Central banks are running the risk of a severe financial crisis through policies aimed at boosting short-term economic growth, the International Monetary Fund has warned.
In its half-yearly global financial stability report, the IMF said the removal of the threat of higher interest rates had prompted a rapid recovery in financial markets after last autumn’s turbulence but would lead to a fresh buildup in already high levels of debt.
The report expressed concern about a sharp increase in lower quality corporate bonds, the vulnerability of European banks to falling government bond prices, debt levels in China, flows of hot money in and out of developing countries, and the risk of house price crashes.
The report said the tightening in financial conditions during the final three months of 2018 – when markets were unnerved by the possibility of the US Federal Reserve tightening policy throughout 2019 – had been too short-lived to have a material impact on the buildup of vulnerabilities.
Tobias Adrian and Fabio Natalucci, two IMF officials, said in a blogpost released alongside the report that policymakers faced a dilemma as they sought to counter a slowdown in the global economy that has seen the IMF cut its growth forecast to 3.3% this year.
“In the United States, the ratio of corporate debt to GDP is at record-high levels. In several European countries, banks are overloaded with government bonds. In China, bank profitability is declining, and capital levels remain low at small and medium-size lenders,” Adrian and Natalucci said.
“By taking a patient approach to monetary policy, central banks can accommodate growing downside risks to the economy. But if financial conditions remain easy for too long, vulnerabilities will continue to build, and the odds of a sharp drop in economic growth at some later point will be higher.”
The report said overall debt and financial risk taking had increased, and the creditworthiness of some borrowers had deteriorated. “Therefore, a significant economic downturn or sharp tightening of financial conditions could lead to a notable repricing of credit risk and could strain the debt-service capacity of indebted firms.”
Looking ahead, the IMF warned of a risk that the return of optimism to financial markets since the turn of the year could prove short-lived. Investor sentiment could deteriorate abruptly, it said, leading to a sharp tightening of financial conditions that would cause particular problems for the more exposed countries.
The fund named three possible events that might trigger turbulence:
A more pronounced global slowdown could lead to falling asset prices due to a weaker outlook for corporate profits, notwithstanding attempts by central banks and finance ministries to provide stimulus.
An unexpected shift to a more aggressive approach to raising interest rates in the leading industrial countries might lead to falling share prices if investors felt they had taken a too-benign view of the stance of monetary policy.
Political and policy risks, such as an escalation of trade tensions or a no-deal Brexit, could affect market sentiment and make investors more risk averse.
