## Preface and Executive Summary — Global Financial Stability Report: Markets in the Time of COVID-19 (information as of April 9, 2020) ## Source details **Canonical URL:** [Preface and Executive Summary — Global Financial Stability Report: Markets in the Time of COVID-19 (information as of April 9, 2020)](https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2020/april/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2020/april/english/text.pdf.json) --- ### Scope and purpose - The GFSR assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks and support global financial stability and sustained economic growth. - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under Tobias Adrian, Director; project directed by Fabio Natalucci, Deputy Director, and others named in the source. - The report reflects information available as of April 9, 2020. ### Key findings and market developments - Pandemic shock and market moves: - The COVID-19 pandemic presents a historic challenge to health, economic activity, and financial stability. - In mid-February, market participants began to fear a global pandemic and: - Equity prices fell sharply from previously overstretched levels. - Credit spreads skyrocketed, especially in high-yield bonds, leveraged loans, and private debt; issuance essentially came to a halt in risky segments. - Oil prices plummeted amid weakening global demand and the failure of the OPEC+ countries to reach an agreement on output cuts. - Yields on safe-haven bonds declined abruptly (flight to quality). - S&P 500 fell 20 percent from its peak in just 16 trading sessions. - The stock of government bonds with yields of less than 1 percent doubled from about 40 percent at end-2019 to about 80 percent in March. - Financial tightening and amplification channels: - Strain in major short-term funding markets, including the global market for US dollars. - Considerable deterioration in market liquidity, including in traditionally deep markets; Treasury market liquidity deteriorated sharply. - Leveraged investors faced margin calls and forced position liquidations. - Evidence of stress: a "two-fold increase" in balances of central counterparty clearing houses with the US Federal Reserve in only two weeks. - Credit-market stress and risky credit scale: - Global risky credit market segments (high-yield bonds, leveraged loans, private debt) reached $9 trillion globally prior to the shock. - High-yield bond market reached $2.5 trillion globally (end-2019); $2 trillion in advanced economies. - Global leveraged loans outstanding reached $5 trillion globally, $4 trillion in advanced economies. - Private debt market reached nearly $1 trillion. - Market-implied US high-yield defaults rose to "8–10 percent." - Macroeconomic outlook: - In only three months, the 2020 outlook moved from expected global growth of more than 3 percent to a sharp contraction of 3 percent. - The projected global recovery in 2021 is predicated on the pandemic fading in the second half of 2020 and the effectiveness of policy actions. - Tail risks: 5 percent probability that global growth could fall below −7.4 percent; upside odds of global growth exceeding zero this year close to only 4 percent. - Severe scenario: global output almost 8 percent below baseline in 2021 if containment takes longer and a second outbreak occurs. ### Emerging and frontier markets — flows, funding, and vulnerabilities - Portfolio flows: - Emerging and frontier markets experienced the sharpest reversal in portfolio flows on record, both in dollar terms and as a share of emerging and frontier market GDP. - Nonresident portfolio outflows from emerging markets exceeded "$100 billion since January 21" (first quarter of 2020). - Outflows reached record levels relative to aggregate GDP in Q1 2020. - Exchange rates and spreads: - Emerging market equity prices fell "by about 20 percent, on net, since mid-January." - Currencies of commodity-producing economies (Brazil, Colombia, Mexico, Russia, South Africa) tumbled "by more than 20 percent" against the US dollar in Q1 2020. - Spreads of dollar-denominated emerging market sovereign bonds rose to "nearly 700 basis points" by end-March. - Number of distressed sovereign issuers (spreads over "1,000 basis points") rose to record levels for some weaker economies. - Debt and rollover concerns: - Foreign investors now hold considerably more debt issued by emerging and frontier markets than in 2008. - Total debt for the median emerging market economy rose to 100 percent of GDP in 2018 from 75 percent before the global financial crisis. - Total debt in China rose to more than 250 percent of GDP in 2018 from 140 percent in 2007. - Frontier market bond spreads are near or at record high levels; some issuers face sizable debt rollovers in coming years. - Countries with elevated vulnerabilities include Brazil, Colombia, Egypt, Hungary, India, South Africa, and Turkey (selected sample also cites Mexico, Russia, Thailand). ### Banking sector and nonbank financial institutions - Banks: - Banks have more capital and liquidity than in the past; average Tier 1 capital ratios across large financial systems are more than 400 basis points higher than end-2007. - Total undrawn lines of credit amounted to $10 trillion at end-2019 for a sample of almost 400 G7-headquartered banks—about 50 percent of risk-weighted assets. - Bank equity prices fell by about 35 percent, on average, since mid-January and up to 60 percent in some countries. - If market valuations are used to calculate capital ratios, many banks would appear weakly capitalized; median market-adjusted capitalization is now higher than in 2008 only in the United States. - Commercial real estate strains: US CMBS spreads widened by about 400 basis points, on average, from mid-February to their peak. - Investment funds and asset managers: - Fixed income funds estimated cash buffers about 7 percent of assets for an average open-end fixed income fund. - US open-ended high-yield bond and leveraged loan funds experienced $34 billion in outflows between late February and end-March 2020 (and $42 billion in Q4 2018 as historical reference). - Asset managers may face further outflows and be forced to sell assets into falling markets, potentially amplifying price moves. - Insurance and pension funds: - US insurers estimated to have over $40 billion of BBB credits at risk of downgrade to sub-investment grade (less than 2 percent of their corporate bond investments). - Insurers face elevated liquidity mismatches and credit risk in the United States; euro area insurers face profitability and solvency challenges from the low-yield environment. ### Risk transmission, leverage, and structured products - CLOs and structured vehicles: - CLOs hold about one-quarter of global leveraged loans and are the largest investor in institutional leveraged loan market (more than 60 percent of institutional loans outstanding). - CLOs outstanding and structures: equity tranche 11.8 percent of liabilities in one simulation; liability structure example includes A–1 (60.5 percent), A–2 (11.5 percent), B (6.4 percent), C (6.4 percent), D (3.4 percent). - Leverage measures: CLOs ~10× debt to equity; Global Leveraged Loans 5.2× debt to EBITDA; Global High-Yield Bonds 5× debt to EBITDA; Global Loans (not syndicated)/Private Credit 5.6× debt to EBITDA. - Severe adverse scenario outcomes: - CLO mark-to-model losses affect 27 percent of the capital stack, reaching mezzanine debt (A and below). - Overall losses in the scenario total more than $1¼ trillion (or almost 20 percent of total exposures). - Many large banks incur losses in excess of 10 percent of their total buffers in the severe scenario. - Assumptions include: three-year default rate entries "24 27 27", recovery rate entries "25 45 45"; recovery on leveraged loans assumed 20 percentage points lower than in the GFC; market price declines listed as "–34 –40 . . .". ### Policy responses implemented and guidance - Immediate priorities: - Save lives, implement containment measures, and support people and companies most affected. - Large, timely, temporary, and targeted fiscal measures to prevent temporary shutdowns from causing permanent damage. - Fiscal and monetary measures: - Country authorities deployed sizable fiscal measures including wage subsidies, unemployment benefits, tax relief, payment moratoriums, and guaranteed credit. - Central banks provided liquidity and asset purchases, including foreign-currency swap lines; the IMF is actively supporting members with "$1 trillion in available resources." - Selected central bank programs and amounts: - Bank of England: Asset Purchase Facility — a £200 billion increase to a total of £645 billion. - ECB: Pandemic Emergency Purchase Program — purchases up to EUR 750 billion; Expanded Asset Purchase Program additional EUR 120 billion. - US Federal Reserve: multiple facilities including Primary Dealer Credit Facility, Commercial Paper Funding Facility, Money Market Mutual Fund Facility, corporate credit facilities, and municipal liquidity facility; US Main Street facilities backed by $600 billion from the CARES act with $75 billion in equity from the US Treasury. - US Federal Reserve repo operations examples: at least $175 billion in overnight repo each day; at least $45 billion in two-week term repo twice per week; $500 billion in one-month term repo each week; $500 billion in three-month term repo each week. - Regulatory and supervisory measures: - Release of macroprudential buffers in some countries; supervisory relaxations (delaying stress tests, easing treatment of nonperforming exposures); restrictions on dividend payouts recommended in some jurisdictions. - Guidance on IFRS 9 ECL: do not apply mechanically; ECL estimates should be reasonable, supportable, and reflect temporary nature of shock and policy support. - Banks encouraged to use existing capital and liquidity buffers and to prudently renegotiate loan terms; supervisors to request capital restoration plans where needed. - International cooperation: - Enhance swap lines and regional financing arrangements; official bilateral creditors called upon to suspend debt payments from countries below the IDA threshold that request forbearance. - Doubling access limits of IMF emergency financing facilities to meet an expected demand of $100 billion in emergency financing; Catastrophe Containment and Relief Trust can currently provide about $500 million in debt service relief. ### Banking sector profitability outlook and recommendations - Long-run profitability pressures: - Simulation indicates a large fraction of banking sectors (by assets) may fail to generate profits above cost of equity in 2025. - Market-implied cost of equity (median for each region) ranged from 8 percent to 14 percent since 2013. - Econometric results: a 100 basis point decline in short-term rates reduces net interest margins by about 6 basis points in normal times and 12 basis points when short-term rates are negative; a 100 basis point fall in the term spread reduces net interest margins by nearly 21 basis points in low-spread periods. - Key numeric simulation inputs and snapshots: - Econometric exercise relies on a sample of about 12,000 banks; forward-looking simulation relies on 1,000 banks; figure-based analysis on more than 5,000 banks across nine advanced economies. - Repricing maturities: loans repriced every three to six years, deposits every two to three years (average). - Simulation starting point: December 2018; interest rates used up to April 6, 2020. - Policy implications for banks: - Near term: provide liquidity, supervisory guidance on loan renegotiation, use regulatory flexibility and buffers. - Medium term: incorporate low-for-longer scenarios in stress tests and supervisory frameworks; encourage revenue diversification and cost efficiency; deploy macroprudential tools if excessive risk-taking emerges. - Consider structural reforms including consolidation where appropriate and maintain financial inclusion and consumer protection. ### Climate change — physical risk and equity prices - Sample and scope: - 68 economies, 34 advanced and 34 emerging; disaster sample includes more than 6,000 disasters over 50 years. - Median disaster damage equals 0.01 percent of GDP; 95th percentile about 0.5 percent of GDP. - Total annual average damage rose to surpass $120 billion in 2010–18 compared with $22 billion in 1980–89; as share of world GDP about 0.2 percent over past 30 years. - Equity market reactions: - Cumulative average abnormal returns around disasters about −1 percent from 21 trading days before to 40 trading days after onset. - Non–life insurers in advanced economies reach a trough of about −2 percent roughly 50 trading days after a large disaster; banks reach a trough of about −1.5 percent 25 trading days after onset. - Insurance penetration matters: a 1 percentage point increase in non–life insurance penetration improves banking and industrial sector returns by about 1.5 percentage points on average; in the left tail improvement is about 3–4 percentage points. - One-notch sovereign rating improvement (scale 1 to 21) boosts aggregate market returns by 0.2 percentage point and banking/industrial returns by 0.3 percentage point on average; left-tail improvements larger. - Pricing of future physical risk: - Cross-country regressions find no evidence that 2019 equity valuations were negatively associated with projected changes in physical hazard occurrence across climate scenarios (RCP 2.6, 4.5, 6.0, 8.5). - Firm-level temperature sensitivity analysis (27 economies, 1998–2017) documents a temperature-related pricing anomaly: in 10 economies a portfolio of the top 20 percent most temperature-sensitive stocks underperformed by at least 0.5 percent a month, on average, controlling for standard risk factors. - Policy implications: - Preserve or enhance sovereign financial strength and reduce protection gaps (increase non–life insurance penetration). - Improve measurement, disclosure, and firm-level data on exposure and vulnerability; promote TCFD-aligned disclosures and consider global mandatory disclosure principles over time. - Use climate stress testing and scenario analysis for financial firms; support adaptation, early warning systems, risk-sharing arrangements, and build fiscal buffers. *Source: Preface and Executive Summary, Global Financial Stability Report: Markets in the Time of COVID-19 (information as of April 9, 2020).