By David Lawder
WASHINGTON (Reuters) - World financial markets have calmed after turmoil earlier this year, but more needs to be done to ensure global financial stability amid slowing growth, weak commodity prices and worries about China's economy, the International Monetary Fund warned on Wednesday.
The IMF said in its latest Global Financial Stability Report that financial system risks have risen since the last report in October and market turmoil could easily recur and intensify if no action is taken to clean up bank balance sheets, particularly in China and Europe.
"If the growth and inflation outlooks degrade further, the risk of a loss of confidence would rise. In such circumstances, recurrent bouts of financial volatility could interact with balance sheet vulnerabilities," the IMF said in the report.
"Risk premiums could rise and financial conditions could tighten, creating a pernicious feedback loop of weak growth, low inflation and rising debt burdens," it added.
Worries about China's growth slowdown and transition to a more consumer-driven economy helped spark the most recent financial turmoil, and the IMF said China's struggling state enterprise sector is straining bank balance sheets. The report estimates that bank loans to companies potentially at risk in China could translate into potential bank losses of approximately seven percent of the country's gross domestic product.
"This may seem like a large number, but it is manageable given China’s bank and policy buffers and continued strong growth in the economy," said Jose Vinals, head of the IMF's Monetary and Capital Markets Department.
The report complements the IMF's gloomy World Economic Outlook publication released on Tuesday, in which the crisis lending institution cut its growth forecasts for the fourth time in the past year.
The report comes as finance ministers and central bankers from around the world convene in Washington this week for the spring meetings of the IMF, the World Bank and Group of 20 finance ministers and central bank governors. The formal meetings begin on Friday and continue through Sunday.
NEGATIVE INTEREST RATES CRUCIAL TO GROWTH
The IMF stability report said negative interest rate policies, along with bond purchases, were "crucial" to boosting economic growth, marking a sharp contrast with German Finance Minister Wolfgang Schaeuble's criticism of the European Central Bank's negative rates as causing problems for German banks and depositors alike.
Although they have reduced bank profit margins, the report said banks would ultimately benefit from stronger growth and the ability to cut non-deposit funding costs.
However, should the IMF's worst-case market disruption scenario occur, its modeling suggests that potential global output growth could be reduced by 3.7 percentage points over five years -- effectively the loss of nearly a year's worth of growth at current levels.
Conversely, the Fund argues in the report that actions to reduce liquidity risks, clean up non-performing loan problems left over from the last financial crisis in advanced economies and reduce vulnerabilities in emerging market banks could add 1.7 percentage points to annual baseline growth by 2018 -- roughly half of this year's estimated growth.
The report also made a case for bank consolidation, particularly in Europe. It argued that banks whose business models are no longer viable following the financial crisis hold some 15 percent of bank assets in advanced economies.