The economic crisis could be entering a “new phase” with rising public debt threatening to undermine the stability of the global financial system, the International Monetary Fund warned Tuesday.
In a biannual report on economic stability, the IMF said the latest challenge to the world’s rocky financial system came as banks were regaining their footing amid the nascent global recovery.
“Risks to global financial stability have eased as the economic recovery has gained steam, but concerns about advanced country sovereign risks could undermine stability gains and prolong the collapse of credit,” the report said.
“Without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders.”
In its Global Financial Stability Report, the IMF scaled back its estimate of bank writedowns since the start of the crisis through 2010 to 2.3 trillion dollars, from 2.8 trillion in October.
The fund also estimated that banks had already written off 1.5 trillion dollars of the 2.3 trillion.
Sovereign debt grew sharply with the economic crisis, as many governments not only had to bail out ailing banks, but also pay for rising unemployment benefits and economic stimulus programs.
Greece was brought to the brink of bankruptcy in recent weeks, forcing the government to increase taxes and cut spending to shrink state debt, while concerns linger over the level of debt in leading economies like Britain, Japan and the United States.
The IMF said that while the world had avoided a full-blown depression, “risks remain elevated due to the still-fragile nature of the recovery and the ongoing repair of balance sheets.
“Attention has shifted toward sovereign risks that could undermine stability gains and take the credit crisis into a new phase, as we begin to reach the limits of public sector support for the financial system and the real economy.”
The fund warned that longer-term concerns about solvency could result in short-term strains on funding markets, which “may have negative implications for a recovery of private credit.”
“Even though capital needs have fallen, banks still face considerable challenges,” it said.
Banks will need to refinance a large amount of short-term funding this year; investors will want to see more and higher-quality capital in anticipation of tougher regulation, and not all losses have been written down, it said.
“All of these factors are likely to put downward pressure on profitability,” the report said. “In such an environment, the recovery of private sector credit is likely to be subdued as credit demand is weak and supply is constrained.”
It said “the most daunting challenge” facing governments in the near-term is putting in place credible, medium-terms plans for bringing their budget deficits under control.
The report called for “transparent” fiscal consolidation plans and structural reforms that enhance growth in order to shore up public confidence.
It said “contingency measures should be in place if the degradation of public finances is greater than expected.”
“Further efforts to address a number of weak banks are still necessary to ensure a smooth exit from the extraordinary central bank support of funding and liquidity.
“The key will be for policymakers to ensure fair competition consistent with a well-functioning and safe banking system,” it said.
The IMF also urged expeditious movement on bank regulatory reform, noting that there were still questions about the magnitude of the reforms and how they will deal with the issue of “too-big-to-fail” banks.
“Resolving the present regulatory uncertainty will help financial institutions better plan and adapt their business strategies,” it said, cautioning that reforms must strike “the right balance” between ensuring safety and allowing room for innovation and efficiency.
President Barack Obama is stepping up pressure on Congress to pass the biggest overhaul of the US regulatory system since the 1930s and a preliminary vote on beginning debate in the Senate is expected as early as this week.