Global Macroeconomic Risks Analysis

Conclusion


Risk management in general and credit risk analys is in particular has been the focus of extensive research in the past several years. Credit risk is the dominant source of risk for banks and the subject of strict regulatory oversight and policy debate.
Several issues remain of primary concern: 1) continued economic sluggishness and financial risk in Europe; 2) a fragile recovery in the U.S.;3) the potential for a slowdown in emerging economies; and 4) increased geopolitical tensions in Asia.
Nordic economies are tightly connected by cross-border bank balance sheet linkages, which extend globally. The development of a structural macroeconometric model of the world economy which articulates these linkages, and its application to the analysis of spillovers to and from the Nor ...

Contents

Introduction 3
1. Global macroeconomic risks 5
2. Global financial stability 16
3. Economic risks in Nordic economies 20
Conclusion 26
Literature 28

Introduction

Confidence in the global financial system has become fragile, as incremental policy making has yet to fully resolve near and medium term vulnerabilities. Recent steps – particularly taken by euro area policy makers – are encouraging and have been essential in addressing investors’ biggest fears, but more complete policies will be needed to stabilize the system. The combination of the weakened outlook for growth and volatile and wide peripheral spreads, has led to an increase in macroeconomic risks. Emerging market risks have also risen. Credit risks remain at elevated levels, especially in the euro area periphery.
The recent global financial crisis has resulted in global, regional and national financial stability becoming important policy issues facing policy makers, financ ial institutions and financial markets. As another global financial crisis is possible in time, the soundness, stability, transparency of financial systems have become one of the more important agenda items of the G20 and other international institutions/forum such as the IMF, the Bank for International Settlements, and the Financial Stability Board (FSB).
The European sovereign debt crisis and high debt in most of the developed world have been the main focus of global macroeconomic risks. But a big driver of global growth is demographics, which will weigh on productive capacity and on government finances. Europe is currently the biggest risk to the global economy. At this point, the dissolution of the eurozone is a remote possibility. The cost of disintegration, relative to the benefit, would be too high for the member countries and the world. The European debt crisis has more to do with the lack of fiscal union than it has to do with debt. The proposals presented at the December 9 EU summit are positive steps toward a fiscal union and necessary for survival of the region
The Nordic countries of Denmark, Finland, Norway and Sweden have small advanced economies that are tightly connected by trade and financial linkages, which extend globally. But these structural similarities are accompanied by important differences. The export bases of Denmark, Finland and Sweden are dive
rsified, while that of Norway is concentrated in energy commodities. These countries also have different monetary policy and exchange rate regimes: Denmark and Finland respectively peg to and use the euro, while Norway and Sweden target inflation.
Today several issues remain of primary concern: 1) continued economic sluggishness and financial risk in Europe; 2) a fragile recovery in the U.S.; 3) the potential for a slowdown in emerging economies; and 4) increased geopolitical tensions in Asia.

