The International Monetary Fund warned on Wednesday that U.S. President Donald Trump's proposed tax cuts and roll-back of financial regulations could spark a new round of financial risk-taking of the type that preceded the last crisis in 2008.
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The IMF said in its semi-annual Global Financial Stability Report that risks to stability have generally diminished in the last six months amid stronger global economic growth and higher interest rates that have improved bank earnings.
But it said that already highly leveraged U.S. companies may not be in a position to translate a cash-flow boost from U.S. Republican tax reform proposals into productive capital investments that can aid sustainable growth.
Instead, the Fund said the slug of cash, which is likely to include repatriation of profits held overseas by multinational corporations, could be channeled into risks such as purchases of financial assets, mergers and dividend payouts. Such temptations would be highest in the information technology and health care sectors, according to the report.
"Cash flow from tax reforms may accrue mainly to sectors that have engaged in substantial financial risk taking," the IMF said. "Such risk taking is associated with intermittent large destabilizing swings in the financial system over the past few decades."
The report noted that past major tax changes typically were followed by increases in financial risk-taking, including the tax reforms in 1986 and a corporate tax repatriation "holiday" in 2004. In both cases, these led to leverage buildups that were followed by recessions, in 1990 and 2008.
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If the U.S. labor market turns out to have little slack left to absorb the stimulus from Trump's proposed tax cuts and spending plans, inflation and interest rates could rise more sharply than expected. This could increase market volatility and raise debt service costs for already-stretched corporate balance sheets, the IMF said.
It added that a shift toward protectionism in the United States and other advanced countries also could reduce trade and capital flows, reducing growth and dampening market sentiment.
"Tighter financial conditions could lead to distress" for weaker firms, the IMF said, noting that resulting losses would be borne by banks, life insurers, mutual funds, pension funds, and overseas institutions.
The report urged U.S. policy makers to be "vigilant" about the increased leverage and declining credit quality in the corporate sector. It said tax measures now under discussion that reduce incentives for debt financing, including the elimination of corporate tax deductibility of interest costs, could help reduce leverage risks.
The IMF said there was room to "fine-tune" U.S. financial regulations, but it warned against a "wholesale dilution" of the stronger U.S. bank capital requirements enacted after the 2008 financial crisis.
Regarding emerging markets, the IMF report said that financial stability risks remain elevated. It said those economies face the double threat of rising protectionism that could reduce demand for their exports, and U.S. inflation and faster interest rate hikes that could spark capital outflows and make it harder for them to service external debt.
It also voiced concerns about the rapid credit growth in China, risks that were also highlighted in the IMF's World Economic Outlook on Tuesday. (Reporting by David Lawder; editing by Diane Craft)