World Economic and Financial Surveys
Favourable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability. However, some market developments warrant attention, as underlying financial risks and conditions have shifted since the September 2006 Global Financial Stability Report (GFSR).
Through the use of a new global financial stability map, Chapter I charts principal nearterm risks. Chapters II and III examine the financial stability implications of two longer-term trends: the changing investor base from which global capital flows are sourced, and the globalization of financial institutions, particularly banks.The changing mix of assets, source countries, and types of cross-border investors identified in Chapter II should, for the most part, help to stabilize global markets. But the secular trend has been reinforced by low interest rates and by low volatility in many mature markets, with investors seeking higher-yielding assets in some emerging markets and other mature markets.
Chapter I examines this investor strategy—the carry trade—noting that while countries’ fundamentals have improved and sovereign external debt has become less risky, international issuance of corporate debt and equities has risen rapidly to accommodate investor demand.A theme of Chapter III—that the globalizationof banks may help reduce individual bank risk but may not necessarily enhance the resilience of financial systems as a whole—is also echoed in Chapter I, which examines possible spillovers from a deterioration in credit quality in the U.S. subprime mortgage market. Chapter I identifies several short-term risks.First, the subprime segment of the U.S. housing market is showing signs of credit quality deterioration.
While the fallout to date has been limited,there is scope for it to deepen and spread to other markets, possibly to structured mortgage credit products held by a variety of global investors. Fortunately, the economic impact of the housing market slowdown has been limited and some market indicators have begun to stabilize, suggesting that the financial effects may also be contained.Second, low interest rates and healthy corporate balance sheets have spurred an increase in private equity buyouts. This has led to a substantial rise in leverage in the acquired firms,potentially making such firms more vulnerable to economic shocks. The increased use of leveraged loans as part of financing also poses risks to some intermediaries that provide bridge financing to leveraged-buyout transactions. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved.Third, capital inflows to some emerging markets have risen rapidly, in part reflecting improved economic fundamentals, but also reflecting the search for yield given low interest rates in most mature markets. In general, strong private capital inflows are to be welcomed, as they reflect a reallocation of capital to more productive investments. However, the shift to private sector debt flows, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa, shows that foreign investors are taking more risk and an abrupt reversal cannot be ruled out.
Finally, while the downside risk from a possible disorderly unwinding of global imbalances has receded somewhat, it remains a concern.The larger role of fixed-income inflows in financing the U.S. current account deficit indicates that inflows into U.S. bond markets may have become more sensitive to changes in world interest rate differentials.
Chapter I: Assessing Global Financial Risks Full Text
Chapter II. Changes in the International Investor Base and Implications for Financial Stability Full Text
Chapter III. The Globalization of Financial Institutions and Its Implication for Financial Stability Full Text