Literacy rates and average life spans have increased globally, particularly in the emerging economies. Higher literacy rates will likely be a driver of future growth, as the ability to read helps people learn new skills and improve existing skills. When people live longer it increases incentives to make long-term investments in human capital (i.e., education and training),resulting in a more productive work force and ultimately more growth.1
Fracking technologies have allowed large new supplies of natural gas and oil to be extracted from rocks, predominantly in the U.S. The large new supply of natural gas has decreased U.S. prices to levels considerably below the rest of the world. Going forward, it is likely that other countries will work to improve their fracking technologies, furtherincreasing the supply of oil and gas globally.
The U.S. housing market continues to show signs of recovery as rents increase and mortgage rates remain at historic lows. Building permits, housing starts, and prices have all increased recently as demand picks-up. A recovery in the U.S. housing market should create jobs both in the construction and financial services industries, potentially decreasing the unemployment rate and ultimately increasing growth.
Developed market central banks have embarked on a massive monetary stimulus campaign in the aftermath of the Global Financial Crisis. The U.S., European, and Japanese central banks continue to maintain interest rates at record lows, as well as purchase assets (quantitative easing). Going forward, increased liquidity and the cheap cost of capital should stimulate growth.2
To fight decades of deflation, the Bank of Japan recently announced that it would target doubling the monetary base over the next two years through purchasing long-term bonds.
The balance of stimulating growth, but not fanning inflation, is a delicate one, particularly for the country with the largest debt-to-GDP ratio in the world (230%).
If interest rates in the Japanese bond market increase in anticipation of higher inflation, Japan’s already bloated debt servicing cost could weigh heavily on its fiscal budget.1
As many countries simultaneously attempt to devalue their currencies to try to boost exports and stimulate economic growth, the potential for “currency wars” grows.
As an example, the Bank of Japan recently announced dramatic monetary easing measures to fight decades of deflation, causing the yen to quickly decline.
2. Global financial stability
Confidence in the global financial system has become fragile, as incremental policy making has yet to fully resolve near and medium term vulnerabilities. Recent steps – particularly taken by euro area policy makers – are encouraging and have been essential in addressing investors’ biggest fears, but more complete policies will be needed to stabilize the system. The combination of the weakened outlook for growth and volatile and wide peripheral spreads, has led to an increase in macroeconomic risks. Emerging market risks have also risen. Credit risks remain at elevated levels, especially in the euro area periphery.
Euro area financial and economic fragmentation has intensified, as the crisis has moved from a sudden stop into a capital – flight phase. Cross-border private capital is being repatriated from the periphery to the core at a pace typically associated with currency crises or sudden stops, while large public sector flows, principally across central bank balance sheets, is replacing private capital. Concerns over a possible euro area breakup have led to extreme fragmentation between financial markets in the core and the periphery, as banks, corporates, and even some households try to limit uncovered exposures to the most vulnerable countries in the euro area periphery. The resulting forces of fragmentation undermine the very foundations of the union: integrated markets and an effective common monetary policy.1
In the United States, unsustainable public debt dynamics remain a medium-term concern, but the looming fiscal cliff, debt ceiling deadline, and related uncertainty also pose near-term risks. Safe haven flows, central bank purchases, and balance sheet derisking have contributed to an unprecedented compression of credit risk premiums and yields. Low rates and suppressed risk premiums could lull markets and policymakers into complacency, leading to a buildup of stability risks.
In Japan, the key risks include high budget deficits and record debt levels, combined with a rising concentration of government bond risk in the domestic banking system. With banks holding a large amount of sovereign bonds, the government may find it hard to act as a financial sector backstop.1
Emerging markets need to guard against potential further shockwaves, including from the euro area, while managing a slowdown in growth that could expose home-grown financial stability risks. So far, inflows into local bond markets have continued even when sovereign fears in the euro area have escalated. However, markets could come under strain if a bout of acute global stress precipitated large-scale capital outflows. Overall, vulnerabilities are most pronounced in many central and eastern European economies because of their high direct exposures to the euro area and some similarities with the euro area periphery. Asia and Latin America generally appear more resilient, but several key economies in those regions are prone to late-cycle credit risks. Meanwhile, the scope to provide fresh policy stimulus is somewhat constrained in several economies. Policymakers therefore need to deftly navigate country-specific challenges to safeguard financial stability.
The United States may soon move to less accommodative monetary policies and higher long-term interest rates as its recovery gains ground. Emerging markets face a transition to more volatile external conditions and higher risk premiums. Japan is moving toward the new “Abenomics” policy regime, and the euro area is moving toward a more robust and safer financial sector. Finally, the global banking system is phasing in stronger regulatory standards.2
What are the Key Stability Risks and Challenges?
