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The International Monetary Fund has warned that the stability of the global financial system is threatened by government debts.
"In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured," said Jose Vinals, Financial Counselor and Director of the IMF's Monetary and Capital Markets Department, at a press conference yesterday.
"If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the very real risk of undermining the recovery and extending the financial crisis into a new phase."
While the financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, the sharp rise in government debt during the economic crisis from already elevated levels is the newest threat to the financial system.
Bank balance sheets still contain bad assets, consumers and businesses remain stretched, and credit recovery is some time off, the IMF said in its latest Global Financial Stability Report (GFSR), released April 20.
Moreover, a large part of the financial system continues to rely in varying degrees upon the extraordinary measures governments began to introduce two years ago—such as purchasing bad assets from, and injecting capital into, troubled institutions.
But the biggest threats have moved from the private to the public sectors in advanced economies.
Governments not only took on many of the bad assets from private institutions but due to the recession face continuing heavy borrowing needs for the next few years.
Slow growth in the real economy and high unemployment will retard tax revenues and require higher government spending—such as on unemployment benefits and job creation activities.
In a wide-ranging assessment of the state of the global financial conditions, the IMF report said:
• Improving economic and financial conditions have helped private bank balance sheets in advanced economies. The IMF sharply reduced its estimate of the writedowns or loan loss provisions banks will have to take—or have taken—to account for bad loans and securities on their books. The improving quality of bank assets means that banks will probably need less capital than previously estimated to absorb losses. But banks still will face funding difficulties in the next few years, as their bonds mature and the special government assistance programs are withdrawn.
• Credit recovery will be "slow, shallow and uneven", as heavy government borrowing soaks up available funds and banks continue their reluctance to lend to repair their balance sheets.
• There is little evidence, at least so far, of bubbles in asset prices in emerging markets, despite strong portfolio flows to Asian and Latin American countries from investors seeking higher returns.
• Authorities must address a number of policy issues, including how to manage borrowing and spending to minimise sovereign risk.
The IMF warned that the increase in sovereign risk can hit banking systems and the real economy that produces goods, services, and jobs. Even with weaker private credit demand, governments could crowd out business and household borrowers, retarding recovery.
Moreover, if jittery investors worried about long-run government solvency cause a decline sovereign bond prices in the advanced economies, still-recovering banks, which are major investors in government debt, could face new hits to the value of assets on their balance sheets. And rising interest rates on public debt could also flow through to the private sector raising borrowing costs for businesses, consumers, and banks.
Dods Parliamentary Communications Ltd