* ### Preface ### Preface ### Scope and purpose - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and aims to help prevent crises by highlighting policies that may mitigate systemic risks and contribute to global financial stability and sustained economic growth of the IMF’s member countries. - The analysis in this report was coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. The project was directed by Fabio Natalucci, Deputy Director, as well as by Claudio Raddatz, Advisor, Anna Ilyina, Division Chief, and Jérôme Vandenbussche, Deputy Division Chief. - This GFSR reflects information available as of April 9, 2020. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the GFSR on April 7, 2020. The analysis and policy considerations are those of the contributing staff and should not be attributed to the IMF, its Executive Directors, or their national authorities. ### Key findings (Executive Summary highlights) - The COVID-19 pandemic presents a historic challenge to health, economic activity, and financial stability. - In mid-February, market participants began to fear a global pandemic and: - Equity prices fell sharply from previously overstretched levels. - In credit markets, spreads skyrocketed, especially in risky segments such as high-yield bonds, leveraged loans, and private debt, where issuance essentially came to a halt. - Oil prices plummeted amid weakening global demand and the failure of the OPEC+ countries to reach an agreement on output cuts. - Yields on safe-haven bonds declined abruptly (flight to quality). - Several amplifying dynamics contributed to a sharp tightening of financial conditions at unprecedented speed: - Strain in major short-term funding markets, including the global market for US dollars. - Considerable deterioration in market liquidity, including in markets traditionally seen as very deep. - Leveraged investors facing margin calls and forced position liquidations. - Markets have pared back some losses after policy actions, but risks remain: - Decisive monetary and fiscal policy actions have stabilized investor sentiment. - There remains a risk of further tightening in financial conditions that could expose preexisting financial vulnerabilities. - Emerging and frontier market economies: - Experienced the sharpest reversal in portfolio flows on record, both in dollar terms and as a share of emerging and frontier market GDP. - Loss of external debt financing is likely to put pressure on more leveraged and less creditworthy borrowers and may lead to a rise in debt restructurings. - Asset managers and investors: - Asset managers may face further outflows and be forced to sell assets into falling markets, potentially exacerbating price moves. - Banking sector: - Banks have more capital and liquidity than in the past and have been subject to stress tests; central bank liquidity support has mitigated funding risks. - Nevertheless, banks’ resilience may be tested in some countries in the face of large market and credit losses, potentially leading them to cut back lending. - Macroeconomic outlook shift: - In only three months, the 2020 outlook moved from expected growth of more than 3 percent globally to a sharp contraction of 3 percent—much worse than the output loss seen during the 2008–09 global financial crisis. - The ultimate impact and timing of a recovery are highly uncertain. ### Policy recommendations and actions emphasized - Immediate priorities: - Save lives and implement appropriate containment measures to avoid overwhelming health systems. - Support people and companies most affected by the virus outbreak. - Fiscal, monetary, and financial policy use: - Fiscal, monetary, and financial policies should be used to support economies stricken by the pandemic. - Central banks should provide liquidity to the financial system, including through foreign-currency swap lines, to maintain the flow of credit to the economy. - Supervisors should encourage banks to prudently renegotiate loan terms for borrowers struggling to service debts, and to use existing capital and liquidity buffers and other regulatory and accounting flexibility to absorb losses. - Country authorities should deploy sizable, timely, temporary, and targeted fiscal measures (payment moratoriums and guaranteed credit) to limit defaults of firms and households. - International cooperation: - International cooperation is essential to tackle this extraordinary global crisis. - The IMF, with $1 trillion in available resources, is actively supporting its member countries. - Post-containment priorities: - Once the virus outbreak is under control, policies should focus on fostering recovery and assessing and healing the damage inflicted on the balance sheets of nonfinancial firms, financial institutions, and governments. ### Report production and inputs - The report drew on discussions with banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers. - Individual contributors and inputs are listed in the Preface (names preserved in the source). - Editorial and production management led by Gemma Diaz from the Communications Department with named editorial assistance and word processing staff (names preserved in the source). - Data and analysis were compiled by IMF staff at the time of publication; corrections and revisions are incorporated into digital editions on the IMF website and IMF eLibrary, with substantive changes listed in the online table of contents. *Source: Preface and Executive Summary, Global Financial Stability Report: Markets in the Time of COVID-19 (information as of April 9, 2020).* ### exeCutIve suMMary ### exeCutIve suMMary ### Policy responses and priorities - Large, timely, temporary, and targeted fiscal measures are necessary to ensure that a temporary shutdown of activity does not lead to more permanent damage to the productive capacity of the economy and to society as a whole. - Authorities across the globe have implemented wide-ranging policies; the April 2020 Fiscal Monitor describes the fiscal support packages announced by governments across the globe. - Central banks have eased monetary policy, purchased a range of assets, and provided liquidity to the financial system to lean against tightening financial conditions and maintain the flow of credit. - With policy rates near or below zero in many major advanced economies, unconventional measures and forward guidance are becoming the main tools; central banks may consider further measures to support the economy. - Multilateral cooperation is essential to reduce the intensity of the COVID-19 shock; the IMF, with $1 trillion in available resources, is actively supporting member countries. ### Financial-stability policy guidance - Banks - Banks’ existing capital and liquidity buffers should be used to absorb losses and funding pressures. - Where the impact is sizable or longer lasting and bank capital adequacy is affected, supervisors should take targeted actions, including asking banks to submit credible capital restoration plans. - Authorities may need to step in with fiscal support—either direct subsidies or tax relief—to help borrowers repay loans and finance operations, or provide credit guarantees to banks. - Supervisors should encourage banks to negotiate, prudently, temporary adjustments to loan terms for companies and households struggling to service debts. - Asset managers - To prudently manage liquidity risks associated with large outflows, regulators should encourage fund managers to make full use of available liquidity tools where it would be in the interests of unit holders. - Financial markets - Market resilience should be promoted through well-calibrated, clearly defined, and appropriately communicated measures, such as circuit breakers. ### Exchange rates, capital flows, and sovereign funding - Emerging market economies facing volatile market conditions should manage pressures through exchange rate flexibility, where feasible. - For countries with adequate reserves, exchange rate intervention can lean against market illiquidity but should not prevent necessary exchange rate adjustments. - In the face of an imminent crisis, capital flow management measures could be part of a broad policy package, but cannot substitute for warranted macroeconomic adjustment. - Sovereign debt managers should prepare contingency plans for longer-term funding disruptions and limited access to external financing. - Official bilateral creditors have been called upon to suspend debt payments from countries below the International Development Association’s operational threshold that request forbearance while battling the pandemic. ### IMF Executive Board discussion: outlook, risks, and policy priorities - Directors agreed the outlook is dominated by the global health crisis from the COVID-19 pandemic and extreme uncertainty about its course, intensity, and impact. - The expected sharp contraction of the global economy in 2020 is likely much worse than during the 2008–09 global financial crisis. - The projected global recovery in 2021 is predicated on the pandemic fading in the second half of 2020 and the effectiveness of policy actions. - Risks of a worse outcome predominate amid exceptionally large uncertainty; Directors noted interest in additional scenario analysis. - Immediate priority: reduce contagion and protect lives, fully accommodate additional health care expenditures. - Economic and financial policies should focus on supporting vulnerable people and businesses, safeguarding the financial system, and reducing scarring effects. - Fiscal policy: need for large, timely, temporary, and targeted fiscal support lifelines (examples cited include government-funded paid sick and family leaves, cash or in-kind transfers, unemployment benefits, wage subsidies, tax relief, and deferral of tax payments). - Good governance, transparency in budget execution and communication are crucial to manage fiscal risks and maintain public trust. - Directors welcomed central banks’ extraordinary actions, including enhanced U.S. dollar swap lines and emergency facilities; some Directors called for extending swap lines to a broader group of countries and utilizing regional financing arrangements. - Directors stressed multilateral cooperation to channel aid and medical resources to countries with weak health systems and to ensure a strong global financial safety net. ### Market developments and macrofinancial impact - The COVID-19 pandemic led to a sudden stop in economic activity and a sharp deterioration of the economic outlook; global growth is now expected to decline by 3 percent in 2020. - Equity markets experienced the fastest drop in history with the S&P 500 falling 20 percent from its peak in just 16 trading sessions. - Asset price declines reached about half the magnitude seen in 2008–09 at the worst point of the sell-off; implied volatility spiked across asset classes to levels in some cases last seen during the global financial crisis. - The stock of government bonds with yields of less than 1 percent doubled from about 40 percent of bonds outstanding at the end of 2019 to about 80 percent in March. - Government bond yields in Germany and the United States fell sharply, reflecting declines in term premiums and a lower expected path of monetary policy. - The market-implied probability of inflation falling below 1 percent in any single year over the next five years spiked in Europe and in the United States. - Early March failure of the OPEC+ agreement pushed oil spot and futures prices down and shifted the entire oil futures curve lower. ### Credit-market stress and vulnerabilities - Corporate credit market conditions deteriorated sharply since late February due to rising credit and liquidity risks; investment grade bond