Global financial stability: in the hands of growth
Over the last few weeks the risk of instability in international financial markets has once again taken centre stage. Firstly, a series of disappointing cyclical indicators for the euro area and some emerging countries aroused fears of a global economic slowdown, resulting in sharp falls in stock markets and other risk assets. Secondly, coinciding with the start of this turbulence, a voice as authoritative as the IMF issued warnings regarding the overheating of some financial asset prices, caused by the abundant liquidity provided by the monetary policies implemented over the last few years. Both aspects are closely related: «financial stability», «economic growth» and «liquidity» make up a trio with complex interactions and uncertain outcomes. If growth picks up, then the risks to financial stability will be limited and manageable. If not, there will be serious reasons to worry about the current situation of extremely accommodative monetary conditions.
The IMF examines this issue in detail in its twice-yearly report on global financial stability (GFSR). Ultimately, the overriding impression is that the IMF is somewhat more concerned than on previous occasions. In its opinion, global financial vulnerability has been aggravated by two factors. First, the continued fall in risk aversion among investors. According to various measures, halfway through 2014 risk aversion had returned to the minimal level seen before the 2007 crisis. This comes as no surprise. Very low levels of interest rates and volatility, resulting from monetary ease, have encouraged investors to search for yield, turning to higher risk assets such as shares and corporate bonds. This has pushed up the price of these assets and narrowed the spreads of their yields compared with other safer investments. One clear example are the gains made by the US stock market since the end of 2012, almost half of which can be explained by the drop in the stock market risk premium, according to IMF estimates. The IMF documents that excessive financial risk taking is widespread, both geographically and also regarding the types of assets involved. However, without denying this evidence, in our opinion the risk of speculative bubbles is still limited and focused primarily on the corporate bond markets. Specifically, the gains made by US high yield bonds and the large volumes of assets issued over the last few months in these markets are clear symptoms of overheating.
Another aspect, which usually receives less attention but which the IMF quite correctly points to as a second factor that could undermine global financial stability, is the underestimation of market liquidity risk, understood as the potential difficulty in finding counterparties to close large-scale operations easily and efficiently (a different concept to monetary liquidity or the aforementioned financing). This higher liquidity risk in the market comes largely from some structural changes occurring in the institutional framework. In particular, the progressive adoption of new regulations for banks, in addition to strengthening the sector as intended, has also led to a reduction in the presence of banks (as investors and market makers) in markets of assets with high credit risk and low liquidity. This effectively reduces the potential breadth and depth of such markets. On the other hand, the relative weight of the non-banking sector has increased significantly. Also in this area, the main cause for concern is the market for US corporate bonds (and foreign bonds) given that households now own, directly or indirectly, 30% of the total (compared with 25% in 2010). The consequences of this change in the nature of the corporate bond market's participants are not irrelevant: higher volatility and a greater likelihood that any initial small losses will be amplified and the negative feedback loop exacerbated.
Nonetheless, we believe that risks to financial stability are limited: sooner rather than later the gradual recovery of the economy will end up supporting the financial markets, taking over this role from liquidity. Meanwhile the correct use of macroprudential policies will be enough to mitigate any overheating that may appear in some localised markets. However, the events of the last few weeks remind us of the possible risks to financial stability involved in any deviation from this scenario.
