IMF – Page 8 – Digital Finance Analytics (DFA) Blog

Looking Back to Move Ahead

While advances in science and technology are rapidly propelling human achievement into the future, Ian Goldin says history shows us how to handle the changes occurring in the world today.

In this podcast, Goldin, Professor of Globalization and Development at Oxford University in the United Kindom, discusses his recent book, Age of Discovery, which compares present-day upheavals with the social and political instability of the 15th Century.

“We are now at a crossroads for humanity,” he says. “This could be the best century ever for humanity, but it’s also a very dangerous time. This duality is manifested in longer human life spans, poverty reduction, and higher literacy, but also by intolerance, fears of terrorism, and environmental concerns.”

Goldin says the 1500’s brought an explosion of genius and creativity across Europe and the world with advances like the Guttenberg printing press. This period also saw destruction and extremism, like religious wars and persecution, because policymakers had difficulty keeping up with the information revolution. Today’s growing influence of social media, globalization, and inequality, mean those disadvantaged by change also feel locked out of opportunities.

“It is not those places where change is occurring that are revolting against change; it is the places that are left behind,” he says.

As societies and policymakers seek change, so should global financial institutions, which need to continue asking whether the right structure is in place to help people deal with disruptions.

“We need to focus on how we can solve 80 percent of the problems with 20 percent of the actors, and they won’t always be governments,” he says. “They could be pharmaceutical or energy companies, cities or states. We are going to have to be more flexible when deciding with whom we engage.”

Two to Tango—Inflation Management in Unusual Times

From The IMFBlog.

Monetary and fiscal policies interact in complex ways. Yet modern institutional arrangements typically feature a strict separation of responsibilities. For example, the central bank targets inflation and smooths business cycle fluctuations, while the fiscal authority agrees to respect its budget constraint and to support financial stability by maintaining the safe asset status of its debt. This gives governments the freedom to pursue a multiplicity of economic and social objectives (in IMF parlance, inclusive growth).

This separation of responsibilities typically works well, but can come at a cost as it limits the potential benefits that arise when fiscal and monetary policy work together. While in normal times the forgone benefits may be small, in more extreme situations the benefits of coordinated policy are much larger.

By looking at the case of low inflation in Japan, we illustrate—in particularly difficult circumstances—how vital it is for these policies to work together. Good coordination between monetary and fiscal policy is key and calls for policies that are:

comprehensive—exploiting the full range of synergies between monetary, fiscal, and appropriate structural policies; and

consistent—anchoring long-term expectations by demonstrating a clear commitment of monetary, fiscal and structural reform policies toward common objectives.

Japan’s low inflation

Japan is an obvious candidate for taking better advantage of the synergies between monetary and fiscal policies. Inflation is well below target after decades of depressed nominal GDP growth, despite the Bank of Japan’s efforts to push the boundaries of monetary policy innovation—including the introduction of yield curve control in September 2016.

However, a lack of consistency in fiscal policy has undermined the effectiveness of monetary policy. Fiscal plans have been caught between the short-term need to help monetary policy escape the low inflation target, and the very clear medium-term priority of reducing Japan’s large and unsustainable burden of public debt.

Setting objectives

The government could build credibility by introducing a policy framework wherein policy actions are data-dependent—so as to promote the achievement of crucial policy objectives, such as inflation or price level targets. If the government feels compelled to tighten certain policies sooner, they should introduce temporary offsetting measures to continue to support progress toward reflation. The resulting higher nominal GDP growth would also have the added benefit of helping reduce the real burden of the debt.

Of course, such conditional policies potentially carry fiscal risks: if the requisite target is not met, then continued fiscal stimulus could imperil debt sustainability. A consistent and comprehensive approach therefore also requires a framework to manage public sector balance sheet risks that mitigates the financial stability risks from a potential loss of safe asset status for Japanese government bonds.

So, as well as being oriented toward key policy objectives, deficits must be offset by real future surpluses. To avoid the appearance of policy inconsistency, the government should tighten fiscal policy gradually, and consistently with the economic cycle. Such an approach should also include structural reforms that boost future surpluses, for example, measures that close wage gaps.

Credible policies

We should also be clear that fiscal policy should be sustainable, taking as given that the central bank has designed monetary policy to achieve the inflation target. It may seem tempting to instead spend without the promise of (or even ruling out) future tax raises, in the hope that the price level rises to equate to the real values of debt and future surpluses. But this idea, which invokes the so-called Fiscal Theory of the Price Level, assumes that the safe asset status of government debt is guaranteed.

