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Global Financial Stability Report, October 2017

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Global Financial Stability Report October 2017

Is Growth at Risk?

Wo r l d E c o n o m i c a n d F i n a n c i a l S u r v e y s

I N T E R N A T I O N A L M O N E T A R Y F U N D

©2017 International Monetary Fund

Cover and Design: Luisa Menjivar and Jorge Salazar Composition: AGS, An RR Donnelley Company

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Joint Bank-Fund Library

Names: International Monetary Fund. Title: Global financial stability report. Other titles: GFSR | World economic and financial surveys, 0258-7440 Description: Washington, DC : International Monetary Fund, 2002- | Semiannual | Some issues also have thematic

titles. | Began with issue for March 2002. Subjects: LCSH: Capital market—Statistics—Periodicals. | International finance—Forecasting—Periodicals. |

Economic stabilization—Periodicals. Classification: LCC HG4523.G557

ISBN 978-1-48430-839-4 (Paper) 978-1-48432-056-3 (ePub) 978-1-48432-057-0 (Mobipocket) 978-1-48432-059-4 (PDF)

Disclaimer: The Global Financial Stability Report (GFSR) is a survey by the IMF staff published twice a year, in the spring and fall. The report draws out the financial ramifications of economic issues high- lighted in the IMF’s World Economic Outlook (WEO). The report was prepared by IMF staff and has benefited from comments and suggestions from Executive Directors following their discussion of the report on September 21, 2017. The views expressed in this publication are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Directors or their national authorities.

Recommended citation: International Monetary Fund. 2017. Global Financial Stability Report: Is Growth at Risk? Washington, DC, October.

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International Monetary Fund | October 2017 iii

CONTENTS

Assumptions and Conventions vi

Further Information and Data vii

Preface viii

Foreword ix

Executive Summary x

IMF Executive Board Discussion Summary xiv

Chapter 1 Is Growth at Risk? 1 Financial Stability Overview 1 Large Systemic Banks and Insurers: Adapting to the New Environment 2 Monetary Policy Normalization: A Two-Sided Risk 17 Has the Search for Yield Gone Too Far? 23 The Rise in Leverage 32 Could Rising Medium-Term Vulnerabilities Derail the Global Recovery? 42 Box 1.1. A Widening Divergence between Financial and Economic Cycles 47 Box 1.2. Cyberthreats as a Financial Stability Risk 49 References 51

Chapter 2 Household Debt and Financial Stability 53 Summary 53 Introduction 54 How Does Household Debt Affect Macroeconomic and Financial Stability? 56 Developments in Household Debt around the World 58 Financial Stability Risks of Household Debt: Empirical Analysis 62 Conclusions and Policy Implications 70 Box 2.1. Long-Term Growth and Household Debt 72 Box 2.2. Distributional Aspects of Household Debt in China 73 Box 2.3. A Comparison of US and Canadian Household Debt 75 Box 2.4. The Nexus between Household Debt, House Prices, and Output 77 Box 2.5. The Impact of Macroprudential Policies on Household Credit 79 Annex 2.1. Data Sources 81 Annex 2.2. Methodology 84 References 87

Chapter 3 Financial Conditions and Growth at Risk 91 Summary 91 Introduction 92 Financial Conditions and Risks to Growth: Conceptual Issues 93 How Do Changes in Financial Conditions Indicate Risks to Growth? 96 How Well Do Changes in Financial Conditions Forecast Downside Risks to Growth? 100 Policy Implications 108 Annex 3.1. Financial Vulnerabilities and Growth Hysteresis in Structural Models 109 Annex 3.2. Estimating Financial Conditions Indices 113

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Annex 3.3. The Conditional Density of Future GDP Growth 115 References 116

Tables

Table 1.1. Sovereign and Nonfinancial Private Sector Debt-to-GDP Ratios 34 Annex Table 2.1.1. Countries Included in the Sample for Household Debt and Data Sources 81 Annex Table 2.1.2. Household Survey Data Sources 82 Annex Table 2.1.3. Description of Explanatory Variables Used in the Chapter 83 Annex Table 2.2.1. Logit Analysis: Probability of Systemic Banking Crisis 84 Annex Table 2.2.2. Panel Regression Estimates for Three-Year-Ahead Growth Regression on

