks should be used.

The crisis legacy has left public balance sheets vulnerable.

After four years of financial crisis, public balance sheets have been saddled with onerous debt burdens and sharply higher funding needs (Table 1.2). Lower tax revenue, weaker growth prospects, and large-scale support for ailing financial institutions have driven public finances into precarious territory. In many cases, these challenges have been added to a legacy of fiscal irresponsibility, as some governments lived beyond their means during more benign times. Policymakers in many advanced economies have begun to address these challenges by tightening the fiscal stance and laying out multiyear plans for deficit reduction. Indeed, as described in the IMF’s September 2011 Fiscal Monitor, progress has been substantial in a few cases, notably in parts of the European Union.

Table 1.2.

Sovereign Debt: Market and Vulnerability Indicators

(Percent of 2011 projected GDP except as noted)

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Sources: Bank for International Settlements (BIS); Bloomberg, L.P.; IMF: International Financial Statistics database, Monetary and Financial Statistics database, World Economic Outlook database (WEO); BIS-IMF-OECD-World Bank Joint External Debt Hub (JEDH); and IMF staff estimates. Note that debt data from the JEDH are not comparable to WEO when they are at market value.Based on projections for 2011 from the September 2011 World Economic Outlook (WEO). Please see the WEO for a summary of the policy assumptions. Debt data from the JEDH are not comparable to WEO debt data when they are at market value.

As a percent of GDP projected for 2011.

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

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.

Primary balance is general government primary net lending/borrowing balance. Data for Korea are for central government.

As a proportion of WEO projected GDP for the year. Note that for Greece these numbers have been calculated assuming a successful debt exchange operation with 90 percent participation.

Most recent data for externally held general government debt from the JEDH divided by projected 2011 GDP. Depending on the country, the JEDH reports debt at market or nominal values. New Zealand data are from Reserve Bank of New Zealand.

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 second quarter of 2011 or latest available.

BIS reporting banks’ international claims on the public sector on an immediate borrower basis as of December 2010, as a percentage of projected 2011 GDP.

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’ ratings.

Despite progress toward fiscal consolidation, policymakers and political leaders have not yet commanded broad political support for medium-term fiscal adjustment and growth-enhancing reforms. Some countries, notably Japan and the United States, need to formulate and implement credible medium-term plans to address looming fiscal challenges. At the same time, a more fragile growth outlook and deteriorating market sentiment over recent months have increased market pressures on sovereigns to adjust further, just to achieve their original targets.2

Markets have reacted to increased risks to policy implementation and a weaker growth outlook with higher sovereign risk premiums and successive rating downgrades or negative outlooks. Some sovereigns find themselves with challenges across multiple dimensions, with weak balance sheets increasing funding pressures (Figure 1.5). These sovereigns are especially prone to periodic bouts of financial market volatility, as changing fundamentals or political developments can dramatically shift the investor base and their perceptions about debt sustainability.

Figure 1.5.
Figure 1.5.

Sovereign Vulnerabilities and Market Pressures

Sources: Bank for International Settlements (BIS); IMF: International Financial Statistics database, World Economic Outlook database; BIS-IMF-OECD-World Bank Joint External Debt Hub; and IMF staff estimates.Note: See Table 1.2 for a description of the variables. Average maturity and 10-year yield on government debt are from Bloomberg (7/25/2011). Nominal GDP growth is for 2011 based on WEO projections. Foreign ownership refers to the sovereign bond holders.

The recent political brinksmanship over raising the U.S. debt ceiling created significant market volatility.

The U.S. federal debt ceiling has been in place for several decades, but its nominal nature has failed to provide any control over rising debt-to-GDP ratios driven by separate budgetary processes. Moreover, the unpredictable political process that accompanies increases in the debt ceiling erodes confidence in policymaking and triggers spurts of market volatility (Figure 1.6).3 During the latest episode, rates on near-term Treasury bills and other money market instruments spiked; repo transaction volumes fell as corporations, money funds, and others shifted holdings into cash; the Treasury bond curve steepened sharply; sovereign credit default swap (CDS) spreads inverted as one-year rates reached record highs; and a flight to quality drove flows into alternative assets like gold, the Swiss franc, and foreign AAA-rated sovereign debt. (Box 1.2 discusses market indicators for assessing U.S. sovereign risk.)

Figure 1.6.
Figure 1.6.

Historical Volatility in One-Month Treasury Bills during Debt Ceiling Negotiations

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.Note: Vertical lines mark dates of changes in debt ceiling.

Market Confidence Deteriorates amid Policy Uncertainty

Recent market developments illustrate how political uncertainty and the perception of a weak policy response to stress can rapidly erode market confidence.

The failure to stem contagion risks and credibly address sovereign and banking system strains—assessed in detail in this GFSR—has led to a wide-scale pullback in risk assets, stoked fears of recession, and sent investors rushing into safe havens (first figure). Market volatility increased markedly beginning in mid-July. The main triggers appear to have been

  • the protracted impasse over the debt ceiling in the United States;

  • S&P’s subsequent downgrade of the U.S. sovereign credit rating;

  • rising concerns about potential downgrades of European sovereigns still rated AAA; and

  • renewed economic growth concerns.

Although the euro area summit of July 21 was an important step toward enhancing the crisis management framework, markets worried about the length of the political process required to implement the summit’s decisions and whether the adopted solutions would be sufficient. The latest bout of market volatility has reminded some investors of the collapse in asset prices following the September 2008 Lehman Brothers bankruptcy. Although the current reaction has not been as severe or as widespread as it was after that event, risk perceptions are greater for European banks and sovereigns (second figure). There is a risk of a further deterioration if appropriate policies are not implemented.

As discussed in the main text, contagion has spread deeper into the euro area, highlighting the speed with which failure to address legacy problems and structural weaknesses can propel financial markets into a downward spiral. Spreads on CDS (and, to a lesser extent, on underlying debt) widened on high-spread sovereigns as well as on AAA-rated euro area credits. Sovereign strains spilled into those parts of the euro area banking system perceived to be heavily exposed to the euro area periphery, or to have a greater reliance on dollar or short-term funding, or to have an insufficient capital base. These strains have raised concern in some cases over bank capital cushions and increased bank funding costs. The sharp declines in bank equity prices prompted U.S. money funds to further reduce lending to European banks, leading to higher dollar funding costs for these banks and a widening of the dollar-euro basis spread. Euro area interbank financing conditions deteriorated amid rising counterparty concerns, pushing the Euribor-OIS spread to its widest level since April 2009 (third figure).


Recent Market Turbulence

Sources: Bloomberg L.P.; and IMF staff estimates.Note: Asset-weighted average of individual bank credit default swaps.Vertical lines:A = EU summit.B = S&P downgrade of U.S. government debt.C = ECB resumes purchases of government debt.

Increased and spreading volatility—exacerbated by tightening credit lines, increased margin requirements, and shallow summer liquidity conditions—led to a broader pullback in global risk assets (such as corporate and emerging market credit) and greater demand for traditional safe-haven assets (including gold, U.S. Treasuries, Japanese yen, Swiss francs, and Singapore dollars). The fall in risk appetite, along with weaker growth prospects, drove U.S. real rates into negative territory and led to a sell-off in growth-sensitive equities and commodities.1 Asset prices of U.S. banks were especially hard hit, as investors perceived some banks as having insufficient capital and funding bases, given their large portfolios of legacy mortgages and the weak economic outlook.

As market stress intensified, the European Central Bank (ECB) responded by extending purchases under its Securities Market Programme to the government bonds of Italy and Spain and increasing its term liquidity provision. The Federal Reserve conditionally pledged to keep interest rates low and signaled a readiness to employ a range of tools; Swiss and Japanese authorities resumed intervention in the foreign exchange market; regulators instituted short-selling bans on selected European equities; and the Federal Reserve and major central banks announced coordinated dollar auctions. For now, these actions have helped to slow the downward spiral, but liquidity conditions are still tight, and sentiment remains fragile.


What’s Different after “Lehman”?

Sources: Bloomberg L.P.; and IMF staff estimates.Note: Lehman Brothers declared bankruptcy on September 15, 2008.

The latest bout of volatility demonstrates that high hurdles for debt rollover can telescope concerns over medium-term debt sustainability into more immediate sovereign funding stress (third figure). The episode also serves as a reminder that bank funding and capital constraints can generate deleveraging pressures and establish a negative feedback loop to the real economy. Until a sufficiently comprehensive strategy is in place to address sovereign contagion, bolster the resilience of the financial system, and reassure market participants of policymakers’ commitment to preserving stability in the euro area, markets are likely to remain volatile.


Euro Area Funding and Dollar Liquidity Risks

(In basis points)

Sources: Bloomberg L.P.; and IMF staff estimates.
Note: Prepared by Kristian Hartelius, William Kerry, and Rebecca McCaughrin.1 During a period of two weeks, $7.3 trillion in global equity market wealth was wiped out. In comparison, in the two weeks after the Lehman Brothers bankruptcy, global equity market wealth fell by $11 trillion.

Because challenges to achieving the longer-term sustainability of U.S. government debt remain unaddressed, they could potentially reignite sovereign risks, with important adverse market implications and global repercussions.

At the eleventh hour, U.S. policymakers agreed to raise the debt ceiling to a level adequate only to get past the November 2012 elections and cut the deficit by an initial $917 billion, to be followed by at least $1.2 trillion of additional cuts over a 10-year period. The debt reduction plan marks an important step toward fiscal stabilization, but it does not put the United States on a sustainable fiscal trajectory. And although market pressures receded, the debt reduction plan was insufficient to avoid a (one-notch) downgrade of U.S. sovereign debt by Standard & Poor’s. This, in turn, led to market fears that other important sovereigns could be downgraded, augmenting sovereign strains in the euro area.

