Financial markets, and especially stock markets, have shown considerable resilience in the face of the Middle East conflict but what are the longer-term risks confronting markets in an environment of great economic and geopolitical turbulence?
Jason Wu, assistant director overseeing the global markets analysis division at the International Monetary Fund and a member of the team that prepared the IMF’s latest Global Financial Stability Report, responds to this and other questions from Asia Asset Management in this interview.
Resilience is a term widely used to describe the reaction – or non-reaction – of financial markets in the wake of the Middle East crisis. Is this really market resilience, or that inflows of institutional investment are big enough to maintain market stability?
Great question. The short answer is, we think resilience has a lot to do with circumstantial factors, and some to do with structural factors.
The circumstantial factors are that since (US President Donald Trump’s) Liberation Day last year, or the outbreak of the war in the Middle East, there has been a lot of ebb and flow in terms of escalation, de-escalation and markets seem to have reacted to these things. They are rational. They’re not completely looking through them.
Some positions of risk-taking have been trimmed. There has not been the type of decisively bad news that wasn’t then corrected the next day and that would lead to a sustained market drawdown.
But I think you’re right that there are structural factors that have made the market more resilient. The core of the financial markets – banks – are just much safer after the global financial crisis and (subsequent) regulatory changes.
Regulation has not only increased capital and liquidity in the banking sector; these kinds of institutions need to be registered and regulated now. I think we should acknowledge that the core of the financial sector has become quite resilient.
Banks have been like a counter-cyclical support in most cases to markets.
After the (2008 financial) crisis, we realised that more risk sharing is needed within the financial system, meaning banks can’t just take all the risks. You have other institutions, pension and insurance companies, as well as various investment funds that are taking a larger share of the financial markets. This is welcome.
What we worry about is that the ‘flow of water from the river’ (institutional investor inflows) is branched into more problematic ponds, whether there is excessive risk-taking into very illiquid assets that these insurers, pensions, non-banks cannot really manage.
One of the key ones that we have demonstrated in the Global Financial Stability Report is, for example, insurance investing in structured credit products. These are ultimately loans to companies, but they also have the so-called private credit flavour. So they are not valued on a day-to-day basis and they are not traded, so there is no market signal on what the value of these things are.
Another example is derivatives. Insurance and pensions are becoming much more involved in structured derivative kinds of transactions. We do worry whether they (major financial institutions) are deviating from investing in very liquid, public and constructive to the economy type of assets to things that might become more opaque, less liquid, and more problematic down the road.
Have these relatively illiquid assets grown significantly in, say, the past three to five years?
They have. A prior edition (of the financial stability report) looked across ten of the largest insurance companies and at the allocation to (very opaque) so-called level 3 assets. They have grown from something like 2% of their total assets to like 10%. Not devastatingly large, but the growth rate is very notable.
And considering that if all 10% of this stuff were to go badly, this would be a significant hit to the capital of the insurance industry.
Once these entities have gotten very large – lots of retirement funds coming in, etc – they have to find stuff to buy. Part of the function of capital markets is for risk-taking to be more buoyant when there’s a lot of liquidity, but what we worry about is the excessive risk-taking part.
What could precipitate a severe shock in markets?
To us, the key thing in the global financial system is the bond market, and relatedly, the funding markets.
Any excessive gyrations in that market could have outsize consequences.
Our definition of instability is if it requires central banks and authorities to step in with extraordinary measures; I think that’s a pretty good sign of instability.
We may never see the sort of humongous collapses that we saw during the global financial crisis again because part of the structural resilience is also that central banks are much more experienced in dealing with this kind of thing. They have the ability to step in with tools to stem extraordinary measures (that start) from the bond market.
(And since short-term bond market borrowing by governments especially has become elevated), they’re subject to rollover risk now that interest rates are going to go higher.
A bond market shock could be a trigger to financial instability. The bond market is very much an important linkage to the rest of the financial system and where perhaps the vulnerabilities may lie.
The other part are the folks like hedge funds, investment funds that have levered up. In other words, they have doubled down on a particular direction for assets to invest in. And…we worry that they will be forced to de-leverage and therefore (to) sell bonds and equities, and that will make any crisis worse.
These risks are probably greatest in the US but how about Asia?
There’s definitely an analogy of non-bank de-risking, deleveraging in Asia as well, because the use of leverage by investment funds such as hedge funds has also gotten bigger in Asia. Leveraging has grown and by over-leveraging themselves during downtimes (Asian institutions) may have to sell into a falling market.
That certainly applies to Europe too because these non-banks are over-large in Europe. So it’s becoming a bit of a global issue.
A lot of these non-banks that are situated in the US or Europe have gone into emerging-market investments. They have pumped funds into equity and bond markets of emerging markets, including in Asia. So you worry that the leveraging there would mean rapid outflows of capital from the region. That could exacerbate a down market there.
China appears to be much more stable apart from the real estate trauma. But is the Chinese financial market fundamentally more stable?
I think Chinese markets just have very low correlation with the rest of the world. Capital flow management and some aspects of openness in capital markets may have to do with this. Openness has improved a lot.
In Hong Kong, there are various connectivity programmes that help investors go into Chinese stocks and bonds. But overall, compared to the size of the financial market there and the economy, the open portion remains pretty low.
So during times like this, it does come across that the Chinese market is a stable beacon. The renminbi also is very carefully managed. And so from an exchange rate perspective, you don’t see the large swings that you might see elsewhere.
