Global Financial Stability

Outlook

Fabio Natalucci Deputy Director

Monetary and Capital Markets Department

International Monetary Fund

1

Financial Stability Risks Could Rise Sharply

Vulnerabilities

Continue to Build

• High nonfinancial leverage

• Stretched asset valuations

• EM external borrowing

• Bank exposures & FX funding

Risks Could Rise Sharply

Possible triggers:

• Broader EM pressures

• Escalation of trade tensions

• Political and policy uncertainty

• Faster monetary policy

normalization

Since the April 2018 GFSR

• Global financial conditions have

tightened somewhat, but remain

broadly accommodative

• Near-term risks have increased

modestly, while medium-term

risks remain elevated

2

MARKET DEVELOPMENTS

3

Financial Conditions Have Diverged Across AEs and EMs

Financial Conditions Indices of Other

Advanced and Emerging Market Economies

(z-scores over 2010-18)

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2015 2016 2017 2018

AE ex. US China EM ex. China

Last GFSR

Tighter conditions

Financial conditions in the US eased,

despite policy rate hikes…

Global Growth Forecast Densities

(Probability density, 2018:Q3)

…offsetting tighter financial conditions

in EMs, and…

4

…supporting near-term growth, while

keeping medium-term risks elevated

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-1 0 1 2 3 4 5 6

Near term

Medium term

5th percentile

Global growth rate (percent)

US Financial Conditions Index and

Federal Funds Rate

(z-scores over 2010-18 and percent)

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

0.0

0.5

1.0

1.5

2.0

2.5

2015 2016 2017 2018

Federal Funds Rate (lhs) FCI (rhs)

Last GFSR

Tighter conditions

Note: Assessment of financial conditions is based on findings of the Global Financial Stability Report – October 2018

The sharp selloff in US stocks triggered a

global stock market correction…

Major Stock Index Performance

(index to Jan 1, 2018; YTD change in parentheses)

… leading to a significant fall in equity

valuations

12-month Forward Price-to-Earnings Ratio

(z-score since 1987; current value in parentheses)

5

Recent Market Movements Have Contributed to Tighter Conditions

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

2012 2013 2014 2015 2016 2017 2018

US (15.3) Europe (11.9)

Japan (12.3) EM (10.2)80

90

100

110

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

US (3.5%) Europe (-8.8%)

Japan (-9.3%) EM (-12.2%)

Markets Are Pricing in a Benign Macroeconomic Outlook

6

Policy rate expectations point to gradual

rate hikes…

… despite relatively benign expectations

of future inflation

Breakeven Swap Rates, 5Y5Y Forward

(Percent)

Overnight Indexed Swap (OIS) Forward Rate Curves for

Advanced Economies

(Percent)

Note: Annual average three-month overnight indexed swap (OIS) rates on forward

contracts for tenors from six months to five years. The OIS forward curves are

constructed from the USD, EUR, JPY, and GBP, and the average, maximum, and

minimum are computed for each tenor across the four jurisdictions.

-2

-1

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

JPY

USD

EURO

-1

0

1

2

3

4

5

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

201

7

201

8 Y

TD

Average

Maximum

Minimum

In Certain Asset Classes, Valuations Still Increasingly Stretched

Term premiums are low, but mostly fairly priced based

on fundamentals…

Credit Spreads on US Investment Grade and

High Yield Corporate Bonds

(Spread over US Treasury in basis points,

Yield on GE bond in percent )

7

…but corporate spreads remain very low, given

creditworthiness of borrowers

Deviation from Fitted 10-Year Premium

(Percentage points)

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00Deviation from weighted-average fitted value

Max-Min of the range

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

0

500

1000

1500

2000

2500

2006 2009 2012 2015 2018

US IG Spread US HY Spread GE 5-Yr USD Sr. Secured (RHS)

%Bps

Intensifying Risks in Leveraged Lending

Leverage Multiple

Global new issuance of leveraged loans

has been growing…

Covenant Quality

… as has been the issuance of such

loans by highly indebted companies…

8

… with fewer investor protections and

lower overall quality

New Issuances of Leverage Loans

(Billion of US Dollars)

Note: 2018 data is through Q3 and annualized to estimate full-year 2018 issuance.

Note: Leverage multiple is defined as the ratio of total

debt-to-earnings before interest, taxes, depreciation and amortization after issuance of the loan.