While a one-notch downgrade of U.S. debt is likely to have only a limited long-term market impact, a larger or broader downgrade would have far more serious implications, adversely affecting global confidence. Possible channels and effects include:

  • Increased Treasury risk premiums. Historical precedents in advanced economies indicate little sustained impact on yields following a downgrade (Figure 1.7).4 Those data show that, in the case of a single-notch or even a two- or three-notch downgrade from AAA, yields rise marginally in the run-up to the downgrade but more than fully recover within a year. That pattern is most consistent in the case of a single-notch downgrade from AAA by only one credit rating agency (as was the case in the U.S. episode). Indeed, 10-year Treasury yields have fallen by roughly 50 basis points since S&P’s downgrade. However, a more pronounced downgrade has historically had a more sustained impact, with government bond yields rising more sharply and for a longer period.

  • Loss of liquidity advantage. U.S. Treasury securities were not unique in their top rating: a number of other sovereigns have equally high credit ratings. But what still sets Treasuries apart is their exceptionally high liquidity. A multinotch downgrade would likely erode that advantage.

  • Destabilizing impact on broader leveraged markets. Given the widespread role that Treasuries play in financial transactions, further downgrades would likely prompt lenders to increase haircuts on repo positions, leading to a rise in margin calls. This could, in turn, lead to a round of deleveraging, with some impact on asset prices as some borrowers are forced to curtail positions financed with Treasuries as collateral.5

  • Forced asset sales. Although most institutional investors are either free from ratings restrictions or have the flexibility to ease them, especially if the downgrade is small, a larger downgrade could lead to some forced sales of Treasuries.

  • Effects on other securities. Further downgrades would likely erode the reserve status of the dollar; weaken counterparty confidence of large investors; and possibly lead to ratings downgrades on debt issued by other U.S. entities (especially Fannie Mae and Freddie Mac), municipalities, insurance companies, banks, and other financial institutions. This would likely be accompanied by repricing across a wide range of assets priced off the Treasury curve, further exacerbating collateral mark-downs and haircut increases. Additional downgrades would also likely raise concerns about potential downgrades of other AAA-rated sovereigns. To some extent, these fears are already materializing, with spreads widening on a number of highly rated European sovereign debt and CDS credits.

Figure 1.7.
Figure 1.7.

Change in Advanced Economy Government Bond Yields around Sovereign Debt Downgrades

(In basis points)

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

How Concerned Are Markets about U.S. Sovereign Risks?

Although markets signaled increased concerns after the U.S. downgrade, they appear to remain confident that stress will be contained. This relatively sanguine view potentially creates a false sense of security: By reducing the urgency to act, it increases the potential for a negative credit event to have a significant adverse market reaction.

Financial markets can provide important signals on market concerns about sovereign risk. The figure in this box summarizes a set of indicators used by market participants to assess concerns about U.S. sovereign risks. None of the measures perfectly captures concerns: Other fundamental and technical factors can also affect market pricing, there is a wide range of potential scenarios and outcomes, and markets may overstate or understate risks. Still, taken together, the indicators may provide useful high-frequency signals on perceptions about sovereign risks. Overall, they suggest that market-implied U.S. sovereign risks have increased, but pricing is still below maximum levels despite a U.S. rating downgrade by Standard & Poor’s, an increased potential for a further U.S. downgrade, increased concerns about sovereign debt risks globally, and limited progress in U.S. domestic debt consolidation.1

Some metrics in the figure that are signaling increased risks include nominal and real Treasury rates, swaps, and other rate curves which have steepened (though yields generally remain below historical averages), suggesting increased concerns about long-term debt consolidation.2 Longerdated swaption volatility is close to its highest level, as the shape of the curve has fluctuated more, reflecting concerns about a wider range of possible outcomes. At the same time, both near-and long-term CDS spreads have widened, suggesting increased demand for protection against default. The dollar has weakened against both the euro and a broad basket of currencies, and gold prices have continued to surge, suggesting some loss of confidence in the dollar’s status as a reserve currency and concerns about external financing needs.

However, other markets are signaling more modest concerns. For example, 30-year swap spreads are not signaling extreme stress, even though they have tended to be well-correlated with CDS spreads and a steepening in the Treasury curve during spikes in sovereign risk; the spreads between U.S. Treasuries and German bunds are contained; and most funding market conditions paint a fairly benign picture.3

Other metrics underscore the U.S. Treasury market’s relative resilience: Auctions have been well received, prime brokers have not increased haircuts, repo volumes normalized following a brief period of volatility during the debt ceiling impasse, major institutions have not substantially altered their holdings of Treasuries relative to cash or other assets, and liquidity in the Treasury market has not been impaired.

A number of financial market issues and considerations may be limiting the stress arising from sovereign risk concerns:


Market-Implied Sovereign Risk Monitor

Sources: Bloomberg L.P.; and IMF staff estimates.Note: The figure represents the average pricing of each underlying indicator during August 2011 compared with maximum and minimum daily levels prevailing over the period January 1, 2009, to the present. January 1, 2009, roughly marks the point at which the financial crisis started to morph into more of a sovereign credit crisis and thus provides a useful basis for comparison. Green signifies that current pricing is closest to the minimum prevailing level or relative complacency on fiscal risks; red signifies proximity to the maximum prevailing level or increased alarm. The aggregate measure is a simple, unweighted average of the underlying market indicators.
  • Countervailing pressures. Factors such as flight-to-quality flows generated by concerns over growth prospects and European sovereign risks are considered more significant market drivers.

  • Past is prologue. Many take comfort from the fact that the U.S. government has never defaulted.4 Even in the event of a cash crunch, most expect the U.S. Treasury to prioritize payments.

  • A lack of substitutable assets. Market participants are confident that no other market is sufficiently deep and liquid to supplant the U.S. Treasury market, which suggests that Treasury investors are a captive investor base.

  • The effect of haircuts. Increased haircuts may (perversely) increase demand for Treasuries. Since Treasury securities are used as collateral to meet margin requirements in a wide range of transactions, some market participants argue that a downgrade would (paradoxically) increase demand for Treasuries as margin calls increase.

  • Flexibility in mandates. Market participants argue that rating-constrained investors would likely adjust their mandates to allow them to purchase lower-rated debt.

  • Extraordinary policy actions. In the event of increased instability in the Treasury market, market participants expect the Federal Reserve to act as a backstop through another round of quantitative easing or some other unconventional measure.

In sum, while market pricing suggests increased concerns about the buildup of fiscal risks, overall signals are still fairly mixed and are below maximum levels.

The policy risk: The lack of a strong market signal may create a false sense of security, thereby reducing the urgency to act and increasing the potential for a negative credit event to produce a significant adverse market reaction. As the main text indicates, a multinotch downgrade or default could increase term premiums, lead to a loss in liquidity, and—given the widespread role that Treasuries play in the pricing and collateralization of other assets—have a destabilizing impact on broader markets and market sentiment.

Note: Prepared by Rebecca McCaughrin.1 Granted, changes in market pricing reflect information other than sovereign risk, such as changes in expectations on interest rates, growth, and inflation as well as technical factors like market liquidity, hedging activity, and supply demand dynamics. For instance, renewed concerns about downside risks to economic growth and a reduction in interest rate expectations may be obfuscating or dominating market concerns about sovereign risks.2 Curvature depends on the market’s horizon. A steepening may reflect market concerns about debt deterioration in the longer run, whereas a flattening may suggest more immediate concerns and the expectation that a missed coupon payment in the near term will prompt more urgent action on fiscal reform in the longer run. With the increase in the debt ceiling, markets are now generally concerned that longer-term debt consolidation will be further delayed.3 Interest rate swap spreads are an indicator of the relative risk of private versus government long-term bonds. The interest rate swap market is very liquid, and, as a derivatives market, it is not affected by the supply-demand imbalances of the Treasury market.4 Apart from two special episodes, one in 1933 and the other in 1979. The United States defaulted in 1933 when it left the gold standard and canceled bondholders’ option to be repaid in gold. In April—May 1979, there was a technical default when payments on maturing Treasury bills were delayed by a processing glitch (see Zivney and Marcus, 1989).

Parts of the euro area remain vulnerable to contagion and weakening fundamentals and to the risk of multiple equilibria.

The vulnerabilities highlighted earlier have been a key focus in euro area sovereign bond markets in the past six months. Spreads have climbed to record levels (Figure 1.8) as political differences within economies undergoing adjustment and among economies providing support have complicated the task of achieving a durable solution. Investors fear that the voluntary private sector participation in debt restructuring that is now envisaged in Greece could set a precedent for other program countries. Difficult political dynamics and increasing concerns about the growth outlook have also raised uncertainty about broader fiscal adjustment in Italy. Given the systemic size of the bond markets in Italy and the sovereign funding needs there, these risks have become key drivers of market conditions, increasing the potential for spillovers across different asset markets.

Figure 1.8.
Figure 1.8.

Developments in Sovereign Credit Default Swap Spreads, 2011

(Five-year tenors, basis points)

Source: Bloomberg L.P.

With fragile balance sheets and debt sustainability influenced heavily by expectations, debt markets can become subject to multiple equilibria. Sovereigns with major vulnerabilities are prone to a sudden loss of investor confidence in their debt sustainability if fundamentals deteriorate sharply. This can result in higher volatility, which would erode the demand for their bonds and weaken their investor base, driving up funding costs for themselves and their banks and potentially choking off economic activity (Figure 1.9). Sovereigns that are unable to mount a credible policy response in the face of such challenges can become mired in a bad equilibrium of steadily deteriorating debt dynamics.

The recent turmoil has been concentrated in European sovereign debt markets. While the euro area greatly benefits its members by broadening and deepening the degree of financial integration across the region, the extensive cross-border bank and fund holdings of sovereign debt in the euro area have facilitated the rapid transmission of shocks across financial markets. The threshold for cross-border asset reallocations is also lowered because domestic savers can now choose from a large stock of high-quality assets in other parts of the area without incurring exchange rate risk.

Recent developments in the wider euro area government bond market underscore investor sensitivities.

