Financial stability risks in China: The revised growth forecast for China embeds slower rebalancing of activity toward services and consumption, a higher debt trajectory, and diminished fiscal space available to respond in case of an abrupt adjustment. Unless the Chinese authorities counter the associated risks by accelerating their recent encouraging efforts to curb the expansion of credit, these factors imply a heightened probability of a sharp slowdown in China’s growth. Such an adjustment could be triggered, for instance, by a funding shock (in the short-term interbank market or in the funding market for wealth-management products), the imposition of trade barriers by trading partners, or a return of capital outflow pressures because of a faster-than-expected normalization of US interest rates. A growth slowdown in China would have adverse repercussions for other economies through weaker trade, commodity prices, and confidence"
"Tightening of global financial conditions: Continued easy monetary conditions in advanced economies can seed excesses and leave the financial system (and the economic recovery) vulnerable to an abrupt decompression of risk premiums. Chapter 1 of the October 2017 GFSR presents a downside scenario in which these risks materialize, entailing a sizable output cost. An eventual repricing of risk could be triggered by a multitude of shocks, including faster-than-expected
normalization of US monetary policy or a rise in global risk aversion. As discussed in the October
2017 GFSR, the search for yield amid historically low interest rates has pushed investors to move beyond their traditional risk mandates and is already causing a buildup of credit and liquidity risks and increased vulnerability to market risks in some countries and market segments. For instance, in the United States, credit risks are rising, as suggested by rising leverage in parts of the non-energy corporate sector and evidence of an erosion of underwriting standards in the corporate bond market. Even as the strength and health of banking systems continue to improve, policies still have a vital role to play in managing risks in the nonbank financial sector."
"Risks of capital flow reversals: Corporate leverage has increased substantially in several emerging market economies (in addition to China) since the global financial crisis, with high levels of foreign currency– denominated corporate debt issuance. As discussed in the April 2017 GFSR, corporate leverage has started to decline from peak levels in some economies, reflecting, in part, a downturn in capital expenditure in extractive industries. Against this backdrop, net financial flows to emerging market and developing economies have picked up over the past year, as the current account balances of commodity exporters have shrunk and global risk appetite has recovered. Following a period of abundant credit supply, a sudden tightening of global financial conditions could expose financial fragilities, especially where buffers may be wearing thin after a period of macroeconomic strains and financial volatility. For instance, faster-than-expected monetary policy normalization in the United States could cause reversals in capital flows to emerging markets and an appreciation of the US dollar, imposing strains on economies with high leverage, balance sheet mismatches, or exchange rates pegged to the US dollar. At the same time, to the extent that such monetary policy tightening reflects a stronger outlook for the US economy, US trading partners would benefit from positive demand spillovers."
"Challenges facing euro area banks: The euro area banking sector has made further progress with balance sheet cleanup since the spring, and bank credit growth to the nonfinancial private sector has been positive since mid-2015 (though below GDP growth). Nonetheless, nonperforming loan (NPL) ratios were still high in the first quarter of 2017, at about 5.7 percent for the euro area, and greater than 10 percent in six countries (including Italy, which accounts for about 30 percent of the euro area’s NPL stock). Profitability also remains a challenge, with stubbornly high cost-to-asset ratios, especially for medium- and small-size banks. As discussed in Chapter 1 of the October 2017 GFSR, about one-third of global systemically important banks (mostly European banks) are not expected by analysts to generate sustainable returns, even by 2019. Low earnings hinder banks’ ability to build cushions against unexpected losses and to raise capital in markets. Without a more concerted effort to clean up balance sheets and improve banks’ cost efficiency, financial stability concerns and fears of adverse feedback loops among weak demand, prices, and balance sheets could be reignited in parts of the euro area. If political risks were to reemerge, for instance, an accompanying rise in long-term interest rates would worsen public debt dynamics, especially if inflation were to remain weak."
"Financial deregulation: As discussed in Box 1.2 of the April 2017 GFSR, a broad rollback of the strengthening of financial regulation and oversight achieved since the global financial crisis—both nationally and internationally—could lower capital and liquidity buffers or weaken supervisory effectiveness, with negative repercussions for global financial stability."
"A Retreat from Cross-Border Economic Integration
Slow growth in median incomes since the global financial crisis and a longer-term trend of worsening income distributions have contributed to disillusionment with globalization in advanced economies— notably in the United States and parts of Europe. Over the longer term, a failure to lift potential growth and make growth more inclusive in advanced economies could exacerbate the risk of a retreat from cross-border integration and hinder the political consensus for necessary market-friendly reforms. Greater protectionism could disrupt global supply chains (Yi 2003; Bems, Johnson, and Yi 2010; Koopman, Wang, and Wei 2014), reduce global productivity, and make tradable consumer goods less affordable, harming low-income households disproportionately (Fajgelbaum and Khandelwal 2016). Similarly, indiscriminate curbs on immigration would hinder a channel for alleviating labor force constraints in aging societies and reduce opportunities for skills specialization and productivity growth over the long term."
"Persistently Low Inflation in Advanced Economies
In many advanced economies, steady progress toward central bank inflation targets has been elusive, reflecting in part the slow reduction of spare capacity in labor markets. An environment of persistently subdued inflation (which could ensue if domestic demand were to falter) can carry significant risks by leading to a belief that central banks are willing to accept below-target inflation, thereby reducing medium-term inflation expectations. Low inflation and interest rates would reduce central banks’ capacity to lower real interest rates to restore full employment in an economic downturn. Real wages would also be less flexible, and when demand falters, firms would be more likely to resort to laying off workers to reduce costs, amplifying the recessionary impulse. In sum, prolonged below-target inflation deepens the downside risks to advanced economies’ medium-term growth prospects."
Rising geopolitical tensions and domestic political discord can hurt global market sentiment and confidence, burdening economic activity. For many countries severely affected by such factors, the baseline scenario assumes a gradual easing of tensions. However, these episodes may turn out to be more protracted, delaying recovery in these economies. Measures of geopolitical risk have risen in recent months (Figure 1.17), and recent research shows that higher geopolitical tensions can weigh on global activity. Weak governance and large-scale corruption can also undermine confidence and popular support, taking a heavy toll on domestic activity. Other noneconomic factors weighing on growth in certain regions include the damaging effect of weather-related disasters, including the persistent effects of drought in eastern and southern Africa. If these factors intensify, the hardship in directly affected countries, especially smaller developing economies, would rise commensurately. The risks discussed above are interdependent and can be mutually reinforcing. For example, a shift toward inward-looking policy approaches to cross-border trade, investment, and migration can increase geopolitical tensions and global risk aversion. In addition, noneconomic shocks can weigh directly on near-term economic activity and hurt longer-term confidence and market sentiment. Also, faster-than-anticipated tightening of global financial conditions or a shift toward protectionism in advanced economies could create capital outflow pressures from emerging markets."
Source: WORLD ECONOMIC OUTLOOK: Seeking Sustainable Growth—Short-Term Recovery, Long-Term Challenge, OCTOBER 2017, pp, 21-23