The risk of such a policy, which relies on the shaky assumption that Japanese consumers have very particular expectations of future policy, is that a bond market scare occurs and government bonds lose their safe asset status. This would then relegate monetary policy’s role to that of guaranteeing fiscal solvency (by guaranteeing the promised nominal payments on government bonds), precluding its use in stabilizing inflation and anchoring inflation expectations. This would destroy policy credibility.

The debate on Japan’s consumption tax increase is a good example to illustrate the importance of consistency and credibility. The planned consumption tax increase has been postponed twice: once from 2015 to 2017, and again until 2019, in fear of a negative impact on growth. This policy reversal and the associated lack of a credible anchor has reduced the effectiveness of fiscal policy.

In our view, a pre-announced, gradual increase of Japan’s consumption tax rate, offset by temporary fiscal measures when necessary, remains a preferred option. The gradual increase should continue until the tax rate reaches a medium-term level that ensures fiscal sustainability. This approach will help raise inflation expectations and has high revenue potential given the relatively low level of revenue collected from the consumption tax in Japan, compared with VAT collections in other Organization for Economic Cooperation and Development countries. In the process, Japan should preserve its single rate, which makes its consumption tax system simple, and constitutes an important structural advantage.

Lessons learned

The experience of low inflation in Japan has a clear message for the interaction between monetary and fiscal policy. And that message is in such extreme circumstances, macroeconomic policies will only be successful if they take full advantage of the synergies of different policies working together.

Why Talk of Bank Capital ‘Floors’ Is Raising the Roof

From The IMFBlog.

Calculating how much capital banks should hold is often a bone of contention between regulators and banks. While there has been considerable progress on reaching consensus on an international standard, one key issue remains unresolved. This is a proposal to establish a “floor,” or minimum, for the level of capital the largest banks must maintain.

Some financial institutions and national authorities question the need for a “floor,’’ arguing either that differences in business models or other elements of the global regulatory framework—notably limits on the amount of leverage banks may take on—make them redundant. We disagree. The floor reduces the chances that banks can game the system to reduce their capital buffers to levels that aren’t aligned with their risks. It is an essential element of global efforts to create a level playing field for banks operating across countries by strengthening common standards for regulation, supervision and risk management.

Why is the issue of calculating capital levels so important? Bank capital serves as a buffer available to absorb losses. When capital is depleted, deposits and other borrowed funds are put at risk, and this can lead to bank runs, bank failures and wider systemic distress. Banks should hold capital commensurate with the business risks they take and the risks they pose to the wider system.

Key element

The Basel Committee on Banking Supervision, which brings together regulators from 28 countries, establishes rules governing the appropriate level of capital. The current version of these rules, known as Basel III, is a key element of the international regulatory reform agenda put in motion following the global financial crisis of 2008.

Adopted in late 2010 for implementation over a seven-year period, Basel III has led to a significantly safer financial system. Not only are banks capitalized with more and higher-quality capital than before, they also meet new standards for liquidity risk (ensuring banks hold enough liquid assets to meet maturing liabilities in times of stress) and limits on leverage (how much banks can borrow relative to their capital.)

The largest global banks have been gradually allowed to use their own internal models to calculate capital needed for different types of risk. The Basel Accord of 1988, known as Basel I, used only standard risk weights provided by supervisors. In 1996, some banks were allowed to develop their own, internal models for evaluating market risk.

Safety net

Basel II, adopted in 2004, introduced both a standardized approach (similar to Basel I but using risk weights based on external credit ratings) and an internal ratings-based approach (based on banks’ own internal models). But it added a wrinkle: banks had to apply both approaches for a period of two to three years before being fully reliant on their internal models. And, in addition, capital levels had to be at least as conservative as a “floor” equivalent to 80 percent of the level calculated from standard risk weights.

The floor serves as a safety net to internal risk-based approaches. It gives banks and their supervisors time to intervene should changes be needed before signing off on the use of full-fledged internal models. Basel III kept the internal models from Basel II, but it did not keep the floor. The Basel committee now seeks to reintroduce the floor.

Why is the issue contentious? In testing whether the new method was being applied consistently across institutions in different countries, the Basel Committee found that banks with similar portfolios came up with very different capital requirements when they used internal models. This raised the possibility that some banks were underestimating the risks or gaming the models to deliver outcomes that required less capital. Hence addressing risk weight variability became a top priority.

