Vulnerabilities in a Maturing Credit Cycle

Introduction

• Financial conditions have tightened since the October 2018 Global Financial Stability Report (GFSR), but remain relatively accommodative, notably in the United States. After sharp declines in the fourth quarter of 2018, financial markets rebounded in early 2019. This turnaround in market sentiment has been supported by the Federal Reserve’s more patient approach to monetary policy normalization.
• Given buoyant market sentiment, financial vulnerabilities—such as high leverage and liquidity, maturity, and currency mismatches—may continue to build, raising medium-term risks to global financial stability.
• Vulnerabilities in sovereign, corporate, and nonbank financial sectors are already elevated by historical standards in several systemically important countries that account for a significant share of the global economy.
• A sudden sharp tightening in financial conditions—triggered by investors’ reassessment of the outlook for monetary policy in major advanced economies, a sharper-than-expected growth slowdown, protracted trade tensions, or a no-deal Brexit—could expose these vulnerabilities and raise near-term financial stability risks.

Medium-Term Financial Stability Risks Remain Elevated and Could Build Further:

1. The tightening in global financial conditions has led to somewhat higher near-term risks to global growth and financial stability.
2. With global financial conditions still accommodative notwithstanding their tightening, financial vulnerabilities will likely continue to build. The recent tightening in financial conditions was too short-lived to cause a meaningful reduction in the buildup in vulnerabilities, leaving medium-term risks to financial stability broadly unchanged.
3. Medium-term risks continue to be elevated, suggesting that a prolonged period of easy conditions could set the stage for a more severe downturn later.

Global Financial Vulnerabilities Remain Elevated:

1. Vulnerabilities in the sovereign, corporate, and nonbank financial sectors are elevated by historical standards in several systemically important countries and regions that account for a significant share of the global economy.
2. Vulnerabilities arise from leverage, liquidity, maturity, and currency mismatches on the balance sheets of sovereigns, firms, households, banks, insurance companies, and other financial institutions.
3. Because these vulnerabilities tend to amplify and propagate the effects of adverse shocks, they may increase financial stability risks.
4. Vulnerabilities in the corporate sector are elevated in systemically important countries accounting for about 70 percent of total GDP.
5. Vulnerabilities continue to build in the corporate sector and among nonbank financial intermediaries. The corporate debt-to-GDP ratio is at a historically high level, though still lower than in some other countries.
6. In the euro area, vulnerabilities are most pronounced in the sovereign sector, with government debt elevated or still growing in some countries (such as Italy). Although corporate sector vulnerabilities in the euro area do not appear elevated on aggregate, corporate debt has increased significantly in a number of countries in recent years (for example, France).
7. In China, nonfinancial and financial sector vulnerabilities remain elevated notwithstanding the authorities’ efforts to reduce them. Vulnerabilities in the banking sector also remain a concern, especially given bank exposures to leveraged borrowers, with small and medium-sized banks particularly in need of balance sheet strengthening.
8. In other major emerging market economies, weaker fiscal balances have been partially mitigated by reduced rollover risk as fiscal authorities have used the low-interest-rate environment to extend the maturity profile of debt. For banks, the picture is more mixed, with strains more pronounced in some emerging market economies.

Asset Valuations Have Declined since the October 2018 GFSR, but Remain Somewhat Stretched:

• Price misalignments have narrowed in most major equity markets since the October 2018 GFSR. In the United States, price declines in late 2018 helped reduce the extent of overvaluation. Since then the recovery in equity prices has been accompanied by a reduction in earnings uncertainty.
• On net, credit spreads have widened since the October 2018 GFSR, mostly as a result of higher credit risk premiums—reflecting the compensation for liquidity and market risk over and above compensation for default risk.
• Term premiums are historically low but mostly fairly priced. Such levels typically reflect, among other things, expectations for low and stable inflation.
• Real estate valuations appear elevated relative to fundamentals in some countries. Commercial real estate is often used as collateral for corporate borrowing, so any sharp adjustment in prices could adversely affect firms’ access to financing. Commercial real estate prices have risen sharply in a number of jurisdictions over recent years.

A Number of Risks Could Trigger a Renewed Sell-Off of Risk Assets

Continued accommodative financial conditions will likely facilitate further buildup of vulnerabilities. These vulnerabilities could be exposed in the event of a sharp tightening in financial conditions. Possible triggers include the following:

1. A sharper-than-expected global growth slowdown: Disappointing economic data releases could lead to further earnings downgrades, poor credit performance, and a repricing of risk assets.
2. Unexpected shifts to a less dovish outlook for monetary policy in advanced economies.
3. Protracted trade tensions: Expectations of a positive outcome in the US-China trade negotiations have lifted asset valuations in trade-dependent sectors, even though China’s export orders have ebbed.
4. Brexit: A stalemate in the Brexit process threatens to unsettle financial markets, damage investors’ confidence, adversely affect business investment, and give rise to some operational and contractual uncertainties in Europe and the UK.

