IMF – Page 13 – Digital Finance Analytics (DFA) Blog

Unintended Consequences of Macroprudential

An IMF working paper, just released examines the impact of macroprudential policy. They conclude that implementing macroprudential does reduce the expansion of bank credit, but this is offset by a growth in non-bank credit and foreign bank lending, so the overall braking effect is less severe than expected. This substitution effect needs to be incorporated into the policy settings to deliver the desired credit growth management. Here is a summary.

Macroprudential policy is alive and kicking. It is being used actively both in emerging market economies and—following the global financial crisis—in advanced economies. It includes measures that apply directly to lenders, such as countercyclical capital buffers or capital surcharges, and restrictions that apply to borrowers, such as loan-to-value (LTV) and loan-to-income (LTI) ratio caps. Most macroprudential measures activated around the globe between 2000 and 2013 apply to the banking sector only, including borrower-based measures.

The widespread use of macroprudential policy is aimed at reducing systemic risks. Yet the use of national sector-based measures may be subject to a boundary problem, causing substitution flows to less regulated parts of the financial sector. Specifically, macroprudential policy may have the consequence of shifting activities and risks both to: (i) foreign entities (e.g., bank branches and cross-border lending); and (ii) nonbank entities (e.g., shadow banking, also referred to as market-based financing). Whereas several papers have estimated intended effects of macroprudential policies (MaPs) on variables such as credit growth and housing prices, and whether measures leak to foreign banks, cross-sector substitution effects have—to the best of our knowledge—not yet been tested empirically.

This paper aims to fill this gap. It investigates whether macroprudential policies lead to substitution from bank-based financial intermediation to nonbank intermediation. In addition, it uses event study methodology to shed light on the timing of the effects of policy measures on bank and nonbank intermediation around activation dates. Moreover, we contribute to the literature by distinguishing between the effects of quantity versus price-based instruments and lender versus borrower-based instruments, given that the effects may differ. We also check whether results differ for advanced economies (AEs) versus emerging market economies (EMEs) and bank versus market-based financial systems.

Our results support the hypothesis that macroprudential policies reduce bank credit growth. In our sample, in the two years after the activation of MaPs, bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure. This effect is much stronger in EMEs than in AEs. Beyond this, our results suggests that quantity-based measures have much stronger effects on credit growth than price-based measures, both in advanced and emerging market economies. In cumulative terms, quantity measures slow bank credit growth by 8.7 percentage points over two years relative to the counterfactual of no policy change.

Our main contribution to the literature relates to substitution effects: we find that the effect of MaPs on bank credit is always substantially higher than the effect on total credit to the private sector. Whereas bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure, total credit growth falls by 4.9 percentage points on average. The reason for this is the increase in nonbank credit growth. We also find significant differences between country groups and instruments. First, substitution effects are stronger in AEs. This is in line with expectations given their more developed financial systems, with a larger role for market-based finance. Second, substitution effects are much stronger in the case of quantity restrictions, which are more constraining than price-based measures. Finally, we find strong and statistically significant effects on specific forms on nonbanking financial intermediation, such as investment fund assets.

Our paper builds on a rapidly expanding literature. While the concept of macroprudential policy can be traced back at least to the late 1970’s, it has become a common part of the policy lexicon in the first decade of this millennium. The global financial crisis has led not only to much more interest in the macroprudential approach, but also to active use of macroprudential instruments around the world.

The active use of instruments has spawned a growing empirical literature on the effectiveness of macroprudential policies, in individual country, regional and global settings. The most comprehensive study, who uses an IMF survey to document macroprudential policies in 119 countries over the 2000–13 period. They find that the implementation of such instruments is generally associated with the intended lower impact on credit, but that the effects are weaker in financially more developed and open economies.

In addition, to its intended effects, macroprudential policy may leak. Macroprudential policy may also increase crosssector substitution. A recent study by the IMF finds that more stringent capital requirements are associated with stronger growth of shadow banking. Our paper uses both net flow measures and an event study methodology to shed light on the size and timing of cross-sector substitution effects. Our empirical framework builds on work that has sought to explain credit growth, for instance to understand credit rationing and the monetary transmission mechanism. We control for macroeconomic fundamentals to filter out effects of policy on credit growth in a crosscountry panel setting.

Our results do not allow us to assess whether substitution effects reduce or increase systemic risks. A lowering of systemic risks may be expected, as risks may shift to institutions that are less leveraged and less subject to maturity mismatch. But this need not be the case, as market failures and systemic risks may also arise outside the regulated banking sector.

Overall, our findings underline the relevance of such a broad approach to monitoring and addressing systemic risks, especially for advanced economies. Earlier findings on cross-border leakages indicate that macroprudential policy should not take a narrow national perspective, as this would fail to internalize cross-border substitution effects. Our results on cross sector substitution complement these findings, and suggest that macroprudential policy should not take a narrow sectoral perspective.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Asia Remains the Engine of Global Growth in 2016 and 2017 – IMF

The latest IMF briefing on Asia says the region is expected to grow by 5.3 percent in 2016 and 2017, which is 2 to 4 percentage points higher than the growth rate in other regions. This growth rate accounts for two-thirds of global growth as it has been since 2010. So Asia remains the engine of the global growth. This is based on data in the Regional Economic Outlook, to be presented on May 3rd in Hong Kong.

While Asia’s relatively in better shape than other regions, it shares the same downside risk that my colleagues have emphasized the last two days, such as weakening global recovery, tighter global financial conditions, and China’s slowdown and its spillover.

In terms of policies, in addition to continuing its structural reform, Asia should prioritize building policy buffers and tackling vulnerabilities while being ready to support aggregate demand if downside risks materialize. Let me explain these points before we go on to the questions.

Overall Asia’s GDP growth rate is expected be 5.3 percent in 2016 and 2017, 0.1 percentage point lower than the growth rate in 2015. However, this aggregate number masks heterogeneity across the regional economies. Let’s start with China.

We actually revised up our growth forecast for China for this year from 6.2 percent to 6.5 percent, and then also revised the overall growth rate for the next year to 6.2 percent in 2017. You may be surprised because the IMF revised downward our global growth rate. Why did we just revise up the overall China’s growth rate? The main reason is that China recently announced its commitment to the new stimulus packages together with a variety of structural reforms in its 13th 5-year plan.

And we believe China has this policy space to achieve its growth target in the short-term. But I’d like to emphasize that depending on where this stimulus is used and whether the stimulus is used wisely and does not just go to boosting the old growth engines, the medium-term risk of ever rising credit and investment can also increase. So in the short-term, due to the structure reform and stimulus, China’s growth rate is upgraded. But on the other hand, depending on where the stimulus can be used, the medium-term risk can also increase.

In Japan, the GDP growth rate is projected to remain 0.5 percent in 2016, but it is expected to significantly slow down to -0.1 percent in 2017 assuming current policies. That means our -0.1 percent growth rate in 2017 incorporates the negative impact of the expected consumption tax increase from 8 to 10 percent in 2017, but does not assume offsetting measures to support economic activity. But in reality you can easily expect that Japan’s government will be more likely to rely on offsetting measures, including fiscal expansion, to offset the negative impact of the consumption tax increase, which means that the actual growth rate in 2017 should be higher than our forecast. And we will adjust once we know the details of Japan’s fiscal plans.