To solve this problem, the Basel Committee considered several proposals:

Revising the standardized approach to better capture the riskiness of bank assets, making it a better complement to the internal risk-based approach;

limiting the use of the internal risk-based approach; and

implementing a floor to mitigate internal model risk and to make it easier to compare outcomes across banks.

The floor—though not new—would become a more permanent feature of the enhanced Basel III capital framework, based on the revised standardized approach. This approach offers the best of both worlds: the flexibility of the internal models combined with the minimum standard represented by the floor.

The discussion raging now is whether there is a need for a floor, given that the leverage ratio established under Basel III serves already as backstop. And if there is a floor, should it be set at 80 percent, as specified in Basel II, or some other level?

Banks’ concerns

Some banks using internal models worry that their capital requirements could go up if these floors were applied, which would reduce their profitability. The governing body of the Basel Committee, however, has emphasized that the enhancements to Basel III should not lead to a significant, overall increase in capital requirements across banks.

It is our view that the risk-weighted capital adequacy ratio, leverage ratio and output floors are all essential elements of a robust capital framework:

The capital adequacy ratio relates risk to capital, but it is complex and makes it difficult to compare capital outcomes among banks.

The leverage ratio constrains the overall ability of the bank to grow its balance sheet out of proportion to capital. It is not risk sensitive but is simple to calculate and provides a backstop to the risk-weighted capital ratio.

The floor addresses the risk that a model may not perform as expected when banks use it to calculate capital. It allows banks to continue using more risk-sensitive approaches but constraints any unwarranted capital relief, while also making it easier to compare institutions through disclosure of the standardized approach outputs.

While we welcome the additional risk sensitivity that internal models bring, we remain cautious about their unconstrained use. Supervisory capacity to ensure effective prudential oversight of internal models remains a work in progress. At the same time, banks will always have incentives to game the models and reduce the amount of capital they hold. Indeed, a recent study by Federal Reserve economists finds manipulation of risk weights to be widespread.

Well-capitalized banks are more likely to lend to the real economy and less likely to indulge in excessive risk-taking that could threaten the stability of the financial system. This only strengthens the case for a robust capital framework.

Properly calibrated and carefully phased, the Basel III enhancements of a floor on risk models can help prevent excessive variability in capital outcomes and allow for meaningful comparison across institutions and countries, while still permitting for risk sensitive approaches to take hold. The capital floor is a linchpin of this system.

Speed Limits for Financial Markets? Not So Fast

From The IMFBlog.

On the afternoon of May 6, 2010, a financial tsunami hit Wall Street. Stunned traders watched as graphs on their computer screens traced the vertiginous 998-point plunge in the Dow Jones Industrial Average, which erased $1 trillion in market value in 36 minutes.

There was little in the way of fundamental news to drive such a dramatic decline, and stocks bounced back later that day. The event, quickly dubbed the “flash crash,” focused attention on the role of high-frequency trading and algorithms in amplifying market volatility.

Thick vs. thin

So far, though, there’s been remarkably little in the way of hard evidence on whether advances in information and communication technology help magnify market turbulence. Now, economists Barry Eichengreen, Arnaud Mehl, and the IMF’s Romain Lafarguette are trying to fill that gap. Their findings, surprisingly, are that faster transmission of market-moving news reduces volatility rather than increasing it.

The three economists present their research in a new IMF working paper titled “Thick vs. Thin-Skinned: Technology, News and Financial Market Reaction.”

The title refers to two popular hypotheses. The “thin-skinned” hypothesis holds that advances in information technology cause prices to react more violently to news by enabling strategies associated with volatility, such as algorithmic trading and stop-loss orders. High-frequency traders popularized by Michael Lewis’s 2014 book, Flash Boys, also have been blamed.

The “thick-skinned’’ hypothesis holds the opposite: advances in technology suppress volatility, because information that spreads more quickly reduces the information disadvantages of uninformed investors. Such investors “follow and amplify market trends by relying excessively on past or present returns to anticipate future returns,” the authors write. In other words, they engage in herd behavior, selling when prices fall and buying when prices rise. Better informed investors are less likely to follow the herd.

Ingenious test

Eichengreen and his co-authors have come up with an ingenious way of testing these hypotheses, by measuring reactions to news transmitted across superfast submarine fiber-optic cables.