Household Debt and Policy Interaction Variables 86 Table 3.1. Forecast of GDP Growth Distribution for the Global Financial Crisis with and

without Financial Conditions Indices 104 Table 3.2. Market Consensus Forecasts for the Global Financial Crisis Were Considerably

More Optimistic Than Forecasts Based on Financial Conditions 104 Table 3.3. Forecast of GDP Growth Distribution for the Global Financial Crisis: Comparing

Partitioned and Univariate Financial Conditions Indices with Autoregressions 105 Annex Table 3.2.1. Country Coverage 113 Annex Table 3.2.2. Data Sources 114 Annex Table 3.2.3. Partitioning of Financial Indicators into Groups 115

Figures Figure 1.1. Global Financial Stability Map: Risks and Conditions 2 Figure 1.2. Global Financial Stability Map: Assessment of Risks and Conditions 3 Figure 1.3. Search for Yield, Asset Valuations, and Volatility 4 Figure 1.4. Global Systemically Important Banks: Significance and Business Model Snapshot 6 Figure 1.5. Global Systemically Important Banks: Capital, Liquidity, and Legacy Challenges 7 Figure 1.6. Global Systemically Important Banks: Market Activity 9 Figure 1.7. Global Systemically Important Banks’ International Activity 10 Figure 1.8. Global Systemically Important Banks: Financial Performance Gaps 12 Figure 1.9. Life Insurance Companies’ Profitability and Capital 13 Figure 1.10. Changes in Life Insurance Companies’ Business Models 14 Figure 1.11. Life Insurers’ Market Valuations and Risk Outlook 16 Figure 1.12. Simulated Mark-to-Market Shocks to Assets and Liabilities 17 Figure 1.13. Central Bank Balance Sheets and the Sovereign Sector 19 Figure 1.14. Policy Rates, 10-Year Government Bond Yields, and Term Premiums 20 Figure 1.15. Emerging Market Economy Capital Flows 22 Figure 1.16. Global Fixed Income Markets and US Corporate Credit Investor Base 24 Figure 1.17. Emerging Market Economies: Debt Issuance, Portfolio Flows, and Asset Prices 25 Figure 1.18. Low-Income Country External Borrowing and Vulnerabilities 26 Figure 1.19. US and Emerging Market Corporate Bond Spread Decomposition and Leverage 27 Figure 1.20. Long-Term Drivers of the Low-Volatility Regime 29 Figure 1.21. Leveraged and Volatility-Targeting Strategies 30 Figure 1.22. Vulnerability of the US Corporate Credit Investor Base to Shocks 31 Figure 1.23. Group of Twenty Nonfinancial Sector Credit Trends 33 Figure 1.24. Group of Twenty Nonfinancial Private Sector Borrowing 35 Figure 1.25. Group of Twenty Nonfinancial Private Sector Credit and Debt Service Ratios 36 Figure 1.26. Chinese Banking System Developments 38 Figure 1.27. China: Regulatory Tightening Has Helped Contain Financial Sector Risks 39 Figure 1.28. Chinese Banks: Financial Policy Tightening and Credit Growth Capacity 40 Figure 1.29. Bank Profitability and Liquidity Indicators 41 Figure 1.30. Global Financial Dislocation Scenario 43 Figure 1.31. Emerging Market Economy External Vulnerabilities and Corporate Leverage 45 Figure 1.1.1. Financial and Economic Cycles 48

C o n t e n t s

International Monetary Fund | October 2017 v

Figure 2.1. Household Debt-to-GDP Ratio in Advanced and Emerging Market Economies 54 Figure 2.2. First- and Second-Round Effects of the Buildup of Household Debt on Financial Stability 57 Figure 2.3. Growth and Composition of Household Debt by Region 60 Figure 2.4. Household Debt: Evidence from Cross-Country Panel Data 61 Figure 2.5. Effects of Household Debt on GDP Growth and Consumption 64 Figure 2.6. Effects of Household Debt on GDP Growth: Robustness Tests 65 Figure 2.7. Micro-Level Evidence Corroborating the Macro Impact 66 Figure 2.8. Banking Crises and the Role of Household Debt 67 Figure 2.9. Bank Equity Returns and Household Debt 68 Figure 2.10. The Impact of Household Debt by Country and Institutional Factors 69 Figure 2.1.1. Long-Term per Capita GDP Growth and Household Debt 72 Figure 2.2.1. Characteristics of China’s Household Debt 73 Figure 2.3.1. US and Canadian Household Debt Developments and Characteristics 75 Figure 2.4.1. Panel Vector Autoregression Dynamic Analysis 77 Figure 2.4.2. Consumption Response to House Prices 78 Figure 2.5.1. Macroprudential Policy Tools and Household Credit Growth 79 Annex Figure 2.1.1. Loan Characteristics, Rules, and Regulations 82 Figure 3.1. Tighter Financial Conditions Forecast Greater Downside Tail Risk to Global Growth 97 Figure 3.2. Risk of Severe Recessions Is Especially Sensitive to a Tightening of Financial Conditions

