Report highlights concern over impact of financial turmoil on major economies
RISKS to the stability of the international financial system remain ‘elevated’ in the wake of the US sub-prime mortgage crisis, the International Monetary Fund (IMF) warned yesterday in a report that also flagged growing concern over the impact of financial system turmoil on the major economies.
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The report was issued as the Group of Seven finance ministers and central bank governors prepare to meet in Washington on Friday to discuss new policy responses to the crisis. In its latest Global Financial Stability Report, the IMF urges policymakers to ‘take immediate steps to mitigate the risks of an even more wrenching adjustment’ in financial markets.
It underlined the systemic risks that are looming as a result of ‘deteriorating credit quality, a drop in the valuations of structured credit products and a lack of market liquidity accompanying broad de-leveraging in the financial system’.
The forceful tone of the document reflects the more central role the IMF is assuming in global monetary and financial affairs under its recently appointed managing director, Dominique Strauss-Kahn.
It is likely to come as a shock to stock, bond and currency markets that have regained some semblance of stability in recent weeks as the impact of the sub-prime crisis has appeared to recede.
Problems are ’spreading beyond the US sub-prime market to prime residential and commercial real estate markets, consumer credit and to corporate credit markets’, according to the report. The US remains the ‘epicentre’ of the crisis but ‘industrialised countries with inflated house price levels relative to fundamentals or stretched corporate or household balance sheets are also at risk’, it says.
The report strikes a chilling note too about the dangers of an economic slowdown. It warns that damage to the capital base of financial institutions, coupled with continuing uncertainty about the size and location of bank losses, will ‘weigh heavily on household borrowing, business investment and asset prices, in turn feeding back into employment, output growth and balance sheets’.
The impact could be more severe than in previous credit cycles because of the huge amount of securitisation and leveraging built into the financial system, the report says. ‘It is now clear that current turmoil is more than simply a liquidity event’ and reflects ‘deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper and more protracted’.
Emerging market countries have been ‘broadly resilient’ so far to the spreading financial system crisis, but with debt markets reeling under the impact of turbulence in advanced countries and funding costs rising, ‘further shocks to investors’ risk appetite for emerging market assets cannot be ruled out’.
Countries with current account deficits and reliant upon foreign debt are especially vulnerable, the IMF says.
It suggests that falling house prices and rising delinquencies on mortgage payments could lead to aggregate losses of around US$565 billion in the US residential mortgage and related securities markets. And if losses on commercial real estate, consumer credit and corporate loans are added, the total rises to US$945 billion, which points to ‘added stress on bank capital and further write-downs’.
Macro-economic policy will have to be the first line of defence ‘to contain downside risks to the US and other leading economies impacted by the crisis’, the IMF says.
Central banks need to ‘reflect further on the role that monetary policy may have played in fostering a lack of credit discipline and to improve their instruments for relieving liquidity stress in today’s more global financial system’.
The challenge will be to control systemic instability ‘in ways that minimise both moral hazard and potential fiscal costs’, the IMF says. And compensation structures that contributed to the credit explosion also need addressing.
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