In India, India is the fastest growing emerging economy with a growth rate at 7.5 percent both in 2016 and 2017. Activity is expected to continue to be underpinned by private consumption, which has benefitted from low energy prices.

Australia’s growth rate is expected to remain stable at 2.5 percent in 2016, while mining investment will continue to contract.

Korea’s growth rate is expect to remain subdued but stable at 2.7 percent this year and rise moderately to 2.9 percent in 2017 as domestic demand benefits from low oil prices.

Developments in ASEAN economies will remain uneven, reflecting the bloc’s heterogeneity. Overall growth in ASEAN countries will average 4.7 percent in this year and 5 percent in 2017. Indonesia is projected to grow at 4.9 percent in 2016 and 5.3 percent in 2017. Growth in the Philippines, Malaysia, and Vietnam is expected to remain robust because of resilient domestic demand. Thailand’s growth rate will continue to be below its potential, but it will pick up modestly, driven by public spending.

For frontier economies and small states, growth remains generally strong, but several countries are facing vulnerabilities such as rising twin deficits, declining reserves, and also challenges from natural disasters. On the strong side Bangladesh’s growth rate is expected to exceed 6.5 percent in 2016 and ’17 helped by low commodity prices and investment in manufacturing. In Myanmar, the growth rate is projected to strengthen partly helped by the peaceful political transition and higher investment.

While this baseline outlook for Asia remains favorable there are downside risks that continue to dominate. External risks emanating from weak global growth and tighter global liquidity conditions compound domestic vulnerabilities. One big difference on the trade side from the past is that emerging markets, including China, are important contributors to the global trade slowdown at this moment, unlike the case in 2009 when advanced economies actually led the slowdown of global trade.

And second, asynchronous monetary policy in the U.S., Euro Area, and Japan can also increase volatility and the possibility of capital outflows from the region. But so far we have not seen major capital outflows in the region, except China, but that does not mean that asynchronous monetary policy of the advanced economies does not have an impact on the region. We saw that financial volatility has been high, and for many Asian countries, their currencies also have depreciated quite significantly.

The turning of the credit and financial cycle amid high debt poses significant risk to the growth in Asia. Several Asian countries have pockets of high corporate debt leverage problems while corporate profit also has significantly weakened.

And as for the spillover impact from China, we believe that while China’s necessary rebalancing will make growth more sustainable and in the longer-term its spillover effect must be positive to the global economy. But in the short-term its transition can have adverse but heterogeneous spillovers in the region through trade channels.

On trade, the impact depends on the type of exposure, type of goods you’re exporting to China. Countries which sell more consumption goods can be winners. On the other hand, countries which are selling more investment goods and manufacturing goods can lose in the near-term. And we also find that spillovers through financial channels are actually increasing as China is more integrated to the global financial market, especially the strength of financial spillovers have increased quite rapidly after the global financial crisis.

China’s slowdown has also had a larger impact on global commodity demand, but here, the impact is also quite heterogeneous. We find that the unexpected decline in demand for commodities such as metals, iron ore, and nickel has been much stronger, as these metals are the major input for construction and heavy industries.

On the other hand, it’s impact on oil demand has been relatively diluted but the demand for food is actually benefiting from China’s rebalancing so in some sense, China’s rebalancing has a very heterogeneous impact on commodities and has focused more and has a larger impact on metals.

In Asia, geopolitical tensions and domestic policy on certain things could also cause trade disruptions for lower growth rate. Natural disasters are another risk to the region, especially low income countries and small states. Small states also face new challenges such as de-risking by global banks which could undermine financial inclusion and growth for many Pacific island countries that heavily depend on remittances.

So far, we have just focused on the downside risk but I want to emphasize, before I move to the policy issues that Asia also has some upside risk. Low commodity prices could be a big net boost to the region, and also progress on the regional and multilateral trade negotiations such as TPP could benefit its member countries even before it is ratified. Finally, China — recent statistics from China show that it has surprised on the upside and that this could be good news for the region.

So let’s move on to the challenges now to navigate the turbulent global environment. I am glad to say that Asia can build on a number of strengths. In general, Asian economies have much stronger efforts and are well positioned to face challenges compared with other emerging markets in the other regions.

Broadly speaking, monetary policy settings are appropriate at this moment and inflation remains quite low, therefore, if growth disappoints, there is room to cut policy rates in a number of Asian economies.

Fiscal conditions vary across countries and several economies have fiscal space that can be used if the downside risk materializes or to prevent the downside risk. However, many others, especially low income Asian economies, are now seeing more vulnerabilities, and gradual fiscal consolidation is desirable to build policy space. For most of them, the composition of spending to allow for the infrastructure and social spending is important, including considering the rising inequality trend in the region.

Exchange rates should remain the major line of defense and macro potential policies, which have been used more extensively in Asia, can be used to deal with financial risk.

On structural reform, Asia has made lots of structure reforms in many countries and I am very glad that in our recent report, Asia is really outstanding, that we are actually doing a lot more structure reform than other regions. Pushing ahead with the structure reform will help ensure that Asia remains a global growth leader and they can also help reduce inequalities and foster inclusive growth. The reform agenda definitely is country specific, but timing and effective implementation will be quite critical.

So in conclusion, let me reiterate that Asia is in a relatively strong position, but there are pockets of vulnerabilities and the external environment has become much more difficult. So in order to build on its strengths during these turbulent times, Asia needs to continue to build buffers and to tackle urgently the high leverage problem it has and also needs to continue to implement structural reform to boost potential growth.

Australia To Pay IMF Centre $2.5m

The IMF announced Australia is joining the Fund as the first external partner of the planned South Asia Regional Training and Technical Assistance Center (SARTTAC), with a financial contribution of AUD2.5 million (US$1.9 million). Deputy Secretary of the Australian Treasury Nigel Ray and IMF Deputy Managing Director Carla Grasso signed a respective Letter of Understanding during the IMF-World Bank Spring Meetings.Located in Delhi, India, SARTTAC is expected to become the focal point for planning, coordinating, and implementing the IMF’s capacity development activities in the region on a wide range of areas, including macroeconomic and fiscal management, monetary operations, financial sector regulation and supervision, and macroeconomic statistics. The Center will begin operations in 2017, providing technical assistance and training services to Bangladesh, Bhutan, India, Maldives, Nepal, and Sri Lanka.

”Australia is pleased to support the IMF’s training and capacity development centre in New Delhi. This builds on Australia’s longstanding partnership with the IMF and highlights Australia’s deepening relations in the South Asian region,” said Deputy Secretary of the Australian Treasury Nigel Ray.”

“This agreement is another milestone in advancing the long-standing partnership between Australia and the IMF in capacity development, a partnership which we value and which has helped us strengthen our coordination and effectiveness in capacity building throughout the world, and now more specifically in South Asia,” said IMF Deputy Managing Director Carla Grasso.