in Major Advanced and Emerging Market Economies 98 Figure 3.3. In Emerging Market Economies, Changes in Financial Conditions Also Affect Upside Risks 99 Figure 3.4. Higher Price of Risk Is a Significant Predictor of Downside Growth Risks within One Year 101 Figure 3.5. Rising Leverage Signals Higher Downside Growth Risks at Longer Time Horizons 102 Figure 3.6. Waning Global Risk Appetite Signals Imminent Downside Risks to Growth 102 Figure 3.7. Probability Densities of GDP Growth for the Depths of the Global Financial Crisis 103 Figure 3.8. In-Sample and Recursive Out-of-Sample Quantile Forecasts: One Quarter Ahead 106 Figure 3.9. In-Sample and Recursive Out-of-Sample Quantile Forecasts: Four Quarters Ahead 107 Annex Figure 3.1.1. Conditional Densities of Growth with High and Low Asset

Prices—One-Period-Ahead Forecasts 110 Annex Figure 3.1.2. One-Period-Ahead GDP and Financial Conditions 111 Annex Figure 3.1.3. Asset Prices and Credit Aggregates before and after a Financial Crisis 111 Annex Figure 3.1.4. Simple Debt Tax Ameliorates Risk of Leverage-Induced Recessions 112

vi International Monetary Fund | October 2017

ASSUMPTIONS AND CONVENTIONS

The following conventions are used throughout the Global Financial Stability Report (GFSR):

. . . to indicate that data are not available or not applicable;

— to indicate that the figure is zero or less than half the final digit shown or that the item does not exist;

– between years or months (for example, 2016–17 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years or months (for example, 2016/17) to indicate a fiscal or financial year.

“Billion” means a thousand million.

“Trillion” means a thousand billion.

“Basis points” refers to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point).

If no source is listed on tables and figures, data are based on IMF staff estimates or calculations.

Minor discrepancies between sums of constituent figures and totals shown reflect rounding.

As used in this report, the terms “country” and “economy” do not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries.

1CHAPTE R

International Monetary Fund | October 2017 vii

This version of the Global Financial Stability Report (GFSR) is available in full through the IMF eLibrary (www. elibrary.imf.org) and the IMF website (www.imf.org).

The data and analysis appearing in the GFSR are compiled by the IMF staff at the time of publication. Every effort is made to ensure, but not guarantee, their timeliness, accuracy, and completeness. When errors are discovered, there is a concerted effort to correct them as appropriate and feasible. Corrections and revisions made after publica- tion are incorporated into the electronic editions available from the IMF eLibrary (www.elibrary.imf.org) and on the IMF website (www.imf.org). All substantive changes are listed in detail in the online tables of contents.

For details on the terms and conditions for usage of the contents of this publication, please refer to the IMF Copyright and Usage website, www.imf.org/external/terms.htm.

FURTHER INFORMATION AND DATA

viii International Monetary Fund | October 2017

The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system. In normal times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic risks, thereby contributing to global financial stability and the sustained economic growth of the IMF’s member countries.

The analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. The project has been directed by Peter Dattels and Dong He, both Deputy Directors, as well as by Claudio Raddatz and Matthew Jones, both Division Chiefs. It has ben- efited from comments and suggestions from the senior staff in the MCM Department.

