Global Financial Stability Report
Vulnerabilities, Legacies, and Policy Challenges
October 2015
Disclaimer: As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.
Risks Rotating to Emerging Markets
Financial stability has improved in advanced economies since April, but risks continue to rotate toward emerging markets. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity. Although many emerging market economies have enhanced their policy frameworks and resilience to external shocks, several key economies face substantial domestic imbalances and lower growth. Recent market developments such as slumping commodity prices, China’s bursting equity bubble and pressure on exchange rates underscore these challenges. The prospect of the U.S. Federal Reserve gradually raising interest rates points to an unprecedented adjustment in the global financial system as financial conditions and risk premiums “normalize” from historically low levels alongside rising policy rates and a modest cyclical recovery.
Chapter 2 examines in detail the factors that influence levels of liquidity in securities markets, as well as the implications of low liquidity. Currently, market liquidity is being supported by benign cyclical conditions. Although it is too early to assess the impact of recent regulatory changes on market liquidity, changes in market structure, such as larger holdings of corporate bonds by mutual funds, appear to have increased the fragility of liquidity.
Chapter 3 studies the growing level of corporate debt in emerging markets, which quadrupled between 2003 and 2014. The report finds that global drivers have played an increasing role in leverage growth, issuance, and spreads. Moreover, higher leverage has been associated with, on average, rising foreign currency exposures. It also finds that despite weaker balance sheets, firms have managed to issue bonds at better terms as a result of favorable financial conditions
Contents
Executive Summary and Preface
Chapter 1: Three Scenarios for Financial Stability
Financial stability has improved in advanced economies since April, but risks continue to rotate toward emerging markets. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity. Although many emerging market economies have enhanced their policy frameworks and resilience to external shocks, several key economies face substantial domestic imbalances and lower growth. Recent market developments such as slumping commodity prices, China’s bursting equity bubble and pressure on exchange rates underscore these challenges. The prospect of the U.S. Federal Reserve gradually raising interest rates points to an unprecedented adjustment in the global financial system as financial conditions and risk premiums “normalize” from historically low levels alongside rising policy rates and a modest cyclical recovery.
| Boxes | |||||
| Chart Chart |
Data | 1.1 China’s Equity Market | |||
| Chart Chart |
Data | 1.2 Compression of Global Risk Premiums and Market Abnormalities | |||
| Chart Chart |
Data Data |
1.3 Banking in Europe: The Impact of Nonperforming Loans | |||
| Tables | |||||
| 1.1 Three Scenarios for Financial Stability | |||||
| 1.2 Why Is Resilient Liquidity Important? | |||||
| Figures | |||||
| Chart | Data | 1.1 Global Financial Stability Map: Risks and Conditions | |||
| Chart | Data | 1.2 Global Financial Stability Map: Components of Risks and Conditions | |||
| Chart | Data | 1.3 Inflation, Monetary Policy, and Policy Rate Normalization | |||
| Chart | Data | 1.4 Economic Risk Taking Remains Weak in Advanced Economies | |||
| Chart | Data | 1.5 Locus of Risks Shifting toward Emerging Markets | |||
| Chart | 1.6 Triad of Global Policy Challenges | ||||
| Chart | Data | 1.7 The Credit Cycle | |||
| Chart | Data | 1.8 Credit Growth, Corporate Leverage, and New Nonperforming Bank Loans | |||
| Chart | Data | 1.9 Emerging Market Companies: Exposure to Dollar Strength and Commodity Prices | |||
| Chart | Data | 1.10 Banking System Average Regulatory Tier 1 Ratio | |||
| Chart | Data | 1.11 Bank Capital and Asset Changes | |||
| Chart | Data | 1.12 Chinese Banks: Asset Quality Challenges | |||
| Chart | Data | 1.13 Evolution of Bank Funding | |||
| Chart | Data | 1.14 Chinese Exchange Rate Movements and Effect on Emerging Market Currencies | |||
| Chart | Data | 1.15 Greece: Developments | |||
| Chart | Data | 1.16 Bank Profitability and Balance Sheet Strength | |||
| Chart | Data | 1.17 Potential Amplifiers of Market Stress | |||
| Chart | Data | 1.18 Large United States and European Regulated Bond Investment Funds with Derivatives-Embedded Leverage | |||
| Chart | 1.19 Systemic Implications of a Liquidity Shock | ||||
| Chart | Data | 1.20 Effect of a Global Asset Market Disruption | |||
| Chart | Data | 1.21 Emerging Market Local Currency Bond Yields | |||
| Chart | Data | 1.22 Corporate Debt Burden Market in Disruption Scenario | |||
| Chart | Data | 1.23 Lower Ratings Would Lock in Higher Borrowing Costs | |||
| Chart | Data | 1.24 Selected Quasi-Sovereign Company Ownership and Debt | |||
| Annex Figures | |||||
| Chart | 1.2.1 Global Asset Market Disruption Scenario: Simulated Peak Effects | ||||
| Chart | 1.2.2 Global Asset Market Disruption Scenario: Aggregated Simulated Paths | ||||
| Chart | 1.2.3 Successful Normalization Scenario: Aggregated Simulated Paths | ||||
| Chart | 1.2.4 Successful Normalization Scenario: Simulated Peak Effects | ||||
Chapter 2: Market Liquidity—Resilient or Fleeting?