Confidence is fragile despite significant policy steps by policymakers and recent market improvements.
The euro area crisis remains the principal risk: recent improvements need to be built upon by further policy action, as the forces of financial and economic fragmentation within the euro area have widened the divide between the core and the periphery.
Safe haven flows have reduced sovereign funding costs in the United States and Japan, but policy makers need to address significant fiscal and financial challenges ahead of market pressures.
Emerging market economies need to keep their “guard up” against global risks, but diminished policy space could pose challenges and domestic vulnerabilities need to be addressed.1
Key policy challenges:
Reversing financial fragmentation within the euro area is the key policychallenge.
Implementation of announced policies is needed. Incremental and reactive policymaking will not restore confidence. Additional policy measures need to be taken swiftly to achieve the ‘complete policies’ scenario. Otherwise, confidence will remain weak, resulting in higher levels of deleveraging, a greater reduction in credit supply, and a steeper drop in output.
Further actions are needed at both the national and euro area levels: (1) make sovereigns safer through well-timed fiscal consolidation; (2) make banks safer, through recapitalization, restructuring, and, when needed, resolution; (3) make adequate use of existing mechanisms, including the European Stability Mechanism and the ECB’s OMT, to fully stabilize the euro area; and (4) establish a single supervisor and provide a clear roadmap for subsequent steps towards a complete banking and fiscal union.
In the United States and Japan, policymakers need to avoid the pitfalls of complacency and tackle the challenges ahead to preserve growth and financial resiliency. The key lesson of the past few years is that imbalances need to be addressed well before markets start signaling credit concerns. Both the United States and Japan need to put forth without delay fiscal consolidation strategies that address important fiscal risks. In the United States, additional measures may be needed to unclog the transmission mechanism and accelerate household balance sheet repair. In Japan, measures to induce banks to take greater account of the risks inherent in large JGB holdings may be necessary.
In emerging markets, policymakers need to remain vigilant and use policy space wisely. They should maintain adequate buffers, including foreign reserves and sufficient exchange rate flexibility, preserve and, if needed, use wisely their available monetary and fiscal policy space; strengthen prudential vigilance in their financial systems; and continue developing domestic capital markets.1
3. Economic risks in Nordic economies
Cyclical output growth dynamics in the Nordic economies have been primarily driven by foreign macroeconomic and financial shocks, reflecting their high trade and financial openness. Indeed, estimated historical decompositions of output growth primarily attribute the recessions they experienced during the global financial crisis to inward spillovers from negative foreign demand and positive world risk premium shocks. Symmetrically, inward spillovers from positive foreign demand and negative world risk premium shocks were primary contributors to their recoveries.
Estimated Historical Decompositions of Output Growth
We analyze inward and outward output spillovers to and from the Nordic economies with output spillover coefficients. These output spillover coefficients measure the peak percent increase in output in the recipient economy in response to a set of macroeconomic or financial shocks in the source economy which induce a peak increase in domestic demand there of one percent. The macroeconomic shocks under consideration are composites of selected real, monetary policy and fiscal policy shocks, where applicable. The financial shocks under consideration are composites of credit risk premium, duration risk premium, and equity risk premium shocks. We distinguish between regional financial shocks which are globally and regionally correlated, versus specific financial shocks which are only globally correlated.
Inward output spillovers to the Nordic economies are moderate from macroeconomic shocks in geographically close trading partners and large from financial shocks in systemic advanced economies. For macroeconomic shocks, estimated inward output spillover coefficients are highest to Denmark from Germany at 0.12, to Finland from the United States at 0.08, to Norway from the United Kingdom at 0.15, and to Sweden from Germany at 0.08. This primarily reflects high export exposures to these destination economies. For financial shocks, estimated inward output spillover coefficients are highest to all of the Nordic economies from the United States, ranging from 0.49 to 0.59. This primarily reflects high direct financial exposures through cross-border debt and equity portfolio asset holdings, together with high indirect financial exposures through international money, bond and stock market contagion. Estimated inward output spillover coefficients are relatively high among the Nordic economies themselves, particularly if they account for regional comovement across financial shocks in addition to global comovement, to an extent consistent with our factor model estimation results. Indeed, this regional comovement is estimated to amplify these inward output spillover coefficients by 33 percent, on average across the Nordic economies.1
Outward output spillovers from macroeconomic and financial shocks in the Nordic economies are small to moderate, commensurate with their small size, and are concentrated among the Nordic economies themselves, reflecting their high trade and financial integration.
For macroeconomic shocks, estimated outward output spillover coefficients are highest from Denmark to Sweden at 0.05, from Finland to Sweden at 0.04, from Norway to Sweden at 0.07, and from Sweden to Denmark at 0.09. This primarily reflects high import dependencies on these source economies. For financial shocks, estimated outward output spillover coefficients are highest from Denmark to Finland at 0.08, from Finland to Sweden at 0.08, from Norway to Sweden at 0.12, and from Sweden to Finland at 0.22. This amplification primarily occurs through international and regional contagion effects.1
