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The World Economic Update by the International Monetary Fund in July confirmed that the global economy has surpassed its pre-pandemic peak. The global upward revision for 2022 results largely from advanced economies, particularly the US, while Emerging Asia has been marked down for 2021. These revisions reflect widening differences in exceptional policy and vaccine support.

Among the dividing fault lines is the financial sector in the US and Europe, and its ability to power the economy, in sharp contrast with the aftermath of the Global Financial Crisis (GFC), when it was the emerging markets that led a global recovery.

The US: The recent financial stress tests done by the Federal Reserve have shown resilience and flexibility of the US banking system after its response to the macro-financial shocks of the covid pandemic. These tests show that the largest lenders could manage potential further shocks from a return of severe recessionary conditions and still meet tier-1 common equity regulatory requirements. As such, America’s banking system is strongly positioned to support its ongoing recovery.

The key lesson is that US banks entered the current crisis with sizeable capital and liquidity buffers—rebuilt after the GFC—and non-banks and capital markets were able to absorb the portfolio shifts that have since occurred. These let the system deal with the significant liquidity problems experienced in the early days of the covid crisis, helped also by actions taken by the Fed to make sufficient liquidity available. Both were critical in assuring that the US financial system would remain resilient in the face of covid disruptions. However, it also raises issues of further regulatory actions that can be taken to prevent a recurrence of vulnerabilities in systemically-important US markets and institutions, and better assess non-bank vulnerabilities.

Europe: We see this in Europe too, although its financial system recovery after the GFC was more protracted. Banks’ capitalization levels are now well above regulatory minimum requirements. The extension of broad support measures during covid underpinned the functioning of Europe’s financial system, prevented widespread bank deleveraging, and maintained accommodative credit conditions. Eurozone banks increased their liquidity buffers significantly in 2020, and their common equity tier-1 ratios generally improved to above 15 %. Thus, market-based financing of the economy has stayed robust. An EU-wide stress test exercise on more than 100 financial institutions that was publicized recently confirmed that its banking sector would remain resilient under a prolonged covid crisis.

Emerging markets: It’s difficult to compare the financial systems in advanced countries with those in emerging markets, where they remain relatively underdeveloped and repressed, reflecting public ownership of banks, regulation of interest rates, intervention in credit allocation, legacy problems that have affected bank balance sheets, and control of cross-border capital flows. These detract them from fully supporting a recovery.

In the case of China, to maintain demand in the wake of the GFC, China helped the global recovery by investing massively in infrastructure. A surge in such lending to local governments and state enterprises kept China’s growth high, but caused its overall indebtedness to grow at an alarming rate.

For now, system-wide buffers in China’s financial sector can continue to absorb shocks. However, there are vulnerabilities that may intensify, and financial stability risks from regulatory forbearance, high corporate leverage and inflated property markets could heighten. Overall, the inability of the system to properly recognize losses, insufficient incentives to avoid bankruptcy, and the resultant evergreening of loans work against offering full support to growth sectors. More fundamentally, to rebuild overall productivity and sustain rapid growth, China needs to transform its financial system so that savings and capital increasingly go to growth sectors, rather than to unproductive state-owned enterprises.

Many of these considerations apply to India, which has also been dealing with high non-performing assets (NPAs) and the deleveraging and repair of corporate balance sheets. Their persistence continues to hold back credit, investment and growth. India’s second wave of covid added to headwinds facing banks and non-banks, and regulatory relief measures have postponed dealing with asset-quality issues.

As such, India’s financial sector generates comparatively low levels of credit and its debt market remains at a nascent stage of development. These hold back support for inclusive and sustained growth. To correct this, credit will have to grow at a much brisker pace while avoiding excessive risk.

Allowing more private sector participation, making it easier for funds to flow into capital markets, and properly regulating public banks and systemically-important non-banks—just like for private banks—could help the financial sector evolve in a direction that positions India for fast, broad-based growth. The government’s plan to consolidate, privatize and recapitalize public-sector banks is an essential first step to strengthen governance, supervision, efficiency and risk management.

Overall, vulnerabilities in the financial systems of many emerging markets present significant fault-lines in the ongoing global recovery from covid, risking their return to sustained and inclusive growth.

Anoop Singh is a distinguished fellow at the Centre for Social and Economic Progress, New Delhi and a former member of the 15th Finance Commission

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