Individual contributors to the report are Ali Al-Eyd, Zohair Alam, Adrian Alter, Sergei Antoshin, Magally Bernal, André Leitão Botelho, Luis Brandão-Marques, Jeroen Brinkhoff, John Caparusso, Sally Chen, Shiyuan Chen, Yingyuan Chen, Charles Cohen, Claudia Cohen, Fabio Cortes, Dimitris Drakopoulos, Kelly Eckhold, Martin Edmonds, Jesse Eiseman, Jennifer Elliott, Aquiles Farias, Alan Xiaochen Feng, Caio Ferreira, Tamas Gaidosch, Rohit Goel, Hideo Hashimoto, Sanjay Hazarika, Dong He, Geoffrey Heenan, Dyna Heng, Paul Hiebert, Henry Hoyle, Nigel Jenkinson, David Jones, Mitsuru Katagiri, Will Kerry, Jad Khallouf, Robin Koepke, Romain Lafarguette, Tak Yan Daniel Law, Feng Li, Yang Li, Peter Lindner, Xiaomeng Lu, Sheheryar Malik, Rebecca McCaughrin, Kei Moriya, Aditya Narain, Machiko Narita, Vladimir Pillonca, Thomas Piontek, Breanne Rajkumar, Mamoon Saeed, Luca Sanfilippo, Jochen Schmittmann, Yves Schüler, Dulani Seneviratne, Juan Solé, Ilan Solot, Yasushi Sugayama, Jay Surti, Narayan Suryakumar, Nico Valckx, Francis Vitek, Changchun Wang, Jeffrey Williams, Christopher Wilson, and Xinze Yao. Magally Bernal, Breanne Rajkumar, and Claudia Cohen were responsible for word processing.

Gemma Diaz from the Communications Department led the editorial team and managed the report’s produc- tion with support from Linda Kean and editorial assistance from Sherrie Brown, Lorraine Coffey, Susan Graham, Lucy Scott Morales, Nancy Morrison, Katy Whipple, AGS, and Vector.

This particular issue of the GFSR draws in part on a series of discussions with banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers.

This GFSR reflects information available as of September 22, 2017. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the GFSR on September 21, 2017. However, the analysis and policy considerations are those of the IMF staff and should not be attributed to Executive Directors or their national authorities.

PREFACE

T wice a year, the Global Financial Stability Report (GFSR) assesses the degree to which developments in the financial sector may affect future economic conditions by

analyzing macro-financial linkages and then identifies policies to mitigate risks to growth from the financial sector. At the current juncture, investor risk appetite is buoyant globally: since the last report in April, funding conditions have continued to improve, asset return volatility has receded to multiyear lows across markets, and global capital flows have surged. This easing of financial conditions has supported global growth and financial inclusion, with credit being allocated to benefit a broad range of borrowers. These favorable conditions create a window of opportunity to strengthen the financial system that should be seized, since experience has taught us that it is during times of easy financial conditions that vulnerabilities build.

Chapter 1 of this GFSR documents how the con- tinuation of monetary accommodation in advanced economies—necessary to support activity and boost inflation—is associated with rising asset valuations and higher leverage, and how this environment makes the system more vulnerable to future shocks. Chapter 2 focuses on household leverage, showing that ample credit growth portends benign conditions in the near term but larger downside risks in the medium term—and thus creates an intertemporal tradeoff. Chapter 3 takes this logic a step further and directly links the easing of financial conditions to downside risks to GDP growth. Easy financial conditions fuel growth in the shorter term, but when those condi- tions are coupled with a buildup in leverage, risks to growth rise in the medium term. In fact, we propose to measure financial stability by a measure of Growth

at Risk, defined as the value at risk of future GDP growth as a function of financial vulnerability.

The analysis in all three chapters underscores that some of the factors that have contributed to recent gains in financial stability could put growth at risk in the medium term in the absence of appropriate policies to address rising financial vulnerabilities. Macropru- dential policies, such as those that address underwriting standards, are the primary tool for guarding against future risks to growth from the global financial system. Now is the time to further strengthen that system, particularly by focusing on nonbank institutions, whose vulnerabilities are rising. Macroprudential policies that mitigate the buildup of medium-term risks can also help to better balance monetary policy tradeoffs.

Whereas vulnerabilities are rising in the nonbank financial system, the safety of the global systemically important banks (GSIBs) has improved significantly. Those banks have more capital and more liquidity and are subject to tighter supervision, thanks to the pivotal reforms undertaken after the 2008 global financial crisis. Yet some GSIBs still struggle to adapt their business models to ensure their continued health and profitability, which is critical if they are to fulfill their primary mandate: lending to the real economy. A review of the unintended consequences of the postcri- sis regulatory reforms will likely lead to some stream- lining in the implementation of banking regulations, but it is essential that the overall high level of capital and liquidity be preserved, regulatory uncertainty be avoided, and the global financial regulatory reform agenda be completed. Equally essential is continuing international regulatory cooperation.