 How Is the Current Corporate Credit Cycle Different from Past Cycles?

Corporate Earnings Growth May Have Peaked

• Corporate profitability has improved over the past two years. The level and growth rate of corporate profits—as measured by returns on assets—have been notably higher in the United States than in other advanced economies. The profitability of large US corporations has been boosted by tax reform, but has also been supported by strong revenue growth and wider profit margins. However, profits declined notably in the fourth quarter last year.
• Global earnings growth has likely peaked. Market analysts’ forecasts of US firms’ earnings growth for 2019 have been revised down, reflecting expectations of fading fiscal stimulus, higher interest rates, rising input costs and wages, trade tensions, and slowing global demand.
• Sectors with high international exposures, such as information technology, have borne the brunt of earnings markdowns, while domestically oriented sectors, such as financials, have been less affected. In other advanced economies, deteriorating global market sentiment and weaker domestic economic data have contributed to downward revisions to 2019 earnings growth as well.

Lower Profits Will Weaken Credit Quality, Given High Debt Levels

• Until recently, cyclical factors supported corporate balance sheets. A prolonged period of monetary accommodation led to a substantial reduction in the debt-servicing costs of nonfinancial firms. At the same time, the global economic recovery sustained corporate profits globally, while tax reform gave an extra boost to corporate profits in the United States. As a result, the share of debt at firms with weak debt-service capacity and significant liquidity and rollover risks, or with excessive net leverage relative to profits, is now broadly lower than both a few years ago and before the global financial crisis in most major advanced economies.
• However, structural leverage indicators have deteriorated. Aggregate corporate debt−to-GDP ratios have risen to historically high levels in advanced economies. Reflecting companies’ efforts to deal with problem debt after the crisis, the share of debt owed by firms with high (above 0.6) debt-to-asset ratios has declined. However, the share of debt at firms with moderate (between 0.3 and 0.6) indebtedness has increased in both the United States and the euro area.

Risks Have Risen in the Leveraged Loan Market

• Over recent years, the leveraged loan market has increased in size, complexity, and riskiness. The value of leveraged loans outstanding is approaching that of high-yield bonds.
• Meanwhile, the investor base for leveraged loans has shifted toward non bank investors. Leveraged loans are increasingly and predominantly being used to fund financial risk taking through mergers and acquisitions and leveraged buyouts, dividends, and share buybacks.
• However, borrowers in the leveraged loan market are also dependent on capital markets for refinancing, which leaves them vulnerable to liquidity stress and potential defaults.

The Euro Area Sovereign–Financial Sector Nexus

• Fiscal challenges in Italy have rekindled worries about the nexus between the sovereign and financial sectors in the euro area. Bank capital ratios are now higher in the euro area and actions have been taken to reduce non performing loans on bank balance sheets.
• But if sovereign yields were to increase sharply, banks’ stronger links to sovereigns in countries with high government debt could result in significant losses on bank bond portfolios. This, along with potential losses on nonperforming loans, could result in a significant hit to capital for some banks. Insurance companies could also become entangled in the nexus given their significant holdings of sovereign, bank, and corporate bonds.
• Against this backdrop, there is a risk that strains in the financial sector could yet again be passed on to companies and households, with negative implications for economic growth.

Vulnerabilities in China, Emerging Markets, and Frontier Economies

• Emerging market asset prices have recovered from their mid-2018 sell-off and were generally resilient during the turbulence in global financial markets in late 2018. As investors reassessed the outlook for monetary policy normalization in the United States, portfolio flows to emerging markets turned positive.
• The resilience of portfolio flows, on aggregate, has been partly due to the trend increase in passive investor flows, as well as flows to China. Given that benchmark-driven investors are more sensitive to changes in global financial conditions than other investors, the benefits of index membership may be tempered by stability risks for some countries.
• As these investors become a larger share of portfolio flows, external shocks may propagate to medium-size emerging and frontier market economies faster than in the past. China, where vulnerabilities remain high, is becoming an increasingly important driver of emerging market flows.
• Chinese authorities have been facing a difficult trade-off between supporting near-term growth in the face of adverse external shocks and containing the buildup of financial imbalances.