Note: Moody’s Loan Covenant Quality Index score is

a year average. Data unavailable from 2008 to 2010. 2018 data is through Q3.

0

100

200

300

400

500

600

700

800

900US Issuers

Non-US Issuers

2.0

2.5

3.0

3.5

4.0

4.5

0

10

20

30

40

50

60

70

80

90

07 08 09 10 11 12 13 14 15 16 17 18

Covenant-lite percent of newissuance (left scale)

Moody's Loan Covenant QualityIndex score (right scale)

Higher Score Equals Weaker Covenants

Portfolio Flows to EMs Have Been Under Pressure

9

EM Portfolio Flows by Investor Type

(US$ bn, 3-month rolling sum)

EM portfolio flows have declined, driven by

a reversal in retail fund flows

Some moderation in EM portfolio flows is expected

due to ongoing US monetary policy normalization

Baseline: Estimated Cumulative Impact of External

Factors on Portfolio Flows to EMs

(US$ bn)

-120

-90

-60

-30

0

30

60

90

120

150

2013 2014 2015 2016 2017 2018

Renminbi

devaluationU.S. electionTaper

tantrum

Institutional

flows

Retail flows

EM

Sell-off

Total flows

-140

-120

-100

-80

-60

-40

-20

0

20

2017Q4 2018Q2 2018Q4 2019Q2 2019Q4

Risk aversion (assumed to stay at 2018:Q3 level)

Fed balance sheet (from Federal Reserve)

Fed rates (consistent with WEO)

Estimates through 2018Q3

Baseline Outlook

-50 0 50 100 150 200 250 300 350 400

ChinaPoland

ChileMalaysia

PeruKazakhstanPhilippines

ColombiaHungary

RussiaIndonesia

Mexico

BrazilSouth Africa

Turkey

EgyptNigeriaUkraine

ArgentinaLebanon

Investors Have So Far Differentiated Among EMs

10

Lower-rated EMs have seen larger widening in

external debt spreads…… but outsized FX currency moves have been limited

to a few countries

USD Government Bond Spreads

(changes since end-March; basis points)

A

BBB

BB

B

EM and AE Currencies against the USD

(index, 3/30/18=100)

Note: Letters refer to foreign currency long-term sovereign credit ratings, as assigned by at least two out of the three major credit rating agencies

Note: “High spread EMs” include Argentina, Brazil, South Africa, and Turkey; “Oil exporters” include Colombia, Kazakhstan, Mexico, and Russia.

65

70

75

80

85

90

95

100

105

Apr May Jun Jul Aug Sep Oct Nov Dec

Advanced economies Oil exporters

All EMs High spread EMs

Depreciation against

the dollar

EM Policy Responses to Market Pressures Have Varied

EM policy responses have included policy rate hikes…

Changes in Actual and Expected Policy Rates

(changes from 3/30/18 to 11/07/18; basis points)

…and foreign exchange market interventions

11

-75

-50

-25

0

25

50

Oct-14 Jul-15 Apr-16 Jan-17 Oct-17 Jul-18

Latin America

EM Asia

CEEMEA

14 EMs excluding China

Reserves Operations

(US$ bn)

Note: In Argentina, the monetary regime was changed on October 1.

-150

-100

-50

0

50

100

150

200

250

300

350

Bra

zil

Chin

a

Mala

ysia

Pola

nd

Colo

mbia

Thaila

nd

Chile

Rom

ania

India

Hunga

ry

Phili

ppin

es

South

Afr

ica

Indon

esia

Mexic

o

Turk

ey

Russia

Arg

entina

Change in forward policy rate forend-2019

Change in actual policy rate

1125

1682

3275

Frontier Markets Face Challenging External Borrowing Conditions

12

Frontier Market International Bond

Issuance and Spread

(US$ bn and bps)

Frontier Issuers’ International

Bond Redemptions

(US$ bn)

Low-income Countries Face Debt

Challenges

(percent share of all LICs)

More low-income countries are

at risk of distress

External borrowing conditions

have deteriorated

Some countries have large rollover

needs over the medium term

0

2

4

6

8

10

12

14

16

18

2019 2020 2021 2022 2023 2024

Africa

Latin America

Asia

Europe

Middle East

0%

10%

20%

30%

40%

50%

60%

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

In debt distress

High risk of debt distress

250

300

350

400

450

500

550

0

2

4

6

8

10

12

Ma

y-1

7Ju

n-1

7Ju

l-1

7A

ug

-17

Se

p-1

7O

ct-

17

No

v-1

7D

ec-1

7Ja

n-1

8F

eb

-18

Ma

r-18

Ap

r-18

Ma

y-1

8Ju

n-1

8Ju

l-1

8A

ug

-18

Se

p-1

8O

ct-

18

No

v-1

8

Frontier spread

(bps, right scale)