spreads widened, with a large share of BBB credits at risk of downgrades. - Global risky credit market segments (high-yield bonds, leveraged loans, and private debt) reached $9 trillion globally prior to the shock, with weakened credit quality, underwriting standards, and investor protections. - High-yield bond spreads widened dramatically, particularly for energy firms and sectors most affected by pandemic containment measures, such as transportation. - Leveraged loan prices experienced sharp declines, about half the drop seen during the global financial crisis at the worst point of the March sell-off. - Rating agencies revised up speculative-grade default forecasts in response to elevated leverage and expected declines in earnings. - Central bank facilities and expanded programs to support corporate debt and commercial paper markets helped reverse some initial widening of investment-grade bond spreads. ### Chapter 1 at a Glance (key summary points) - Global financial conditions have tightened abruptly with the onset of the COVID-19 pandemic. - Risk asset prices have dropped sharply as investors have rushed for safety and liquidity. - Emerging and frontier markets have experienced a record portfolio flow reversal. - A further tightening of financial conditions may expose financial vulnerabilities: - Asset managers may become distressed sellers, exacerbating asset price declines. - Leveraged firms may lose market access and defaults may spike. - Banks’ resilience may be tested as economic and financial market stress rise. - Strong policy response and international cooperation are needed to tackle these challenges. *International Monetary Fund | April 2020* ### 1. Global Investment Grade (IG) Corporate Spreads ### 1. Global Investment Grade (IG) Corporate Spreads ### Corporate credit markets: pricing higher default risk - High-yield spreads rose to post-GFC highs, driven by the energy and transportation sectors. - Global investment grade corporate spreads sharply widened. - Leveraged loan prices experienced a decline of "about half the drop seen during the global financial crisis." - US investment grade firms continued to issue in March—in contrast to European firms—because of increased need for cash and strains in the commercial paper market. - With credit risk rising, rating agencies revised up default forecasts to "recessionary levels." - Market-implied US high-yield defaults rose to "8–10 percent." - The primary market for high-yield bonds and leveraged loans dried up in March; global issuance of high-yield bonds came to a halt and issuance of leveraged loans fell considerably. - Spreads started to narrow after the US Federal Reserve decision to extend its emergency facilities to corporate debt, including collateralized loan obligation vehicles. ### Short-term funding markets: pressures and central bank responses - The US commercial paper market "froze" as prime money market funds sought to reduce commercial paper holdings and dealer banks faced balance sheet constraints and risk limits; commercial paper spreads widened dramatically. - Short-term funding markets in Australia, Canada, and the United Kingdom experienced similar pressures. - Global US dollar funding conditions tightened: the spread between LIBOR and a risk-free rate widened sharply; the cross-currency basis widened for most currencies. - Initial tightening was more severe in economies with large dollar funding demand but with no swap lines with the US Federal Reserve. - Several central banks augmented provision of US dollar liquidity through enhancements to existing swap lines or new temporary swap lines; since end-March, pressures in global US dollar funding markets appeared to have abated somewhat. - Central bank actions noted elsewhere in the chapter included emergency facilities that provided relief to short-term funding markets. ### Financial deleveraging and strained market liquidity - The sharp tightening in financial conditions forced leveraged investors to close positions to meet margin calls or rebalance portfolios, amplifying asset price declines. - Evidence of stress: a "two-fold increase" in the balances of central counterparty clearing houses with the US Federal Reserve in only two weeks. - Unwinding of Treasury basis trades increased dealers’ holdings of Treasury bonds and, with surging volatility, dealers’ risk limits constrained their ability to intermediate markets. - Treasury market liquidity deteriorated sharply; liquidity conditions worsened across a broad range of markets per IMF staff high-frequency jump analysis, though liquidity "reported[ly] improved somewhat" in recent weeks. - US Federal Reserve steps to prevent disruptions and improve liquidity included: - increasing the scale of asset purchases; - introducing additional large open-market operations to inject liquidity; - allowing foreign central banks to repo their Treasury holdings in exchange for dollars; - temporarily excluding US Treasury securities and reserves from the calculation of the supplementary leverage ratio for bank holding companies. ### Stretched asset valuations magnified price declines - Equity price-earnings ratios had reached the highest levels since the global financial crisis prior to the COVID-19–induced sell-off. - Equity valuations had become increasingly stretched since the October 2019 GFSR, with the extent of overvaluation approaching historically high levels in several countries in the last quarter of 2019. - After the COVID-19 outbreak, equity prices fell sharply through mid-March, wiping out a significant portion of overvaluation in many markets and sectors; the US equity market was an exception where positive misalignment increased as fundamentals deteriorated faster than prices. - Dispersion in earnings forecasts "spiked to historically high levels (about two times the level seen in the global financial crisis)." - Estimates of S&P 500 EPS growth in 2020 by analysts at major investment banks range from "−8 percent to −33 percent." - In credit markets, spread misalignment had increased in the United States and in the euro area and remained high in the emerging markets high-yield segment in the last quarter of 2019; after the outbreak, most spreads widened dramatically, wiping out prior overvaluations. ### Emerging and frontier markets: the perfect storm - An unprecedented combination of external shocks (COVID-19 pandemic, oil price decline, increased global risk aversion, and a prospect of global recession) produced a broad-based sell-off in emerging and frontier markets. - Emerging market equity prices fell "by about 20 percent, on net, since mid-January" despite a recent rebound. - Currencies of commodity-producing economies (Brazil, Colombia, Mexico, Russia, and South Africa) tumbled "by more than 20 percent" against the US dollar in the first quarter of 2020. - Spreads of dollar-denominated emerging market sovereign bonds rose to "nearly 700 basis points" by the end of March—the highest level since the global financial crisis—though they narrowed somewhat in recent weeks. - The number of distressed sovereign issuers (those with spreads over "1,000 basis points") rose to record levels for some weaker economies. - Nonresident portfolio outflows from emerging markets reached a record level in dollar terms "(more than $100 billion since January 21)" and were the highest ever relative to aggregate GDP in the first quarter of 2020. - Outflows were initially especially strong from Asia and from equity markets; oil-importing economies generally fared better but faced risks from lower remittances, reduced external funding availability, and lower external demand. *Sources: Bloomberg Finance L.P.; S&P Global Ratings; S&P Leveraged Commentary Data; and IMF staff calculations.* ### 1. Emerging Market Equity Market Performance ### 1. Emerging Market Equity Market Performance ### Equity, currency, and bond market dynamics - Equity indices referenced to "Index Jan. 17, 2020 = 100" show a large sell-off as markets priced in "a sizable growth contraction." - Currency performance shown "Versus dollar; percent; bars are max drawdown in 2020:Q1, points are change through April 9" — "currencies depreciated against the US dollar, particularly for the commodity-producing economies." - "Spreads of Dollar-Denominated Debt (Basis points, left scale; number of countries, right scale)" widened substantially: "Dollar debt spreads widened to distressed levels in a record number of countries." - "Spreads of Dollar-Denominated Debt and Sovereign Ratings (Basis points, EMBIG spread change through March 31; ratings)" — "bond spreads spiked more for lower-rated and oil-producing economies." ### Portfolio flows and breadth/depth of outflows - "During the COVID-19 sell-off, emerging markets saw the strongest reversal since 2008 both in US dollar terms and relative to GDP." - Breadth: "The breadth of outflows—in terms of the number of affected countries—was the largest since the global financial crisis." - Depth: "South Africa and Thailand witnessing outflows of more than 1 percent of GDP in just two months." - Retail vs institutional: "Retail outflows surged, but institutional investors reportedly also had to reduce positions because of redemptions or risk limits given heightened volatility." - Bond fund categories: "The reversal of bond portfolio fund flows was broad-based, but relatively worse for hard currency bond funds." - Regional pattern: "The strongest initial outflows were in emerging Asia (excluding China) and equity markets, while debt outflows accelerated more recently as the crisis widened." ### Global financial conditions and downside risk metrics - Financial conditions: "Global financial conditions ... tightened sharply in March" with the 2020:Q1 FCI values "based on the March 2020 average." - Growth forecast revisions: "the significant downward revision of the 2020 global growth forecast from 3.3 percent in the January 2020 World Economic Outlook Update to −3 percent in the April 2020 WEO" shifted the distribution left. - Tail risk: "there is a 5 percent probability (an event that happens once every 20 years) that global growth could fall below −7.4 percent." - Upside odds: "the odds of global growth exceeding zero this year close to only 4 percent." - Severe scenario: "In the most severe scenario, where it would take longer than expected to contain the outbreak in 2020 and there is also a second outbreak in 2021, global output would continue to fall throughout 2020 and 2021 and would be almost 8 percent below baseline in 2021." ### Sectoral and institutional vulnerabilities - Summary: "Vulnerabilities are elevated in the corporate and sovereign sectors as global nonfinancial sector debt has reached new highs, while asset managers have taken on more risks in the low-yield environment." - Nonfinancial firms: "Nonfinancial corporate sector vulnerabilities are significantly higher now than in 2008–09, implying that a prolonged period of negative growth and elevated cost of funding could lead to a large-scale corporate distress." - Asset managers: "Vulnerabilities remain high among asset managers and close to the levels seen during the global financial crisis ... entered the COVID-19 crisis with higher leverage, maturity, and liquidity mismatches." - Banks: "Bank vulnerabilities are moderate overall, though there are pockets of weaker institutions. For example, vulnerabilities continue to be high in China and they have increased in other emerging market economies and the euro area." - Insurers: "In the United States, insurers face elevated liquidity mismatches and credit risk ... In the euro area, vulnerabilities in the insurance sector are less pronounced, but credit risks are elevated and coupled with profitability and solvency challenges from the low-yield environment. Chinese insurers operate with high liquidity mismatches." ### Potential amplification channels and policy responses - Fire-sale risk: "Asset managers may be forced to sell assets, thus amplifying asset price declines. Since the virus outbreak, investment funds have faced large portfolio losses ... leading to concerns about actual and anticipated redemptions, especially in the case of fixed income funds." - Domestic mitigation actions: "To mitigate the impact of outflows on domestic economies, country authorities have stepped up currency interventions, provided liquidity support to the bond market and to the banking system, and sought to establish swap lines with the US Federal Reserve and the European Central Bank." - Systemic risk concern: "A widespread distress of banks and other financial institutions could lead to a permanent scarring of balance sheets, which may further delay the recovery." *Sources: Bloomberg Finance L.P.; J.P. Morgan Chase & Co.; EPFR Global; Haver Analytics; Institute of International Finance; IMF staff calculations.