“This result is consistent with the view that technology levels the informational playing field by easing access to information and that it thereby reduces trend following behavior,” they write.

Their laboratory is the world’s biggest financial market, the one for currencies, where average daily volumes exceed $4 trillion (more than the combined GDP of Italy and Brazil). They measured the reactions of currencies to major US economic news such as changes in gross domestic product, consumer prices and monetary policy.

London calling

To see how the speed of transmission affects the magnitude of the market reaction, they divided the markets into two groups: One receives news faster because it has direct fiber-optic connections with the major financial centers—Tokyo, London, and New York. The second set receives news more slowly, because it lacks direct fiber optic connections.

The amount of data they amassed is impressive: 240,430 observations for 56 bilateral exchange rates against the dollar between January 1, 1997, and November 30, 2015. Their conclusion: currencies traded in places which get their news faster via direct fiber-optic connections react less than currencies in places that receive their news more slowly. In fact, the reaction in markets with direct connections is 50 percent to 80 percent smaller.

Authors Eichengreen, Lafarguette, and Mehl decline to pass judgment on proposals to damp asset-price volatility by slowing the velocity of data flows with measures such as electronic “speed bumps.” But their study does suggest that transmitting information more broadly may reduce volatility.

Bank Stress Tests Are Not Up To The Job

An important IMF working paper, released today suggests that the standard stress test models used to assess risks in the banking system are likely to underestimate the impact of stress on bank solvency and financial stability because they do not consider the dynamics between solvency and funding costs.

The global financial crisis appears to have been a liquidity crisis, not just a solvency crisis. Yet the failure to adequately model interlinkages and the nexus between solvency risk and liquidity risk led to a dramatic underestimation of risks. Liquidity risk manifests primarily through a liquidity crunch as firms’ access to funding markets is impaired, or a pricing crunch, as lenders are unwilling to lend unless they receive much higher spreads.

A sudden increase in bank funding costs can have an adverse impact on financial stability through the depletion of banks’ capital buffers. To preserve financial stability, it is important to assess banks’ vulnerability to changes in funding costs. The reason is twofold. First, to the extent funding costs reflect counterparty credit risk, it is of particular interest for supervisors to determine the level of capital buffers that should be held to keep funding costs at bay if and when market conditions deteriorate. Second, funding costs are linked not only to banks’ initial capital position but also they determine their capital position going forward, paving the way for adverse dynamics. The magnitude of this effect is likely to depend on the bank’s behavioral reaction to rising funding costs. On the one hand, it may react by setting higher lending rates to its borrowers. Yet this action reduces the bank’s market share and its franchise value. On the other hand, the bank might not be able to passthrough additional funding costs to new lending so its internal capital generation capacity is reduced. Even if some pass-through is possible, the erosion of profits is likely to be
substantial given the shorter time to repricing of liabilities relative to assets with the margin impact on the carrying values of assets outweighing that of new asset generation.

“Bank Solvency and Funding Cost: New Data and New Results” presents new evidence on the empirical relationship between bank solvency and funding costs. Building on a newly constructed dataset drawing on supervisory data for 54 large banks from six advanced countries over 2004–2013, we use a simultaneous equation approach to estimate the contemporaneous interaction between solvency and liquidity. Our results show that liquidity and solvency interactions can be more material than suggested by the existing empirical literature. A 100 bps increase in regulatory capital ratios is associated with a decrease of bank funding costs of about 105 bps. A 100 bps increase in funding costs reduces regulatory capital buffers by 32 bps. We also find evidence of non-linear effects between solvency and funding costs. Understanding the impact of solvency on funding costs is particularly relevant for stress testing. Our analysis suggests that neglecting the dynamic features of the solvency-liquidity nexus in the 2014 EU-wide stress test could have led to a significant underestimation of the impact of stress on bank capital ratios.

The results are also highly relevant for cost impact assessments of capital regulation, as the costs of higher capital requirements are partly offset by lower debt servicing costs.

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.

Productivity, Technology, and Demographics

From The IMF Blog

Hal Varian, chief economist at Google, says that if technology cannot boost productivity, then we are in real trouble.

In a podcast interview, Varian says thirty years from now, the global labor force will look very different, as working age populations in many countries, especially in advanced economies, start to shrink. While some workers today worry they will lose their jobs because of technology, economists are wondering if it will boost productivity enough to compensate for the shifting demographics—the so-called productivity paradox.