The stability of the investor base has been a particularly critical determinant of the recent debt dynamics in the euro area. For the program countries, the hollowing out of the investor base has been a significant factor in the eventual cutoff from funding markets (Figure 1.10). Over the past year, foreign banks have reduced their share of Italy’s and Spain’s total government debt outstanding, although foreign nonbanks have remained net buyers in Italy. The latter’s high rollover funding needs for its sovereign debt make it vulnerable to a pullback in demand by domestic banks and institutional investors, who already have significantly more domestic sovereign exposure than their euro area counterparts.

Figure 1.10.
Figure 1.10.

Changes in the Sovereign Investor Base

(In percent)

Sources: BIS Banking Statistics; European Central Bank; European Union; Eurostat; IMF-World Bank Quarterly External Debt Statistics; national central banks; and IMF staff estimates.

The dramatic price action in sovereign debt markets during July 2011 demonstrated how shocks to fundamentals and market sentiment in vulnerable sovereigns can create a corrosive dynamic that spills over to broader debt markets. Sovereign bond spreads for the peripheral euro area countries rose to record levels with extreme volatility and spillovers to Italy and Spain (Figure 1.11). Previously, Italy’s 10-year spread over German bunds had been relatively stable, around 150 basis points during 2011, as investors had taken comfort from the relatively low level of private sector debt in Italy, the well-developed domestic investor base for government bonds, and the bonds’ high degree of liquidity. These factors resulted in many investors in euro area sovereign bonds holding long-Italy positions against their benchmarks to compensate for short positions in program countries, leaving the market vulnerable to a sharp correction.

Figure 1.11.
Figure 1.11.

Bond Market Volatility

(Realized volatility of two-year government bond yields in basis points)

Sources: Bloomberg L.P.; and IMF staff estimates.Note: Vertical lines represent the range of realized volatility for the period.

Like the debt path of many advanced economy sovereigns, Italy’s remains highly sensitive to a rise in funding costs (Figure 1.12).6 In such circumstances, a change in fundamentals (such as expected growth or fiscal adjustment) can cause a substantial shift in expectations about debt sustainability. This can make normally liquid bond markets more vulnerable if marketmakers and investors pull back from risk when volatility rises.7 The turmoil in the trading for Italy’s debt in July and August illustrates how such bouts of volatility, if left unchecked, has the potential to erode a sovereign’s investor base and lead to a permanent repricing of debt.

Figure 1.12.
Figure 1.12.

Financing Sensitivity to an Interest Rate Shock

(In percent of GDP)

Sources: Bloomberg L.P.; IMF, World Economic Outlook database; and IMF staff estimates.Note: WEO projections for 2011 and 2016. In addition, we calculate interest rate expenditures for 2016 when the sovereign refinances 300 basis points above current market forward rates, taking the detailed profile of future funding needs into account and assuming a constant maturity structure of issuance. The baseline in our forward-rate-based methodology differs from that in WEO projections. Assumptions on assets do not deviate from the baseline WEO scenario. For Greece, gross government debt.

Sovereign strains have spilled over to the EU banking system, increasing systemic risks.

Sovereign risks have spilled over to the banking system, and these spillovers have grown as the sovereign crisis has spread from Greece to Ireland and Portugal, and then to Spain, Belgium, and Italy. Nearly half of the €6.5 trillion stock of government debt issued by euro area governments is showing signs of heightened credit risk (Figure 1.13).

Figure 1.13.
Figure 1.13.

Size of High-Spread Euro Area Government Bond Markets

(In percent of total euro area government debt)

Sources: Bank for International Settlements; Bloomberg L.P.; and IMF staff estimates.Note: The size of the euro area government debt market was €6.5 trillion as of end-2010. Components may not sum to 100 because of rounding.

As a result, banks that have substantial amounts of more risky and volatile sovereign debt have faced considerable strains in markets.8 Figure 1.14 shows that high-spread euro area bank credit default swaps have widened by around 400 basis points since January 2010, in line with the increase in sovereign credit default swap spreads. At the same time, the equity market capitalization of EU banks has declined by more than 40 percent. These market pressures have intensified in recent weeks.

Figure 1.14.
Figure 1.14.

European Credit Risks and Market Capitalization

(Change since January 2010)

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

Spillovers from high-spread euro area sovereigns have affected local banking systems but have also spread to institutions in other countries with operations in the high-spread euro area and with cross-border asset holdings. In addition to these direct exposures, banks have taken on sovereign risk indirectly by lending to banks that hold risky sovereigns. Banks are also affected by sovereign risks on the liabilities side of their balance sheet as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and bank ratings downgrades have followed cuts to sovereign ratings.

All of this has increased the riskiness of exposures to banks in the high-spread euro area. Because banks lend to banks, the system is highly interconnected, both within and across borders. Consequently, the banking system can amplify the size of the original sovereign shock through funding markets. Indeed, sovereign spillovers have also had an impact on bank funding markets. This can be illustrated by the sharp widening in credit default swap spreads for banks in the high-spread euro area countries (Figure 1.15);9 the continued reliance of banks in Greece, Ireland, and Portugal on central bank liquidity support; and the difficulties that some banks in these countries have had in issuing debt (Figure 1.16).10

Figure 1.15.
Figure 1.15.

Spreads on Bank Five-Year Credit Default Swaps

(In basis points)

Sources: Bloomberg L.P.; and IMF staff estimates.Note: End-2010 asset-weighted spreads for a sample of banks in each economy. High-spread euro area countries are Belgium, Greece, Ireland, Italy, Portugal, and Spain.
Figure 1.16.
Figure 1.16.

Bank Debt Issuance as a Percent of Maturing Debt, 2011

Sources: Dealogic; and IMF staff estimates.Note: For presentational purposes, the chart maximum is set to 100.

This GFSR seeks to explain why bank equity and funding markets are under strain. It measures the size of credit-related strains emanating from a widening group of euro area sovereign bond markets that have come under pressures and their spillover to banks. It measures the impact of this increase in credit risk since the end of 2009 on bank exposures to selected sovereigns and banks (an integral part of sovereign spillovers). These sovereign credit strains are a signal of vulnerability, as they have become substantial in magnitude and have continued to mount (see Box 1.3).

Quantifying Spillovers from High-Spread Euro Area Sovereigns to the European Union Banking Sector

European banks have become vulnerable to perceived increases in sovereign risk. In order to help explain the significant market pressures that some banks are facing in funding and equity markets, the analysis in this chapter aims to quantify the spillovers from highspread euro area sovereigns to the European banking sector. This box discusses the choices made in methodology and their implications.

Since the outbreak of the sovereign crisis in 2010, sovereign bonds in several euro area countries are no longer perceived by markets as “risk free.” This exercise seeks to measure the impact of this increase in credit risk on bank exposures to selected sovereigns and interbank exposures (an integral part of sovereign spillovers). These estimated sovereign credit risks serve as a vulnerability indicator, as they have become substantial in magnitude and have continued to mount. This box also reviews accounting and regulatory practices and discusses the extent of recognition of sovereign strains. This exercise is not aimed at calculating the net impact of gains and losses on sovereign debt, nor is it intended to determine the size of bank capital needs, which would call for a full-fledged stress test.

Methodological Choices

In undertaking this exercise, several key methodological choices have been made—specifically: (i) the countries included as a source of sovereign strains; (ii) the class of assets included—exposures to sovereigns and interbank exposures; (iii) the market price/instrument used to measure credit strains; and (iv) the extent of balance sheet coverage. Since these choices have important implications for the resulting estimates, it is necessary to clarify the economic rationale behind them and the sensitivity of the results.

Country coverage:1 The analysis is based on the six high-spread euro area countries. This group includes the three program countries—Greece, Ireland, and Portugal—and the three countries that have more recently experienced market strains and widening financing spreads—Belgium, Italy, and Spain. As shown in Figure 1.13, this group accounts for about half of the euro area government bond market. The decision to limit the analysis to high-spread countries is motivated by the desire to better isolate the source of current market strains. Arguably, credit strains have increased somewhat in other euro area countries, and if the analysis were to be extended to all euro area sovereigns, the estimated impact of sovereign credit risk—measured by CDS spreads—would be higher.

Assets: In addition to banks’ sovereign exposures, we include bank exposures to banks located in the high-spread euro area.2 Interbank exposures are an integral part of sovereign spillovers because of contemporaneous linkages between sovereign and bank credit risks, complex interconnectedness of the banking system, and substantial holdings of interbank debt. Banks located in the high-spread euro area are directly affected by sovereign credit risks through both the asset and liability sides of the balance sheet, as evidenced by close correlation of sovereign and bank credit spreads.3

Credit risk measure—bond yields or bond spreads? Credit risks are commonly assessed using credit spreads for a wide range of risky assets—including bank debt, corporate debt, and emerging market government and corporate debt—although the market may overshoot during periods of market strain. Credit spreads or bond spreads—rather than bond yields—are used to isolate the credit risk component and to remove the effect of the risk-free rate. For this reason we choose to use sovereign CDS spreads.4 The change in credit risk is calculated from the end of 2009, before the escalation of the sovereign crisis, to September 2011. Similarly, this analysis could have been done using bond spreads to German bunds and is shown to give very similar results (see first table). For comparison purposes, if government bond yields were used instead of CDS spreads, the total impact from the high-spread euro area would be 31 percent lower for sovereign exposures (see first table), largely reflecting the decline in the risk-free rate.5

Spillovers from High-Spread Euro Area Sovereigns to the European Banking System

(In billions of euros)

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Source: IMF staff estimates.Note: Based on changes in market prices from the end of 2009 to September 2011.