* ### 2. Daily Fund Flows ### 2. Daily Fund Flows ### Investment funds: losses and redemptions - Estimated daily net flows reported for a sample of fixed income funds with assets of more than $700 million; flow rates have been winsorized at an absolute value of 50 percent. - As asset prices declined, investment funds’ losses began to mount. - Fixed income funds—especially those exposed to risky credit market segments—faced rapidly growing outflows. - Cash buffers, a first line of defense against redemptions, are estimated at about 7 percent of assets for an average open-end fixed income fund. - Outflows, if they continue or accelerate, could exhaust cash buffers and force sales of high-quality liquid assets or less-liquid assets, reinforcing price declines across markets. - Liquidity management mechanisms that may mitigate pressures include: - tapping of credit lines by funds; - central bank purchases of corporate bonds; - liquidity facilities offering relief for money market funds. - Some funds may have de-risked portfolios early by selling less liquid and lower-rated credit assets to strengthen liquidity, actions that may have initially exacerbated price declines in riskier markets. - Very few suspensions of investor redemptions have occurred so far; in the United Kingdom several property funds were gated, and some smaller European bond funds were reported suspended but most suspensions were lifted within days. ### Banks could act as an amplifier should the crisis deepen - Average Tier 1 capital ratios across economies with large financial systems are more than 400 basis points higher than they were at the end of 2007. - Substantial and coordinated central bank actions (including repo operations and dollars via central bank swap lines) provide liquidity to banks. - Total undrawn lines of credit amounted to $10 trillion at the end of 2019 for a sample of almost 400 banks headquartered in Group of Seven (G7) economies—some 50 percent of risk-weighted assets. - Despite stronger starting positions, banks likely to face both mark-to-market and credit losses due to the COVID-19–induced slowdown: - Commercial real estate strains: US commercial mortgage-backed security spreads widened by about 400 basis points, on average, from mid-February to their peak. - Banks account for about 50 percent to 70 percent of debt in commercial real estate. - The longer the sudden stop in economic activity continues, the more likely banks will see credit losses on lending to households and companies. - Low bank profitability in some advanced economies implies less income available to offset losses. - The WEO baseline shock to economic activity (change in the baseline economic forecast since the January 2020 WEO Update) is greater over a one-year horizon than economic shocks typically assumed in FSAP stress tests; the WEO adverse (alternative scenario with fight against the virus taking roughly 50 percent longer than in the baseline) results in a much larger growth shock in the first year than typically assumed in FSAP stress tests. - Bank equity prices fell by about 35 percent, on average, since mid-January and by up to 60 percent in some countries. - If market valuations are used to calculate capital ratios, many banks would appear to have weak capitalization—similar to levels during the global financial crisis; median market-adjusted capitalization is now higher than in 2008 only in the United States. - Calls on lines of credit and higher wholesale funding costs may impair banks’ ability or willingness to maintain the flow of credit to the economy. ### Insurance companies: potential losses and capital pressures - Shares of insurers in major jurisdictions experienced declines of more than 30 percent before reversing some losses in late March to early April. - Insurance portfolios are heavily skewed toward long-term sovereign and corporate bonds; heavy losses on fixed income investments weighed on portfolio returns through mid-March. - US insurers are estimated to have over $40 billion of BBB credits at risk of downgrade to sub-investment grade. - This amount is less than 2 percent of their corporate bond investments. - Further increases in corporate bond downgrades could increase losses and capital requirements for insurers. - Some supervisors have used flexibility in current frameworks to mitigate shocks and preserve operational viability of insurers. - Derivative exposures could come under pressure and subject insurers to further losses. ### Emerging and frontier markets: stress tests and vulnerabilities - Emerging market bond issuers are much more leveraged now than in 2008 and include new issuers more dependent on oil and other commodities and lower-rated issuers. - Real policy rates in most emerging market economies are now lower than before 2008; fiscal space is more constrained with debt at significantly higher levels in some economies (examples cited: Brazil, China, South Africa). - Many emerging and frontier economies are more reliant on foreign portfolio investors and external funding than in 2008. - Main vulnerabilities under current shocks include limited fiscal space, high financing needs, or external financing vulnerabilities; economies highlighted as vulnerable include Brazil, Colombia, Egypt, Hungary, India, South Africa, and Turkey. - Countries likely to face meaningful output declines also include Mexico, Russia, and Thailand. - Oil exporters are at risk given the nearly 60 percent oil price collapse in the first quarter of 2020; countries most exposed include Colombia, Nigeria, Russia, and Saudi Arabia. - As a result of pressures, Colombia, Mexico, South Africa, and several Middle Eastern economies have been downgraded or put on negative outlook by rating agencies. - Some economies have large foreign currency reserves and other buffers that can be used to absorb shocks. - Systemic state-owned enterprises are more vulnerable due to lower oil prices (example: Mexico’s Pemex) or weaker electricity demand (example: South Africa’s Eskom) and higher funding costs. - In China, vulnerabilities are elevated in the corporate, banking, and shadow-banking sectors: - Small- and medium-sized banks’ balance sheets likely to weaken further as they support vulnerable small and private borrowers. - Large, heavily indebted property developer sector faces rising credit and liquidity risks due to dollar funding strains and slowdown in sales. - Outflows from nonbank financial institutions, many with liquidity and maturity mismatches and high leverage, could be triggered by slumping equity prices, rising bond defaults, or weakening investor confidence. - Frontier markets saw borrowing spreads reach their highest levels since 2008 while rollover needs are set to rise; debt restructuring is under way in Argentina, Ecuador, Lebanon, and Zambia. ### Policy priorities: what has been done so far? - Country authorities have implemented urgent measures to address health concerns and safeguard economic and financial stability: - Timely, temporary, targeted fiscal measures including additional support for health agencies, wage subsidies, cash payments to citizens, government-funded paid sick and family leaves, expanded unemployment benefits, and deferral of tax payments. - Measures to support firms and individuals facing payment difficulties through loan moratoria, restructuring of loan terms, or credit guarantees. - Several countries have expanded loan programs, including guarantees, for financing. - Central bank liquidity measures and facilities have been used to alleviate liquidity strains (see discussion of repo operations, swap lines, central bank purchases of corporate bonds, and liquidity facilities for money market funds in preceding sections). *Source: Chapter 1 excerpts from “2. Daily Fund Flows,” GLOBAL FINANCIAL STABILITY REPORT: MARKETS IN THE TIME OF COVID-19 (April 2020).* ### 1. Total Emerging and Frontier Market Debt ### 1. Total Emerging and Frontier Market Debt ### Key quantitative findings from Figures and Notes - Panel 1: based on 59 emerging market countries. - Panel 3: frontier and emerging market samples include 30 countries each. - Panel 4: based on 20 large emerging market countries. - EMBI = J.P. Morgan Emerging Markets Bond Index; GCC = Gulf Cooperation Council; GFC = global financial crisis; IG = investment grade. - Selected country sample for vulnerability analysis (panel 1 of Figure 1.16): Brazil, China, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Nigeria, Peru, Philippines, Poland, Russia, Saudi Arabia, South Africa, Thailand, and Turkey. ### Debt, leverage, and external financing - Foreign investors hold a considerably larger amount of debt issued by emerging and frontier market economies than in 2008. - Leverage has risen considerably in emerging market economies, especially in China. - Dependence on external financing has increased. - More emerging and frontier market debt issuers have weaker credit ratings now than in 2008. ### Market conditions and vulnerabilities - Frontier market bond spreads are near or at record high levels. - Some frontier market issuers face sizable debt rollovers in the coming years. - Some emerging market economies show vulnerabilities across fiscal, external, and growth dimensions: - Fiscal indicators include central government balance (share of GDP), public debt (share of GDP), and gross financing needs (share of GDP). - External indicators include current account balance (share of GDP), short-term debt to remaining maturity (share of GDP), external debt (share of GDP), foreign holdings of government debt (share of total), and IMF’s reserve adequacy metric. - Exposure to oil decline is measured by oil balance as a share of GDP. - Growth challenges highlighted where GDP is expected to contract by more than 5 percentage points year-over-year in 2020. - Countries identified with elevated vulnerabilities are those in the bottom quartile when ranked across multiple indicators in each category. ### Central bank and market-support actions (selected quantified measures) - In 13 of the 29 jurisdictions with systemically important financial sectors, policy rates were cut by 50–150 basis points. - US Federal Reserve repo operations (example): - at least $175 billion in overnight repo each day, - at least $45 billion in two-week term repo twice per week, - $500 billion in one-month term repo each week, - $500 billion in three-month term repo each week. - Swap lines and US dollar liquidity: - On March 15, the Bank of Canada, the European Central Bank, the Bank of England, the Bank of Japan, and the Swiss National Bank started offering US dollars with 84-day terms, in addition to the existing one-week operation. - On March 19, the Federal Reserve announced the establishment of temporary US dollar swap lines with nine central banks including four emerging market economies. - Selected central bank facilities and amounts: - Bank of England: Asset Purchase Facility — a £200 billion increase in the central bank’s holdings of UK government bonds and sterling nonfinancial investment-grade corporate bonds to a total of £645 billion. - European Central Bank: Pandemic Emergency Purchase Program — purchases up to a total amount of EUR 750 billion; Expanded ECB Asset Purchase Program with additional EUR 120 billion focusing on the corporate sector. - US Federal Reserve: several facilities including Primary Dealer Credit Facility, Commercial Paper Funding Facility, Money Market Mutual Fund Facility, Primary Market Corporate Credit Facility, Secondary Market Corporate Credit Facility, Term Asset-Backed Securities Loan Facility, Municipal Liquidity Facility. - Main Street facilities (US): backed by $600 billion from the CARES act with $75 billion in equity from the US Treasury. ### Regulatory and supervisory measures - Release of macroprudential buffers in some countries (for example, countercyclical capital buffers, domestic systemic risk buffers). - Supervisory relaxations including delaying stress tests, flexibility in the treatment of nonperforming exposures, easing other requirements, and recommendations to restrict dividend payouts in some jurisdictions. - Insurance supervisors: measures to support business continuity and fair treatment of policyholders (for example, grace periods on premium payments). - Asset manager support: temporary regulatory forbearance in some jurisdictions (for example, US SEC halted enforcement actions against affiliated parties’ purchases from money market funds and permitted certain borrowing arrangements). - Short-sale bans and circuit breaker triggers implemented in many countries to reduce downward price spirals and support orderly trading. ### Policy guidance and next steps - A combination of monetary, fiscal, and financial sector policies will continue to be needed to support global financial stability and preserve soundness of financial institutions if economic activity remains paralyzed for longer than expected. - Policy tool constraints: - Policy rates in most advanced economies are now close to or below zero, reducing room for conventional rate cuts. - Only about a third of systemically important jurisdictions had the option of releasing the countercyclical capital buffers before the virus outbreak, limiting macroprudential headroom in some countries. - Some countries have limited or no fiscal space, making credible fiscal backstops challenging. - Remaining gaps: riskiest credit markets remain beyond the reach of some central bank facilities; efforts are under way in several countries to close these gaps. - Financial sector policy principles: - Encourage prudent loan restructurings and renegotiations without lowering loan classification and provisioning standards. - Banks should assess borrowers’ creditworthiness on an ongoing basis and reflect deterioration in asset quality in a timely manner. - Consideration may be needed regarding capital adequacy at banks and liquidity support for a broad range of market participants, including nonbank financial institutions, under more severe scenarios. *Source: Bloomberg Finance L.P.; J.P. Morgan Chase & Co.; and IMF staff calculations.