“I would say there are at least three forces at work,” says Varian. “One of these is the investment hangover from the recession—companies have been slow to reestablish their previous levels of investment. The second has been the diffusion of technology—the increasing gap between some of the more advanced companies and less advanced companies. And third, existing metrics are facing some strains in terms of adapting to the new economy.”

Varian believes demographics is important, particularly now that baby boomers, who made up most of the labor force from the 1970s through 1990s, are now retiring but will continue to be consumers.

“Today, the working labor force is growing at less than half of the rate of population growth, which is a concern in terms of how to make the amount produced equal to the amount that people want to consume,” he said.

Varian’s answer to the concern of older workers who are afraid robots will take over their jobs:

“There’s a saying in Silicon Valley that we overestimate what can happen in two years, and we underestimate what can happen in ten years—this has proven true time and again. What the 40- and 50-year-olds should be doing is continuing to learn. Lifetime learning is the norm now.”

More political and policy uncertainties as global economic recovery improves – IMF

The Communiqué of the Thirty-Fifth Meeting of the IMFC says the global economic recovery is gaining momentum, commodity prices have firmed up, and deflation risks are receding. While the outlook is improving, growth is still modest and subject to heightened political and policy uncertainties.

Crisis legacies, high debt levels, weak productivity growth, and demographic trends remain challenging headwinds in advanced economies; while domestic imbalances, sharper-than-expected financial tightening, and negative spillovers from global uncertainty pose challenges for some emerging market and developing countries.

Trade, financial integration, and technological innovation have brought significant benefits, improving living standards, and lifting hundreds of millions out of poverty. However, the prolonged period of low growth has brought to the fore the concerns of those who have been left behind. It is important to ensure that everyone has the opportunity to benefit from global economic integration and technological progress.

We reinforce our commitment to achieve strong, sustainable, balanced, inclusive, and job-rich growth. To this end, we will use all policy tools—monetary and fiscal policies, and structural reforms—both individually and collectively. We reaffirm our commitment to communicate policy stances clearly, avoid inward-looking policies, and preserve global financial stability. We recognize that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will refrain from competitive devaluations, and will not target our exchange rates for competitive purposes. We will also work together to reduce excessive global imbalances by pursuing appropriate policies. We are working to strengthen the contribution of trade to our economies. Our priorities include:

Accommodative monetary policy: In economies where inflation is still below target and output gaps remain negative, monetary policy should remain accommodative, consistent with central banks’ mandates, mindful of financial stability risks, and underpinned by credible policy frameworks. Monetary policy by itself cannot achieve sustainable and balanced growth, and hence must be accompanied by other supportive policies. Monetary policy normalization, where warranted, should continue to be well-communicated, also to mitigate potential cross-border spillover effects.

Growth-friendly fiscal policy: Fiscal policy should be used flexibly and be growth-friendly, prioritize high-quality investment, and support reforms that boost productivity, provide opportunities for all, and promote inclusiveness, while enhancing resilience and ensuring that public debt as a share of GDP is on a sustainable path.

Tailored, prioritized, and sequenced structural reforms: We will advance structural reforms to lift growth and productivity and enhance resilience, while assisting those bearing the cost of adjustment. The design, prioritization, and sequencing of reforms should reflect country circumstances; aim to boost investments in infrastructure, human capital development, and innovation; promote competition and market entry; and raise employment rates.

Safeguarding financial stability: We will further strengthen the resilience of the financial sector to continue to support growth and development. This requires sustained efforts to address remaining crisis legacies in some advanced economies and vulnerabilities in some emerging market economies, as well as monitoring potential financial risks associated with prolonged low or negative interest rates and with systemic market liquidity shifts. We stress the importance of timely, full, and consistent implementation of the agreed financial sector reform agenda, as well as finalizing remaining elements of the regulatory framework as soon as possible.

A more inclusive global economy: We will implement policies that promote opportunities for all within our countries, sustainability over time, and cooperation across countries. We will implement domestic policies that develop an adaptable and skilled workforce, assist those adversely affected by technological progress and economic integration, and work together to ensure that future generations are not left to pay for the actions of the current one. Recognizing that every country benefits from cooperation through a collaborative framework that evolves to meet the changing needs of the global economy, we will work to tackle common challenges, support efforts toward the 2030 Sustainable Development Goals (SDGs), and ensure the orderly functioning of the international monetary system (IMS). We will support countries dealing with the consequences of conflicts, refugee and humanitarian crises, or natural disasters. We will work to promote a level playing field in international trade and taxation; tackle the sources and channels of terrorist financing, corruption, and other illicit financial flows; and address correspondent banking relationship withdrawal.

