The main financial advisor of the International Monetary Fund, Tobias Adrian, assures elEconomista that the Spanish economy “is recovering strongly” . In fact, he predicts that “Spanish banks will recover even more.” That being said, in the Global Financial Stability Report released Tuesday in Washington, Adrian and his team acknowledge that vulnerabilities for the financial sector increase as monetary and fiscal stimulus decline.
Are financial vulnerabilities masked or “hidden under the rug” due to huge fiscal and monetary stimulus?
We have seen how leverage in the corporate sector, in the sovereign sector and, in some countries, in the housing sector, has been increasing. This has helped economic activity in the last 18 months, but it is also a vulnerability going forward.
For the moment, interest rates are still low and financial conditions are easy, but at some point, that could change and high debt could become a problem. What is a short-term solution can become a problem in the medium term.
The second vulnerability is high valuations. Relaxed financial conditions cause asset prices to rise and credit spreads tighter. When we examine the valuation models, We detect that there is an overvaluation in many corners of the equity markets and other asset markets.
And then the third vulnerability is related to emerging markets. Outside of China, they have struggled to recover local currency debt flows. They issued a lot of domestic debt, but global investors didn’t buy as much. Domestic banks had to absorb a relatively large share and there is concern about the sovereign-banking nexus that is emerging as a result.
The case of China is a little different because it manages to sell its debt in national currency to international investors. They have had difficulties in recovering debt flows in local currency. They issued a lot of domestic debt, but global investors didn’t buy as much. Domestic banks had to absorb a relatively large share and there is concern about the sovereign-banking nexus that is emerging as a result.
The case of China is a bit different because it manages to sell its debt in national currency to international investors. They have had difficulties in recovering debt flows in local currency.
They issued a lot of domestic debt, but global investors didn’t buy as much. Domestic banks had to absorb a relatively large share and there is concern about the sovereign-banking nexus that is emerging as a result. The case of China is a little different because it manages to sell its debt in national currency to international investors.
Is the current rise in inflation a transitory event or is it becoming a new normal?
The current high level of inflation is a temporary phenomenon, but there is an upside risk, both in terms of the level and duration of inflation. To date we have been surprised by both the magnitude and the duration and could do it even more. There are three reasons for this. One is the base effect. This is temporary, since inflation is usually calculated over a 12-month window.
Then there are transport and delivery bottlenecks, as well as supply constraints. The world economy partially closed last year due to the pandemic and the revival is taking much longer. We still think that bottlenecks are largely temporary, but they are already lasting longer than we expected.
And the third factor is the labor market. Vacancies are high while employment remains well below pre-crisis levels. There is a kind of mismatch that is new and difficult to understand. At the same time, we have a slack, although wages are increasing in some sectors. There is something that is happening and we must look more closely.
And how does this affect central banks?
Central banks face difficult trade-offs. On the one hand, they would like to support economic activity with easy monetary policy. And that is the position of most advanced economies. Only Norway and New Zealand have tightened their monetary policy so far. But on the other hand, inflation is a threat. In emerging markets, particularly in Latin America, there has already been a tightening. Expectation formation occurs in an environment with less credibility from central banks.
Even considering inflation is temporary, central banks might want to raise interest rates, a temporary rise in inflation could lead to higher inflation expectations in the medium term. Concern about inflation expectations is undoubtedly one of the main risks for the future. In advanced economies, in general, we see inflation expectations falling again in the medium term and in the euro zone they remain below target. In Japan, inflation and inflation expectations are also below target. In the United States, short-term expectations are above target, but in the medium term they are well anchored.
“Rising financing costs could negatively affect emerging markets. Some are weak and developing economies tend to be even weaker.”
How important will it be for the Fed to get right on its path to monetary normalization to avoid triggering a tightening of global financial conditions?
I am concerned that we may see a tightening of financial conditions, especially if communication is not clear. We could see a revaluation of risk asset markets, a widening of credit spreads and a rise in interest rates. Interest rates have already risen quite a bit in September.
Much of this is associated with uncertainty about the future path of interest rates. Once the tapering is announced, a tightening of financial conditions could be seen. The normalization of monetary policy means that financial conditions should tighten, but the magnitude could be difficult to gauge.
Will the potential increase in financing costs strangle emerging markets?
Rising financing costs could adversely affect emerging markets. Some are weak, and developing economies tend to be even weaker. More than half have unsustainable or very close to unsustainable debt. A sharp move in interest rates could shift some countries from close to unsustainable to unsustainable.
For emerging markets, there are also weak points. Some have performed very well, but this tends to be based on lax financial conditions. That context could be changing. If emerging markets have to tighten their monetary policy and external financial conditions also tighten, it could present a very difficult scenario for some countries. And, of course, capital flows could be reversed.