Should safe-haven gains be included? The increase in sovereign credit risk and the widening of spreads have been accompanied by flows into “safe havens” such as German bunds, which have risen in price, creating a capital gain for banks that are holding these bonds. One might argue that these gains offset some of the potential losses from holdings of riskier sovereign debt. However, this exercise is focused on measuring the vulnerability of banks to rising sovereign risks. Netting the gains from safe-haven bonds would mask the overall size of the problem, and could not be a panacea for the sovereign crisis. In addition, the distribution of gains from holdings of highest quality government bonds within the banking system is uneven—with banks in the high-spread euro area holding relatively fewer—resulting in increased segmentation of funding markets in the euro area. Importantly, if safe-haven gains are included, the exercise ought to be broadened to a stress test that would include the full range of banks’ assets affected by the crisis. This would include other risky assets, such as holdings of bank equities, corporate bonds and loans, and other assets originated in the high-spread euro area. Including other private sector exposures would be expected to generate an additional sizeable impact, as corporate credit spreads are often significantly correlated with sovereign credit spreads.

Recognition of Sovereign Strains in Bank Capital

This exercise is not intended to measure the losses and gains that arise from the change in bond prices, some of which is due to increased sovereign risk. Nonetheless, increased losses owing to increased default risk or declines in market value are partly taken into capital.

Loss recognition and its impact on capital are determined by accounting and regulatory standards and how those standards are put into practice, which can vary from bank to bank and country to country. The points below summarize the current state of play (see also second table).

European Banks: Loss Recognition on Sovereign Exposures

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Based on the European Banking Authority’s data on banks’ exposures to high-spread euro area sovereigns. Held-to-maturity value is calculated as the residual. MTM = mark to market.

Trading book. Securities held in the trading book are mostly marked to market, so losses go through profit and loss accounts and are recognized in equity capital. However, accounting standards allow the use of internal models in the event of an inactive market. Around 12 percent of sovereign exposures (based on the EBA dataset) are held in the trading book and their fair value should be fully reflected in both accounting and regulatory capital measures.

Available for sale. Accounting rules state that the available-for-sale (AFS) portfolio should be marked to market and recorded in tangible common equity. Recent criticisms expressed by the International Accounting Standards Board (IASB) concerning the treatment of Greek government debt suggest that banks have recognized losses in an inconsistent fashion, sometimes reclassifying government debt as illiquid and in some cases using internal valuation models instead of market prices. From a regulatory perspective, Basel II is silent on the treatment of unrealized AFS losses, resulting in diverging practices across countries. Unrealized losses (as well as unrealized gains) on the AFS portfolio have not always been incorporated in regulatory capital calculations.6

Held to maturity. There are several issues with the implication of the accounting rules determining the provisions associated with sovereign exposures in the held-to-maturity (HTM) portfolio. The calculation process (which is based on internal models) underestimates the effect of credit risk deterioration and therefore will produce lower provisions than marking to market. This is partly because the current approach is based on “incurred loss”; thus, risks—unless materialized—cannot be quantified.7 As a result, provisioning has been predominantly on the sovereign debt of Greece eligible for the ongoing debt exchange process, in some cases amounting to 21 percent of face value.

In sum, although losses are likely to have been recognized in the trading book, loss recognition has been slow and inconsistent in the banking book. To improve transparency, more clarity in the accounting standards is required for the application of mark-to-market valuation for thinly traded government bond markets and the method of provisioning in HTM should be revisited. In addition, more consistency is needed in the recognition of AFS losses in regulatory capital across jurisdictions (see the discussion in the “Policy Priorities” section of the main text).

Note: Prepared by Sergei Antoshin and William Kerry.1 The analysis is conducted for 20 banking systems in the European Union as well as for the sample of banks in the European Banking Authority’s (EBA) 2011 stress test. Spillovers are quantified by applying an estimate of the increase in credit risk to the latest available balance sheet data on a consolidated basis. The exercise includes exposures to sovereigns and banks in the high-spread euro area. For the banking system exercise, domestic exposures—such as Greek bank exposures to the Greek sovereign—are estimated from data published with the EBA 2011 stress test. These data are adjusted to the banking system level using information on the coverage of the EBA stress test. International exposures are from the Bank for International Settlements (BIS) dataset. For some banking systems, data on cross-border exposures are not available from the BIS data, so cross-border exposures from the EBA dataset are used. Exposures for the individual bank exercise are taken from the EBA dataset.2 The exercise uses latest available balance sheet data, so some of the exposures—such as securities held in the trading and available-for-sale portfolios—may be recorded at fair value. In the EBA dataset, around 12 percent of government exposures are in the trading book and a further 49 percent are held as available for sale. As we apply changes in credit spreads to these marked-down exposures, we may underestimate total spillovers for the period since end-2009.3 Interbank exposures are reduced by adjusting for repos using the data available. Nevertheless, interbank deposits may still include some collateralized exposures, which may experience less deterioration in credit quality than that implied by CDS spreads.4 Changes in credit risk are estimated from CDS spreads (S) by converting them into synthetic prices (P) using Pt = exp(-St T). The calculation uses a weighted average maturity (T) and a matching CDS spread. For sovereign exposures, the weighted average maturity is calculated from the EBA dataset. For interbank exposures, weighted average maturities are estimated using information on maturities of bank bonds issued by institutions from the high-spread euro area countries and on an assumed three-month maturity of interbank lending.5 There are other reasons for not choosing bond yields. Downward shifts in the yield curve and its flattening generally have an adverse impact on bank income margins that would have to be taken into account. In high-spread euro area countries, rising bank credit spreads also have an impact on net interest income, as funding costs increase and often become prohibitive, while the extent of the pass-through to customers is limited, especially for retail loans. This has so far been mitigated in part by the increased recourse to central bank funding.6 This will change under Basel III, as institutions will be required to take unrealized AFS losses into account in their regulatory capital calculations; and the BCBS will continue to review the appropriate treatment of unrealized gains.7 The IASB is currently finalizing a new approach based on “expected loss” that will replace the existing IAS 39 arrangements. These are due for release shortly.

However, it is important to note that the exercise is not a calculation of the capital needs of banks (that could be different from the size of spillovers in this report). Determining capital needs would call for a full-fledged stress test that seeks to identify the full range of stresses and offsets covering all balance sheet assets, liabilities, and income/losses on banks. A typical stress test would have several components that are beyond the scope of this exercise. For example, it would include an economic scenario that would result in rising losses on bank’s loan books, a marking to market of securities, including corporate bonds, and a projection of new income and how this would be affected by funding strains. In addition, it would include the size of capital buffers and provisions available to cushion increased losses, and from there it would derive a capital need.

The epicenter of sovereign risk has been Greece, which generated the first of four waves of spillover to European banks. The analysis suggests that, first, spillovers on European bank exposures to the Greek sovereign have amounted to almost €60 billion (Figure 1.17). Second, as sovereign risks spread to other governments, the spillovers to banks have mounted. If the sovereign stresses in Ireland and Portugal are included, the total spillover rises to €80 billion. Third, the governments in Belgium, Italy, and Spain have also come under market pressure; incorporating credit risks from these sovereigns into the analysis further raises the total estimated spillover, to about €200 billion. Fourth, bank asset prices in the high-spread euro area have fallen in concert with sovereign stresses, leading to a rise in the credit risk of interbank exposures; including those exposures increases the total estimated spillover to €300 billion overall. Although these numbers are based on market assessments of credit risk, which may reflect a degree of overshooting, the underlying problems that they highlight are real.

Figure 1.17.
Figure 1.17.

Cumulative Spillovers from High-Spread Euro Area Sovereigns to the European Union Banking System

(Billions of euros)

Source: IMF staff estimates.Note: The size of the circles is proportional to the size of the spillover. Includes banking systems in 20 European Union countries. The high-spread euro area countries are Belgium, Greece, Ireland, Italy, Portugal, and Spain. Figures are rounded to the nearest 10 billion euros.

Banking systems in the high-spread euro area are likely to be most affected.

This aggregate picture masks a heterogeneous range of spillovers on country banking systems (Figure 1.18). High-spread euro area systems have faced the most severe spillovers from their local sovereigns. The key exception to this is Cyprus, which has high spillovers from bank exposures to the Greek sovereign. A number of other banking systems such as those of Luxembourg, France, and Germany have experienced spillovers from the high-spread euro area to their foreign operations or cross-border exposures, but these represent a smaller percentage of assets. Finally, several European banking systems have had little or no spillover from high-spread euro area sovereigns.

Figure 1.18.
Figure 1.18.

Spillovers from High-Spread Euro Area Sovereigns to Country Banking Systems

(In percent of assets)

Source: IMF staff estimates.Note: The high-spread euro area countries are Belgium, Greece, Ireland, Italy, Portugal, and Spain.

Conducting the analysis on individual bank balance sheets confirms the results of the aggregate exercise.11 Banks from the high-spread euro area have had the greatest spillovers (Figure 1.19). But even within banks in these countries, the spillovers have been uneven. There are also a few banks from other countries where spillovers have been large.

Figure 1.19.
Figure 1.19.

Distribution of Spillovers from High-Spread Euro Area Sovereigns to European Banks

Source: IMF staff estimates.Note: For presentational purposes, the cutoff points for capital ratios and spillovers are 16 percent. The high-spread euro area countries are Belgium, Greece, Ireland, Italy, Portugal, and Spain. Data are based on the sample of 90 EU banks in the EBA 2011 stress test.1Includes core Tier 1 capital at end-2010, actual equity raising in January-April 2011, and commitments for equity raisings made by April 2011.

Overall, only a small number of banks in the sample fall in the red zone of Figure 1.19. These banks represent about 1 percent of assets in the sample, while 22 percent of banks in the sample, representing 12 percent of assets, fall in the red, orange, and yellow zones, where spillovers represent more than half the level of core Tier 1 capital. Some of these spillovers will have been recognized by banks, but the full extent to which losses on government bonds have been recognized in bank accounts is unclear (see Box 1.3).

Spillovers could spread to other financial institutions.

Insurance companies have also been affected by sovereign credit risk spillovers through their direct holdings of both sovereign and bank debt. The spillovers to insurance companies were assessed in a manner similar to that for banks.