FINANCIAL VULNERABILITIES

13

Non-financial Sector Debt Vulnerabilities Continue to Rise

14

Leverage Heatmap: 2018

(percentile ranks; pooled sample, 2000 or earliest available to 2018)

REGIONS

Non-financial sector leverage has increased since the global financial crisis and is high in some regions,

while banking sector leverage has broadly improved

S

E

C

T

O

R

S

Note: the heatmap is based on the data for 29 jurisdictions with systemically important financial sectors.

United States Euro area Other AEs China Other EMs

Corporates

Households

Sovereigns

Banks

Insurers

Asset

managers

< 20% 20-40% 40-60% 60-80% > 80%

Banks’ Exposure to Opaque and Illiquid Assets a Concern

15

... but these holdings are still large relative

to capital of some G-SIBs.

Note: the vertical axis shows the estimated loss (in percent) on Level 2 and Level 3

assets that would result in a 1 percentage point reduction in each bank’s leverage ratio.

Exposure to Level 2 and Level 3 Asset, 2018

(percent)

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12

North America

Euro area

Other Europe

Asia and Pacific

Level 2 and Level 3 assets to Basel III Tier 1 capital (times)

0

1

2

3

4

5

6

7

8

9

10

2014 2015 2016 2017 2018

Other

Europe

Asia and Pacific

North

America

Euro

area

G-SIB Holdings of Level 2 and Level 3 Assets

(Multiple of Basel III Tier 1 capital)

G-SIB holdings of illiquid assets have fallen …

EM Vulnerabilities Need to Be Carefully Monitored

16

Emerging Markets: Key Risks and Vulnerabilities

VulnerabilitiesRisks Buffers

Faster monetary policy normal-

ization in advanced economies

• Strong U.S. dollar

• Rising interest rates

Political risks

• Trade tensions

• Policy uncertainty

Contagion

• High leverage

• Large external financing needs

• Short-term foreign currency debt

• Flighty investors

• Trade exposures

• Sound policy frameworks

• Foreign exchange reserves

• Fiscal buffers

• Deep and liquid local markets

• Strong local investor base

30

50

70

90

110

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

20

15

20

17

75th 90th Median

High Public and External Debt Are Key Vulnerabilities for EMs

17

Global

Financial

Crisis

90

140

190

240

290

340

390

440

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

20

15

20

17

75th 90th Median

0

20

40

60

80

100

120

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

20

15

20

17

10th 25th Median

Government Debt to GDP Reserves to ARA Metric 1/External Debt to Exports

Public debt and external debt ratios have increased across many EMs since the global financial crisis,

while FX reserve ratios have remained close to the pre-crisis levels

Notes: all ratios in percent. Red shades show the weakest percentiles of all EMEs for each vulnerability metric.

1/ The ARA metric reflects potential balance-of-payment FX liquidity needs in adverse circumstances and is used to assess adequacy of FX reserves against potential FX liquidity

drains (see IMF Policy Paper, 2015 “Assessing Reserve Adequacy-Specific Proposals.”)

China: Deleveraging and De-risking Progress

18

Regulatory tightening has slowed the

buildup of risks in financial sector…

Investment Products and Small-to-Medium

Bank Claims on Financial Institutions

(Three-month change, trillions of renminbi)

Corporate Defaults and Corporate

Bond Spreads

(Billions of renminbi, basis points)

… and led to tighter credit

conditions for weaker borrowers…

Leverage at Nonfinancial Traded

Companies

(Top 100 Chinese firms by assets)

… but the deleveraging process is

far from complete.

Note: Leverage is measured as the ratio of liabilities to

common equity.