Intensification of the Euro Area Sovereign Debt Crisis. This scenario represents an intensification of the Euro Area sovereign debt crisis with the escalation of financial stress in 2013Q1, which induces balance sheet deleveraging by banks and fiscal consolidation by governments. Within the Euro Area, these effects are differentiated across a high beta group (Greece, Ireland, Italy, Portugal, Spain), a medium beta group (Austria, Belgium, France), and a low beta group (Finland, Germany, Netherlands). Outside of the Euro Area but within Europe, we also identify a low beta group (Denmark, Switzerland). We represent the intensification of stress in the money, bond and stock markets of the high beta group within the
Euro Area with positive credit risk premium shocks which raise short term nominal market interest rates by 150 basis points, positive duration risk premium shocks which raise long term nominal market interest rates by 300 basis points, and positive equity risk premium shocks which reduce equity prices by 40 percent. These risk premium shocks are correlated internationally to account for contagion effects, with the calibration of beta coefficients informed by event study estimation results. We account for balance sheet deleveraging by banks with negative private domestic demand shocks which reduce domestic demand by 1.5 percent in the high beta group within the Euro Area, and by 0.5 percent in the rest of the Euro Area, as well as in the low beta group outside of the Euro Area but within Europe, informed by deleveraging simulation results. We assume fiscal consolidation reactions by governments which raise the ratio of the primary fiscal balance to nominal output by 2.0 percentage points in the high beta group within the Euro Area, and by 1.0 percentage point in the medium beta group within the Euro Area. Expenditure measures represented by negative fiscal expenditure shocks account for 50 percent of these fiscal consolidations, while revenue measures represented by positive fiscal revenue shocks account for the remainder. We assume that all of these shocks are temporary but persistent, following first order autoregressive processes having coefficients of 0.85.
Assumed Financial Market Impacts.
Under this scenario, severe output losses in the Euro Area, concentrated in the high beta group and to a lesser extent the medium beta group, are accompanied by mild to moderate output losses in the rest of the world, concentrated in the rest of Europe. Simulated peak output losses within the Euro Area range from 2.9 to 7.5 percent in the high beta group, to 2.9 to 3.6 percent in the medium beta group, to 1.8 to 2.7 percent in the low beta group.1
Outside of the Euro Area, simulated peak output losses range from 0.3 to 2.6
percent in other advanced economies, and from 0.7 to 2.3 percent in emerging economies. Aggregating these simulated peak output losses, which all occur during 2014, implies a peak world output loss of 1.6 percent. The associated peak decline in the price of energy commodities is 7.1 percent, while that for the price of nonenergy commodities is 3.5 percent.1
Inward output spillovers to the Nordic economies are moderate under this scenario, with simulated peak output losses ranging from 1.2 to 1.9 percent. These output spillovers are primarily transmitted via trade and indirect financial linkages. Trade spillovers arising from reductions in export demand are reflected in lower contributions from net exports to output, and vary primarily with export exposure to the high beta group and to a lesser extent the medium beta group within the Euro Area. They are less persistent for Finland, reflecting its high export exposures to China and Russia, where the zero lower bound constraint on monetary policy does not bind. Financial spillovers are reflected in lower contributions from domestic demand to output, and vary widely across the Nordic economies. Financial spillovers to Denmark and Finland are relatively high, reflecting the assumed balance sheet deleveraging by banks, as well as some tightening in financial conditions induced by losses on internationally diversified equity portfolios, in spite of declines in nominal market interest rates associated with safe haven capital inflows. They are also relatively persistent, reflecting the zero lower bound constraint on monetary policy. Financial spillovers to Norway and Sweden are lower, arising from tightening in financial conditions induced by losses on internationally diversified equity portfolios due primarily to contagion effects, again in spite of declines in nominal market interest rates associated with safe haven capital inflows.2
Conclusion
Risk management in general and credit risk analys is in particular has been the focus of extensive research in the past several years. Credit risk is the dominant source of risk for banks and the subject of strict regulatory oversight and policy debate.
Several issues remain of primary concern: 1) continued economic sluggishness and financial risk in Europe; 2) a fragile recovery in the U.S.;3) the potential for a slowdown in emerging economies; and 4) increased geopolitical tensions in Asia.
Nordic economies are tightly connected by cross-border bank balance sheet linkages, which extend globally. The development of a structural macroeconometric model of the world economy which articulates these linkages, and its application to the analysis of spillovers to and from the Nordic economies, remains an objective for future research.
Four primary concerns face the global economy:
1. continued economic sluggishness and financial risk in Europe;
2. a fragile recovery in the U.S.;
3. the potential for a slowdown in emerging economies;
4. increased geopolitical tension in Asia.
In the developed economies, it is expected GDP growth to remain sluggish in 2013 due to high unemployment, fiscal austerity measures, and continued deleveraging.
As governments loosen monetary policy in emerging economies, the cyclical slowdown could experience a turning point in 2013.