Washington: Financial stability has broadly improved in advanced countries and has deteriorated in emerging economies in the past six months, the International Monetary Fund said in its latest Global Financial Stability Report released Wednesday.
"I am pleased to tell you that global financial stability is improving - we have begun to turn the corner.
"But it is too early to declare victory as there is a need to move beyond liquidity dependence by overcoming the remaining challenges to global stability," Jose Vinals, IMF's Financial Counsellor, told reporters at the release of the report on the sidelines of the IMF and World Bank Group Spring Meetings.
The US economy is gaining strength, setting the stage for normalisation of monetary policy, he said. In Europe, better policies have led to substantial improvements in market confidence in both sovereigns and banks.
In Japan, Abenomics (measures taken by Japanese Prime Minister Shinzo Abe to revive the economy) has made a good start as deflationary pressures are abating and confidence for the future is rising.
"And emerging market economies, having gone through several recent bouts of turmoil, are adjusting policies in the right direction," Vinals said.
The IMF, he said, continues to track growing hot spots in the US financial system.
Many of these are in the shadow banking system, such as strong issuance of high-yield bonds and leveraged loans, weakened underwriting standards and underpricing of risk.
High-yield issuance over the past three years is more than double the amount recorded before the last downturn, while high-yield bond spreads have fallen close to pre-crisis levels.
Supervisory measures, while now more intense, have not yet sufficiently restrained some of these excesses.
A sudden rise in yields could lead to substantial widening of credit spreads and add to concerns about leverage and future defaults.
Emerging markets are vulnerable to tightening in the external financial environment after a prolonged period of capital inflows, easy access to international markets and low interest rates, he said, adding that this had induced substantial borrowing, particularly by companies.
"But rising interest rates, weakening earnings and depreciating exchange rates could put substantial pressure on emerging market corporate balance sheets under our adverse scenario.
"In this scenario, emerging market corporates owing almost 35 per cent of outstanding debt could find it hard to service their obligations," Vinals said.
While the situation varies across countries, economies under recent pressure due to macroeconomic imbalances share some vulnerabilities in their corporate sectors, he said.
In China, achieving orderly de-leveraging of the shadow banking system is a key challenge. He said non-bank financial institutions have become an important source of financing in China, doubling since 2010 to some 30 to 40 per cent of GDP.
"Savers may not realise the higher risks that lie behind the more attractive rates of return offered by non-bank savings products due to the perception of implicit guarantees," he said.
The challenge is to transit to a financial sector in which market discipline plays a larger role and prices more accurately reflect risks, without triggering systemic stress, Vinals said.
The IMF said there is a need to get normalisation of US monetary policy right vis-a-vis timing, execution and communication.
"Effective macro-prudential policy is key to allow for smooth exit by containing financial stability risks, particularly in the shadow banking system," he said.
"Emerging markets need to continue to prepare for tightening in global financial conditions by enhancing resilience through strong macro and prudential policies, building policy buffers and managing corporate leverage.
"They should also stand ready to ensure orderly market conditions through adequate provisioning of liquidity in the event of turbulence," he added.
While Japan needs to complete Abenomics, the euro area needs to finish cleansing of both banks and corporates, start the Banking Union right and develop non-bank sources of credit to smaller companies. This is paramount for confidence and recovery, the IMF official said.