Background

SARTTAC will augment the IMF’s global network of regional technical assistance and training centers. Nine regional technical assistance centers in the Pacific, the Caribbean, Africa, the Middle East, and Central America help countries strengthen human and institutional capacity to design and implement policies that promote growth and reduce poverty, supported by regional training centers and programs in Africa, Asia, Europe, and the Western Hemisphere. The centers focus on topics that are key to helping countries advance towards the sustainable development goals: domestic resource mobilization, better public spending and investment, financial stability and inclusion, and the improvement and dissemination of macroeconomic statistics as the basis of informed economic policy decision-making.

Risks to Global Financials Stability Have Increased – IMF

The IMF just released the latest edition of its Global Financial Stability Report. It’s 118 pages makes grim reading. They highlight a number of elevated risks, and advocate more proactive policies, including the adoption of macroprudential measures. They highlight elevated funding risks to banks, risks to banking models from the ultra low interest rates, and disruption to global asset markets. Significantly, the indicators are that interest rates are likely to fall, not rise.

Risks to global financial stability have increased since the October 2015 Global Financial Stability Report. In advanced economies, the outlook has deteriorated because of heightened uncertainty and setbacks to growth and confidence.

Disruptions to global asset markets have added to these pressures. Declines in oil and commodity prices have kept risks elevated in emerging market economies, while greater uncertainty about China’s growth transition has increased spillovers to global markets. These developments tightened financial conditions, reduced risk appetite, raised credit risks, and stymied balance sheet repair, undermining financial stability.

Many market prices dropped dramatically during the turmoil in January and February, moving asset valuations to levels below those consistent with macroeconomic fundamentals that suggest a steady but slowly improving growth path (see the April 2016 World Economic Outlook). Instead, heightened market volatility and risk aversion may have reflected rising economic, financial, and political risks as well as weakened confidence in policies. The recovery in asset prices since February has reversed much of these losses and lowered volatility. Market sentiment has been supported by higher oil and commodity prices, stronger data out of the United States, and supportive actions by central banks. But the net impact of the turmoil has been a shock to confidence, with negative repercussions for financial stability.

The main message of this report is that additional measures are needed to deliver a more balanced and potent policy mix for improving the growth and inflation outlook and securing financial stability. In the absence of such measures, market turmoil may recur. In such circumstances, rising risk premiums may tighten financial conditions further, creating a pernicious feedback loop of fragile confidence, weaker growth, lower inflation, and rising debt burdens. Disruptions to global asset markets could increase the risks of tipping into a more serious and prolonged slowdown marked by financial and economic stagnation. In a situation of financial stagnation, financial institutions responsible for the allocation of capital and mobilization of savings might struggle with impaired balance sheets for an extended period of time. Financial soundness could become eroded to such an extent that both economic growth and financial stability are adversely affected in the medium term. In such a scenario, world output could fall by 3.9 percent relative to the baseline by 2021.

Policymakers need to build on the current economic recovery and deliver a stronger path for growth and financial stability by tackling a triad of global challenges—legacy challenges in advanced economies, elevated vulnerabilities in emerging markets, and greater systemic market liquidity risks. Progress along this path will enable the world’s economies to make a decisive break toward a strong and healthy financial system and a sustained recovery. In such a scenario, world output could expand by 1.7 percent relative to the baseline by 2018.

Advanced economies must deal with crisis legacy issues. Banks in advanced economies have become safer in recent years, with stronger capital and liquidity buffers and progress in repairing balance sheets. Despite these gains, banks came under market pressure at the start of the year, reflecting concerns about the profitability of banks’ business models in a weak economic environment. Approximately 15 percent of banks in advanced economies (by assets) face significant challenges in attaining sustainable profitability without reform.

In the euro area, market pressures also highlighted long-standing legacy issues, indicating that a more complete solution to European banks’ problems cannot be further postponed. Elevated nonperforming loans urgently need to be tackled using a comprehensive strategy, and excess capacity in the euro area banking system will have to be addressed over time. In the United States, mortgage markets—which were at the epicenter of the 2008–09 crisis—continue to benefit from significant government support. Authorities should reinvigorate efforts to reduce the dominance of Fannie Mae and Freddie Mac and continue with reforms of these institutions.

Chapter 3 shows that across advanced economies, the contribution of the insurance sector—particularly life insurers—to systemic risk has increased, although not yet to the level of the banking sector. This increase is largely a result of growing common exposures to aggregate risk, partly because insurers’ interest rate sensitivity has risen and partly because of higher correlations across asset classes. In the event of an adverse shock, therefore, insurers are unlikely to fulfill their role as financial intermediaries at a time when other parts of the financial system are also struggling to do so. These findings suggest that a more macroprudential approach to supervision and regulation of insurance companies should be taken. Measures could include regular macroprudential stress testing or the adoption of countercyclical capital buffers. Steps that would complement a push for stronger macroprudential policies include the international adoption of capital and transparency standards for the sector. In addition, the different behavior of smaller and weaker insurers warrants attention by supervisors.

Emerging markets need to bolster their resilience to global headwinds. Emerging market economies are faced with a difficult combination of slower growth, weaker commodity prices, and tighter credit conditions, amid more volatile portfolio flows. This mixture has kept financial and economic risks elevated. So far, many economies have shown remarkable resilience to this more difficult domestic and external environment, as policymakers have made judicious use of buffers in strengthened policy frameworks.

Commodity-related firms are cutting capital expenditures sharply as high private debt burdens reinforce risks to credit and banks. Commodity exporting countries and those in the Middle East and the Caucasus are particularly exposed to strains across the real economy and the financial sector. The nexus between state-owned enterprises (SOEs) and sovereigns has intensified, and could increase fiscal and financial stability risks in countries with repayment pressures. More broadly, debt belonging to nonfinancial corporations with reduced ability to repay have risen to $650 billion, or 12 percent of total corporate debt of listed firms considered in this report. Bank capital buffers are generally adequate, but will likely be tested by weaker earnings and the downturn in the credit cycle.

Emerging market economies generally have the tools to boost their resilience and counter the effects of lower commodity prices and the slowdown in growth and capital flows. Authorities in emerging market economies should continue to use their buffers and policy space, where available, to smooth adjustment and strengthen sovereign and bank balance sheets. This includes using external buffers, fiscal and monetary policy, and macroprudential and supervisory frameworks, among other tools. Countries with insufficient buffers and limited policy space should act early by adjusting macroeconomic policies to address their vulnerabilities, including by seeking external support.

China’s economic rebalancing is gaining traction. The country has made notable progress in rebalancing its economy toward new sources of growth and addressing some financial sector risks. In addition, stricter regulation of shadow banking activities has helped steer the composition of financing toward bank loans and bond issuance. Nevertheless, China’s rebalancing is inherently complex, and commitment to a more ambitious and comprehensive policy agenda is urgently needed to stay ahead of rising vulnerabilities.

Slowing growth has eroded corporate sector health, with falling profitability undermining the debt servicing capacity of firms holding some 14 percent of the debt of listed companies, adding to balance sheet stresses across the system. A comprehensive plan to address the corporate debt overhang would assist a steady deleveraging process. Corporate deleveraging should be accompanied by a strengthening of banks and social safety nets, especially for displaced workers in overcapacity sectors. A comprehensive restructuring program to deal with bad assets and strengthen banks should be developed swiftly, along with a sound legal and institutional framework for facilitating bankruptcy and debt-workout processes.

