The International Monetary Fund released its semi-annual Global Financial Report yesterday, and the news was generally positive.
The resilience of the global financial system has further improved in the past six months, largely because of solid global economic growth, buoyant financial markets, and continued improvement in the balance sheets of the corporate, financial, and household sectors in many countries. The ongoing improvement in the economic fundamentals of many emerging market countries—including efforts to enhance the credibility of their policy framework and the quality of their debt structure—has led to a string of upgrades of sovereign credit ratings, contributing to the benign financial market conditions.
The report contains many observations that seem to be lifted right off the pages of the U.S. economic news. Their observation on corporate liquidity, for example, echoes an observation made on this blog some months ago.
In particular, the overall excellent profitability of the corporate and financial sectors over the past few years has been an important factor in strengthening their balance sheets. The ratio of liquid assets to debt in their balance sheets has risen and stayed at a relatively high level for some time now. So far, the preference for liquidity reflects the caution exercised by corporate executives in making investments—also mergers and acquisitions have picked up only quite recently. This cautious approach has contributed to the slow growth in employment in many countries. By the same token, it has helped to contain the risk of creating investment excesses that in the past have helped trigger sharp market corrections.
The risks to the outlook sound pretty familiar as well.
Possibly, a combination or correlation of several less spectacular events might cause markets to reverse their course, and create a less hospitable environment for investors and borrowers who have become accustomed to low rates. Such risks include disappointing developments as to the narrowing of the U.S. current account deficit, continuing rises in commodity and oil prices feeding through to inflation, larger-than-expected rises in interest rates, as well as negative surprises for corporate earnings and credit quality.
There is this on the dollar...
There is an emerging view among market participants that currency adjustments on their own are insufficient to reduce the global imbalances and that some reduction in growth differentials between the United States and several of its major trading partners is needed. However, market participants are also acutely aware that the financing of the U.S. current account deficit—at least for the time being— hinges, to a certain degree, on the willingness of central banks, especially in Asia, to accumulate further dollar assets...
... and this on monetary policy:
While financial markets have largely priced in a moderate and gradual monetary tightening, they might be less prepared if market interest rates—especially long-term rates— were to go up more abruptly, either because of a sharp decline of the dollar or worse-than expected inflation data. This would lead to the unwinding of many investment positions predicated on low or gently rising rates, leading to corrections in many asset markets.
The Wall Street Journal Online picks up on the IMF's warnings about the growing complexity of financial instruments.
Moreover, otherwise normal market fluctuations could be amplified through liquidity problems. An increasingly relevant contributor to this liquidity risk is the recent proliferation of complex and leveraged financial instruments, including credit derivatives and structured products such as collateralized debt obligations (CDOs). While secondary trading for these products exists, these instruments still rely on quantitative models for relative value assessment, investment decisions, and pricing... While risk management at many financial institutions has been strengthened and become more sophisticated in recent years, the risk management process still hinges, to a crucial extent, on the ability of market participants, in times of market stresses, to execute trades quickly without having prices move too much against them. However, most recent risk management models dealing with the new and complex credit instruments have not yet been put to a live test, that is, whether in time of need, the anticipated counterparties will stand ready to absorb the additional market and credit risks from those who would like to shed it.
Maybe so, but it does seem to me that the global financial system had a pretty significant "live test" in 1998 (in the aftermath of the collapse of the Russian rouble, the failure of Long Term Capital Management, and the market turmoil that continued on into late fall). There was a lot of individual pain, to be sure. But when the hint of systemic market seizure arrived, it was met with aggressive liquidity provision by the world's major central banks. Central banks, in other words, did what central banks are supposed to do, with relatively good results in my view. I doubt that those lessons have been unlearned.