January 25, 2011
Global Financial Stability Still at Risk
Nearly four years after the onset of the largest financial crisis since the Great Depression, global financial stability is still not assured and significant policy challenges remain to be addressed. Balance sheet restructuring is incomplete and proceeding slowly, and leverage is still high. The interaction between banking and sovereign credit risks in the euro area remains a critical factor, and policies are needed to tackle fiscal and banking sector vulnerabilities. At the global level, regulatory reforms are still required to put the financial sector on a sounder footing. At the same time, accommodative policies in advanced economies and relatively favorable fundamentals in some emerging market countries are spurring capital inflows. This means that policymakers in emerging market countries will need to watch diligently for signs of asset price bubbles and excessive credit.
Even though global economic growth has accelerated somewhat (see the World Economic Outlook Update), global financial stability has yet to be secured. The two-track global recovery—with advanced countries growing much more slowly than the rest of the world—continues to pose policy challenges. The slow growth prospects of advanced economies and the continued weakness in their fiscal balances have raised the market’s sensitivity to debt sustainability risks. The evident links between weak balance sheets of government and banking sectors have led to renewed pressures in funding markets in the euro area and widening strains. At the same time, accommodative monetary policies in advanced countries and relatively favorable fundamentals in emerging market economies have spurred capital flows to such economies. This creates upward pressure on asset markets in receiving countries, while raising the latent risk that inflows could reverse and, as a result, poses considerable policy challenges on how best to absorb the flows.
Notwithstanding these factors, financial market performance has been favorable thus far in early 2011, reflecting the more positive economic climate, ample liquidity, and expanding risk appetite. Equity markets in advanced and emerging market countries have risen since the October 2010 Global Financial Stability Report (GFSR). Commodity prices have taken off—with oil, food, metals, and raw material prices all rising rapidly. However, such positive developments have been notably absent for many advanced country sovereigns and their banking systems (Figure 1). In fact, there are now several cases in which sovereign credit default swap (CDS) spreads exceed those in large emerging market countries. Banks in those advanced economies also have elevated CDS spreads.
http://www.imf.org/External/Pubs/FT/fmu/eng/2011/01/index.htm