Chapter 2 of the October 2015 Global Financial Stability Report examines the determinants of market liquidity and of its resilience. Only some markets show obvious signs of worsening market liquidity, although dynamics diverge across bond classes. The current levels of market liquidity are being sustained by benign cyclical conditions and accommodative monetary policy. At the same time, some structural developments may be eroding its resilience. Policymakers should have a policy strategy in hand to cope with episodes of dry ups of market liquidity. A smooth normalization of monetary policy in advanced economies and the continuation of market infrastructure reforms to ensure more efficient and transparent capital markets are important to avoid disruptions of market liquidity in advanced and emerging market economies.
| Boxes | |||||
| 2.1 How Can Market Liquidity Be Low Despite Abundant Central Bank Liquidity? | |||||
| Chart Chart |
Data | 2.2 Electronic Trading and Market Liquidity | |||
| Chart Chart |
2.3 Structural Drivers of the Resilience of Market Liquidity | ||||
| Chart | 2.4 Market Liquidity and Bank Stress Testing | ||||
| Tables | |||||
| 2.1 Liquidity Measures | |||||
| 2.2 Determinants of Low-Liquidity Regime Probability in the U.S. Corporate Bond Market | |||||
| 2.3 Determinants of Low-Liquidity Regime in the Foreign Exchange and European Sovereign Bond Markets | |||||
| 2.4 Bond Returns and Liquidity Risk | |||||
| 2.5 Summary of Findings and Policy Implications | |||||
| Figures | |||||
| Chart | 2.1 Drivers of Liquidity and Liquidity Resilence | ||||
| Chart | Data | 2.2 Trends in Bond Marktets—Market Liquidity Level | |||
| Chart | Data | 2.3 Bond Market Liquidity—Bifurcation and Price Impact of Large Transactions | |||
| Chart | Data | 2.4 Trends in Market Making | |||
| Chart | 2.5 Dealers’ Balance Sheet Space | ||||
| Chart | 2.6 Central Bank Collateral Policies | ||||
| Chart | 2.7 Regulation and Market Liquidity: Two Examples | ||||
| Chart | 2.8 Fed Purchases and Mortgage-Backed Securities Liquidity | ||||
| Chart | 2.9 Main Drivers of Market Liquidity | ||||
| Chart | 2.10 Financial Sector Bond Holdings | ||||
| Chart | Data | 2.11 Probability of Liquidity Regimes | |||
| Chart | Data | 2.12 Liquidity Spillovers and Market Stress | |||
Chapter 3: Corporate Leverage in Emerging Markets—A Concern?
Chapter 3 of the October 2015 Global Financial Stability Report studies the growing level of corporate debt in emerging markets, which quadrupled between 2004 and 2014. The chapter finds that global drivers have played an increasing role in leverage growth, bond issuance, and corporate spreads. Higher leverage has been associated with, on average, rising foreign currency exposures. The chapter also finds that despite weaker balance sheets, firms have managed to issue bonds at better terms as a result of favorable financial conditions. The greater role of global factors during a period when they have been exceptionally favorable suggests that emerging markets must prepare for the implications of global financial tightening.
| Boxes | |||||
| Chart | Data | 3.1 Shadow Rates | |||
| 3.2 Corporate Foreign Exchange Rate Exposures | |||||
| Chart | Data | 3.3 Corporate Leverage in China | |||
| 3.4 Firm Capital Structure, the Business Cycle, and Monetary Policy | |||||
| Chart | 3.5 The Shift from Bank to Bond Financing of Emerging Market Corporate Debt | ||||
| Chart | 3.6 Taper Tantrum: Did Firm-Level Factors Matter? | ||||
| Tables | |||||
| 3.1 Worsening Emerging Market Firm-Level and Macroeconomic Fundamentals | |||||
| Figures | |||||
| Chart | Data | 3.1 Emerging Market Economies: Evolving Capital Structure | |||
| Chart | Data | 3.2 Emerging Market Economies: Selected Leverage Ratios | |||
| Chart | Data | 3.3 Emerging Market Economies: Changing Composition of Corporate Debt | |||
| Chart | Data | 3.4 Domestic Banks: Ratio of Total Corporate Loans to Total Loans in 2014 | |||
| Chart | Data | 3.5 Emerging Market Economies: Corporate Leverage by Selected Regions and Sectors | |||
| Chart | 3.6 Foreign Exchange Exposures in Emerging Market Economies (Listed Firms) | ||||
| Chart | 3.7 Change in Foreign Exchange Exposures and Corporate Leverage, by Sector | ||||
| Chart | Data | 3.8 Corporate Liabilities and Solvency | |||
| Chart | 3.9 Key Determinants of Emerging Market Economies' Corporate Leverage | ||||
| Chart | Data | 3.10 Leverage, Cash Holdings, and Corporate Investment | |||
| Chart | Data | 3.11 Bond Issuance by Regions and Sectors | |||
| Chart | Data | 3.12 Bond Issuance: Currency Composition | |||
| Chart | Data | 3.13 Deteriorating Firm-Specific Fundamentals for Bond-Issuing Firms | |||
| Chart | Data | 3.14 Bond Issuance: Yields and Maturity | |||
| Chart | 3.15 Factors Influencing the Probability of Bond Issuance | ||||
| Chart | 3.16 Factors Influencing Bond Maturity | ||||
| Chart | Data | 3.17 Emerging Market Economies: Secondary Market Corporate Spreads | |||
| Chart | 3.18 Emerging Market Economies: Effects of Domestic and Global Factors on Corporate Spreads | ||||
Disclaimer: As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.