Chapter 2 finds that spillovers of emerging market shocks to equity prices and exchange rates have risen substantially, and now explain more than a third of the variation in asset returns. This underscores the importance for policymakers in both advanced economies and emerging markets of taking account of economic and policy developments in emerging market economies when assessing domestic macro-financial conditions.

Financial integration, more than economic size and trade integration, is key to an emerging market economy’s role as receiver and emitter of financial spillovers. The level of integration explains, for example, why purely financial contagion from China remains less significant even as the impact of Chinese growth shocks is increasingly important for equity returns in both emerging market and advanced economies. As China’s role in the global financial system continues to grow, clear and timely communication of its policy decisions and transparency about its policy goals and strategies consistent with their achievement will be ever more important. Given the evident relevance of corporate leverage and mutual fund flows in amplifying spillovers of shocks, shaping macroprudential surveillance and policies to contain systemic risks arising from these channels will be vital.

The resilience of market liquidity should be enhanced. As discussed in previous reports, a comprehensive approach to reducing risks of liquidity runs on mutual funds and strengthening the provision of market liquidity services is needed to avoid the risk of amplifying market shocks.

The stakes are high. First, rising risks of weakening growth and more instability must be avoided. Then, growth must be strengthened and financial stability improved beyond the baseline. An ambitious policy agenda is required, comprising a more balanced and potent policy mix, including stronger financial reforms together with continuing monetary accommodation. Increased confidence in policies will help reduce vulnerabilities, remove uncertainties, and touch off a virtuous feedback loop between financial markets and the real economy.

IMF Cuts Growth Forecast Again – Down 0.2%

The latest IMF World Economic Outlook, just released, cuts growth forecasts by 0.2%. Whilst stronger growth is still forecast, they say downside risks have intensified. Risks include China’s re-balancing, falls in commodity prices, asymmetric central bank policies and heightened geopolitical uncertainties. Global growth, currently estimated at 3.1 percent in 2015, is projected at 3.4 percent in 2016 and 3.6 percent in 2017. The pickup in global activity is projected to be more gradual than in the October 2015 World Economic Outlook (WEO), especially in emerging market and developing economies.

In 2015, global economic activity remained subdued. Growth in emerging market and developing economies—while still accounting for over 70 percent of global growth—declined for the fifth consecutive year, while a modest recovery continued in advanced economies. Three key transitions continue to influence the global outlook: (1) the gradual slowdown and rebalancing of economic activity in China away from investment and manufacturing toward consumption and services, (2) lower prices for energy and other commodities, and (3) a gradual tightening in monetary policy in the United States in the context of a resilient U.S. recovery as several other major advanced economy central banks continue to ease monetary policy.

Overall growth in China is evolving broadly as envisaged, but with a faster-than-expected slowdown in imports and exports, in part reflecting weaker investment and manufacturing activity. These developments, together with market concerns about the future performance of the Chinese economy, are having spillovers to other economies through trade channels and weaker commodity prices, as well as through diminishing confidence and increasing volatility in financial markets. Manufacturing activity and trade remain weak globally, reflecting not only developments in China, but also subdued global demand and investment more broadly—notably a decline in investment in extractive industries. In addition, the dramatic decline in imports in a number of emerging market and developing economies in economic distress is also weighing heavily on global trade.

Oil prices have declined markedly since September 2015, reflecting expectations of sustained increases in production by Organization of the Petroleum Exporting Countries (OPEC) members amid continued global oil production in excess of oil consumption.¹ Futures markets are currently suggesting only modest increases in prices in 2016 and 2017. Prices of other commodities, especially metals, have fallen as well.

Lower oil prices strain the fiscal positions of fuel exporters and weigh on their growth prospects, while supporting household demand and lowering business energy costs in importers, especially in advanced economies, where price declines are fully passed on to end users. Though a decline in oil prices driven by higher oil supply should support global demand given a higher propensity to spend in oil importers relative to oil exporters, in current circumstances several factors have dampened the positive impact of lower oil prices. First and foremost, financial strains in many oil exporters reduce their ability to smooth the shock, entailing a sizable reduction in their domestic demand. The oil price decline has had a notable impact on investment in oil and gas extraction, also subtracting from global aggregate demand. Finally, the pickup in consumption in oil importers has so far been somewhat weaker than evidence from past episodes of oil price declines would have suggested, possibly reflecting continued deleveraging in some of these economies. Limited pass-through of price declines to consumers may also have been a factor in several emerging market and developing economies.

Monetary easing in the euro area and Japan is proceeding broadly as previously envisaged, while in December 2015 the U.S. Federal Reserve lifted the federal funds rate from the zero lower bound. Overall, financial conditions within advanced economies remain very accommodative. Prospects of a gradual increase in policy interest rates in the United States as well as bouts of financial volatility amid concerns about emerging market growth prospects have contributed to tighter external financial conditions, declining capital flows, and further currency depreciations in many emerging market economies.

Headline inflation has broadly moved sideways in most countries, but with renewed declines in commodity prices and weakness in global manufacturing weighing on traded goods’ prices it is likely to soften again. Core inflation rates remain well below inflation objectives in advanced economies. Mixed inflation developments in emerging market economies reflect the conflicting implications of weak domestic demand and lower commodity prices versus marked currency depreciations over the past year.

The Updated Forecast

Global growth is projected at 3.4 percent in 2016 and 3.6 percent in 2017.

Advanced Economies

Growth in advanced economies is projected to rise by 0.2 percentage point in 2016 to 2.1 percent, and hold steady in 2017. Overall activity remains resilient in the United States, supported by still-easy financial conditions and strengthening housing and labor markets, but with dollar strength weighing on manufacturing activity and lower oil prices curtailing investment in mining structures and equipment. In the euro area, stronger private consumption supported by lower oil prices and easy financial conditions is outweighing a weakening in net exports. Growth in Japan is also expected to firm in 2016, on the back of fiscal support, lower oil prices, accommodative financial conditions, and rising incomes.

Emerging Market and Developing Economies

Growth in emerging market and developing economies is projected to increase from 4 percent in 2015—the lowest since the 2008–09 financial crisis—to 4.3 and 4.7 percent in 2016 and 2017, respectively.

Growth in China is expected to slow to 6.3 percent in 2016 and 6.0 percent in 2017, primarily reflecting weaker investment growth as the economy continues to rebalance. India and the rest of emerging Asia are generally projected to continue growing at a robust pace, although with some countries facing strong headwinds from China’s economic rebalancing and global manufacturing weakness.

Aggregate GDP in Latin America and the Caribbean is now projected to contract in 2016 as well, albeit at a smaller rate than in 2015, despite positive growth in most countries in the region. This reflects the recession in Brazil and other countries in economic distress.

Higher growth is projected for the Middle East, but lower oil prices, and in some cases geopolitical tensions and domestic strife, continue to weigh on the outlook.

