When there’s a boom let’s not bust it

As world stock markets hit record highs experts warn of financial vulnerabilities that must be addressed in order to prevent a massive shock to the global economy.

MSCI’s world equity index, which tracks shares in 47 countries, gained 0.13 percent after hitting a record of 497.00, its highest in a month. The Dow, S&P 500 and Nasdaq ended October in record highs; South Korea’s Kospi, Japan’s Nikkei 225 Index, Hong Kong’s Hang Seng, and markets in India, Taiwan and Indonesia were all reaching new heights.

The gains on Wall Street seem to be reverberating throughout the world as will an economic collapse (recall the global financial crisis of 2008), if nothing is done to stave off its causes, which, ironically, take root in a buoyant macro-financial environment.

One precursor to an economic crash is this: The ease of borrowing and high asset prices tend to lead to the poor management of liquidity and solvency risks.

According to IMF’s latest report on global financial stability, perceptions of high investment returns relative to the cost of funding and of the improved quality of collateral tend to encourage households and firms to increase their leverage without considering the negative impact of their collective borrowing decisions.

A second precursor is that booming asset prices tend to increase the risk appetite of financial intermediaries. When intermediaries pump in short-term wholesale funding to finance long-term credit exposures, balance sheet weaknesses build up in the financial sector.

“For example, lenders’ incentives to invest in costly underwriting are reduced, which can lead to significant mispricing of credit risk.” In such a context, the IMF report says, “even small negative shocks can cause significant reversals because they force lenders to face up to the true quality of exposures and collateral.”

It is exactly these kinds of perceptions and over-leveraging that lead to the speculative bubbles that precede a crash.

In an interview with the Financial Times last month, former German finance minister Wolfgang Schäuble cautioned that spiraling levels of global debt and liquidity are a major threat to the global economy.

“Economists all over the world are concerned about the increased risks arising from the accumulation of more and more liquidity and the growth of public and private debt. I myself am concerned with this, too,” he said.

His comments underscored IMF’s head Christine Lagarde’s observation that although the world is enjoying its best growth since 2010 there are “threats on the horizon” from “high levels of debt in many countries to rapid credit expansion in China, to excessive risk-taking in financial markets”.

Policymakers should be vigilant to risks facing growth. Monitoring shifts in the domestic price of risk, which is a flag for imminent threats to GDP growth and overall financial stability, will aid in the quick delivery of remedial actions such as monetary easing.

Another way to mitigate the impact of a crash is to introduce countercyclical macroprudential tools, such as bank capital buffers and limits on loan-to-value ratios, to contain the growth of asset bubbles during buoyant financial conditions.

 

 

 

 

 

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