Government spending helped avert a global economic catastrophe in 2009. Now, those deficits risk impeding the recovery.
That paradox is at the heart of the International Monetary Fund's latest review of the global financial system, which warns that credit over the next couple of years will remain expensive because financial institutions are facing a bevy of factors that likely will drive their costs higher.
To be sure, the international banking system is in better shape than when the IMF published its last review in October. All of the indicators the fund monitors to gauge the health of the system have improved, mostly as the result of stronger economic growth.
While the fund continues to characterize the financial system as fragile, the faster-than-expected expansion is helping banks recover. The IMF reduced its estimate of bank writedowns since the start of the crisis to $2.3-trillion (U.S.) from $2.8-trillion in October.
Yet a new risk has emerged: sovereign debt.
Debt in the Group of Seven countries - the United States, Japan, Germany, Britain, France, Italy and Canada - is in excess of 100 per cent of gross domestic product for the first time since the early 1950's. European countries outside the G7 are similarly strained.
"The deterioration of fiscal balances and the rapid accumulation of public debt have altered the global risk profile," the IMF said in the report, which was released Tuesday in Washington. "Vulnerabilities now increasingly emanate from concerns over the sustainability of governments' balance sheets."
The IMF's financial system review shows why it's important that governments in those countries convince investors that they are serious about getting their deficits under control. Failure to do so will not only increase the cost of funding for governments, but banks as well, which would push up the cost of obtaining consumer and business loans.
Deteriorating sovereign credit risk could quickly spill over to the financial sector, which is closely linking to the public debt market.
If bond prices drop because investors grow more concerned about default, any bank holding large portfolios of government bonds would suffer abrupt losses. At the same time, banks' funding costs in the wholesale market tend to be linked to the yields that governments offer on their debt because of a long-standing belief that domestic institutions must be inherently riskier than governments, the IMF said.
'Unnecessary Extension' of Crisis
The global nature of bank lending threatens to transmit one country's sovereign risk issues to other economies. Higher government borrowing risks crowding out private lending because financial institutions could opt to invest in relatively safe sovereign debt. Multinational banks in these countries could withdraw from cross-border lending, putting a strain on countries that rely on international sources for their borrowing, thus spreading sovereign risk. This is especially a threat in Eastern Europe, the IMF said.
"The skillful management of sovereign risks is essential for maintaining financial stability and preventing an unnecessary extension of the crisis," the report said.
The challenge posed to the financial system from rising government debt comes as banks continue to face losses from bad real estate loans and personal and corporate bankruptcies related to the global recession. The likelihood of these losses will require financial institutions to hold extra capital, further restricting the amount of money available to lend.
To alleviate the risks to the financial system, policy makers should carefully assess the implications of any decisions on credit, including the timing of their exits from the programs implemented last year to reverse the downturn, the IMF said. At the same time, governments must present credible deficit-reduction plans and should consider ways to restore the securitization market, an important source of credit that remains tarnished by its role in the crisis, the IMF said.
This has been corrected from an earlier version.