Policymakers Face Triad of Challenges to Ensure Financial Stability

Financial stability not assured, 3 percent of global output at stake

Risks in emerging markets remain elevated, with global implications

Goal is successful normalization of monetary and financial conditions

The Federal Reserve is poised to raise interest rates in the United States, and European Central Bank policies have bolstered confidence in the euro area, where credit conditions are improving. Although many emerging market economies have enhanced their policy frameworks and built up greater resilience to external shocks, several face domestic imbalances, slower growth, and lower commodity prices. A buildup of credit in emerging market economies since the global financial crisis has made them vulnerable to the expected increase in interest rates in advanced economies and potential economic downturns, which may create additional pressure on banks, the IMF said.

“Vulnerabilities in emerging markets are important, given their significance to the global economy, as are the role of global markets in transmitting shocks to other emerging markets and to advanced economies,” said José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department. “The recent financial market turmoil is a demonstration of this materialization of risks.”

To secure global financial stability, the IMF said policymakers must address a triad of policy challenges.

A triad of challenges

Emerging market vulnerabilities. Corporate and bank balance sheets are currently stretched in emerging markets, with an estimated total of up to $3.3 trillion in overborrowing. This has resulted in sharply higher debt in the private sector, particularly among commodity producers, accompanied by rising foreign currency exposures.

Crisis legacies in advanced economies. In the euro area, tackling the large amount of nonperforming loans and completing the banking union remain critical to consolidate financial stability and to reduce headwinds to growth. In the United States, embarking on the much telegraphed, although unprecedented, process of increasing interest rates for the first time in nine years is going to be an important transition for global markets.

Global financial markets under strain. As seen in recent episodes of market turmoil, weak market liquidity amplifies shocks and acts as a source of volatility and contagion. Low interest rates for a long period of time and quantitative easing have compressed risk premia across a range of asset markets...