The International Monetary Fund (IMF) today warned that increasing leverage levels in financial markets may signal “risks down the road” for the global economy, despite benign current conditions.
In pre-released chapters of its global financial stability report, the IMF warned financial policymakers to remain on their guard, saying they should maintain “heightened vigilance” as benign conditions “may provide a fertile breeding ground for the accumulation of financial vulnerabilities.”
In an article accompanying the report, Claudio Raddatz, division director of financial policy at the Central Bank of Chile and Jay Surti, the IMF’s deputy chief of the global financial stability analysis division, said: “Growing debt levels signal risks down the road. A rapid increase in credit spreads and greater market volatility could significantly worsen the outlook for global growth.”
The risk posed by excessive borrowing is currently relatively low, the IMF’s report noted, saying it has a “sanguine view of risks to the global economy in the near term”. However, over the medium term rising global leverage represents a “downside risk” to the global economy.
Policymakers around the world have persistently warned in recent months that debt build-ups in Asian economies in particular are storing up financial crisis risks.
The IMF is afraid that if global borrowing costs rise – as measured by increased credit yield spreads between benchmark US government debt and other lending – it could leave markets with excessive leverage exposed, as happened during the Western financial crisis in 2007 and 2008.
Decompression in credit spreads or big increases in asset price volatility act together as a “significant predictor of large macroeconomic downturns within a one-year horizon”, the report said.
Asset price volatility is currently at a historically low level: the Vix index of US market volatility – the so-called fear index – last summer hit a record low.
Raddatz and Surti said governments could combat the risks by forcing banks to hold more capital as buffers against losses, as well as restricting households from borrowing too much. The Bank of England has itself carried out versions of both of these actions during the last year.
The IMF also warned that high levels of household debt can pose a risk to financial stability.
The report said: “Higher household debt is associated with a greater probability of a banking crisis, especially when debt is already high, and with greater risk of declines in bank equity prices.”
Peaks in household debt come “about three years before the onset of a banking crisis”, the IMF said, with developed nations particularly at risk to build-ups.