World Economy

OECD Sees Elevated Risks in Global Financial System

The era of ultra-low interest rates and liquidity was unlikely to last and rising debt levels would put recent financial reforms to the test
OECD says central banks face a difficult balancing act when it comes to unwinding stimulus.OECD says central banks face a difficult balancing act when it comes to unwinding stimulus.

The exit from crisis-era stimulus by the world’s central banks won’t be an easy ride, and previous market turmoil could well be repeated, according to the Organization for Economic Cooperation and Development.

It sees “elevated” risks ahead in the global financial system, citing the shift in monetary policy, high levels of public debt and leverage in China’s banking and shadow-banking businesses, Bloomberg reported.

The US Federal Reserve has already begun raising interest rates, and others are following, but the prospect of returning to pre-crisis normality is daunting.

Central bank balance sheets in the US, the eurozone, Britain and Japan stood at around $15 trillion at the start of this year, an almost fivefold increase from 2007, the OECD said.

“This shift to normalization has already led to extreme movements in asset prices in the early part of 2018,” it said in a report published Monday. “This may be a foretaste of things to come.”

The report isn’t the first to point out that central banks face a difficult balancing act when it comes to unwinding stimulus. The Bank for International Settlements has offered a variation of that view, saying that normalization will be “bumpy”, but policymakers shouldn’t be distracted if market wobbles are contained.

Test of Regulations

In its annual report on business and finance, the OECD said that the end of easy money will test the robustness of regulations designed to avoid a repeat of the 2008 financial crisis.

While progress has been made in boosting banks’ capital levels, not enough has been done to untangle commercial from investment banking, and many regulations don’t address new risks from fraud and disruptive technologies.

“The period of monetary support for the banking system would have been a good opportunity to fundamentally change the business models and governance of banks,” the OECD said. “This opportunity was used only partially.”

China's Shadow Lending

China's ability to manage its debt and the "vast" off-balance-sheet loans held by the country's banks have been singled out as a key risk to the global economic outlook by the OECD, AFR reported.

The annual financial outlook released by the Paris-based institution, which now counts former Australian corporate watchdog Greg Medcraft as a senior official, also raised concerns about the role of China's giant Belt and Road Initiative infrastructure project in shaping global economic forces.

The report said the global financial outlook would be shaped by China's ability to manage its debt and leverage in its banking, shadow banking and wealth management industries.

It warned that any problems could force Chinese authorities to sell down US securities, which would increase liquidity pressures in the advanced economies it represents.

"The extent of non-performing loan problems in China is obscured by the lack of information about which assets are sitting in off-balance-sheet vehicles.

But it is clear that these vast off-balance sheet exposures have increased leverage risk and could lead to destabilizing credit events," the report said.

"They have the potential to disrupt growth beyond China if further changes to the structure of financial markets and institutions are not considered in major advanced and emerging economies."

Rising Debt Levels

The threat of a US trade war and slowing economic growth have raised fears that cracks are appearing in President Xi Jinping's mission to keep the world's second-largest economy on a stable footing, as state-owned enterprises and local governments battle to wean themselves off cheap debt.

Medcraft, the director of the OECD Directorate for Financial and Enterprise Affairs, wrote in an editorial accompanying the OECD report that the era of ultra-low interest rates and liquidity was unlikely to last and that rising debt levels would put recent financial reforms to the test.

He also called for transparent "rules of the game" to ensure a level playing field for investment when it came to infrastructure investment.

Medcraft also touched on growing concerns globally about the viability of some of China's proposed infrastructure spending under BRI and the ability of poorer nations to pay off debt incurred.

"Investment projects must be viable, cost effective and appropriately selected, regardless of the source of funding. This is particularly important given that the Belt and Road Initiative's investments will be largely debt-funded, and often directed to jurisdictions with challenging business environments," he wrote.

The report notes that China's total debt was $11.2 trillion in the third quarter of 2017 with sovereign debt accounting for $4.1 trillion. Australia has one of the world's largest markets for total debt, alongside Spain with a total of $2 trillion outstanding. The two countries follow Britain, France, Germany, Italy and the Netherlands, the report said.

Add new comment

Read our comment policy before posting your viewpoints