* ### 1. Actual and Expected Policy Rates ### 1. Actual and Expected Policy Rates ### Monetary and Macroprudential Policy Space - Policy rates are close to or below zero in many countries, and few additional rate cuts are expected. - Panel 2 shows the latest data on the countercyclical capital buffer (CCYB) levels in 29 systemically important jurisdictions, with CCYB rates as of February 2020. - Figure 1.17. Shrinking Monetary and Macroprudential Policy Space (chart notes include axis ticks: 0.0, 0.5, 1.0, 1.5, 2.0, 2.5, 3.0 and –1.0, 1.0, 3.0, 5.0, 7.0, 9.0, 11.0). - Countries shown include: Mexico, Russia, South Africa, India, Brazil, Korea, Poland, Australia, Norway, Canada, US, UK, Japan, Euro area, Switzerland. - Average nonfinancial private sector vulnerability is plotted against the level of countercyclical capital buffer (percent) with vulnerability quintiles indicated by green (lower two), yellow (middle), and red (upper two). ### Regulatory and Supervisory Guidance for the Financial Sector - Accounting treatment of credit losses: - Regulators globally provided guidance on applying IFRS 9 Expected Credit Loss (ECL) requirements in light of COVID-19. - Guidance: requirements should not be applied mechanically; forward-looking ECL estimates should be reasonable and supportable, taking into account the expected nature of the shock (likely temporary), impact of economic support measures, and scarcity of reliable information. - Banks: - Existing capital and liquidity buffers should be used first to absorb financial costs of customer loan restructuring and relieve funding and liquidity pressures using full flexibility within existing regulatory frameworks. - If impacts are sizable and longer lasting and bank capital adequacy is affected, supervisors should take targeted actions, including asking banks to submit credible capital restoration plans. - Authorities may need to provide fiscal support to banks’ clients (direct subsidies or tax relief) or provide credit guarantees to banks. - Transparent risk disclosure and supervisory expectations are important; supervisors should discuss operational risks and business continuity plans with banks. - Insurance companies: - Solvency frameworks often include a ladder of supervisory intervention allowing some flexibility in extreme market stress, including extending allowed recovery periods. - Temporary regulatory accommodation may be necessary, but supervisors should not signal a lowering of standards. - Supervisors should require credible plans to maintain or restore solvency while continuing necessary insurance coverage and consider macroprudential implications to avoid incentivizing fire sales. - Asset managers: - Regulators should ensure robust application of risk management frameworks and support availability of liquidity management tools (gates/deferred redemptions, swing pricing). - Authorities should monitor valuation difficulties and provide clarity to fund managers on expectations, including circumstances that may justify temporary suspension of redemptions. - Financial markets: - Circuit breakers, volatility controls, and other market resilience measures must be well calibrated, clearly defined, and appropriately communicated. - Temporary restrictions (e.g., short selling) should consider potential negative impacts on liquidity and price discovery; such restrictions should be temporary and implemented within a predictable framework. - Liquidity provision by central banks: - Central banks may intervene to prevent impairment in money, securities, and foreign exchange markets when funding or market liquidity deteriorates substantially. - Operations may include short- and long-term repo operations, discount window (possibly at longer maturities), foreign exchange swaps, and outright asset purchases. - Central banks may need to expand the range of eligible collateral and counterparts and carefully assess which markets are critical to support while minimizing moral hazard and risks to the central bank. ### How Should Emerging and Frontier Markets Address External Pressures? - Manage exchange rate pressures: - Use exchange rate flexibility where feasible. - Multilateral and bilateral swap lines may be needed to alleviate foreign currency funding pressures. - For countries with adequate reserves, exchange rate intervention can lean against market illiquidity but should not prevent necessary adjustments; interventions should be planned on the basis that pressures may last several months or longer. - If macroprudential buffers exist, their relaxation can reduce the shock’s impact; for example, relax foreign currency reserve requirements to mitigate foreign-exchange funding pressures. - Managing capital outflows: - Outflow capital flow management measures (CFMs) could be part of a broad policy package but cannot substitute for warranted macroeconomic adjustment. - CFMs need to consider international obligations, be broad-based, effectively enforced, transparent, temporary, and lifted once crisis conditions abate. - Prepare for longer-term external funding disruptions: - Sovereign debt managers should prepare contingency plans for limited access to external funding markets for a prolonged period. - Reducing rollover risks should take priority over containing costs when large downside risks exist. - Using cash buffers may become necessary; some countries may need bilateral and multilateral assistance. - Countries with rapidly deteriorating debt dynamics, limited market access, high external financing requirements, or high volatility may need to preemptively and cooperatively seek debt resolution with creditors, including official creditors. ### International Policy Coordination - Multilateral cooperation is needed to avoid price controls and ease trade restrictions on essential medical supplies. - Bilateral and multilateral swap lines may need to be provided to a broader range of emerging markets. - Greater international coordination may be needed to reduce broader capital flow disruptions. - The considerable international efforts to bolster financial regulation since the global financial crisis should be maintained; avoid rollback of regulation or fragmentation through domestic actions that undermine international standards. - IMF financial support and resources: - The IMF has $1 trillion in available resources. - Doubling of access limits of the IMF’s emergency financing facilities will allow the Fund to meet an expected demand of $100 billion in emergency financing, provided through the Rapid Credit Facility and the Rapid Financing Instrument (the former is only for low-income countries). - The Catastrophe Containment and Relief Trust can currently provide about $500 million in debt service relief, including a recent $185 million pledge by the United Kingdom and $100 million provided by Japan. - Official bilateral creditors have been called upon to suspend debt repayment from International Development Association countries that request forbearance. ### Risky Credit Markets — Key Findings and Metrics - Market deterioration: - By late March, US and European markets for high-yield bonds and leveraged loans experienced market declines of nearly two-thirds of the falls seen during the global financial crisis (before partially reversing). - Liquidity deteriorated significantly with exceptionally high bid-ask spreads. - Since late March, credit spreads retraced part of their earlier widening and bid-ask spreads largely normalized following rapid policy responses, but earnings forecasts continued to decline and rating downgrades gained momentum. - Scale of markets (end-2019 / recent figures): - Global leveraged loans outstanding reached $5 trillion globally, of which $4 trillion was in advanced economies. - CLOs outstanding more than doubled since 2010 (driven by activity in the United States); formation of new CLOs remained robust before the COVID-19–related slowdown. - High-yield bond market reached $2.5 trillion globally, of which $2 trillion was in advanced economies. - The private debt market reached nearly $1 trillion. - Structural changes and vulnerabilities: - Rapid growth of risky credit markets over the past decade has increased complexity. - Key vulnerabilities: weaker credit quality of borrowers, looser underwriting standards, liquidity risks at investment funds, and increased interconnectedness. - Positive developments: use of financial leverage by investors and direct bank exposures have declined; run risks lessened in some segments due to long-term locked-in capital in private debt and CLO markets. - Risk transmission and stress scenarios: - In an illustrative severe adverse scenario, total losses at nonbank financial institutions could be substantial, while aggregate losses at banks appear to be manageable, though losses at a few large banks could be substantial. - Given the now-limited role played by banks, losses at nonbank financial institutions could impair credit provision and deepen a recession. - Market structure: - Banks’ direct exposures to credit risk have declined as they shifted from originate-to-retain to originate-to-distribute models. - A broader investor base beyond banks has distributed exposures across creditors with varying risk profiles, reducing some bank risks but increasing market complexity and opacity. - Mutual funds and ETFs play a key role in the US high-yield bond market; CLOs and banks account for a large share of leveraged loan holdings globally. - In the US market, banks are exposed to CLOs primarily through AAA tranches. *International Monetary Fund | April 2020* ### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS ### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS ### Market size, issuance, and recent dynamics - Global high-yield bond market climbed to $2.5 trillion globally by the end of 2019, benefiting from falling interest rates. - On net, the leveraged loan market grew through the end of 2019 to $5 trillion globally, $4 trillion of which was in advanced economies. - CLO volume surged through 2019; issuance of CLOs remained robust before the COVID-19 outbreak, but declined sharply thereafter. - Issuance of risky credit was strong before the COVID-19 outbreak, but has slowed sharply since late February. - Private debt market expansion: a boom driven by institutional investors seeking long-term investments; private debt funds have large amounts of committed but not yet invested capital (“dry powder”). - Figure annotations (growth/scale metrics shown): - 10-year growth = 78 percent - 10-year growth = 217 percent - 10-year growth = 116 percent ### Investors, exposures, and the ecosystem - CLOs: - CLOs hold about one-quarter of global leveraged loans. - CLOs are the largest investor in the institutional leveraged loan market, accounting for more than 60 percent of institutional loans outstanding. - CLOs benefit from stable funding sources in the form of long-term locked-in capital; they face pressure when the share of assets rated CCC or below increases or when failing overcollateralization tests. - Investor composition (selected reported positions and aggregates from visualization): - Global Leveraged Loans ($4 tn) - Global High-Yield Bonds ($1.9 tn) - Global Loans (not syndicated)/Private Credit ($0.7 tn) - Banks ($1.9 tn) (of which Term loan A’s ($620 bn); Revolving credit drawn ($640 bn); Revolving credit undrawn ($640 bn)) - Mutual funds and ETFs ($900 bn) - CLOs ($750 bn) - Private Debt Funds ($540 bn) - Business Development Companies ($100 bn) - Middle Market CLOs ($60 bn) - CLO managers ($40 bn) - Investor concentration and roles: - Asset managers and hedge funds are most exposed to riskier tranches of CLOs. - Pension funds are the largest investors in private debt vehicles. - High-yield dedicated and multisector investment funds hold almost half of the high-yield bond market. - Globally, banks are the largest holders of leveraged loans. - Indirect/connected exposures: - International banks, including large banks in advanced Asia, hold about one-third of global CLOs. - Insurance companies have become the second-largest CLO buyer. - For private debt funds, the primary source of capital appears to come from institutional investors such as global private and public pension funds, foundations, and endowments. ### Key vulnerabilities identified - Table 2.1 summary (vulnerability types mapped to market segments; sizes preserved): - High-Yield Bond Market — $1.9 trillion - High valuations before the COVID-19 outbreak - High firm leverage; EBITDA add-backs; large share of B credit; LBO activity - Active CDX market - Fund outflows can be sizable - Top borrowers represent a sizable share of the market - Complexity and opacity: low transparency of the riskiness of investors’ exposures - Leveraged Loan Market — $4.0 trillion - Repo, TRS, CLO warehouse lines have declined - Bank credit lines can be quickly repriced - Top lenders account for a large share of the market - Complexity and opacity: limited data on prices - Private Debt Market — $0.7 trillion - High return targets - Capital call lines of credit - Large locked-in capital and HTM positions - Lenders in both LL and PD markets - Complexity and opacity: low visibility of borrowers, investors, and transactions ### Leverage, underwriting standards, and credit quality - Increased borrower leverage and weaker earnings have uniquely exposed risky credit markets to the COVID-19 shock. - Leverage observations: - The share of highly leveraged deals in the United States has risen more rapidly for deals financed by nonbank financial institutions than for those with loans held by banks. - Leverage is higher for smaller companies than for larger firms (middle-market defined as firms with earnings below $50 million). - Deals sponsored by private equity firms have increased considerably faster in terms of leverage multiples. - Understatement of leverage: - Leverage in the US loan market appears to be underestimated because of significant earnings adjustments and inflated goodwill. - Market participants perceive potential repricing associated with unrealized earnings addbacks as a key risk. - Interest coverage and covenant deterioration: - Despite very low interest rates, interest coverage ratios have continued to decline steadily, particularly for smaller, middle-market firms. - Underwriting standards and investor protections have deteriorated in recent years in both the high-yield and leveraged loan markets (weaker covenants and thinner loss-absorbing buffers). - As a result, recovery values for leveraged loans in the event of default may be lower in this economic downturn. - Changes during the COVID-19 outbreak: - The primary market for risky credit has reportedly become more disciplined, with higher spreads, more protections, and less leverage, as lenders apparently apply more conservative underwriting standards. ### Embedded and financial leverage in structured vehicles - CLO structure and ratings: - Deterioration in ratings quality in leveraged loan markets, including expansion of B-rated credit, has been pronounced during the current long credit cycle. - Risk ratings for CLOs have deteriorated. - Compared with pre-global financial crisis CLOs, current CLOs have less “embedded” leverage: a higher share of equity and mezzanine debt (rated A and below) serves as a cushion to protect AAA tranche holders. - Implication: AAA tranche investors are less likely to suffer credit losses even in a severe downturn; equity and mezzanine investors may experience credit losses (simulation evidence referenced). - Reduced use of financial leverage relative to the global financial crisis: - Use of repurchase transactions to fund CLO AAA tranches is reportedly limited. - Investors do not appear to widely employ total-return swaps to gain leveraged exposure to the loan market. - Banks appear more conservative on pipeline risk in newly underwritten loans. - CLO warehouse lines often assign first-loss risks to portfolio managers or third parties rather than banks. ### Refinancing, liquidity risks, and fund flows - Maturity and refinancing concerns: - Refinancing risks for high-yield bonds and leveraged loans seem manageable in the short term but the maturity profile is more challenging over the medium term, with a record amount of loans maturing in five years. - Maturing debt is concentrated in lower-rated loans, raising the risk of downgrades and defaults in an economic downturn. - Fund flows and liquidity: - Growth in fixed-income funds holding relatively illiquid instruments increases the risk that large withdrawals could contribute to asset price moves and deteriorating liquidity conditions, especially for funds not managing liquidity risk properly. - Fund outflows have become more volatile. - Historical episodes: - US open-ended high-yield bond and leveraged loan funds experienced $42 billion in outflows in the fourth quarter of 2018. - Between late February and the end of March 2020, US open-ended high-yield bond and leveraged loan funds experienced $34 billion in outflows. - Despite sizeable past outflows, funds in aggregate were able to meet redemptions in the 2018 episode without severe market-functioning dislocations; that episode was short-lived and occurred against continued growth. ### Interconnectedness and balance-sheet exposures - Banks remain vital to risky credit markets by providing senior secured loans and credit lines; before COVID-19 about half of bank credit lines were estimated to be undrawn, but firms began drawing on them to shore up cash. - Undrawn credit lines may absorb some refinancing pressure (if covenants are not breached) but can increase credit and liquidity risk at banks. - Banks have indirect exposures through CLOs and various forms of financing and leverage. - Bank lending to nonbank financial institutions has nearly doubled since 2013, reaching $1.4 trillion in the United States. *International Monetary Fund | April 2020 — CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS* ### 1. Leveraged Loan Deals with Leverage >5 ### 1. Leveraged Loan Deals with Leverage >5 ### Key metrics and market structure - New CLO simulation portfolio assumptions: - Portfolio: 100 senior secured first lien loans. - Adjusted weighted average life: 4.894 years. - Weighted average rating: B. - Expected portfolio default rate: 15.9 percent. - Equity tranche: 11.8 percent of liabilities. - Liability structure: A–1 notes (rated AAA, par amount equal to 60.5 percent of liabilities); A–2 notes (rated AA, par amount equal to 11.5 percent of liabilities); B tranche (rated A, par amount equal to 6.4 percent of liabilities); C tranche (rated BBB, par amount equal to 6.4 percent of liabilities); D tranche (rated BB, par amount equal to 3.4 percent of liabilities). - Monte Carlo simulation: run 10,000 times using S&P’s Global CDO Evaluator v 8.1 and employing default settings. - Probabilities of default and assumed recovery values: from S&P historical values. - Yields on loans and CLO tranches: derived from JPMorgan market rates. - Leverage and balance-sheet measures (end of 2019): - CLOs (general): 10× debt to equity. - Global Leveraged Loans: 5.2× debt to EBITDA. - Global Loans (not syndicated)/Private Credit: 5.6× debt to EBITDA. - Global High-Yield Bonds: 5× debt to EBITDA. - Middle-Market CLOs: 10× debt to equity. - Business Development Companies: Up to 2× debt to equity. - Market size and funding lines (comparative snapshots): - CLO warehouses: 2007 $330 billion; Today ~ $50 billion. - Total return swap lines: 2007 $250 billion, 8–10× leverage; Today ~ <$75 billion, ~3–4× leverage. - CLO warehouse lines (other figure): 2007 $40–50 billion; Today $15 billion. ### Concentration, interconnectedness, and exposures - Concentration highlights: - More than $130 billion in high-yield debt is subject to concentration risk (debt issued by firms where an investment fund family owns more than 10 percent of debt). - Top 10 shares: Primary market participants — Top 10 = 28% (1,301 participants); another measure Top 10 = 36% (673 participants). - Bank and nonbank footprint: - Several large banks account for significant portions of the speculative-grade credit and CLO markets. - Top lenders by region include eight European banks, nine North American banks, and five advanced Asian banks among active participants. - Cross-market holdings and correlation: - High-yield and loan funds have material holdings across debt markets, increasing potential for price correlations during stress. - US leveraged loan—high-yield bond index correlation shows spikes during market stress episodes, including the COVID-19 episode. ### Maturities, liquidity mismatches, and recent flows - Maturity profile and flows: - Global high-yield bond and leveraged loan maturity profile: $4 trillion due over five years. - Outflows in late February to end-March: $34 bn. - Quarterly outflows cited: $42 bn. - Liquidity buffers and fund liquidity: - Recent episodes showed that outflows can be sizable; liquidity buffers proved to be sufficient, on aggregate, in the 2018:Q4 episode. - A significant portion of maturing loans is accounted for by companies rated single-B and lower. ### Risk transmission channels and layering of leverage - Types of leverage and potential amplifiers: - Embedded leverage (structured finance vehicles such as CLOs). - Balance sheet leverage (borrower debt levels). - Financial leverage (lines of credit, repos, derivatives, capital call lines, CLO warehouse lines). - Feedback loops of concern: - Capital call lending to private debt funds can worsen losses at private debt funds in a downturn and increase credit and liquidity risks for banks. - Links in the intermediation chain and interconnectednes s of bank and nonbank lenders may transmit and amplify adverse shocks across financial institutions. - Financial leverage assessment: - Use of financial leverage appears limited compared with the period preceding the global financial crisis, but monitoring is difficult due to data limitations and novel forms of leverage. ### Severe adverse scenario — assumptions and implications - Scenario calibration: - Applies the credit rating transition matrix estimated for speculative-grade credit after the global financial crisis to current credit rating compositions of the high-yield bond and leveraged loan markets to obtain downgrades and defaults. - Recovery rate on high-yield bonds: same as experienced during the global financial crisis. - Recovery rate on leveraged loans: assumed to be 20 percentage points lower than during the global financial crisis (to account for reduced credit protections and repricing of earnings addbacks). - Market prices: experience the same declines as during the global financial crisis. - Additional amplification mechanisms assumed: sales by investment funds and a reduction in CLO demand for leveraged loans. - Scope and limits: - Analysis considers only losses from direct exposures of banks, nonbank financial institutions, and CLOs to risky credit markets. - Second-round effects (not modeled here) could be significant, including impacts on banks from lending to nonbank lenders that suffer losses. *International Monetary Fund | April 2020 — Chapter 2, "Risky Credit Markets: Interconnecting the Dots"* ### 1. Assumptions about Defaults, Recoveries, and Market Price 2. Assumptions about Types of Losses, by Asset Class and ### 1. Assumptions about Defaults, Recoveries, and Market Price 2. Assumptions about Types of Losses, by Asset Class and Lender Type ### Assumptions (defaults, recoveries, market price) - Defaults, recoveries on HY, and market price declines are the same as in the GFC. Recoveries on LL are 20 ppts lower. - Three-year default rate: 24 27 27 - Recovery rate: 25 45 45 - Credit loss rate: 6 12 12 - Market price decline: –34 –40 . . . - "Credit" refers to held-to-maturity exposures that incur credit losses. - "Market" is for mark-to-market exposures that incur market losses. - "Model" is for exposures to CLO mezzanine debt and equity that are mark-to-market based on a standard overcollateralization test. - Note: Credit losses on CLO highly rated debt for banks, insurers, and pension funds are assumed to be zero. ### Assumptions about types of losses, by asset class and lender type - Asset classes listed: High-Yield Bonds; Institutional Leveraged Loans; Bank Leveraged Loans; Private Debt; CLO Equity and Mezzanine Debt. - Lender types and loss treatment (as in the source table): - Banks: Credit . . .. . . - Insurers: Credit Credit. . .. . .. . . - Pension Funds: Credit Credit. . .. . .. . . - Mutual Funds and ETFs: Market Market. . . . .Model - Hedge Funds: Market Market. . .. . .Model - Others (AM, SMA, BDC): Market Credit. . .CreditModel - Private Debt Funds: . . .. . .. . .Credit. . . - Sources used for assumptions: Bloomberg Finance L.P.; Financial Stability Board; Moody’s; S&P Leveraged Commentary and Data; S&P Ratings; and IMF staff calculations. ### Scenario outcomes and key statistics - CLO mark-to-model losses affect 27 percent of the capital stack, reaching mezzanine debt (A and below) in the scenario. - Overall losses in the scenario total more than $1¼ trillion (or almost 20 percent of total exposures). - Investors in CLO equity and mezzanine debt tranches and those with mark-to-market positions (such as mutual funds and ETFs) have higher nominal losses. - Banks have the lowest loss rates (defined as a share of