Arun Kumar

Washington, Jan 27 The global economy is at last emerging out of the crisis with financial markets rebounding after the collapse of Wall Street investment firm Lehman Brothers in 2008, but extraordinary challenges remain, says the International Monetary Fund (IMF).

The rebound is a result of wide-ranging policy actions by central banks and governments, but challenges remain as they unwind their unprecedented fiscal, monetary and financial stimuli to prevent their economies, financial institutions and markets from collapsing, says the IMF's update of its Global Financial Stability Report (GFSR).

"Notwithstanding the recent sell-off, risk appetite has returned, equity markets have improved, and capital markets have reopened," Jose Vinals, director of IMF's Monetary and Capital Markets Department, said at the fund's headquarters here.

Yet, policymakers must restore the health of banking systems still saddled with impaired assets and ensure the nascent recovery is not undermined by strengthening balance sheets and restructuring weak banks and even dissolving insolvent ones to get credit flow back.

They also must make changes in supervision and regulation that lead to a safer and more resilient financial system, the IMF said, outlining three potential issues for financial stability arising from higher fiscal deficits and transferred private risks:

- Public debt issuance "could crowd out private sector credit growth, gradually raising interest rates for private borrowers and putting a drag on the economic recovery".

- A rapid increase in interest rates on public debt, which "could have negative effects on a wide variety of financial institutions and the recovery as sovereign debt is repriced".

- The remote possibility of "a substantial loss in investor confidence in some sovereign issuers".

To reduce public sector risks, the IMF stressed the importance of getting fiscal policy in order over the medium term. At the same time, policymakers must be mindful of the timing of the withdrawal of their support.

If they act too early, recovery could be aborted, while if they are too late, they risk triggering inflation and rekindling asset bubbles — a fear that is already present in some emerging market economies.

At the same time that policymakers must exit from their extraordinary measures, they must aim at a financial system that balances the need for safety and the need to foster enough innovation and dynamism "to support sustained growth", the report said.

Moreover, policymakers across the globe must coordinate implementation of new regulatory frameworks "to avoid an uneven playing field and regulatory arbitrage that could compromise financial stability", the IMF said.