Global Financial Stability Report: Improved financial market conditions offer scope to make timely structural reforms

• Author: David J. Ordoobadi
• Position: IMF International Capital Markets Department
• Pages: 107-108

Page 107

Improved economic fundamentals and stimulative monetary policies in the major financial centers contributed significantly to the global equity market rally and to the reduction in credit spreads of mature and emerging market bonds in 2003. The stronger fundamentals are rooted in firming global economic growth, rising corporate earnings, and strengthening balance sheets in the household, corporate, and banking sectors as the corporate and household sectors continue to build up liquidity and rising asset values buoy net worth.

A number of key emerging market countries have also taken steps to put their public finances on a sounder footing and increase their resilience. Many countries have used the favorable external financing environment to raise funds on international capital markets and improve the structure of their public debt by lengthening maturities and reducing the share of outstanding obligations indexed to foreign currencies and short-term interest rates. In addition, many emerging market countries have benefited from increased demand for their exports and higher commodity prices. The consequent gains in credit quality and low interest rates in the major financial centers contributed to an impressive compression of spreads on emerging market bonds last year (see chart, this page).

The improved outlook for financial stability is not without risks. The report notes that vigilance is needed, not least because of the potentially interconnected nature of these developments. One potential source of vulnerability arises from the impact of exceptionally low interest rates on investor behavior and asset valuations. Monetary stimulus aimed at boosting economic growth can encourage excessive risk taking and boost asset valuations beyond levels justified by fundamental economic improvements. Low short-term interest rates and a steep yield curve in the United States provide powerful incentives to boost leverage by borrowing at short maturities to venture out along the risk spectrum.

In the current low interest rate environment, the report explains, it is desirable to remain alert to the potential for excessively leveraged or concentrated investor positions (see chart, page 108).

If asset valuations become rooted in expectations of continued low short-term interest rates, an abrupt move to higher rates could be disruptive. Moreover, rising interest...