It was fitting that I should present our latest assessment of global financial stability in Sao Paulo, the financial center of one of the leading emerging economies. In common with many of its peers in Latin America, Brazil is recovering strongly from the crisis. But new financial stability challenges are emerging in this, and other fast-growing regions.

Let me start with three key messages:

• First, financial risks have increased since April.
• Second, as a result, policymakers in both advanced and emerging economies need to step up their efforts to preserve financial stability and safeguard the recovery.
• And third, we have entered into a new phase of the crisis – a political phase- when tough political decisions will need to be made, because the window for substantial policy action is closing. Time is of the essence.

Let me delve into the details of the increased financial stability risks, which have kept policymakers and investors, on the edge of their seats.

First, a string of negative surprises in recent economic data is prompting investors to reassess the sustainability of the economic recovery. While a global recovery remains the most likely scenario, downside risks to this forecast have increased. Any weakening in the economic outlook will threaten to stall—and possibly reverse—improvements in the balance sheets of banks and households.

Second, there are increasing concerns about the political resolve to support the adjustment efforts in Europe. The lack of a comprehensive solution to this problem has led to increased financial market pressures on some European governments, and has rekindled worries about potential contagion within and beyond Europe.

In the United States, there are increased financial market concerns, due to the continuing political stalemate over the debt ceiling and the longer-tern fiscal path. And Japan’s medium-term fiscal adjustment targets may have become even more challenging because of the impact of the recent earthquake and tsunami.

And third, we are concerned about the effects of a prolonged period of low interest rates. Accommodative monetary policies remain necessary in advanced economies, partly because of the limited progress in resolving structural problems. But a prolonged period of low interest rates may lead investors to underestimate risk in their search for yield. This could promote the buildup of financial imbalances.  We have noticed two trends

• The declining cost of debt is prompting some companies and investors to rediscover their appetite for financial leverage. There is evidence of such re-leveraging in the market for corporate high-yield bonds and leveraged loans
• Investors’ search for yield has also spurred strong capital inflows into some key emerging markets, although such flows have recently eased. For example, buoyant foreign demand has led to a recent surge in international corporate bond issuance, notably from Latin America, and a decline in corporate bond yields.

Policy priorities

Given these risks, policymakers need to increase their efforts to tackle longstanding financial challenges once and for all.

In Europe, there is a need to finally cut the Gordian knot of mutually reinforcing financial exposures between banks and governments, which has fuelled worries about potential contagion.

To reduce the contagion risk, policymakers need to follow a two-pronged approach—(i) push for a comprehensive plan to repair the financial system and (ii) reduce sovereign risk through credible medium-term fiscal consolidation.

1. Financial System. So far, there has been insufficient progress in strengthening bank funding and capital positions in some European Union countries. The forthcoming stress tests by the European Banking Authority will be a decisive opportunity to enhance transparency and address the weak tail of undercapitalized banks.
2. Governments. Political resolve is required to address medium-term fiscal adjustment needs in several advanced countries, including the United States and Japan, which have yet to take decisive action in this area.

In short, when it comes to financial systems and governments, advanced economies need an orderly de-leveraging, which means they would cut back on the amount they borrow.

By contrast, emerging economies need to focus on orderly re-leveraging.

• They should do so by guarding against overheating and the buildup of financial imbalances—with strong credit growth, rising inflation, and surging capital inflows.
• Corporate leverage is also rising, and weaker firms are now accessing international capital markets. This could make corporate balance sheets more vulnerable to external shocks.
• With strong domestic demand pressures—especially in emerging Asia and Latin America—macroeconomic measures are needed to avoid overheating, accumulating financial risks, and undermining policy credibility.
• Macroprudential tools, such as higher reserve requirements, and, in some cases, a limited use of capital controls, can play a supportive role in managing capital flows and their effects. However, they cannot substitute for appropriate macroeconomic policies.

Policymakers continue to face potentially large future shocks to the financial system, at a time when its resilience is not yet assured.

And there is less room for maneuver to counter these shocks through traditional fiscal and monetary policies. Moreover, in increasingly gridlocked political systems, policymakers may find it progressively harder to take substantial policy action to address sovereign and financial risks.

We are now in a new phase of the crisis – the political phase – and tough political decisions need to be made.  Time is of the essence.

This post originally appeared at iMFdirect and is reproduced here with permission.