Recent Market Developments

1. Emerging Markets Have Held Up Well: Emerging market currencies and equities have been resilient during the sell-off in mature markets in late 2018 and have rebounded in early 2019, supported by a turnaround in global risk sentiment.
2. Emerging credit markets have recovered as well but were more affected by the global market turbulence in late 2018 due to the large weight of sovereign issuers with weaker economic fundamentals in benchmark indices.
3. China’s equity market sold off more sharply than other emerging markets in 2018 before rebounding in early 2019. Trade tensions and the global sell-off added to pressures from the financial regulatory tightening campaign.
4. To offset tightening financial conditions, Chinese authorities have eased monetary and credit policies. The required reserve ratio for banks was cut three times since the October 2018 GFSR, and a variety of other credit-easing measures and liquidity injections were undertaken.
5. These measures together with improved global risk sentiment have led to the equity market rising by more than 25 percent and nonfinancial credit growth accelerating in early 2019.

China’s Vulnerabilities

• While vulnerabilities remain elevated in China, regulatory tightening has succeeded in containing the buildup in risks. Since the start of a wide-ranging and welcome campaign to strengthen macro- and microprudential regulation nearly two years ago, bank asset growth has slowed considerably, driven by a sharp reduction in claims on other financial institutions. Banks have largely stopped increasing credit via on- and off-balance-sheet investment vehicles, leading to slower overall shadow credit growth. The slowdown was led by a sharp contraction in credit by small and medium-sized banks, which were previously the biggest contributors to the shadow credit expansion.

Bank Weaknesses Exacerbate the Tightening in Financial Conditions for Smaller Firms:

• Small and medium-sized bank balance sheets remain weak, which is contributing to tighter financing conditions for smaller firms. Profitability and capital ratios at small and medium-sized banks continue to edge lower, with many banks facing core Tier 1 capital ratios near regulatory minimums and significant future capital needs from unrecognized shadow credit positions. Funding cost pressures are also higher at these banks given that they must compete to raise deposits, limiting the benefit of loosening interbank funding conditions.

Policy Priorities

1. As the global economic expansion loses momentum, policymakers should aim to prevent a sharper economic slowdown while safeguarding the resilience of the financial system. Monetary policy should be data dependent, and any change in its outlook should be well communicated to avoid unnecessary swings in financial markets or undue compression of market volatility.
2. Efforts should also focus on developing prudential tools to address risks related to rising corporate debt funded by nonbank credit and to address maturity and liquidity mismatches in nonbank financial intermediaries. Measures are needed to mitigate the sovereign–financial sector nexus.
3. Emerging market economies should bolster their resilience to be able to cope with capital flow volatility. In China, authorities should continue financial sector de-risking and deleveraging policies and put greater emphasis on addressing bank vulnerabilities.
4. To mitigate financial stability risks stemming from corporate sector vulnerabilities, countries may consider developing prudential tools for highly leveraged firms (akin to those applied to households) where overall debt is systemically high.
5. In addition, supervisors should ensure that more comprehensive stress tests—that take into account macro-financial feedback effects from high corporate sector indebtedness, as well as correlated risks in related sectors (such as commercial real estate)—are conducted for banks and nonbank financial intermediaries with significant corporate exposures.
6. For leveraged loans, supervisors should take a comprehensive view of risks, intensify oversight, and enforce sound underwriting standards and risk management practices at banks and nonbank financial intermediaries active in the market.
7. To mitigate financial stability risks linked to rising house prices, loan-to-value ratios, debt-service ratios, and/or debt-to-income ratios should be applied more consistently and broadly to nonbank lenders and should be calibrated to increase resilience to shocks to asset prices, interest rates, and incomes.

Policies to Increase Resilience in Emerging Markets and China

1. Reduce external vulnerabilities and strengthen buffers: Emerging market sovereigns should aim to reduce excessive external liabilities and reliance on short-term debt, as well as to maintain adequate fiscal buffers, bank liquidity buffers, and foreign exchange reserves. Authorities should also monitor risks related to the foreign ownership of local currency bonds, especially when a large share of these bonds is held by benchmark-driven investors.
2. Use the exchange rate as a shock absorber (in countries with flexible exchange rate regimes) and intervene in foreign exchange markets if market conditions become disorderly: Before intervening, policymakers should consider the level of the exchange rate relative to fundamentals, the adequacy of foreign exchange reserves, the monetary policy stance, and private sector balance sheet exposures in foreign currencies.
3. Use capital flow management measures on outflows only in crisis or near-crisis situations: These measures should not substitute for necessary macroeconomic adjustment and should be part of a comprehensive policy package to address the causes of the crisis.