exposures) across investors because they hold mostly senior loans with the highest recovery rates and highly rated CLO debt with negligible losses. - Mutual funds/ETFs and hedge funds have similar loss rates, but mutual funds/ETFs have substantially larger nominal losses than hedge funds because they have considerably larger exposures to risky credit than hedge funds. - Many large banks incur losses in excess of 10 percent of their total buffers—that is, the sum of capital and loan loss reserves—in the severe adverse scenario. - Market losses can be reversible after the end of the scenario, but that eventuality is not captured in this exercise. - During the recent COVID-19 outbreak, weaker CLOs—with a high share of CCC credits—have already started to incur mark-to-model losses amid mounting credit rating downgrades. - In the scenario, mark-to-model losses represent lost cash income to equity and mezzanine debt tranche investors (income is diverted to deleverage the CLO or to improve its asset quality composition). The exercise does not incorporate mark-to-market losses on CLO tranches if investors sell them in the secondary market. - The scenario’s estimated losses are partial—they encompass only the losses incurred in risky credit markets; deterioration in these markets is assumed to be triggered by a recession that would bring wider losses in global equity and investment-grade bond markets. ### Investor and market dynamics observed during COVID-19 episode (as described) - High-yield-bond and leveraged-loan market price declines reached two-thirds of the descent during the global financial crisis in March, but the speed of deterioration was unprecedented. - Preexisting concerns (elevated borrower leverage; earnings addbacks; sectoral structural weaknesses; weak covenants; reduced investor protections; large shares of weak credit) likely magnified investors’ perception of credit risk. - Selling pressure from broad-based demand for cash raised liquidity risk: sharp declines in new issuance of risky credit, record-high bid-ask spreads on corporate bonds, and deep ETF price discounts in March. - Mutual funds experienced large outflows, though outflows moderated more recently. - Capital committed but not yet invested ("dry powder") did not appear to have been deployed yet. - Foreign portfolio flows: total portfolio flows reversed dramatically in March, with more than $100 billion (or 3½ percent of asset holdings) since January 21, led initially by equity outflows. ### Policy implications and recommendations - Immediate (crisis management) priority: act decisively to contain the economic fallout of the COVID-19 outbreak and support the flow of credit to firms. - Authorities in major economies have provided considerable support through monetary, fiscal, and financial policies; major advanced economy central banks have initiated or increased purchases of investment-grade corporate debt. - The US Federal Reserve extended support to some investment-grade bonds downgraded after March 22, some ETFs invested in high-yield bonds, newly issued highly rated CLO tranches, and some small- and medium-sized enterprises meeting specific leverage thresholds. - The European Central Bank expanded eligible collateral for loans to banks to include investment-grade bonds downgraded to speculative grade after April 7. - Should financial conditions deteriorate further (credit downgrades and defaults rise meaningfully), authorities may consider further extending support to risky credit markets to maintain credit flow in these segments. - Supervisors should continue to monitor the banking sector to ensure banks can provide funding to speculative-grade firms; banks’ existing capital and liquidity buffers should be used flexibly within existing regulatory frameworks to absorb financial costs of customer loan restructuring and relieve funding and liquidity pressures. - After the crisis, authorities should: - Conduct a comprehensive analysis to identify sources of market dislocations and assess vulnerabilities unmasked by the episode. - Consider whether widening the regulatory and supervisory perimeter to include nonbank financial institutions active in risky credit markets may be warranted. - Develop a framework for macroprudential regulation of nonbank financial institutions, taking into account the global nature of these markets. - Promote greater transparency in credit markets and ensure sufficient data to analyze risks from current origination practices and chains of intermediation. - Improve measurement of cross-border and global exposures to risky credit markets. - Enhance international collaboration among bank supervisors on data sharing to gauge macro-financial interconnections domestically and internationally. *Source: IMF staff calculations and analysis (Global Financial Stability Report: Markets in the Time of COVID-19, April 2020).* ### Chapter 3 at a Glance ### Chapter 3 at a Glance ### Key summary findings - The COVID-19 pandemic led to an unprecedented sharp reversal of portfolio flows, highlighting challenges of managing such volatility in emerging and frontier markets. - Main empirical findings: - Changes in global financial conditions tend to influence portfolio flows more during surges and reversals than in normal times. - Stronger domestic fundamentals do not always lead to surges in portfolio flows but do help mitigate outflows. - Greater foreign investor participation in local currency bond markets can help reduce borrowing costs, but it may also increase price volatility where domestic markets lack depth, especially in frontier markets. - Persistent portfolio inflows can create vulnerabilities by encouraging excessive domestic credit creation and an overvaluation of local currency and other financial assets. ### Stylized facts and trends - Foreign participation in emerging and frontier markets has grown significantly in the 10 years since the global financial crisis. - Nonresident bond portfolio flows dominate equity flows in aggregate. - Foreign portfolio investment in emerging market debt is still predominantly in foreign currencies, but there has been a long-term shift to local-currency-denominated debt since the Asian financial crisis. - Portfolio flows to emerging markets have been more volatile since the global financial crisis; since 2013 inflow periods have become shorter while outflow episodes have lasted longer. - The share of foreign participation in local currency debt markets grew from 10 percent of the total in 2000 to almost 25 percent recently. ### Key statistics (preserved exactly) - Total debt for the median emerging market economy rose to 100 percent of GDP in 2018 from 75 percent before the global financial crisis. - Total debt in China rose to more than 250 percent of GDP in 2018 from 140 percent in 2007. - The share of foreign participation in local currency debt markets grew from 10 percent of the total in 2000 to almost 25 percent recently. ### Drivers and empirical approach - The chapter uses the capital-flows-at-risk methodology to study the impact of global and domestic factors on predicted distributions of near-term portfolio flows (current quarter and next two quarters). - Baseline specification regresses portfolio flows (in percent of GDP) on: - Global (push) factors: Chicago Board Options Exchange Volatility Index (VIX), US Dollar Index (DXY), US 10-year Treasury yield. - Domestic (pull) factors (lagged): domestic GDP growth, the ratio of short-term foreign exchange debt to international reserves, the depth of domestic financial markets, GDP per capita, and capital account openness. - Regressions include country fixed effects and period dummies prior to, during, and following the global financial crisis. - Focus is on nonresident flows (referred to as “gross inflows”). ### Empirical insights on flows and funding costs - Debt flows tend to be influenced more by global (common) factors than by country-specific (idiosyncratic) factors. - Equity flows are more heavily influenced by domestic factors, such as growth. - For both bond and equity flows, changes in global financial conditions tend to affect the “tails” of predicted portfolio flow distributions (the likelihood of future surges or reversals) more than the likelihood of median flows. - The outlook for local currency bond flows is more sensitive to domestic vulnerabilities than the outlook for hard currency bond flows. - Strong growth prospects can limit the likelihood of future outflows from local currency bond markets but can also amplify future surges. - Domestic bond yields are highly sensitive to external factors, especially for low-rated economies. - Domestic currency hedging by foreign investors could exert substantial pressure on exchange rates and the cost of funding during stress. ### Risks, trade-offs, and thresholds - Increased foreign participation in debt markets, particularly in many frontier market economies, exposes them to changes in global financial conditions through foreign investor behavior and preferences. - During periods of risk aversion, foreign investors are likely to reduce exposure and might not roll over maturing positions, triggering outflows and disrupting bond markets. - A rise in foreign investor participation in the local currency bond market beyond a certain critical threshold—controlling for the domestic investor base—can significantly increase yield volatility. - Greater depth of domestic financial markets and a stronger local investor base can help reduce volatility of local currency bond prices. - Some frontier markets already exceed the critical threshold for foreign participation, increasing their vulnerability. - Improving liquidity of foreign currency markets and availability of hedging instruments is important to balance attracting foreign investors and developing domestic markets. ### Policy-relevant implications - Policymakers should use distributional (capital-flows-at-risk) analysis to assess the likelihood of extreme portfolio flow outcomes and prepare for potential reversals or surges. - Managing the trade-off between lowering funding costs via foreign participation and increasing rollover and price volatility requires: - Strengthening domestic financial market depth and the local investor base. - Enhancing availability of hedging instruments and liquidity in foreign currency markets. - Monitoring excessive credit creation and asset overvaluation associated with strong and persistent inflows. *Source: Chapter 3 at a Glance, text - Chapter 3 at a Glance* ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOWS ### Debt versus Equity Portfolio Flows — Drivers and Asymmetric Sensitivities - Core finding: Changes in global conditions disproportionately affect the outlook for large debt inflows, while changes in domestic fundamentals contribute more to the likelihood of negative or weak inflows than to very large inflows. - Global factors: - Easier global financial conditions (FCI) today boost the near-term outlook for debt portfolio flows across the distribution. - Lower US Treasury yields and a weaker US dollar (or equivalently, stronger domestic currencies) increase the likelihood of strong debt portfolio inflows by considerably more than they decrease the likelihood of negative or weak flows. - Risk aversion (VIX) affects the outlook for strong and weak debt flows in roughly equal magnitudes. - Quantified sensitivities (from Figure 3.5): - A 1 point increase in the FCI increases the average size of flows in the lower tail of the predicted distribution by 0.06 percent of GDP. - A 1 point increase in the FCI increases the average size of flows in the upper tail of the predicted distribution by 0.09 percent of GDP. - Domestic factors: - Stronger domestic growth reduces the likelihood of negative or weak debt inflows but does not necessarily generate very large debt inflows. - Greater external vulnerabilities (measured by higher short-term foreign currency debt relative to international reserves) are linked to a larger likelihood of negative or weak debt inflows; higher short-term debt today also increases the likelihood of very strong inflows, but to a lesser extent. - Deeper domestic financial markets improve the outlook for debt flows across the board. - COVID-19 impact on debt flows: - Downgraded GDP forecasts imply a greater likelihood of weak or negative debt flows. - Tightened global financial conditions reduce the likelihood of large inflows in the near term. - The combined effect of a strengthening US dollar and higher market volatility alone weakens the median predicted quarterly flows by 1 percent of GDP for an average emerging market economy. - Equity flows: - Equity portfolio flows are less sensitive to global factors than debt flows; the disproportionate impact on the likelihood of strong inflows (relative to weak inflows) is present mainly for debt. - A stronger US dollar weakens the near-term outlook for equity flows across the board, but its impact is an order of magnitude smaller than for debt flows. - Stronger domestic growth contributes more to increasing the likelihood