Tobias Adrian Financial Counsellor

International Monetary Fund | October 2017 ix

FOREWORD

x International Monetary Fund | October 2017

Near-Term Risks Are Lower The global financial system continues to strengthen

in response to extraordinary policy support, regulatory enhancements, and the cyclical upturn in growth. The health of banks in many advanced economies contin- ues to improve, as progress has been made in resolv- ing some weaker banks, while a majority of systemic institutions are adjusting business models and restoring profitability. The upswing in global economic activity, discussed in the October 2017 World Economic Outlook (WEO), has boosted market confidence while reducing near-term threats to financial stability.

But beyond these recent improvements, the environ- ment of continuing monetary accommodation—neces- sary to support activity and boost inflation—is also leading to rising asset valuations and higher leverage. Financial stability risks are shifting from the bank- ing system toward nonbank and market sectors of the financial system. These developments and risks call for delicately balancing the eventual normalization of monetary policies, while avoiding a further buildup of financial risks outside the banking sector and address- ing remaining legacy problems.

The Two Sides of Monetary Policy Normalization

The baseline path for the global economy, envisaged by central banks and financial markets, foresees contin- ued support from accommodative monetary policies, as inflation rates are expected to recover only slowly. Thus, the gradual process of normalizing monetary policies is likely to take several years. Too fast a pace of nor- malization would remove needed support for sustained recovery and desired increases in core inflation across major economies. Unconventional monetary policies and quantitative easing have forced substantial portfolio adjustments in the private sector and across borders, making the adjustment of financial markets much less predictable than in previous cycles. Abrupt or ill-timed shifts could cause unwanted turbulence in financial markets and reverberate across borders and markets. Yet the prolonged monetary support envisaged for the major

economies may lead to the buildup of further financial excesses. As the search for yield intensifies, vulnerabilities are shifting to the nonbank sector, and market risks are rising. There is too much money chasing too few yield- ing assets: less than 5 percent ($1.8 trillion) of the cur- rent stock of global investment-grade fixed-income assets yields over 4 percent, compared with 80 percent ($15.8 trillion) before the crisis. Asset valuations are becoming stretched in some markets as investors are pushed out of their natural risk habitats, and accept higher credit and liquidity risk to boost returns.

At the same time, indebtedness among the major global economies is increasing. Leverage in the non- financial sector is now higher than before the global financial crisis in the Group of Twenty economies as a whole. While this has helped facilitate the economic recovery, it has left the nonfinancial sector more vul- nerable to changes in interest rates. The rise in leverage has led to a rise in private sector debt service ratios in several of the major economies, despite the low level of interest rates. This is stretching the debt servicing capacity of weaker borrowers in some countries and sectors. Debt servicing pressures and debt levels in the private nonfinancial sector are already high in several major economies (Australia, Canada, China, Korea), increasing their sensitivity to tighter financial condi- tions and weaker economic activity.

The key challenge confronting policymakers is to ensure that the buildup of financial vulnerabilities is contained while monetary policy remains supportive of the global recovery. Otherwise, rising debt loads and overstretched asset valuations could undermine market confidence in the future, with repercussions that could put global growth at risk. This report exam- ines such a downside scenario, in which a repricing of risks leads to sharp increases in credit costs, falling asset prices, and a pullback from emerging markets. The economic impact of this tightening of global financial conditions would be significant (about one- third as severe as the global financial crisis) and more broad-based (global output would fall 1.7 percent relative to the WEO baseline with varying cross-coun- try effects). Monetary normalization would go into

EXECUTIVE SUMMARY

e x e C u t I v e s u M M a r y

International Monetary Fund | October 2017 xi

reverse in the United States and would stall elsewhere. Emerging market economies would be disproportion- ately affected, resulting in an estimated $100 billion reduction in portfolio flows over four quarters. Bank capital would take the biggest hit where leverage is highest and where banks are most exposed to the housing and corporate sectors.