Emerging Europe is projected to continue growing at a broadly steady pace, albeit with some slowing in 2016. Russia, which continues to adjust to low oil prices and Western sanctions, is expected to remain in recession in 2016. Other economies of the Commonwealth of Independent States are caught in the slipstream of Russia’s recession and geopolitical tensions, and in some cases affected by domestic structural weaknesses and low oil prices; they are projected to expand only modestly in 2016 but gather speed in 2017.

Most countries in sub-Saharan Africa will see a gradual pickup in growth, but with lower commodity prices, to rates that are lower than those seen over the past decade. This mainly reflects the continued adjustment to lower commodity prices and higher borrowing costs, which are weighing heavily on some of the region’s largest economies (Angola, Nigeria, and South Africa) as well as a number of smaller commodity exporters.

Forecast Revisions

Overall, forecasts for global growth have been revised downward by 0.2 percentage point for both 2016 and 2017. These revisions reflect to a substantial degree, but not exclusively, a weaker pickup in emerging economies than was forecast in October. In terms of the country composition, the revisions are largely accounted for by Brazil, where the recession caused by political uncertainty amid continued fallout from the Petrobras investigation is proving to be deeper and more protracted than previously expected; the Middle East, where prospects are hurt by lower oil prices; and the United States, where growth momentum is now expected to hold steady rather than gather further steam. Prospects for global trade growth have also been marked down by more than ½ percentage point for 2016 and 2017, reflecting developments in China as well as distressed economies.

Risks to the Forecast

Unless the key transitions in the world economy are successfully navigated, global growth could be derailed. Downside risks, which are particularly prominent for emerging market and developing economies, include the following:

A sharper-than-expected slowdown along China’s needed transition to more balanced growth, with more international spillovers through trade, commodity prices, and confidence, with attendant effects on global financial markets and currency valuations.

Adverse corporate balance sheet effects and funding challenges related to potential further dollar appreciation and tighter global financing conditions as the United States exits from extraordinarily accommodative monetary policy.

A sudden rise in global risk aversion, regardless of the trigger, leading to sharp further depreciations and possible financial strains in vulnerable emerging market economies. Indeed, in an environment of higher risk aversion and market volatility, even idiosyncratic shocks in a relatively large emerging market or developing economy could generate broader contagion effects.

An escalation of ongoing geopolitical tensions in a number of regions affecting confidence and disrupting global trade, financial, and tourism flows.

Commodity markets pose two-sided risks. On the downside, further declines in commodity prices would worsen the outlook for already-fragile commodity producers, and increasing yields on energy sector debt threaten a broader tightening of credit conditions. On the upside, the recent decline in oil prices may provide a stronger boost to demand in oil importers than currently envisaged, including through consumers’ possible perception that prices will remain lower for longer.

The “deadly embrance” between housing, house prices, and bank mortgages

An interesting IMF working paper “Mitigating the Deadly Embrace in Financial Cycles: Countercyclical Buffers and Loan-to-Value Limits” examines the limitations of Basel III in the home loan market, and makes the point that the risk-weighted focus, even with enhancement, does not cut the mustard especially in a rising or falling property market. Indeed, there is a “deadly embrance” between housing, house prices, and bank mortgages which naturally leads to housing boom and bust cycles, which can be very costly for the economy and difficult for central banks to manage. They find that macroprudential measures may assist, but even then the deadly embrace remains.

The financial history of the last eight centuries is replete with devastating financial crises, mostly emanating from large increases in financial leverage. The latest example, the Global Financial Crisis of 2008-09, saw the unwinding of a calamitous run-up in leverage by banks and households associated with the housing market. As a result, the financial supervision community has acknowledged that microprudential regulations alone are insufficient to avoid a financial crisis. They need to be accompanied by appropriate macroprudential policies to avoid the build-up of systemic risk and to weaken the effects of asset price inflation on financial intermediation and the buildup of excessive leverage in the economy.

The Basel III regulations adopted in 2010 recognize for the first time the need to include a macroprudential overlay to the traditional microprudential regulations. Beyond the requirements for capital buffers, and leverage and liquidity ratios, Basel III regulations include CCBs between 0.0 and 2.5 percent of risk-weighted assets that raise capital requirements during an upswing of the business cycle and reduce them during a downturn. The rationale is to counteract procyclical-lending behavior, and hence to restrain a buildup of systemic risk that might end in a financial crisis. Basel III regulations are silent, however, about the implementation of CCBs and their cost to the economy, leaving it to the supervisory authorities to make a judgment about the appropriate timing for increasing or lowering such buffers, based on a credit-to-GDP gap measure. This measure, however, does not distinguish between good versus bad credit expansions and is irrelevant for countries with significant dollar lending, where exchange rate fluctuations can severely distort the credit-to-GDP gap measure.

One of the limitations of Basel III regulations is that they do not focus on specific, leverage-driven markets, like the housing market, that are most susceptible to an excessive build-up of systemic risk. Many of the recent financial crises have been associated with housing bubbles fueled by over-leveraged households. With hindsight, it is unlikely that CCBs alone would have been able to avoid the Global Financial Crisis, for example.

For this reason, financial supervision authorities and the IMF have looked at additional macroprudential policies. For the housing market, three additional types of macroprudential regulations have been implemented: 1) sectoral capital surcharges through higher risk weights or loss-given-default (LGD) ratios;3 2) LTV limits; and 3) caps on debt-service to income ratios (DSTI), or loan to income ratios (LTI). Use of such macroprudential regulations has mushroomed over the last few years in both advanced economies and emerging markets. At end-2014, 23 countries used sectoral capital surcharges for the housing market, and 25 countries used LTV limits. An additional 15 countries had explicit caps on DSTI or LTI caps. The experience so far has been mixed.in a sample of 119 countries over the 2000-13 period find that, while macroprudential policies can help manage financial cycles, they work less well in busts than in booms. This result is intuitive in that macroprudential regulations are generally procyclical and can therefore be counterproductive during a bust when bank credit should expand to offset the economic downturn.

Macroprudential regulations are often directed at restraining bank credit, especially to the housing market. They do not, however, take into account the tradeoffs between mitigating the risks of a financial crisis on the one side and the cost of lower financial intermediation on the other. In addition, given that these measures are generally procyclical, they can accentuate the credit crunch during busts. More generally, an analytical foundation for analyzing these tradeoffs has been lacking. MAPMOD has been designed to help fill this analytical gap and to provide insights for the design of less procyclical macroprudential regulations.

The MAPMOD Mark II model in this paper includes an explicit housing market, in which house prices are strongly correlated with banks’ credit supply. This corresponds to the experience prior and during the Global Financial Crisis. This deadly embrace between bank mortgages, household balance sheets, and house prices can be the source of financial cycles. A corollary is that the housing market is only partially constrained by LTV limits as the additional availability of credit itself boosts house prices, and thus raises LTV limits.

The starting point of the MAPMOD framework is the factual observation that, in contrast to the loanable funds model, banks do not wait for additional deposits before increasing their lending. Instead, they determine their lending to the economy based on their expectations of future profits, conditional on the economic outlook and their regulatory capital. They then fund their lending portfolio out of their existing deposit base, or by resorting to wholesale funding and debt instruments. Banks actively seek new opportunities for profitable lending independently of the size or growth of their deposit base—unless constrained by specific regulations.

