Global financial conditions remain quite precarious
If it wasn’t bad enough that the IMF further lowered its global growth forecasts a few days ago, the Global Financial Stability Report (GFSR) puts several important caveats to even this growth. As the report puts it, ‘although economic benefits are becoming evident in some countries, market and liquidity risk have increased to levels that could compromise financial stability if left unaddressed’. A sample of the 300 largest banks in advanced economies finds that 40% of them—70% in the euro area—are not strong enough to support the credit required in case there is a recovery.
Though the impact of extra QE-liquidity is well known, the GFSR’s numbers highlight the extent of the vulnerability. So, after pointing out that volatility levels across asset classes are at a 15-year low, the GFSR makes a few additional points. One, capital markets have become a far more significant provider of capital since the crisis—the share of credit instruments held in mutual fund portfolios has doubled since 2007 and currently accounts for 27% of global high-yield debt. Two, around half the increase in US equity prices since the end of 2012 has been due to a decline in risk premiums, not due an increase in earnings. Three, US corporate bonds spreads—for B- and CCC—are no longer sufficient to protect against even an average default cycle; indeed, around 30% of leveraged loan transactions this year had leverage ratios of more than six times ebitda. As a result, a simulation that the IMF does, of credit risk premiums reverting to historic norms—this means repricing of credit risk by 100 bps—as a result of US interest rates rising, for instance, shows over $3.8 trillion of global bond portfolios getting wiped out. Considering that’s around 8% of their value, that’s a big risk and can cause significant disruption in global markets.
For emerging markets like India, the worry is an immediate one. Equity portfolio allocations to EMEs from advanced economies have risen from 7% of the stock of advanced economy portfolio investments in 2002 to around 20% in 2012. And in the case of fixed income allocations to EMEs, this grew from 4% of the total stock of outward portfolio investments from advanced economies in 2002 to almost 10% in 2012. While the natural response for the RBI is to buy as much of forex reserves as it can in case equity and debt inflows start reversing—$13.7 billion of equity inflows have in this calendar and $20 billion of debt inflows—there is more that needs to be done. For one, if more swap lines, including from the IMF, can be tied up, the government would do well to do this before there is a crisis. Two, if the right policy decisions in the oil and telecom sectors are taken, large amounts of FDI inflows will come in from these two sectors alone. Three, especially given the RBI data on how just 15% of India Inc’s foreign borrowings in July-August were hedged, the central bank needs to strengthen provisioning norms further—a decision on lowering bank exposure norms to individual corporates has still not been taken—and to force more transparency in corporate foreign currency exposures.