Watch the press conference here.

IMF More Bullish On Global Financial Stability

The IMF Transcript of the release of the April 2017 Global Financial Stability Report suggests that global financial stability has improved in the last six months. They say global growth could strengthen, and deflation risks could continue to fade. This would benefit emerging markets and advanced economies alike, even as interest rates and monetary policies normalize. [DFA Note – more upward pressure on mortgage rates!]

However, the IMF warns that failing to get the policy mix right could reverse market optimism.

As Maury Obstfeld explained yesterday at the release of the World Economic Outlook, economic activity has gained momentum. We have greater confidence in the outlook. Hopes for reflation have risen. Monetary and financial conditions remain highly accommodative. Investor optimism over the new policies under discussion has boosted asset prices.

But failing to get the policy mix right could reverse market optimism. It could also ignite new downside risks to financial stability. In the United States, policies could increase fiscal imbalances and could push up interest rates and global risk premia. A shift toward protectionism globally could drag down trade and growth, triggering capital outflows from emerging markets.

The loss of global cooperation on regulatory reforms could reverse some of the gains that have made financial systems safer. Markets expect these adverse developments will be avoided and policymakers will implement the right mix of policies. In the United States, this means policies that will invigorate corporate investment. In emerging markets, this means addressing domestic and external imbalances to enhance resilience to external shocks. Finally, in Europe, this means that policies will have to strengthen the outlook for banks by tackling the structural causes of weak profitability. That is why the focus of this report is on “Getting the policy mix right”.

Let me now turn to the key policy questions. First, can the corporate sector in the United States support a safe economic expansion? Investment spending has been languishing for over 15 years now. Recently, discussions of corporate tax reform, infrastructure spending, and reductions in regulatory burdens have boosted confidence. This could herald a much‑needed rebound in investment to build for the future.

The good news is that many firms have the capacity for capital expenditures. Increased cash flows from corporate tax reform could bring about increased investment. This would be welcome rather than financial risk taking, such as the acquisition of financial assets and using debt to pay out shareholders. The bad news is that sectors accounting for almost half of U.S. investment—namely, energy, utilities, and real estate—are already highly levered. This means that expanding investment, even with tax relief, could increase already elevated debt levels.

Why is this a problem? A sharp rise in interest rates—for example, owing to increased financial imbalances—could push corporate debt servicing capacity to its weakest level since the crisis. Under such a scenario, corporates with some $4 trillion of assets may find servicing their debt challenging. This is almost a quarter of the assets we capture in our analysis.

In an integrated world, what happens in advanced economies has repercussions for emerging markets. We all remember the taper tantrum in 2013, when interests rose sharply and emerging markets suffered badly. Is this time different? With the right policy mix, it can be.

Global growth could strengthen, and deflation risks could continue to fade. This would benefit emerging markets and advanced economies alike, even as interest rates and monetary policies normalize. So far, we have been on this good path. But emerging market economies could face trying times. In fact, political and policy uncertainty in advanced economies opens new channels for negative spillovers.

A sudden reversal of market sentiment could reignite capital outflows and hurt growth prospects, as could a global shift toward protectionism. We estimate that debt held by the weakest firms in emerging markets could rise to $230 billion under such a scenario. In turn, banks in some countries would need to rebuild their buffers of capital and provisions. Those are the banks that are already experiencing a decline in asset quality after a long credit boom.

China is a key contributor to global growth but has also notable vulnerabilities. Credit in relation to China’s economy has more than doubled in less than a decade, to over 200 percent. Credit booms this big can be dangerous. The longer booms last and the larger credit grows, the more dangerous they become. The Chinese authorities continue to adjust policies to limit the growth of the banking and shadow banking systems, but more needs to be done to slow credit growth and reduce vulnerabilities. The authorities’ progress and success are essential for global financial stability.

Turning to Europe, policymakers need to make further progress in addressing structural impediments to profitability in the banking system. Significant advances have already been made. European banks hold higher levels of capital, regulations have been strengthened, and supervision has been enhanced. Over the past six months, bank equity prices have risen as yield curves steepened and the economic recovery has firmed.