Disclosure of the insurance sector’s exposures to the high-spread euro area, however, remains limited and mostly voluntary,12 so the analysis could be applied only to selected large insurers from data they have published on sovereign exposures. Nevertheless, spillovers are significant at a number of large insurers, particularly in France and Italy (Figure 1.20). All told, spillovers amounted to more than 20 percent of tangible common equity for about 38 percent of large insurers (representing 39 percent of total assets in the sample).13 These results, however, may overestimate the ultimate impact of sovereign risks on insurers as, in contrast to banks, insurers can mitigate their spillovers by passing on costs to policyholders.

Figure 1.20.
Figure 1.20.

Spillovers from High-Spread Euro Area Sovereigns to Insurers

(Based on gross exposures)

Source: IMF staff estimates.

For other financial institutions—such as pension funds and sovereign wealth funds—exposures to high-spread euro area sovereign credit risk are even less clear, but these entities are less likely to have a significant impact on the financial system, as their positions are largely held in unleveraged portfolios.

The potential exists for funding market disruption to intensify.

A number of factors could cause the disruption to funding markets to spread and intensify. Banks affected by sovereign spillovers might decide to pull back funding to other banks to reduce credit risk or even to preserve liquidity in anticipation of future funding problems. That could be significant given the highly interconnected nature of the global banking system: interbank funding represents about one-fourth of total financing for the banking sector (Figure 1.21).14

Figure 1.21.
Figure 1.21.

Advanced Economy Bank Funding by Source, 2011:Q1

(In percent)

Sources: Bank for International Settlements; national authorities; and IMF staff estimates.Note: Aggregate funding of banks located in the euro area, Japan, the United Kingdom, and the United States. “Banks” includes institutions in the domestic economy and rest of the world.

Also, banking groups that operate across national borders pose risks to banking systems. Banks facing funding pressures could reduce or withdraw intragroup financing from foreign branches to help preserve liquidity, thereby transmitting the funding shortages from one country to another. This is particularly an issue for those emerging market banking systems with a large foreign presence and considerable intragroup financing.

Other financial institutions—such as insurance companies, pension funds, and money market funds—are the source for nearly one-fifth of banking financing (see Figure 1.21). The role of these institutions in debt and repo markets is much greater, so any cutback in funding could significantly disrupt wholesale funding markets.

Indeed, U.S. money market funds have reduced their funding of euro area banks, particularly institutions in high-spread countries (Figure 1.22). As Box 1.4 discusses, this has already created some pressures in dollar funding markets. If investors in money market funds become concerned about potential losses from euro area banks and seek to redeem their money, money market funds might pull back further from bank funding.

Figure 1.22.
Figure 1.22.

U.S. Prime Money Market Fund Exposures to Banks

(Percent of total assets)

Source: Fitch.Note: The high-spread euro area consists of Belgium, Greece, Ireland, Italy, Portugal, and Spain.

Why Do U.S. Money Market Funds Hold So Much European Bank Debt?

Given their sizable holdings of European bank paper, U.S. money market mutual funds are a potential transmission channel of the European sovereign debt crisis. Why have the money funds built up such a large exposure, and what are the implications if they significantly reduce it?

With $2.7 trillion in assets, U.S. money market mutual funds (MMMFs, or money funds) are systemically important institutions. Prime MMMFs account for the largest share of the market, representing $1.6 trillion, or around 60 percent, of total MMMF assets. The remaining 40 percent is in government and tax-free money funds.1

A number of factors have reduced the supply of dollar-denominated money market instruments in recent years, from a peak of about $12 trillion in 2008 to about $9.1 trillion currently.2 First, the collapse in the ABCP conduit model during the crisis shrank the stock of investible ABCP paper.3


Outstanding Dollar-Denominated Commercial Paper and Time Deposits, by Issuer

(In billions of U.S. dollars except as noted)

Sources: Federal Reserve; and IMF staff estimates.Note: CD = certificate of deposit; CP = commercial paper.

Second, the supply of Treasury bills was curtailed by flight-to-quality flows and the mid-2011 end of the U.S. Treasury’s Supplementary Financing Program.4 Third, the supply of CP declined as U.S. nonfinancial corporations built up large cash positions. Fourth, the supply of agency notes declined as Fannie Mae and Freddie Mac were wound down. Fifth, banks’ reduced dependence on wholesale funding cut the supply of bank CDs.

In response to the decrease in the supply of domestic dollar-denominated instruments, MMMFs increased their holdings of dollar-denominated foreign debt and so-called Yankee paper (the latter being dollar-denominated debt issued in the United States by foreign entities), especially by European banks with a small deposit base seeking to finance their large dollar-denominated assets. Until recently, the stock of dollar-denominated foreign- and Yankee-issued CP and CDs had grown to more than 60 percent of the outstanding stock of financial and nonfinancial CP and CDs, up from 45 percent in 2008 (first figure). As a result of sovereign stress, money funds gradually reduced their exposure to euro area banks in early 2010, paring exposures further in mid-2011 to 23 percent of total assets (table).

Prime Money Fund Exposure to Short-Term Bank Credit, as of End-June 2011

(In billions of U.S. dollars except as noted)

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Sources: Investment Company Institute; and JPMorgan Chase.Note: Monthly portfolio holdings of top 18 money market funds. ABCP = asset-backed commercial paper; CD = certificates of deposit; CP = commercial paper.

Any change in MMMF willingness to hold European bank paper is likely to affect the cost and availability of dollar funding. The MMMFs have provided a convenient way for U.S. branches and subsidiaries of foreign banks to build up precautionary dollar reserves (second figure).5 Ample funding had also helped to contain pressures in dollar funding markets despite intensifying sovereign risk. That is no longer the case: Offshore dollar-denominated issuance by European banks and dollar-denominated foreign issuance has begun to decline, as money funds are reluctant to increase exposure to European banks and pressures in dollar funding markets have risen (third figure). The cushion of reserves built up by U.S. branches of European banks helps to buy time, but the cushion is at risk of being depleted if a pullback by the money funds is accompanied by a generalized rise in risk aversion among other lenders. This could lead to further pressures in bank funding markets.6


Reserves of U.S. Banks and U.S. Offices of Foreign Banks

(In billions of U.S. dollars)

Sources: Federal Reserve; and IMF staff estimates.Note: A more negative drawdown implies increased funding provided by U.S. offices of foreign banks to parent offices, while a less negative drawdown implies foreign parents are draining less liquidity from their U.S. operations. QE1 and QE2 are announcements of quantitative easing.

Three-Month Euro-Dollar FX Swap Basis, 2011

(In basis points)

Source: Bloomberg L.P.
Note: Prepared by Rebecca McCaughrin.1 Prime MMMFs invest in high-quality, short-term credit instruments—primarily certificates of deposit (CDs), repurchase agreements (repos), commercial paper (CP), asset-backed CP (ABCP), short-term corporate notes, and other money funds. Government and tax-free funds invest mainly in Treasuries, agency debt, and municipal bonds.2 This figure includes the outstanding stock of repurchase agreements, Treasury bills, commercial paper, banker’s acceptance paper, large time deposits, and other instruments.3 The stock of ABCP fell from a precrisis level of $1.2 trillion to about $380 billion. ABCP conduits are bankruptcy-remote special-purpose vehicles that issue short-term paper backed by the cash flows from physical assets. Before the financial crisis, banks relied on ABCP conduits as a short-term funding vehicle backed mostly by mortgage-related assets. Deterioration in the underlying assets and the inability of conduits to roll over their paper eventually led to the contraction in the ABCP market.4 The Treasury program temporarily added as much as $200 billion to the supply of Treasury bills.5 U.S. branches and subsidiaries of foreign banks sometimes channel dollar funding to their overseas parent offices. Beginning April 1, 2011, the Federal Deposit Insurance Corporation (FDIC) started to assess domestic banks a fee based on their total assets, but branches and subsidiaries of foreign banks that are not insured by the FDIC are exempt. This risk-free arbitrage for foreign banks has likely led to excess liquidity being channeled to their U.S. offices because they are still eligible to hold reserves at the Federal Reserve for 25 basis points. The FDIC exemption, as well as excess dollar liquidity created by the Federal Reserve’s second round of quantitative easing and the increase in offshore dollar funding by foreign parent banks, has led to an accumulation of cash in U.S. offices of foreign banks. If needed, these reserves could be funneled to foreign parents.6 A more general pullback by money market funds could also lead to higher funding costs and difficulties in rolling over funding at municipalities and other issuers. Tax-exempt mutual funds currently hold $300 billion in municipal paper, which is helping to fund roughly 12 percent of state and local government liabilities.

The disruption in euro area wholesale funding markets could also spread to depositor funding. At banks in Greece and Ireland, both wholesale and customer deposits have fallen since the end of 2009 (Figure 1.23). It is essential to prevent these withdrawals from moving into a more virulent phase, as has happened in past emerging market crises.

Figure 1.23.
Figure 1.23.

Deposit Growth in High-Spread Euro Area Countries

(Cumulative percent change since end-2009)

Source: Haver Analytics.

A worsened funding market would pressure banks to deleverage.

Funding strains are likely to increase deleveraging pressures on banks. Indeed, there have been significant reductions in wholesale and nonresident funding in several European countries since the end of 2009 (Figure 1.24). In some cases, this has been associated with planned deleveraging of banking systems. But in other countries, such as Greece, deleveraging has been prevented only by an increase in central bank liquidity support. The important recent decision by the European Central Bank to offer six-month liquidity is, therefore, likely to help address pressures in bank funding markets. But the scale of support that may be needed to tackle the full consequences of sovereign spillovers could well be large. In the long run, such support would be neither healthy nor sustainable for the banking system.

Figure 1.24.
Figure 1.24.

Contributions to Change in Bank Balance Sheets since End-2009

(In percentage points)

Sources: European Central Bank; Haver Analytics; and IMF staff estimates.Note: “Other” includes liabilities to nonresidents (which, for euro area banking systems, are residents outside the euro area).