-4

-2

0

2

4

6

8

2015 16 17 18

Investment products

Bank intrafinancial sector claims

4.0

4.5

5.0

5.5

6.0

6.5

2010 2011 2012 2013 2014 2015 2016 2017 2018:Q1 2018:Q2

0

5

10

15

20

25

30

35

40

45

200

250

300

350

400

450

500

2014 2015 2016 2017 2018

Annual defaulted bonds (billions of renminbi, right scale)

2018 pace (billions of renminbi, annualized, right scale)

Yield spread of AA- bonds to five-year government bonds(basis points, left scale)

Liquidity Risk in the Chinese Bond Market

19

Trading turnover fluctuates more than

in other countries…

Annual Growth in 3-Month Average Bond

Trading Volumes, by Country and Bond Type

(Percent)

Rolling 60-day Sum of Daily Bond

Trading to Outstanding Total and

One-Month SHIBOR interbank Rate

… and volumes tend to fall when

interbank rates rise.

Repo Borrowing Outstanding and

Trading Volumes

(Trillions of Renminbi)

Trading volumes decline poses risks

given growing short-term borrowing

-100

-50

0

50

100

150

200

250

300

2013 2014 2015 2016 2017 2018

US government China government

US corporate China corporate

0.0

0.2

0.4

0.6

0.8

1.0

0

2

4

6

8

10

12

60-day bond

turnover ratio

(right scale)

Interbank

yield

(left scale)

>1.5x standard

deviation 60-day

move in bond yields

0

2

4

6

8

10

12

Total short-term borrowing

Average daily trading volume

Japanese Banks Cross-Currency Funding

20

Japanese banks are reliant on cross-

currency funding via swaps…

US Dollar Cross-Currency Funding Ratio

(Net cross-currency derivatives

as percent of total assets)

Cross-Currency Basis Swaps

(Spread on three-month swaps, basis points)

Dollar funding conditions remain

relatively tight

Supply of Foreign Exchange Derivatives

to Japanese Financial Institutions

(Billions of US dollars)

... while supply is shifting from banks

to nontraditional financial institutions

Note: Data as of October 2018 Global Financial Stability Report

51% 59% 61%

75%70%

65%68% 71%

49%

41%39%

25%30%

35%

32% 29%

0

200

400

600

800

1,000

1,200

1,400 Non-Japanese, non-traditional lenders

Non-Japanese banks

-20

-10

0

10

20

30

40

50

2000 2002 2004 2006 2008 2010 2012 2014 2016

Non-US banks CAN CHE DEU FRA GBR JPN

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

20

2013 2014 2015 2016 2017 2018

JPY

EUR

GBP

FINANCIAL STABILITY RISKS

21

The Outlook for EMs Remains Challenging

22

Adverse scenario assumptions:

• US corporate bond spreads widen

by 100 bps

• US 10-years bond yields fall 30 bps

• The US dollar rises 5 percent

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0

Baseline

Scenario

5th percentile

A deterioration in the global risk appetite could lead to larger portfolio outflows from EMs

Portfolio flows in percent of EM GDP

Baseline and Adverse Scenarios:

Near-Term Debt Portfolio Flows Forecast Densities

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

-1.5 0.5 2.5 4.5 6.5

Baseline

Trade scenario

1.5 ppts

An Escalation of Trade Tensions Could Raise Financial Stability Risks

23

Near Term Medium Term

WEO/GFSR Trade Tensions Scenario: Growth Forecast Densities

Global GDP growth rate (percent)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

-1.5 0.5 2.5 4.5 6.5

Baseline

Trade scenario with persistent financialconditions shock

Global GDP growth rate (percent)

An Increase in Policy Uncertainty Could Trigger A Risk-off Sentiment

25

Markets remain concerned about

fiscal policy uncertainty in Italy…

…and redenomination risk

Italian Sovereign Spreads and Bank Equities Italy Redenomination Risk

(CDS spread difference between ISDA ’03 and ‘14 definitions, bps)

0

20

40

60

80

100

120

2016 2017 2018

Italy

France

Spain

French

presidential

elections

Italian

general

elections

0.5

0.6

0.7

0.8

0.9

100

150

200

250

300

350

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

10-year Bond Spreadover Bunds (bps, LHS)

Italian Banks Price-to-Book (RHS)

Large Financial Sector Exposure to the Sovereign is a Concern

25

… and these risks are not limited to

banking institutions

Insurers’ Exposure to Southern European

Sovereigns, 2017Q4

(Percent of capital)

… but risks from growing

“sovereign-bank” nexus are rising…

Banking System Exposure to Domestic

Governments, 2018

(Percent of assets)