But this is not the end of the story. As we established in the last GFSR, a cyclical recovery is unlikely to fully resolve the profitability challenge that many banks face. Why is this important? Weak profitability limit the banks’ ability to retain capital, thus constraining their ability to weather shocks and increasing risks to financial stability.

In this GFSR, we examine many European banks, representing $35 trillion of assets. We divide them into three groups: global, European‑focused, and domestic. Domestic banks face the greatest profitability challenges, with almost three quarters of them having very weak returns in 2016. This analysis suggests that the domestic operating environment for banks plays a significant role.

While no single structural factor clearly explains chronic low profitability, overbanking is a common challenge. Overbanking takes many different forms: for example, weak banks with low buffers, too many banks with a regional focus or narrow mandate, or too many branches and low branch efficiency. Measures are being taken to address these concerns, but countries with the biggest challenges need to make more progress. Otherwise, low profitability could impede the recovery or, worse, reignite systemic risks.

Let me sum up. What does it take to get the policy mix right? US policy proposals should aim to increase economic growth but should also avoid creating fiscal imbalances and negative global spillovers. Healthy corporate balance sheets will be essential to facilitate an increase in productive investment. Policymakers should preemptively address areas in which risk‑taking appears excessive.

Emerging market policymakers should address their external and domestic imbalances. That includes improving corporate restructuring mechanisms, monitoring corporate vulnerabilities, and ensuring that banks have healthy buffers. In Europe, more comprehensive efforts are needed to address banking system and bank business model challenges. The authorities should focus on removing system‑wide impediments to profitability. Such measures should include promoting bank consolidation and branch rationalization, reforming bank business models, and addressing nonperforming loans.

At the global level, successful completion of the Regulatory Reform Agenda is vital. It relies on continued multilateral cooperation and coordination. Completing the Reform Agenda, especially the adoption of the Basel III enhancements, will ensure that the global financial system is safe and can continue to promote economic activity and growth.

Designed For Growth

From iMFdirect.

Productivity drives our living standards. In our April 2017 Fiscal Monitor, we show that countries can raise productivity by improving the design of their tax system, which includes both policies and administration. This would allow business reasons, not tax ones, to drive firms’ investment and employment decisions.

Countries can substantially increase productivity by eliminating barriers that hold more productive firms back. These barriers include badly designed economic policies, or markets that do not function as they should. We estimate that eliminating such barriers would, on average across countries, lift annual real GDP growth rates by roughly 1 percentage point over 20 years. We also find that emerging market and low-income countries can achieve one quarter of these gains by improving the design of their tax policies and revenue administrations.

Doing more with the same

Countries can increase productivity by tackling the barriers that give rise to poor use of existing resources within countries—resource misallocation. Such barriers prevent productive firms from expanding and allow unproductive ones to survive.

When comparing a less efficient country with another closer to the world’s productivity frontier, the contrast is stark. As the figure below illustrates, the less efficient country does have several highly productive firms. The main difference stems from the fact that the less efficient country has many more unproductive firms.

How can a better allocation of resources across firms raise productivity?

Imagine two firms that produce software, with identical technologies but different behavior towards taxation. Because of a weak tax administration, one firm avoids detection by the tax authority and doesn’t pay taxes, therefore facing a lower user cost of capital. The other firm is tax-compliant due to greater scrutiny from the tax authority, therefore facing a higher user cost of capital. The difference in user cost means that the tax-evading firm can afford to undertake investments in lower-return projects, while the fully taxed firm can only undertake investments in higher-return projects. In this example, aggregate output would be higher if capital were to move from the untaxed firm to the fully taxed firm, allowing for more investment in higher-return projects.

How governments tax matters for productivity

What drives the misallocation of resources? Misallocation arises when government policies or poorly functioning markets favor some firms over others. Examples include tax incentives that depend on firm size or type of investment, weak tax enforcement, tariffs applied to particular goods, product market regulations that limit market access, preferential loans granted to specific firms, and financial markets that are not fully developed. Tackling all these policies and practices is very complex.

The Fiscal Monitor explores a selection of tax policies that discriminate against firms in different ways, giving rise to resource misallocation. In this blog, we focus on one: tax evasion. This example is especially relevant for emerging market and low-income developing countries. It illustrates clearly that a weak tax administration not only hurts revenue collection, but it also hurts productivity.