These deleveraging pressures, if not effectively countered, risk pushing down credit growth to levels even lower than the current anemic rates in many high-spread euro area countries (Figure 1.25). The September 2011 World Economic Outlook discusses the impact of lower credit growth on economic activity. It is projected that banks will respond to a fall in capital by raising interest rates on their loans and restricting lending to the economy. As a result, it is estimated that, in a downside scenario, growth in the euro area and the United States could decline relative to the WEO baseline by 3.5 percentage points and 2.2 percentage points, respectively.

Figure 1.25.
Figure 1.25.

Deleveraging Scenario: Change in High-Spread Euro Area Bank Credit to the Nonfinancial Private Sector

(In percent, year-on-year)

Sources: Bloomberg L.P.; Haver Analytics; and IMF staff estimates.Note: The dotted lines are estimates based on the assumption that banks are unable to obtain funding in markets.

Spillovers could also spread to derivatives and other financial markets.

Sovereign risks could also spill over to credit derivatives markets. Some investors have bought credit default swaps on sovereign debt to hedge their direct exposures to sovereigns, while other investors have used the market to express a view on a country. There is some risk that a credit event that triggered sovereign credit default swaps could place strains on institutions that have sold credit protection; however, these risks appear contained given the relatively small size of outstanding credit default swap markets for the countries with the widest spreads (Figure 1.26).

Figure 1.26.
Figure 1.26.

Sovereign Credit Default Swaps: Gross Outstanding Amount

(In billions of U.S. dollars and percent of total)

Source: The Depository Trust & Clearing Corporation.Note: Global total was $2.6 trillion at week ending August 5, 2011.

Also, the contagion to financial markets could widen if investor risk appetite is weakened by sovereign stress, especially if the current crisis spreads and intensifies. This could create a second round of impacts on financial institutions, including banks and insurance companies, particularly if they are forced to sell assets at low prices, for example if they face a rationing of funding market liquidity.

Comprehensive, coherent policies are needed to resolve sovereign risks, increase the resilience of the European banking sector, and prevent contagion risks.

Appropriate fiscal action, combined with measures to strengthen banks through balance sheet repair and adequate levels of capital, can help to break the link between sovereigns and banks. If a country’s fiscal measures are successful in restoring the long-term sustainability of public finances, its sovereign risk premium will be reduced, putting public debt on a “good equilibrium” path. This will go a long way toward reducing pressures on banks. Nevertheless, in view of the heightened risks and uncertainty—and the need to convince markets—a number of banks, especially those exposed to strained public debt (directly or through cross-border holdings) and most of those dependent on wholesale financing, may also need more capital. Additionally, the amount of new capital needed would also depend, in part, on the credibility of the macroeconomic policies pursued to address the roots of sovereign risk.

The various channels of propagation from sovereign risk into the wider economy carry an enormous potential for contagion. First, some European banks urgently need to bolster their capital levels to mitigate the risks posed by these spillovers and to help restore funding market confidence. This conclusion echoes the call from the European Banking Authority (EBA) for strengthening the capital positions both at failing institutions and at those that passed the 2011 stress test but which were nonetheless close to the minimum capital threshold and were carrying significant sovereign exposures.15 In current market conditions, however, this may not always be possible, so public backstops first at the national level and ultimately through the European Financial Stability Facility should be used to provide capital to banks as needed.

Second, capital is also required by weaker institutions with high leverage and remaining exposures to poorly performing assets. These banks need to be restructured and, where necessary, resolved in order to reduce overcapacity in the system as well as to improve the profitability and resilience of the remaining institutions. Banks have started to raise equity and have plans to increase capitalization further through issuance or government support. But even after these plans have been accounted for, banks representing nearly one-fifth of total assets of institutions in the EBA 2011 stress test would have core Tier 1 capital below 8 percent (Figure 1.27).

Figure 1.27.
Figure 1.27.

European Bank Core Tier 1 Ratios

(In percent of risk-weighted assets)

Sources: European Banking Authority; and IMF staff estimates.Note: Includes core Tier 1 capital at end-2010, actual equity raising from January to April 2011, and commitments for equity raisings and government support made by April 2011.

Third, lower leverage is required by investors to cope with uncertainty over economic prospects and sovereign risks in the euro area. This is particularly the case in Europe, where banks have a relatively high reliance on wholesale funding and are more vulnerable to funding shocks. The more uncertain operating environment is prompting creditors to require capital buffers that are above regulatory minima to continue to lend to banks. Having adequate capital is necessary to avoid banks being pushed to deleverage through asset sales as well as by restricting new credit and cutting contingent credit lines, thereby exacerbating the economic slowdown.

Is the Search for Yield Leading to Credit Excesses?

The combination of low interest rates and tight credit spreads is generating a search for yield that could jeopardize financial stability. In advanced economies, safeguarding stability calls for greater emphasis on balance sheet repair so as to avoid credit cycle excesses. Being further along in the credit cycle, emerging markets need policies to guard against a buildup of financial imbalances and to strengthen the resilience of their financial systems.

The April 2011 GFSR emphasized that policymakers must shift their focus from maintaining accommodative macroeconomic policies to strengthening balance sheets and reducing debt burdens through structural approaches. Although necessary under current conditions, low rates threaten financial stability if they are prolonged and are not accompanied by balance sheet repair and prudential oversight. In particular, maintaining low real risk-free yields at a time when some credit cycles are shifting into the expansion phase could set the stage for credit excesses while leaving balance sheets vulnerable to a downturn. Although recent economic fragilities may reduce the propensity to take risk, they are also likely to lead to a weakening in credit fundamentals. Finally, with bank balance sheets still in need of repair, low rates may divert credit creation into more opaque channels, such as the shadow banking system.

The flow of capital away from the low interest rates in advanced economies and toward the brighter growth prospects elsewhere is intensifying the expansion of domestic liquidity, credit, balance sheet leverage, and asset prices in emerging market economies. Combined with stimulative domestic policies, these pressures raise the risk of overheating and a buildup of financial imbalances that could erode asset quality even if demand and credit conditions normalize. We model such a scenario in this section. At the same time, with the increase in global stability risks, emerging markets may face an external shock in the form of a sharp reduction in global growth and a reversal in capital flows, and emerging market banks could be weakened by a rise in funding costs. We model the implications for the capital strength of emerging market banks under such a scenario.

Where are we in the credit cycle?

Unless an economy is operating under financial and monetary policies appropriate to its stage of the credit cycle, imbalances can occur. The traditional credit cycle goes through four distinct phases in sequence: repair (cleansing balance sheets); recovery (restructuring, increasing margins, falling leverage); expansion (rising leverage, increasing volatility, increased speculation); and downturn (falling asset prices, increased defaults). We assessed the trend of various credit metrics in several countries and regions to pinpoint their current location in the credit cycle.16 Generally speaking, the global financial crisis has left advanced economies at an earlier phase in the credit cycle and allowed emerging markets to move further along it (Figure 1.28).

Figure 1.28.
Figure 1.28.

Phases of the Credit Cycle

Source: IMF staff estimates.
  • The United States straddles the recovery and expansion phases of the credit cycle. This reflects a bifurcation among sectors: on the one hand, households and banks are still repairing balance sheets. Household leverage remains elevated, and a large shadow inventory of houses continues to dampen housing prices and exacerbate negative equity, in turn posing risks to bank balance sheets (Figure 1.29).17 A weaker economic trajectory and mounting legal pressures on U.S. banks with large mortgage-related exposures are likely to further exaggerate these risks. On the other hand, large nonfinancial corporations are moving closer to the expansionary phase: Profits have returned to precrisis levels, cash balances are still at record highs, funding pressures are limited (as firms took advantage of lower rates mostly to refinance rather than fund capital expenditures), default rates are low (and are expected to remain contained because the funding gap is low), and bank lending conditions and capital market financing remain easy.18 Until the recent bout of economic weakness, there were signs that corporate credit metrics had reached an inflection point: organic growth was weakening, and share repurchases, mergers and acquisitions, and leveraged buyout (LBO) activity were gaining momentum.

  • The euro area remains at an earlier stage of the credit cycle, in part because the economic cycle is lagging and the repair of bank balance sheets has lagged that in the United States (see the April 2011 GFSR). Household leverage is still too high (especially in the euro area periphery), while some banks continue to struggle with funding pressures, deteriorating asset quality, and an insufficient capital base. Firms continue to deleverage, and corporate downgrades continue to exceed upgrades. Credit conditions (Figure 1.30) remain difficult, and near-term funding pressures are still high.

  • Japan is somewhere between recovery and expansion. Corporate leverage is at precrisis levels, bank lending conditions are fairly loose, and, despite the strong yen, corporate earnings have rebounded sharply, as they have in the United Kingdom and the United States.

  • Except in the Europe, Middle East, and Africa (EMEA) region, emerging markets are the furthest along in the credit cycle, as they were hit less hard by the global financial crisis and their growth remains strong. Credit growth has continued to expand at a fast clip—especially compared with that in advanced economies—while strong demand for their assets is contributing to releveraging of corporate balance sheets, particularly in Asia and Latin America. The EMEA region is still in the recovery phase except for Turkey, where credit grew rapidly until June 2011 as households and smaller enterprises leveraged. The combination of releveraging and rapid credit growth is stretching valuations. Underwriting standards may be weakening, and due diligence is becoming more lax amid increased lending to weaker credits.

Figure 1.29.
Figure 1.29.

U.S. Household Debt and Mortgage Delinquencies

Sources: Federal Reserve; Haver Analytics; and IMF staff estimates.
Figure 1.30.
Figure 1.30.

Bank Lending Conditions for Nonfinancial Corporations

(Net percentage of respondents reporting tightening loan standards)

Sources: Haver Analytics; national authorities; and IMF staff estimates.Note: For Japan and the United Sates, a simple average of responses from small, medium-size, and large firms.

