The IMF has released its latest Financial Stability Report, in which it warns of the potential for falls in market liquidity, as well as rising corporate debt – as well as the implication that the inevitable rise in central bank interest rates – particularly that of the US Federal Reserve – would have.
“Market participants in advanced and emerging market economies,” the report warns, “have become worried that both the level of market liquidity and its resilience may be declining, especially for bonds, and that as a result the risks associated with a liquidity shock may be rising.” Liquidity in markets is vital to financial stability in order to make the market less susceptible to large fluctuations in price.
The growth of corporate debt has largely been the result of an accommodating monetary policy from advanced economies for the
Whether or not declines in market liquidity are the result of new post-2008 financial crisis regulation, the IMF states, is unclear. On the one hand, restrictions on derivatives trading, with the example of the European Union in 2012 given, have weakened liquidity in underlying assets. On the other hand, “regulations to increase transparency have improved market liquidity by facilitating the matching of buyers and sellers and reducing uncertainty about asset values.”
However, with the regime of loose monetary policy soon coming to an end, there are worries over the impact of this on liquidity. As the report puts it, there are “concerns about the resilience of market liquidity to larger shocks, such as a “bumpy” normalization of monetary policy in advanced economies.”
The IMF also outlines its fears for the impact of the expected tightening of US monetary policy on corporate debt in emerging markets. As the report outlines, “The corporate debt of nonfinancial firms across major emerging market economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014. The average emerging market corporate debt-to-GDP ratio has also grown by 26 percentage points in the same period.”
This rise in corporate debt can be beneficial, through allowing for productive investment, spurring on growth. However, there are concerns that the level of corporate leverage could lead to unwanted consequences, particularly because, as the IMF economists note, “many emerging market financial crises have been preceded by rapid leverage growth.”
The growth of corporate debt has largely been the result of an accommodating monetary policy from advanced economies for the past decade. Low interest rates in the West have resulted in emerging market corporate debt build up through emerging economy banks setting their own rates lower to match that of the advanced economies – easing up credit in emerging markets, and greater capital flows into emerging markets from advanced economies in search of higher yields.
This steady build up on corporate debt under the auspices of low interest rates will result in trouble for firms that have binged on corporate debt, once the various central banks of the world start to raise interest rates, as is soon to be expected. Emerging markets should be “prepared for the eventuality of corporate failures,” once rates rise. “Where needed,” the report argues “insolvency regimes should be reformed to enable rapid resolution of both failed and salvageable firms”.