In MAPMOD, Mark II, we extend the original model by introducing an explicit housing market. We use the modular features of the model to analyze partial equilibrium simulations for banks, households, and the housing market, before turning to general equilibrium results. This incremental approach sheds light on the intuition behind the model and simulation results.

The housing market is characterized by liquidity-constrained households that require financing to buy houses. A house is an asset that provides a stream of housing services to households. The value of a house to each household is the net present value of the future stream of housing services that it provides plus any capital gain/loss associated with future changes in house prices. We define the fundamental house price households are willing to pay to buy a house the price that is consistent with the expected income/productivity increases in the economy. If prices go above the fundamental house price reflecting excessive leverage, we refer to this as an inflated house price. The supply of houses for sale in the market is assumed to be fixed each period. House prices are determined by matching buyers and sellers in a recursive equilibrium with expected house prices taken as given. We abstract from many real-world complications such as neighborhood externalities, geographical location, square footage or other forms of heterogeneity.

Bank financing plays a critical role in the determination of house prices in the model. If banks provide a larger amount of mortgages on an expectation of higher household income in the future, demand for housing will go up, thus inflating house prices. Conversely, if banks reduce their loan exposure to the housing market, demand for houses in the economy will be reduced, leading to a slump in house prices. House prices therefore move with the credit cycle in MAPMOD, Mark II, just as in the real world.

Nonperforming loans and foreclosures in the housing market occur when households are faced with an idiosyncratic, or economy-wide, shock that affects their current LTV or LTI characteristics. Banks will seek to reduce the likelihood of losses by requiring a sufficiently high LTV ratio to cover the cost of foreclosure. But they will not be able to diversify away the systemic risk of a general fall in house prices in the economy. Securitization of mortgages in MAPMOD is not allowed. And even if banks were able to securitize mortgages, other agents in the economy would need to carry the systemic risk of a sharp fall in house prices. At the economy-wide level, the systemic risk associated with the housing market is therefore not diversifiable. The evidence from the Global Financial Crisis on securitization and credit default swaps confirms that this is the case, regardless of who holds mortgage-backed securities.

This paper presented a new version of MAPMOD (Mark II) to study the effectiveness of macroprudential regulations. We extend the original MAPMOD by explicitly modeling the housing market. We show how lending to the housing market, house prices, and household demand for housing are intertwined in the model in a what we call a deadly embrace. Without macroprudential policies, this naturally leads to housing boom and bust cycles. Moreover, leverage-driven cycles have historically been very costly for the economy, as shown most recently by the Global Financial Crisis of 2008–09.

Macroprudential policies have a key role to play to limit this deadly embrace. The use of LTV limits for mortgages in this regard is ineffective, as these limits are highly procyclical, and hold back the recovery in a bust. LTV limits that are based on a moving average of historical house prices can considerably reduce their procyclicality. We considered a 5 year moving average, but the length of the moving average used should probably vary based on the specific circumstances of each housing market.

CCBs may not be an effective regulatory tool against credit cycles that affect the housing market in particular, as banks may respond to higher/lower regulatory capital buffers by reducing/increasing lending to other sectors of the economy.

A combination of LTV limits based on a moving average and CCBs may effectively loosen the deadly embrace. This is because such LTV limits would attenuate the housing market credit cycle, while CCBs would moderate the overall credit cycle. Other macroprudential policies, like DSTI and LTI caps, may also be useful in this respect, depending on the specifics of the financial landscape in each country. It is, however, important to recognize that all these macroprudential policies come at a cost of dampening both good and bad credit cycles. The cost of reduced financial intermediation should be taken into account when designing macroprudential policies.

From Global Savings Glut to Financing Infrastructure

A new IMF working paper investigates the emerging global landscape for public-private co-investments in infrastructure. The creation of the Asian Infrastructure Investment Bank and other so-called “infrastructure investment platforms” are an attempt to tap into the pool of both public and private long-term savings in order to channel the latter into much needed infrastructure projects. This paper puts these new initiatives into perspective by critically reviewing the literature and experience with public private partnerships in infrastructure. It concludes by identifying the main challenges policymakers and other actors will need to confront going forward and to turn infrastructure into an asset class of its own.

Institutional investors such as pension funds, insurance companies and mutual funds, and other investors such as sovereign wealth funds hold around $100 trillion in assets under management. One gets a clearer grasp of the enormous size of this global wealth by comparing it to US nominal GDP $18 trillion in 2015.

Against this backdrop of a largely untapped pool of global savings, estimates suggest that the world needs to increase its investment in infrastructure by nearly 60 percent until 2030. There is a huge infrastructure investment gap in a large number of countries. The average infrastructure investment gap amounts to between $1 to 1.5 trillion per year. Infrastructure investment needs are mostly earmarked for upgrading depreciating brownfield infrastructure projects in the EU and in the US and for greenfield investments in low-income and emerging markets. The future growth in the demand for infrastructure will come increasingly from emerging economies.

There is growing recognition globally that development banks can play an important role in facilitating the preparation and financing of infrastructure projects by private long-term investors. A number of infrastructure platform initiatives have been launched very recently, most of them still at a prototype development stage. We discuss four different models that are currently at various stages of development. These platforms are all different attempts to tap into the vast pool of global long-term savings by better meeting long-term investor needs to attract them to infrastructure assets and by relaxing operating and governance constraints traditional development banks have been facing.

A first obvious lesson from an analysis of these platforms, is that the ability of development banks to leverage public money –committed capital from government contributions—by attracting private investors as co-investors in infrastructure projects is increasing the efficiency of development banks around the world. It is not just the fact that development banks are able to invest in larger-scale infrastructure projects and thus obtain a greater bang for the public buck, but also that these private investors together with development banks can achieve more efficient PPP concession contracts. Development banks are not just lead investors providing some loss absorbing capital to private investors. They also give access to their expertise and unique human capital to private investors, who would otherwise not have the capabilities to do the highly technical, time-consuming, due diligence to identify and prepare infrastructure projects. In addition, they offer a valuable taming influence on opportunistic government administrations that might be tempted to hold up a private PPP concession operator. Private investors in turn keep development banks in check and ensure that infrastructure projects are economically sound and not principally politically motivated. No wonder that this platform model is increasingly being embraced by development banks around the world.

The paper has documented that new platforms of investments have emerged. Notwithstanding, they are confronted with serious structural limitations. These platforms will certainly help on two important fronts namely on financing and origination of infrastructure projects, which this paper has focused on. Formally integrating these dimensions in models of PPP are important avenues for academic research.