Low interest rates and abundant liquidity have spurred the search for yield…

In the advanced economies, real interest rates are much lower and liquidity is more abundant than is normal for this point in the cycle. For example, the real federal funds rate has historically been at around 1 percent—well above the current rate—whenever spreads on investment-grade corporate bonds (a proxy for the credit cycle) reached current levels (Figure 1.31). A similar situation is evident in other advanced economies, where countercyclical policy stimulus resulted in ultralow policy rates, quantitative easing, and large-scale refinancing operations. With low or negative real interest rates, yields on a wide range of asset classes are too low to meet the return targets for many pension funds and insurance companies or to maintain positive portfolio returns for asset managers.

Figure 1.31.
Figure 1.31.

U.S. BBB-Rated Corporate Credit Spreads versus Real Federal Funds Rate

Sources: Deutsche Bank; Haver Analytics; national authorities; and IMF staff estimates.1Prevailing federal funds rate when credit spreads were historically within 50 basis points of current levels.

…leading to a compression in spreads that may not be fully justified by fundamentals…

While the cyclical pattern has not changed, this credit cycle has been faster and more pronounced than in the past because of rapid central bank easing. From as long ago as the 1930s, no other cycle has seen corporate credit spreads narrow from such elevated levels in such a short period. Only in the 1930s credit cycle were spreads as elevated as they were in this one, but then it took nearly twice as much time for spreads to normalize.

Credit spreads have also narrowed sharply in Europe and Asia, although not to the same extent as in the United States. Other credit metrics exhibit a similar pace and magnitude of change: earnings, the credit rating upgrade-to-downgrade ratio, and default rates have all improved sharply. The global default cycle has been shorter than in earlier cycles in which defaults had reached similar peaks. Low rates have enabled issuers to quickly refinance into longer-dated debt, swap unsecured debt for secured financing, and refinance debt to more manageable repayment levels.

…especially when viewed against the anemic economic recovery.

The overall tightening of corporate credit spreads is occurring against a backdrop of a relatively tepid economic recovery. The current economic cycle is lagging the trajectory of the last 14 cycles, going back to 1929, yet investment-grade spreads have narrowed more sharply and more quickly than during prior cycles as large liquidity injections spread into credit markets and other risky assets (Figure 1.32). A rapid snap-back in spreads could impose losses, thereby undermining corporate as well as funding market confidence.

Figure 1.32.
Figure 1.32.

Current versus Past U.S. Credit and Economic Cycles: Nominal Federal Funds Rate, BBB-Rated Corporate Spread, and Real Cumulative GDP Growth

Sources: Deutsche Bank; Haver Analytics; National Bureau of Economic Research (NBER); and IMF staff estimates.Note: Economic cycles based on quarterly data for real GDP since 1929; estimates for 1929–1947 interpolated from annual data.

And as spreads narrow, investors have started to increase leverage to enhance yield, including through the shadow banking system.

Investors have continued to exercise discipline, as lessons from the crisis remain fresh and as concerns about a growth slowdown have returned. However, at the margin, the sustained period of low yields has prompted some investors (especially those with return targets) to take on more credit, liquidity, structural, and duration risk or to increase leverage to enhance returns.19 While welcome as an indication that credit flows remain largely unimpeded, this trend may have stability implications if it gains momentum.

At the start of the year, the strategies employed by investors to increase yield included extending duration and purchasing less liquid and lower quality assets. As spreads continued to narrow, financial leverage began to rise, as manifested by (i) greater use of leverage (e.g., hedge fund leverage ratios have risen since the start of the year, and in general the use of total return swaps has increased); (ii) more issuance of products with embedded leverage (e.g., structured notes; Figure 1.33);20 and (iii) increased provision of leverage (e.g., by some prime brokers, though levels are not yet excessive). Overall leverage is not particularly high by historical standards—and in fact there have been some recent reversals—but such trends bear close monitoring.

Figure 1.33.
Figure 1.33.

Global Securitized and Structured Products Issuance

(In trillions of U.S. dollars)

Sources: Association for Financial Markets in Europe; Bloomberg L.P.; Securities Industry and Financial Markets Association; and IMF staff estimates.Note: For definition of products, see text note 20.

There are also signs of “style drift,” or increased cross-over investment, which is consistent with the search for yield.

To compensate for low returns on traditional products, new investor classes are gravitating to unorthodox market sectors. For instance, high-yield funds are shifting into equity tranches and alternative assets, nonspecialized investors are gravitating to structured products (e.g., collateralized loan obligations and mortgage-related credit), and retail investors are increasingly seeking out leveraged loan mutual funds and complex types of exchange traded funds (ETFs).

The trend toward riskier investments has been underscored by an increase in alternative investment vehicles. At $1.8 trillion, the assets of global hedge funds are up 25 percent since the trough in late 2009 (Figure 1.34). New private equity transactions as well as refinancings of existing LBOs are also on the rise. Having stayed on the sidelines for some time, private equity funds have sizable cash levels and are increasing leverage.21 While the shift into such investment vehicles may help reduce direct risks to the banking system, their greater opacity and potentially riskier investment strategies create additional challenges.

Figure 1.34.
Figure 1.34.

Hedge Fund Assets under Management

(In trillions of U.S. dollars)

Source: Hedge Fund Research; and IMF staff estimates.

More broadly, with bank balance sheets still in need of repair, credit is increasingly being intermediated through nonbank channels.

The current credit cycle has been distinguished in the United States and, to a lesser extent, in Europe by a shift from banks to the capital markets as the preferred source of corporate financing (Figure 1.35), even though bank lending conditions have eased. The shift reflects the fact that asset markets have been normalizing more rapidly than banking systems. Nonfinancial corporations are determined not to be beholden to banks, given the uncertainty about future commitments. As the source of funding has shifted from banks to markets, the bifurcation between small and large firms has deepened. Small and medium-sized enterprises (SMEs)—which tend to be almost exclusively reliant on bank financing—are getting left behind, while larger firms have easy access to cheap credit.22

Figure 1.35.
Figure 1.35.

Financing by U.S. Nonfinancial Corporations

(In trillions of U.S. dollars except as noted)

Sources: Federal Reserve; Haver Analytics; and IMF staff estimates.

Pockets of leverage could become excessive in some segments.

The high-yield bond market and the leveraged loan market have been especially affected by the search for yield. Issuance has risen (Figure 1.36), while strong demand has enabled issuers to extract more favorable terms, leading to spread compression, weaker covenants, and a greater degree of leverage. Furthermore, compared with more traditional institutional investors that are locked in, retail investors have expanded into the leveraged loan segment through mutual funds and ETFs, whose liquidity could become strained in the event of a pullback.

Figure 1.36.
Figure 1.36.

High-Yield Gross Issuance and Leveraged Loan Covenants

Sources: Bank of America Merrill Lynch; and Bloomberg L.P.Note: Issuance data for 2011 annualized; covenant lite 2011 data as of Q2.

These conditions increase the potential for a sharper and more powerful turn in the cycle.

The trade-off between macroeconomic and financial stability risks needs to be carefully considered. Stability risks are still in their infancy, but with interest rates lower than they usually are at this point in the cycle, there is a potential for a greater deterioration in credit quality down the road. Moreover, because yields have narrowed during a relatively weak economic recovery, there is less of a buffer once the cycle finally turns. The shift away from bank financing exposes corporate issuers to the fickleness of capital markets. Furthermore, the shift into weaker-quality credits, combined with leverage, can be risky if not properly managed. While dimmer prospects for economic growth may temporarily slow this momentum, safeguarding stability calls for greater emphasis on balance sheet repair so that interest rates can be normalized and credit cycle excesses avoided in mature markets. These risks are even more apparent in emerging markets.

Low rates and unfinished balance sheet repair in advanced economies have helped spur flows into emerging markets…

Net capital flows to emerging markets remained relatively strong—although volatile—during the first half of 2011 (Figure 1.37), reflecting higher nominal interest rates, the perception that currencies will appreciate, and relatively strong fundamentals. In turn, the elevated inflows, surging credit growth, and rising debt issuance are supporting a releveraging of balance sheets.

Figure 1.37.
Figure 1.37.

Emerging Markets: Capital Flows, Credit, and Equity Prices

Sources: Bloomberg L.P.; CEIC; and IMF staff estimates.Note: Twelve-month moving sums. Asia = China, Indonesia, India, Korea, Malaysia, and Thailand. Latin America = Brazil, Chile, Colombia, Mexico, and Peru. EMEA = Hungary, Poland, Russia, Turkey, and South Africa.Sources: CEIC; IMF, International Financial Statistics database; and IMF staff estimates.

Net capital inflows to emerging markets have not been excessively strong by historical standards. However, portfolio and bank-related (other) inflows have dominated inflows, particularly in EMEA and Asia (Figure 1.38). The volatile nature of portfolio flows means that they could reverse rapidly if investors take fright or valuations are perceived as too stretched.

Figure 1.38.
Figure 1.38.

Net Capital Flows by Region

(Percent of aggregate GDP, four-quarter moving average)

Sources: Haver Analytics; IMF, International Financial Statistics database; and IMF staff estimates.Note: Asia = China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan Province of China, and Thailand; Europe, Middle East, and Africa = Egypt, Hungary, Israel, Poland, Russia, South Africa, and Turkey; Latin America = Argentina, Brazil, Chile, Colombia, Mexico, and Peru.

…as the search for yield directs flows into emerging market corporate debt securities…

Over the past year, flows into emerging market corporate external debt have surpassed flows into U.S. high-yield debt on an asset-weighted basis. Gross issuance accounted for nearly half of all new private credit in some regions (e.g., Latin America). This is part of a cyclical and structural trend, with emerging market corporate debt increasingly viewed as a substitute for U.S. high-yield debt (Figure 1.39).

Figure 1.39.
Figure 1.39.

Emerging Market Corporate External Issuance

(In billions of U.S. dollars, 12-month moving average)

Sources: Dealogic; and IMF staff estimates.

…which may lead to a mispricing of credit risk and a weakening of due diligence.