Deleveraging in China: Challenges Ahead Steady growth in China and financial policy tighten-

ing in recent quarters have eased concerns about a near-term slowdown and negative spillovers to the global economy. However, the size, complexity, and pace of growth in China’s financial system point to elevated financial stability risks. Banking sector assets, at 310 percent of GDP, have risen from 240 percent of GDP at the end of 2012. Furthermore, the grow- ing use of short-term wholesale funding and “shadow credit” to firms has increased vulnerabilities at banks. Authorities face a delicate balance between tightening financial sector policies and slowing economic growth. Reducing the growth of shadow credit even modestly would weigh on the profitability and broader provision of credit by small and medium-sized banks.

Global Banks’ Health Is Improving The health of global systemically important banks

(GSIBs) continues to improve. Balance sheets are stron- ger because of improved capital and liquidity buffers, amid tighter regulation and heightened market scrutiny. Considerable progress has been made in addressing legacy issues and restructuring challenges. At the same time, while many banks have strengthened their profit- ability by reorienting business models, several continue to grapple with legacy issues and business model chal- lenges. Banks representing about $17 trillion in assets, or about one-third of the GSIB total, may continue to generate unsustainable returns, even in 2019. As problems in even a single GSIB could generate systemic stress, supervisory actions should remain focused on business model risks and sustainable profitability. Life insurers have also been adapting their business strate- gies in the low-yield environment following the global financial crisis. They have done this by reducing legacy exposures, steering the product mix away from high guaranteed returns, and seeking higher yields in invest- ment portfolios. Meanwhile, supervisors need to moni- tor rising exposure to market and credit risks.

Policymakers Must Take Proactive Measures Policymakers must take advantage of the improving

global outlook and avoid complacency by addressing rising medium-term vulnerabilities. • Policymakers and regulators should fully address

crisis legacy problems and require banks and insur- ance companies to strengthen their balance sheets in advanced economies. This includes putting a resolution framework for international banks into operation, focusing on risks from weak bank busi- ness models to ensure sustainable profitability, and finalizing Basel III. Regulatory frameworks for life insurers should be enhanced to increase reporting transparency and incentives to build resilience. A global and coordinated policy response is needed for resilience to cyberattacks (see Box 1.2).

• Major central banks should ensure a smooth normalization of monetary policy through well- communicated plans on unwinding their holdings of securities and guidance on prospective changes to policy frameworks. Providing clear paths for policy changes will help anchor market expectations and ward off undue market dislocations or volatility.

• Financial authorities should deploy macroprudential measures, and consider extending the boundary of such tools, to curb rising leverage and contain grow- ing risks to stability. For instance, borrower-based measures should be introduced and/or tightened to slow fast-growing overvalued segments, and bank stress tests must assume more stressed asset valua- tions. Capital requirements should be increased for banks that are more exposed to vulnerable borrowers to act as a cushion for already accumulated expo- sures and incentivize banks to grant new loans to less risky sectors.

• Regulation of the nonbank financial sector should be strengthened to limit risk migration and excessive capital market financing. Transition to risk-based supervision should be accelerated, and harmonized regulation of insurance companies—with emphasis on capital—should be introduced. Tighter micro- prudential requirements should be implemented in highly leveraged segments.

• Debt overhangs—especially among the largest borrowers as potential originators of shocks—must be addressed. Discouraging further debt buildup through measures that encourage business invest- ment and discourage debt financing will help curb financial risk taking.

xii International Monetary Fund | October 2017

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• Emerging market economies should continue to take advantage of supportive external conditions to enhance their resilience, including by continu- ing to strengthen external positions where needed, and reduce corporate leverage where it is high. This would put these economies in a better position to withstand a reduction in capital inflows as a result of monetary normalization in advanced economies or waning global risk appetite. Similarly, frontier market and low-income-country borrowers should develop the institutional capacity to deal with risks from the issuance of marketable securities, including formulating comprehensive medium-term debt man- agement strategies. This will enable them to take advantage of broader financial market development and access, while containing the associated risks.

• In China, the authorities have taken welcome steps to address risks in the financial system, but there is still work to do. Vulnerabilities will be difficult to address without slower credit growth. Recent policies to improve the risk management and transparency of the banking system and reduce the buildup of maturity and liquidity transformation risks in banks’ shadow credit activities are essential and must continue. How- ever, policies should also target balance sheet vulnera- bilities at weak banks. The government’s commitment to reducing corporate leverage is welcome and should remain a priority as part of a broader effort to insulate the economy against slower credit g

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