Besides financing and origination, there are other important challenges to complete the broader task that lie ahead, such as in making infrastructure investment an asset class of its own. Two important directions are needed to further the agenda. First, the lack of standardization of underlying infrastructure projects is an important impediment to the scaling up of investment into infrastructure-based assets. Large physical infrastructure projects are indeed complex and can differ widely from one country to the next. In that respect, making use of securitization techniques such as collateralized bond obligations (or CBOs) or collateralized loan obligations (or CLOs) allow for better price discovery which will enhance the efficiency of the market and allow a more effective pooling of risk. It would also allow to “bulk up” the bond offering by addressing the problem of insufficient large sized bond issues. Overall, securitization will provide many advantages such as diversification for investors, lower cost of capital by allowing senior tranches to be issued with higher credit ratings, as well as higher liquidity. At the same time, securitization also creates debt instruments of variable credit risks to match the different risk appetites of investors. Second, there are important complementarities between actors participating in the “value chain” created by platforms including host countries, financial investors, guarantors and financial intermediaries. For all these reasons, the EIB has recently launched a renewable energy platform for institutional investors (REPIN) to offer repackaged renewable energy assets in standardized, liquid forms to institutional investors15. Although interest from institutional investors has been limited so far, the new carbon footprint disclosures and regulations of institutional investors that are expected be implemented after the Paris COP 21 climate summit, could nudge more pension and sovereign wealth funds to take on these securities.

Finally, host countries may put forth viable long term infrastructure projects but without the provision of guarantees to address construction, demand, exchange rate risks or without the securitization of underlying assets by financial intermediaries, those projects will not be funded, thus leaving everyone worse off. There is obviously also a need for enhanced coordination and cooperation across the various platforms in existence and for the creation of a global infrastructure investment platform. Part of the coordination should lead to risks being assumed by those best placed to hold them. Governments are the natural holders of political, regulatory and governance risks. The private sector for obvious incentive reasons should take on most of the construction risk, and demand risk should probably be shared, depending on the sector and type of project.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate.The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board,or IMF management.

IMF Highlights Risks In NZ Economy

On February 5, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand. In the report, they examine a number of issues, including high house prices in Auckland, trade exposures, low GDP per capita and chronic low household savings. “From the 2000s, New Zealand has lagged behind top OECD countries in output per worker by 20–25 percent. This gap can be explained by both substantial productivity gaps and lower levels of capital. While the latter may be partly influenced by the low savings rate (and higher interest rates), the productivity gap is striking, particularly when taking into account New Zealand’s sound institutional and policy settings: New Zealand’s per capita should be 20 percent above the OECD average based on structural policy settings, not 20 percent below”.

The economy’s strong growth after the global financial crisis has been supported by rising terms of trade and reconstruction activity after the 2010–11 Canterbury earthquakes, as well as high net immigration. Growth peaked at 3.5 percent year-on-year (y/y) in Q4 2014, bringing output slightly above potential. However, the tailwinds have recently waned. In 2014, dairy prices began to fall from historic highs, leading to a sharp drop in income growth after the positive effect of declining oil prices had worn off, and investment activity related to the Canterbury rebuild has reached a plateau. As a result, output growth is estimated to have slowed to 2.3 percent in 2015, despite resilient consumption. Meanwhile, unemployment has been edging up reaching 6 percent in Q3 2015. Due largely to the decline in oil prices, inflation has dropped to 0.3 percent (y/y) in Q3 2015. House price inflation in Auckland has remained high, driven fundamentally by supply shortages.

The exchange rate depreciation has cushioned some of the impact of the decline in dairy prices. The bilateral exchange rate against the U.S. dollar has depreciated as dairy prices fell and the Reserve Bank of New Zealand (RBNZ) eased monetary policy. The depreciation has mitigated the impact of the international dairy price decline on farmers’ incomes, and supported exports of travel and education services.

With growth below potential, measures of core inflation around the lower half of the target band, and a still strong exchange rate, monetary policy has been eased since June and the Reserve Bank stands ready to reduce rates further if warranted.

To manage risks arising from house price inflation in Auckland, macroprudential measures were introduced in 2013, leading to a temporary slowdown in price hike. A package of additional macroprudential regulations and tax measures was announced in May 2015, but having become fully effective only in November. The banking sector has increased capital and liquidity buffers, but reliance on offshore funding and a large share of mortgage lending remain sources of vulnerability.

Fiscal policy is also supportive of the economy in the short term, while consolidation is projected to resume in the medium-term. Automatic stabilizers have been allowed to work and public investment is being increased. Net debt is projected to decline further to around 5 percent of GDP in the medium term.

With chronically low national saving, New Zealand’s economy is dependent on borrowing from abroad. Its persistently negative savings-investment balance has led to the accumulation of a large net negative international investment position (IIP) which reached65 percent of GDP in 2014.

The short-term outlook is challenging with both external and domestic risks, the latter arising from rapid house price inflation in Auckland. However, New Zealand’s flexible economy is resilient, and medium-term prospects remain positive. New Zealand’s main exports—agricultural consumer products and tourism—should benefit from the ongoing shift to a more consumption-oriented growth model in China. Consumer demand in other Asian countries is also expected to grow. Overall, output growth is projected to recover to its estimated potential rate of 2.5 percent. With measures of core inflation around the lower end of the target range and expectations consistent with the band’s midpoint, inflation is forecast to rise to within the RBNZ’s target range of 1–3 percent in 2016.

Executive Board Assessment

Executive Directors welcomed that New Zealand’s economy continues to perform well despite the slowdown imposed by the fall in dairy prices, plateaued investment associated with the Canterbury rebuild, and slower growth in trading partners. Directors agreed that New Zealand’s sound and flexible policy frameworks, including the important buffer provided by the flexible exchange rate, position the country well to weather the recent slowdown. Medium-term prospects remain positive, and Directors were encouraged by the authorities’ alertness to the downside risks and challenges arising from real estate market pressures, a persistently low savings rate, and relatively low productivity.

Directors considered the current accommodative monetary stance to be appropriate and agreed that, if needed, the authorities should stand ready for further easing given low inflationary pressures and below potential output. With regard to fiscal policy, they agreed that the planned easing this year and next, including through an acceleration of public investment in infrastructure, combined with a resumption of gradual fiscal consolidation thereafter, is appropriate. These measures should support the economy in the short term and bolster the public sector balance sheet in the longer term.

Directors noted that the banking system is resilient and well-supervised. They commended the proactive prudential and tax measures being taken to address the risks stemming from the housing market. Noting that the underlying cause of the housing market boom in Auckland is a supply/demand mismatch, they encouraged the authorities to be ready to use additional prudential measures and consider steps to reduce the tax advantage of housing over other forms of investments, while continuing to address supply-side bottlenecks.

Directors agreed that raising national and in particular private saving is critical to reducing external vulnerabilities from the still heavy reliance on offshore funding. They noted that higher saving may also reduce capital costs by lowering the risk premium and thereby support productive investment and long-term growth. They encouraged the authorities to consider comprehensive policy measures to boost long-term financial savings, including through reform of retirement income policies, as this could also help deepen New Zealand’s capital markets and broaden options for retirement planning.

Directors observed that, notwithstanding high living standards, New Zealand incomes lag those of other advanced economies, due to relatively low capital intensity and productivity. Acknowledging that the economy’s small size and distance from markets likely limit gains from trade, they encouraged the authorities to build on the country’s business-friendly environment to take steps to boost competition in key service sectors, leverage ICT more intensively, and address key infrastructure bottlenecks. They welcomed the focus of the government’s Business Growth Agenda on these issues.