The issuance of emerging market corporate debt is on track to reach another record high this year, with firms in Latin America and Asia leading the expansion. High issuance can represent a healthy development to the extent that some previously credit-constrained companies gain access to capital markets; but the risk is that large capital flows may be moving too quickly into this asset class, potentially leading to mispricing and a sudden reversal. Reports of accounting scandals and fraudulent practices suggest that due diligence is slackening, and investors have continued to move down the credit spectrum (Figure 1.40).

Figure 1.40.
Figure 1.40.

Emerging Market Corporate versus U.S. High-Yield Debt: Yields, Leverage, Returns

Sources: Bank of America Merrill Lynch; JPMorgan Chase & Co.; and IMF staff estimates.Note: Leverages calculated as total debt/EBITDA. Returns are estimated for the six months through June 2011.

Emerging market credit risk is being “exported” to international investors.

In response to tightened prudential regulations and, for some sectors, less accommodative domestic credit conditions, emerging market corporations have shifted into international debt issuance, effectively exporting credit risk overseas (Figure 1.41). For example, offshore debt issuance by Chinese firms has surged as credit has been tightened onshore. Chinese companies are also motivated to borrow in dollars to benefit from lower interest rates, ample foreign demand, and expected appreciation of the renminbi. Large property developers have been among the most active external issuers, as their access to mainland credit has been curtailed by official measures to cool the property market.

Figure 1.41.
Figure 1.41.

Emerging Markets External Corporate Issuance, by Sector

Sources: Bank of America Merrill Lynch; JPMorgan Chase & Co.; and IMF staff estimates.

At the same time, rapid growth of domestic credit may weaken the quality of bank assets.

Rapid credit growth in many emerging markets raises the risk of deteriorating credit quality. During credit booms, strong balance sheets tend to generate excessive lending against inflated collateral values (Figure 1.42), while the herd behavior of bank managers tends to cause a deterioration in credit quality. China is arguably at an advanced stage of the credit cycle, reflecting the legacy of its policy-induced lending boom of 2009–10, which has already brought asset quality concerns to the fore (Box 1.5). In other emerging markets, including Brazil and Turkey, credit quality appears strong on the surface, but rapid growth in domestic credit—particularly to the household sector—poses a key challenge to future stability.

Figure 1.42.
Figure 1.42.

Emerging Markets: Total Credit to the Nonbanking Sector

(Deviation from 1996–2010 trend, in Z-scores)

Sources: Bank for International Settlements; IMF, International Financial Statistics database; and IMF staff estimates.Note: Total credit is scaled by GDP and includes total domestic credit by banks, external loans to nonbank sector, and nonfinancial corporate external and domestic debt issuance. Four-quarter moving average of deviation from a 1996–2010 trend. EMEA = Europe, Middle East, and Africa. Z-score = standard deviations from mean.

As the credit cycle advances, some markets for high-end real estate are showing signs of bubble dynamics. Although this is most evident in Hong Kong SAR and Singapore—prices there have been fueled by negative real interest rates, demand from wealthy mainland investors, and the booming financial sector—several other major cities have also seen large price gains. For now, low leverage in this market segment appears to be limiting the risks to financial stability. However, if price corrections spread to lower-income segments and other markets where leverage is higher, there could be broader effects on economic activity and financial stability. It is reassuring, therefore, that recent tightening measures in Hong Kong SAR and Singapore appear to have had some effect in slowing speculative activity and that increased property supply is seen as a powerful tool to combat price increases (Box 1.6).

Historical experience suggests that bank asset quality in many emerging markets is likely to deteriorate in coming years…

Econometric analysis indicates that sizable capital inflows, favorable terms of trade, and strong real growth have all contributed to credit creation in emerging markets.23 Our model predicts that nonperforming loan (NPL) ratios will rise in many emerging markets, even in a baseline scenario in which external and domestic variables normalize gradually as the expansion phase of the credit cycle reaches its end (Figure 1.43). The predicted increase is largest in Asia, where strong credit growth has been supported by accommodative monetary policy, and NPL ratios are at recent lows. In central and eastern Europe, on the other hand, the model does not project a deterioration in credit quality under the base case, as credit growth has been muted in recent years.

Figure 1.43.
Figure 1.43.

Model Prediction for NPL Ratios in 2011 and 2012 Based on 2010 Values

(In percent; no shock)

Sources: Bankscope; IMF, International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: Forecasts based on a panel VAR with ratio of private credit to GDP, NPL ratio, ratio of net capital flows to GDP, and growth rates of terms of trade and real GDP. NPL = nonperforming loan. See Annex 1.1.

…and emerging markets remain vulnerable to external shocks.

Sovereign risks in the euro area, or fiscal strains elsewhere, could spill over to global markets, resulting in risk retrenchment, a reversal of capital inflows, and a decline in commodity prices. Our analysis indicates that vulnerabilities to a sudden stop currently are less elevated in EMEA than in Asia and Latin America, which are at more advanced phases of the credit cycle and have had sharper recent increases in foreign currency liabilities than EMEA. The analysis also indicates that a negative terms-of-trade shock would have the largest impact in Latin America, which has benefited from favorable terms-of-trade shifts in recent years (Figures 1.44 and 1.45).

Figure 1.44.
Figure 1.44.

Impact when Net Capital Flows Decline

Sources: Bankscope; Haver Analytics; IMF, International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: Response to decline in net capital flows of two standard deviations (8.7 percentage points, calculated from pooled sample). Shown are responses relative to the baseline in a panel VAR with ratio of private credit to GDP, NPL ratio, ratio of net capital flows to GDP, and growth rates of terms of trade and real GDP. See Annex 1.1.NPL = nonperforming loan.
Figure 1.45.
Figure 1.45.

Impact when Terms of Trade Decline

Sources: Bankscope; Haver Analytics; IMF, International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: Response to terms-of-trade deterioration of two standard deviations (15.8 percentage points, estimated from pooled sample). Shown are responses relative to the baseline in a panel VAR with ratio of private credit to GDP, NPL ratio, ratio of net capital flows to GDP, and growth rates of terms of trade and real GDP. See Annex 1.1.NPL = nonperforming loan.

…which could pressure emerging market banks.

The vulnerability of growing loan books to macroeconomic shocks means that emerging market policymakers need to carefully monitor the strength of bank balance sheets. An analysis using economic capitalization measures indicates that the capital adequacy of banks in all emerging market regions could be considerably impacted by shocks in GDP growth, terms of trade, and funding costs (Table 1.3). Banks in Latin America would suffer a larger impact from terms-of-trade shocks, while banks in Asia and EMEA would be somewhat more sensitive to a 300 basis point increase in funding costs, as they operate in an environment of lower interest rates.24 In an exceptionally severe case, in which all three types of shocks occur simultaneously, simulations suggest that the absolute changes to capital adequacy ratios would be similar across regions, whereas Asian capital buffers would be somewhat slower to recover in the absence of capital injections, given the weaker outlook for asset quality in Asia over the medium term (Figure 1.46).25

Table 1.3.

Emerging Market Banks: Sensitivity to Macroeconomic and Funding Shocks

(Percentage point deviations from baseline capital adequacy ratios in 2013)

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Sources: Bankscope; IMF, International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: Red cells indicate the largest deviation for the indicated shock, yellow cells the smallest. Capital adequacy ratios calculated as regulatory capital divided by risk-weighted assets using economic (Basel II internal ratings based) risk weights. See Annex 1.1.
Figure 1.46.
Figure 1.46.

Change in Capital Adequacy Ratios under Combined Macro Shocks

(In percentage points, using Basel II IRB risk weights)

Sources: Bankscope; IMF, International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: IRB = internal ratings based. See Annex 1.1.

A balanced policy response is needed to safeguard against overheating risks and to strengthen financial resilience.

Although the intensity of capital inflows in emerging markets has abated somewhat, and policymakers have generally tightened monetary policies, risks of overheating and asset price bubbles persist in some countries (Table 1.4). Structural fiscal deficits are still large; inflation, credit growth, and corporate leverage have continued to rise; and debt and equity valuations appear stretched.

Table 1.4.

Macroeconomic and Financial Indicators for Selected Economies

(Shaded cells represent five economies with highest values for each indicator)1

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Sources: Bank for International Settlements (BIS); Worldscope; Bloomberg, LP.; Consensus Economics; Haver; IBES; IMF: International Financial Statistics database, World Economic Outlook database; and IMF staff estimates.Note: FDI = foreign direct investment; EMEA = Europe, the Middle East, and Africa. In the following notes, Z-score = number of standard deviations from the mean.

In each column except VII and VIII, red cells signal two highest values and yellow cells signal next three highest values; in columns VII and VIII, colors signal lower values.

In percent of GDP 4Q moving average, in Z-scores. Mostly up to March 2011

July 2011 levels in Z-scores relative to 2004–11 period, and change in year-on-year inflation in July 2011. For the Philippines, June 2011 data; for India, the wholesale price index.

In percent of potential GDP 2011 (September 2011 WEO).

Gross international reserves minus gold, year-on-year changes in June 2011; for Egypt and Peru, updated to May 2011 as a percent of 2010 GDP.

Policy rate as of end-August 2011 minus 2011 inflation expectations, in percent.

Estimates of 2011 structural balance, in percent of potential GDP.

Total credit to households and businesses obtained from domestic and international banks and capital markets.

Deviations from 1996–2010 trend, in Z-scores in December 2010.

In percent, annual change to December 2010.

Calculation is based on the International Financial Statistics database, mostly updated to 2011 :Q1. For China, loans are banking sector claims on other sectors; and deposits are calculated as the sum of time, savings, and demand deposits.

In Z-scores, up to December 2010

Z-scores of valuation ratios for equities (average of price-to-book ratio and dividend yield) at May 2011 and of deviations from estimated equilibrium values for local government bond yields at March 2011 (see April 2010 GFSR, Annex 1.9).

Current account balance plus net FDI inflows (reverse signs) in percent of GDP 2011 (September 2011 WEO). Positive number represents financing need