Note: Based on the latest available data in 2018. The size of

the circles is proportional to the banking systems’ exposure

to their domestic government (relative to assets)

Bank balance sheet weaknesses

are gradually being addressed…

Italian Banks: Non-Performing Loans

(Percent of total bank loans)

0.0

4.0

8.0

12.0

16.0

20.0

20

05

Q4

20

06

Q3

20

07

Q2

20

08

Q1

20

08

Q4

20

09

Q3

20

10

Q2

20

11

Q1

20

11

Q4

20

12

Q3

20

13

Q2

20

14

Q1

20

14

Q4

20

15

Q3

20

16

Q2

20

17

Q1

20

17

Q4

ITAPRT

JPNBEL

ESP

USA

GRCKOR

CHE

IRL

DEU

GBRFRA0

2

4

6

8

10

12

14

0 100 200 300 400 500 600

Domestic sovereign CDS spread (basis points)

Asia and Pacific

Euro area

North America

Other Europe

0

50

100

150

200

250

300

ITA ESP PRT GRC

Domestic

Cross-border

Brexit – Financial Stability Considerations

Recommendations

• Financial institutions should

step up their preparations

• Authorities should continue to

work with private parties to

reduce risks of disruption

• Authorities should provide more

clarity on their intention to

mitigate cliff-edge risks

Medium-Term Challenges

• Market liquidity could be

fragmented raising cost of funding

• Onshore and offshore markets:

Trading venues could be

duplicated

• Challenges of risk management

because institutions could become

more complex

Short-Term Risks

• Contractual Risks: Unexpected

changes to the legal framework

governing financial services (e.g.,

derivative and insurance contracts)

• Operational risks: Uncertainties

regarding regulatory environment in

which financial institutions will

operate during the transition

26

A DECADE AFTER THE CRISIS: ARE WE SAFER?

27

Regulatory Reform Agenda Is Yet to be Completed and Fully Implemented

28

Quality of Regulation and Supervision Macroprudential Authorities’ Powers

Percent of

banking assets

Compliant

Largely compliant

Materially noncompliant

Capital

Liquidity Percent of countries, 2017

Compel

Comply or explain

Recommend

None

New Risks Need to Be Actively Monitored

29

… and the assets of nonbank financial institutions

have increased

Bank and Other Financial Institutions’ Assets

(percent of GDP)

80

100

120

140

160

180

200

220

240

OFIs Banks

The systemic importance of central counterparties

has grown…

CCPs and Other Counterparties in Derivatives Clearing

(share of different counterparties, percent )

0

10

20

30

40

50

60

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

Central counterparties

Banks and securities firms

Hedge funds

Other residual financial institutions

Insurance and special purpose vehicles

Note: the remaining two categories, “reporting dealers” and “nonfinancial

institutions”, are not shown in the chart

Need to Actively Develop and Apply Macroprudential Tools

30

Availability of Macroprudential Tools for Addressing Key Vulnerabilities

Note: Colors depict number of countries reporting at least one macroprudential tool:

White shading means policy tools are unavailable or not reported. “Others” includes prudential tools such as risk management requirements, reporting duties,

and, less frequently fiscal measures. The tale covers 29 economies with systemically important financial sectors.

< 20% 20-40% 40-60% 60-80% > 80%

Vulnerabilities

AE EM AE EM AE EM AE EM AE EM AE EM

Leverage 14.00 6.00 16.00 5.00 21.00 7.00 13.00 1.00 12.00 4.00 2.00 1.00

Liquidity Mismatch 0.00 0.00 0.00 0.00 21.00 7.00 3.00 2.00 15.00 3.00 0.00 1.00

Maturity Mismatch 1.00 0.00 5.00 2.00 0.00 0.00 0.00 0.00 0.00 1.00 0.00 0.00

FX Mismatch 0.00 5.00 0.00 3.00 7.00 6.00 13.00 2.00 0.00 0.00 0.00 0.00

Valuation Misalignment 0.00 0.00 0.00 0.00 0.00 0.00 12.00 1.00 12.00 1.00 0.00 0.00

Interconnectedness 1.00 1.00 0.00 0.00 22.00 7.00 13.00 2.00 13.00 2.00 0.00 1.00

Others 2.00 0.00 2.00 1.00 0.00 0.00 0.00 0.00 13.00 3.00 0.00 0.00

Corporates Households Banks Non-Bank Financials

Insurers Pension FundsAsset Managers