Commodity Price Shocks and Financial Sector Fragility

A newly released IMF working paper investigates the impact of commodity price shocks on financial sector fragility.

Using a large sample of 71 commodity exporters among emerging and developing economies, it shows that negative shocks to commodity prices tend to weaken the financial sector, with larger shocks having more pronounced impacts. More specifically, negative commodity price shocks are associated with higher non-performing loans, bank costs and banking crises, while they reduce bank profits, liquidity, and provisions to nonperforming loans. These adverse effects tend to occur in countries with poor quality of governance, weak fiscal space, as well as those that do not have a sovereign wealth fund, do not implement macro-prudential policies and do not have a diversified export base.

The recent decline in commodity prices, especially for oil, has revived once again interest in their economic impact. Most commodities prices have declined by about 50 percent between mid-2014 and mid-2015, leading to significant losses in export earnings for commodity exporters. While commodity markets may be undergoing a transition to an era of low prices, such a sharp decline is not unprecedented.

Adverse commodity price shocks can also contribute to financial fragility through various channels. First, a decline in commodity prices in commodity-dependent countries results in reduced export income, which could adversely impact economic activity and agents’ (including governments) ability to meet their debt obligations, thereby potentially weakening banks’ balance sheets. Second, a surge in bank withdrawals following a drop in commodity prices may significantly reduce banks’ liquidity and potentially lead to a liquidity mismatch.

If large enough, commodity price shocks can also adversely affect bank balance sheets by weighing on international reserves and increasing the risk of currency mismatches. Third, a decline in commodity prices can reduce commodity exporters’ fiscal performance (by lowering revenue), which in turn may push government to adjust their budgets to accommodate revenue shortfalls. Often this can happen in a disorderly manner through the accumulation of payment arrears to suppliers and contractors, who in turn are unable to adequately service their bank loans.

Macro-prudential policies are gaining attention internationally as a useful tool to address system-wide risks in the financial sector. Macro-prudential policies act as an important factor for the stability of the financial sector. Macro-prudential instruments cover policies related to borrowers, loans, banks’ assets or liabilities, foreign currency credit, reserve requirements and policies that encourage counter-cyclical buffers (capital, dynamic provisioning and profits distribution restrictions). They may act as a tool to monitor the financial sector, therefore reducing the risk-taking and allowing the government to intervene on time.

The results show that negative commodity price shocks increase NPLs and bank costs, and decrease bank profits only in countries without macro-prudential policies. In contrast, countries with macro-prudential instruments are better able to cope with the detrimental impacts of adverse commodity price shocks. The implementation of macroprudential policy does not matter when it comes to provisions to NPLs as commodity price slumps lower provisions to NPLs in countries with or without macro-prudential policy.

Adverse commodity price shocks tend to lead to financial problems in non-diversified economies. The results also highlight that the detrimental effects of commodity price shocks are more common in countries with a low diversification of their export base. A lack of diversification may increase exposure to adverse external shocks and vulnerability to macroeconomic instability. While a diversified export base may allow countries to better handle declines in commodity related revenues with alternative sources.

In terms of policy implications, the findings underscore the necessity of adopting policies to increase the resilience of resource rich-countries. First, developing countries should promote sound economic policies and good governance that will ensure the effective use of natural resource windfalls and build fiscal buffers, including through sovereign wealth funds or similar arrangement. The presence of a sovereign wealth fund can effectively mitigate the impact of commodity price shocks and stabilize the economy. More generally, sound fiscal policy, characterized by low debt levels is an important buffer against exogenous shocks. Second, countries should implement macro-prudential policies in order to limit or mitigate systemic risk. Finally, countries should diversify their production and exports base in order to have more alternative sources of revenues allowing them to deal with the volatility of commodity exports related revenues.

Note: IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Will Virtual Currencies Go Main Stream?

Virtual currencies (VCs) and especially their underlying technologies are a potentially important advance for the financial sector that could increase efficiency and financial inclusion, but can also serve as vehicles for money laundering, terrorism financing, and tax evasion. Achieving a balanced regulatory framework that guards against risks without suffocating innovation is a challenge that will require extensive international cooperation, says a new IMF staff paper, “Virtual Currencies and Beyond: Initial Considerations,” released by the International Monetary Fund (IMF) during the World Economic Forum.

The report provides an overview of virtual currencies, how they work and how they fit into monetary systems, both domestically and internationally. It discusses the potential implications of the technological advances underlying virtual currencies, such as the distributed ledger system, before examining the regulatory and policy challenges posed by VCs, in the areas of consumer protection, financial integrity (money laundering and terrorism financing), taxation, financial stability, exchange and capital controls and monetary policy. The paper also sets out principles for the design of regulatory frameworks for VCs at both the domestic and international levels.

As digital representations of value, VCs fall within the broader category of digital currencies (Figure 1). However, they differ from other digital currencies, such as e-money, which is a digital payment mechanism for (and denominated in) fiat currency. VCs, on the other hand, are not denominated in fiat currency and have their own unit of account.

High price volatility of VCs limits their ability to serve as a reliable store of value. VCs are not liabilities of a state, and most VCs are not liabilities of private entities either. Their prices have been highly unstable (see Figure 2), with volatility that is typically much higher than for national currency pairs. Both prices and volatility appear to be unrelated to economic or financial factors, making them hard to hedge or forecast.

Computing technology has made possible decentralized settlement systems built on distributed ledgers distributed across individual nodes in the payment system. Centralized systems have a master ledger keeping track of transactions maintained by a trusted central counterparty. In a distributed ledger system, multiple copies of the central ledger are maintained across the financial system network by a large number of individual private entities. The network’s distributed ledgers—and hence individual transactions—are validated by using technologies derived from computing and cryptography, most often derived from the so-called blockchain technology. These technologies allow a consensus to be achieved across members of the network regarding the validity of the ledger. This distributed ledger concept underpins decentralized VCs—for example the blockchain technology behind Bitcoin. The distributed ledger provides a complete history of transactions associated with the use of particular units of a decentralized VC. They provide a secure permanent record that cannot be manipulated by a single entity and do not require a central registry.

A key conclusion of the paper is that the distributed ledger concept has the potential to change finance by reducing costs and allowing for deeper financial inclusion in the longer run. This could be especially important for remittances, where transaction costs can be high, around 8 percent. Distributed ledgers can also shorten the time required to settle securities transactions, which currently take up to three days, as well as lower counterparty and settlement risks.

“Virtual currencies and their underlying technologies can provide faster and cheaper financial services, and can become a powerful tool for deepening financial inclusion in the developing world,” said IMF Managing Director Christine Lagarde, who presented the report at the World Economic Forum, in Davos, during the panel Transformation of Finance. “The challenge will be how to reap all these benefits and at the same time prevent illegal uses, such as money laundering, terror financing, fraud, and even circumvention of capital controls.”

Note: Staff Discussion Notes (SDNs) showcase policy-related analysis and research being developed by IMF staff members and are published to elicit comments and to encourage debate. The views expressed in Staff Discussion Notes are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.