Emerging Economies Vulnerable to Credit Crunch, Says IMF – Hands-on Policies to Fix

Jaime Caruana, Counsellor and Director of the Monetary and Capital Markets Department of the International Monetary Fund, sumarizes the main points of the GFSR.

The International Monetary Fund’s latest Global Financial Stability Report is warning that the credit crunch that has started in the United States, spreading to other developed ecponomies now threatens emerging economies and requires hands on policies to correct a crisis.

The report released Tuesday in washington, asses risks to global financial atability and documents “how the crisis is spreading beyond the US subprime market—namely to the prime residential and commercial real estate markets, consumer credit, and the low- to highgrade corporate credit markets.”

“The United States remains the epicenter, as the US subprime market was the origin of weakened credit standards and was the first to experience the complications arising from the associated structured credit products,” the IMF said. “But financial institutions in other countries have also been affected, reflecting the same overly benign global financial conditions and— to varying degrees— weaknesses in risk management systems and prudential supervision.”

Industrialized countries with inflated house price levels relative to fundamentals or stretched corporate or household balance sheets are also at risk, it added.

“Emerging market countries have been broadly resilient, so far. However, some remain vulnerable to a credit pullback, especially in those cases where domestic credit growth has been fueled from external funding sources and large current account deficits need to be financed.”

The IMF said that debt markets, particularly for external corporate debt, have felt the impact of the turbulence in advanced countries and costs of funding haverisen and further shocks to investors’ risk appetite for emerging market assets cannot be ruled out if financial conditions worsen.

Losses stemming from credit deterioration and forced sales, as well as reduced earnings growth, have significantly tested the balance
sheets of both banks and nonbank financial institutions. The Fund says the latest report revisits and extends the analysis of subprime-related losses in the October 2007 GFSR and projects that falling US housing prices and rising delinquencies on mortgage payments could lead to aggregate losses related to the residential mortgage market and related securities of about $565 billion, including the expected deterioration of prime loans.

“Adding other categories of loans originated and securities issued in the United States related to commercial real estate, the consumer credit market, and corporations increases aggregate potential losses to about $945 billion.

“These estimates, while based on imprecise information about exposures and valuation, suggest potential added stress on bank capital and further writedowns. Moreover, combined with losses to nonbank financial institutions, including monoline bond insurers, the danger is that there may be additional reverberations back to the banking system as the deleveraging continues. The risk of litigation over contract performance is also growing.

“Macroeconomic feedback effects are also a growing concern. Reduced capital buffers and uncertainty about the size and distribution
of bank losses, combined with normal credit cycle dynamics, are likely to weigh heavily on household borrowing, business investment, and asset prices, in turn feeding back onto employment, output growth, and balance sheets.

“This dynamic has the potential to be more severe than in previous credit cycles, given the degree of securitization and leverage in the financial system. Thus, it is now clear that the current turmoil is more than simply a liquidity event, reflecting deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper, and more protracted.

“Macroeconomic policies will have to be the first line of defense containing downside risks to the economy, but policymakers need to move on broader fronts. A key challenge is to ensure that large systemically important financial institutions continue to move quickly to repair their balance sheets, raising equity and medium-termfunding, even if it is more costly to do so now, in order to boost confidence and avoid further undermining the credit channel.

“Equity inflows have already been forthcoming from various investors, including sovereign wealth funds, but more equity infusions will likely be needed to help recapitalize institutions.

“In addition to forceful monetary easings by a number of major central banks, liquidity has also been provided to money markets at various maturities to ensure their smooth functioning.

“These actions, in some cases coordinated across central banks, have been supported by a strengthening of their operational procedures.

“Looking forward, recent developments suggest that central banks need to reflect further onthe role that monetary policy may have played in fostering a lack of credit discipline and to improve their instruments for relieving liquidity stress in today’s more global financial system.

“However, the immediate priority facing policymakers in some mature market countries is to address vulnerabilities to systemic instability in ways that minimize both moral hazard and potential fiscal costs. In addition to an examination of underlying causes, it will be important to address private sector incentives and compensation structures so that a similar buildup of vulnerabilities is less likely in the future.”