The European Central Bank warned of a rapid repricing of global risk premia, focused on emerging markets, especially if the U.S. Federal Reserve increases interest rates faster than expected.
"Highly indebted foreign-currency borrowers may be vulnerable to a prospective normalization of financial conditions in the U.S. and other advanced economies," the ECB said in its twice-yearly Financial Stability Review published Wednesday. "A faster than expected withdrawal of monetary-policy accommodation in other major advanced economies could trigger a reversal of global term premia, which may also spill over to the euro area."
The ECB raised its risk-assessment level for global financial-market instability to 'medium' and kept the same level for dangers to the banking system due to low interest rates. The Frankfurt-based institution said very loose monetary policy intended to help spur inflation and economic growth is pushing asset valuations higher, so they face a greater risk of correction.
"Misaligned asset prices are a key vulnerability in that they could potentially lead, at some point, to sharp adjustments of risk premia," according to the report. "The impacts that China, in particular, had on advanced economies' financial markets during the summer point to the need for close monitoring going forward."
QE Program
The ECB is considering whether it needs to expand monetary stimulus in the euro area even more to counter a stagnation in consumer prices. Options included stepping up the 1.1-trillion euro ($ 1.2 trillion) bond-buying program and cutting the deposit rate further below zero. The Governing Council will make a decision on Dec. 3.
"We have inflation which is very low and we want to ensure price stability in both directions," ECB Vice President Vitor Constancio said in an interview with Bloomberg TV after the publication of the Financial Stability Review. "The rest is up to the markets to react to our policies which are strictly determined by domestic factors."
Equity-market turmoil and currency devaluation in China, the world's second-largest economy, have raised vulnerability in other emerging markets, the ECB said, and there are signs that low financial-market liquidity is exacerbating the swings. Borrowers in emerging markets are still susceptible to Fed rate increases, which may start next month, even though U.S. central-bank officials have signaled that the path of tightening will be gradual.
Macroeconomic Fragilities
"In contrast to the Asian crisis in the late 1990s, most emerging-market economies now have smaller macro-financial imbalances, stronger macroeconomic policy frameworks, more flexible exchange-rate regimes and larger buffers," according to the report. "However, macroeconomic fragilities are still present and elevated growth in private-sector credit — partly denominated in foreign currencies — in several economies signals increased risks for the financial system down the road."
Claudia Buch, Vice President of Germany's Bundesbank, warned on Wednesday at a separate press conference that a conflict of objectives between expansive monetary policy and financial stability could arise if risks existing in the system are not tackled now.
"The danger exists that monetary-policy normalization in the future could be put off for too long, because of the financial stability risks that have accumulated," Buch said. "And this in turn would encourage the build-up of further risks."
The Bundesbank also released its own financial stability report, saying that the current low interest-rate environment poses challenges primarily for smaller German banks and insurance companies.
The ECB said that the possibility that Greece could leave the euro and wreak havoc on the currency area's bond markets, a key risk present at the time of its last report in May, had few major effects on the region's financial stability.
The report also raised the risk-level assigned to developments in the shadow-banking sector, such as investment funds, to 'potential.'
"The shadow-banking sector continues to grow at a rapid pace," the ECB said. "At the same time it is becoming more central in the financial system, amid limited standardized data collection for adequate monitoring and oversight. All these factors — size, interconnectedness and opacity — suggest that the potential for systemic impacts emanating from this sector is increasing."
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