Through tax evasion, “cheats”—by which we refer to firms that are registered with the tax authority but underreport their sales for tax purposes—enjoy a potentially large implicit subsidy that allows them to stay in business despite low productivity. As a result, “cheats” gain market share even if they are less productive, reducing the market share of more productive, tax compliant businesses.

Our empirical results show that a stronger tax administration reduces the prevalence of cheats. By getting rid of the implicit subsidy, the less productive “cheats”, unable to compete, will go out of business. This makes room for productive, tax-compliant firms to gain market share and absorb greater amounts of labor and capital, raising aggregate productivity.

Our estimates show that in emerging market and low income developing countries, closing the productivity gap between tax compliant firms and cheats would add ½ to 1 percentage points to aggregate productivity.

All countries have much to gain from removing the policies and practices that prevent resources from going to where they are most productive. Upgrading the tax system can play an important part.

Drivers of Declining Labor Share of Income

From iMFdirect.

After being largely stable in many countries for decades, the share of national income paid to workers has been falling since the 1980s. Chapter 3 of the April 2017 World Economic Outlook finds that this trend is driven by rapid progress in technology and global integration.

Labor’s share of income declines when wages grow more slowly than productivity, or the amount of output per hour of work. The result is that a growing fraction of productivity gains has been going to capital. And since capital tends to be concentrated in the upper ends of the income distribution, falling labor income shares are likely to raise income inequality.

Trending down

In advanced economies, labor income shares began trending down in the 1980s. They reached their lowest level of the past half century just prior to the global financial crisis of 2008, and have not recovered materially since. Labor income shares now are almost 4 percentage points lower than they were in 1970.

Despite more limited data, labor shares have also declined in emerging market and developing economies since the early 1990s. This is especially the case for the larger economies in this group. In China, for example, despite impressive gains in poverty reduction over the past two decades, labor shares still fell by almost 3 percentage points.

Indeed, as growth remains subpar in many countries, an increasing recognition that the gains from growth have not been broadly shared has strengthened a backlash against economic integration and bolstered support in favor of inward-looking policies. This is especially the case in several advanced economies.

Our study takes an in-depth look at the symptoms and drivers of this downward trend in labor share of income.

Technology: a key driver in advanced economies

In advanced economies, about half of the decline in labor shares can be traced to the impact of technology. The decline was driven by a combination of rapid progress in information and telecommunication technology, and a high share of occupations that could be easily be automated.

Global integration—as captured by trends in final goods trade, participation in global value chains, and foreign direct investment—also played a role. Its contribution is estimated at about half that of technology. Because participation in global value chains typically implies offshoring of labor-intensive tasks, the effect of integration is to lower labor shares in tradable sectors.

Admittedly, it is difficult to cleanly separate the impact of technology from global integration, or from policies and reforms. Yet the results for advanced economies is compelling. Taken together, technology and global integration explain close to 75 percent of the decline in labor shares in Germany and Italy, and close to 50 percent in the United States.

Global integration: largely benign in emerging market economies

In emerging markets and developing economies, global integration has allowed for expanded access to capital and technology and, by raising productivity and growth, has led to a rise in living standards and lifted millions from poverty.

However, these forces may also be associated with declining labor income shares, by shifting the production in emerging market and developing economies towards more capital-intensive activities. We find that global integration, and more specifically participation in global value chains, was the key driver of declines in labor shares in emerging markets.

This effect could, however, be interpreted as benign: it is the result of capital deepening that is not necessarily accompanied by dislocation of employment or reduction in wages. In Turkey, for example, the decline in labor income share of around 5 percentage points is explained almost exclusively by the rapid rise in participation in global value chains.

Technology, in contrast, has played a small role in these economies. This reflects a smaller decline in the relative price of investment goods as well as a lower share of automatable jobs.

Hollowing out of the middle-skilled labor share

Another key finding of our research is that the decline in labor shares in advanced economies has been particularly sharp for middle-skilled labor. Routine-biased technology has taken over many of the tasks performed by these workers, contributing to job polarization toward high-skilled and low-skilled occupations.

This “hollowing-out” phenomenon has been reinforced by global integration, as firms in advanced economies increasingly have access to a global labor supply through cross-border value chains.

Dealing with disruption

We conclude that although technological advancement and global economic integration have been key drivers of global prosperity, their effects on labor shares challenge policymakers to find ways to spread those benefits more broadly. The design of specific policy responses, of course, will have to depend on country circumstances and be anchored in their social contracts.