of strong equity inflows than to strong debt inflows. - Weakened growth prospects from COVID-19 will worsen the outlook for equity portfolio flows more than for debt portfolio flows. - Deeper domestic financial markets do not reduce the likelihood of negative or weak equity inflows in the same way as for debt flows. ### Hard Currency versus Local Currency Debt Portfolio Flows - Differential sensitivity: - Local currency debt flows are more sensitive to domestic factors than hard currency debt flows. - Local currency flows are more sensitive to external vulnerabilities (short-term debt/reserves) than hard currency flows. - Quantified example: - A 1 percentage point rise in the ratio of short-term debt to international reserves could lower the local currency debt flows at risk by 0.4 percent of GDP and hard currency debt flows at risk by 0.2 percent of GDP. - Local currency debt flows are more sensitive to domestic growth prospects, especially in the tails: - Higher growth boosts expected flows and affects the tails of the distribution twice as much; the outlook for local currency flows is almost three times more sensitive to domestic growth than the outlook for hard currency flows. - Deeper domestic financial markets improve the outlook for both hard and local currency flows and significantly limit the likelihood of negative or weak flows: - The probability of significant bond outflows (equivalent to the 5th percentile of historical events) declines from about 35 percent to less than 10 percent when market depth increases by one standard deviation. - Tighter global financial conditions decrease expected portfolio flows and have a disproportionately larger impact on the likelihood of extreme flows: - Hard currency flows are almost twice as sensitive as local currency flows to changes in global financial conditions. - Implication for COVID-19: - A much weaker growth outlook for emerging markets due to COVID-19 will significantly worsen the outlook for local currency flows. - The outlook for hard currency flows will be relatively more affected by the sharp tightening in global financial conditions. ### Impact of Portfolio Flows on Funding Costs and Volatility - Relationship overview: - Pricing of sovereign debt securities is linked to country-specific fundamentals and global investors’ risk appetite. - Strong domestic fundamentals help lower funding costs; tight global financial conditions can widen spreads. - Global risk appetite becomes especially relevant during periods of stress because it can interact with domestic vulnerabilities to amplify borrower impacts. - Foreign participation in local currency bond markets — benefits and risks: - Benefits: - Nonresident holdings can reduce borrowing costs, currency mismatches, and rollover risks associated with external borrowing. - Diversifying the investor base can increase issuer flexibility and boost potential market size beyond domestic absorption capacity. - Risks: - Foreign investor decisions can strengthen the link between exchange rate fluctuations and domestic financial conditions. - Reductions in foreign positions can create domestic debt rollover risks, increase term premiums, and raise long-term interest rates, affecting domestic activity. - Foreign holdings can transmit global financial shocks to local currency sovereign bond markets by increasing yield volatility and, beyond a threshold, amplifying spillovers from global shocks. - Ownership statistic: - Median foreign ownership of emerging market local currency bonds is just about 20 percent. - Level of funding costs — sensitivities: - Stronger domestic fundamentals are associated with lower funding costs. - High inflation increases local currency bond yields; better growth prospects contribute to lower yields. - Elevated vulnerabilities and lower buffers increase the cost of funding: higher external debt and lower foreign exchange reserves are associated with higher local currency yields. - IMF staff analysis suggests: - The sensitivity of local currency bond yields to the level of foreign exchange reserves has increased in recent years. - Sensitivity to external debt appears to have declined somewhat. *Source: CHAPTER 3 EMERGING AND FRONTIER MARKETS: MANAGING VOLATILE PORTFOLIO FLOWS (text - CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS).* ### 2. Sensitivity of Local Currency Yields to Reserves/GDP and ### 2. Sensitivity of Local Currency Yields to Reserves/GDP and External Debt/Exports ### Key findings - Funding cost is lowered by stronger domestic fundamentals and higher foreign participation. - Local currency bond yields have become more sensitive to reserve adequacy and less sensitive to the level of external debt. - For every 10 basis point increase in growth, yields change by –0.9 basis points (example in panel 1). - For every 1 percentage point increase in external debt (to exports), yields change by 1 percentage point (note in panel 1). - Local currency bonds now account for almost 90 percent of the marketable emerging market fixed-income universe compared with 75 percent in 2008. - For 80 percent of the countries in the sample, there is currently no difference between the local and foreign currency rating, compared with 50 percent at the time of the global financial crisis and 20 percent during the Asian financial crisis. ### Drivers of yields and spreads - Lower-rated bond issuers are more vulnerable to swings in global investor risk sentiment: - A 100 basis point increase in US BBB-rated corporate spreads could widen yields of high-yield emerging market bonds by almost 100 basis points, compared with only 40 basis points for investment-grade issuers. - Greater foreign participation helps reduce local currency yields through investor confidence and market development channels. - Credit ratings materially affect funding costs even after accounting for fundamentals. - Hard currency versus local currency differences: - Hard currency bond spreads, especially for high-yield issuers, are affected about 60 percent more by global risk aversion shocks. - Local currency spreads are more sensitive to domestic vulnerabilities, including external debt and reserve adequacy. - Every percentage point rise in inflation increases local currency bond spreads by more than 70 basis points, but by only 20 basis points for hard currency bond spreads. - GDP growth has a greater impact on hard currency bond spreads. ### Volatility of funding costs and foreign participation - IMF staff analysis: greater foreign participation in local currency bond markets increases the volatility of yields after it reaches a threshold; further domestic financial deepening helps reduce volatility. - Threshold and effect estimates (Table 3.1): financial market depth coefficient and dummy for foreign participation at different thresholds (percent): - Threshold 37 — Financial Market Depth: –1.051*** ; Dummy: Foreign Participation: 0.009 - Threshold 38 — Financial Market Depth: –1.029*** ; Dummy: Foreign Participation: 0.060 - Threshold 39 — Financial Market Depth: –1.015*** ; Dummy: Foreign Participation: 0.090 - Threshold 40 — Financial Market Depth: –0.980*** ; Dummy: Foreign Participation: 0.147** - Threshold 41 — Financial Market Depth: –0.969*** ; Dummy: Foreign Participation: 0.163** - Threshold 42 — Financial Market Depth: –0.967*** ; Dummy: Foreign Participation: 0.205*** - Threshold 43 — Financial Market Depth: –0.980*** ; Dummy: Foreign Participation: 0.188** - When foreign investor bond holdings exceed about 40 percent of the country’s international reserves, the volatility of yields is found to increase by about 15 percent. - On average, domestic financial market deepening helped emerging market economies dampen volatility by 39 percent during 2004–17. ### Frontier markets: foreign participation, liquidity, and rollover risks - Strong investor interest in frontier market economies in 2017–19 led to notable increases in nonresident exposures in FX and local currency bond markets; Egypt and Nigeria had large overweight exposures concentrated in high-yielding short-term debt segments. - Evidence from COVID-19 market turbulence: - Economies with greater nonresident investor participation experienced larger yield increases and higher exchange rate volatility. - Frontier markets underperformed, experiencing large outflows and acute exchange rate pressure; some 12-month nondeliverable forwards depreciated by more than 20 percent in some cases. - Frontier market structural features: - Many frontier markets rank well below the emerging market median in overall financial development and depth of local financial markets. - Limited market liquidity is reflected in larger bid-offer spreads and greater price impact of trades than in other emerging markets, compounding pressures in stress episodes and impairing monetary policy transmission when foreigners concentrate in short-term instruments. - Potential benefits from deeper domestic markets (empirical estimates): - Further deepening of domestic financial markets and institutions to the emerging market average level could help an average frontier market economy lower the volatility of its local currency bond yield by almost 30 percent. - The capital-flows-at-risk analysis suggests that increasing financial depth to the emerging market average could improve portfolio debt flow outlook by 1.2 percent of GDP, on average. - The probability of net nonresident outflows could decline by 15 percentage points. ### Policy priorities and recommendations - General guidance: policy responses depend on nature of shock (liquidity versus solvency), fiscal and monetary space, financial market depth, and balance-sheet vulnerabilities. - Foreign Currency Interventions: - For countries with flexible exchange rates, credible monetary frameworks, low inflation, deep financial markets, and absence of large currency mismatches, the exchange rate should be a key shock absorber. - For countries with adequate reserves, exchange rate intervention can lean against market illiquidity to mute excessive volatility, but should not prevent necessary exchange rate adjustments; interventions should be based on the expectation that pressures could last several months or longer. - For countries with fixed or tightly managed regimes, maintaining the currency regime may be best in the short term if reserves are adequate; interventions may need support from monetary tightening and possibly capital flow management measures, recognizing pressures could last several months or longer. - Capital Flow Management Measures: - In an imminent crisis, capital outflow management measures can be part of a broad package but cannot substitute for warranted macroeconomic adjustment. - If nonresident outflows are a significant driver, measures such as minimum holding periods, caps, and limits on nonresidents’ transfers abroad could be considered with due regard to international obligations; measures should be transparent, temporary, and lifted once crisis conditions abate. - Sovereign Debt Management Strategy: - Sovereign debt managers should prepare for long-term external funding disruptions. - Countries with market access at reasonable rates should actively decrease rollover risks; lowering rollover risks should take priority over containing costs when large downside risks to market access exist. - Sovereign financing strategies should consider interactions with private sector and state-owned enterprise sensitivities (for example, to commodity prices) to avoid exacerbating risks. - Macroprudential Policy: - If macroprudential buffers are available, relaxing these tools can reduce the impact of the shock on markets and the economy (for example, relaxing foreign currency reserve requirements or liquidity coverage ratio requirements in foreign currency to allow banks to use buffers). ### Looking beyond the current crisis: frontier market development priorities - For frontier markets with less-developed financial systems, priority reforms include: - Developing efficient money markets. - Strengthening primary market practices to enhance transparency and predictability of issuance. - Bolstering market liquidity. - Developing robust market infrastructure. - Coordination among public stakeholders and proper sequencing of reforms are required to promote a stable and diversified local investor base. *Source: IMF staff calculations and analysis, chapter section "2. Sensitivity of Local Currency Yields to Reserves/GDP and External Debt/Exports", Global Financial Stability Report: Markets in the Time of COVID-19.* ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOWS ### Managing portfolio inflows and market development - Establish a sound legal and regulatory framework for securities. - During periods of strong investor appetite, macroprudential tools may be put in place or tightened preemptively—before an inflow surge occurs—and maintained over the long term or permanently to build resilience and/or contain the buildup of systemic financial risk. - Policymakers should weigh all evidence about encouraging the participation of foreign investors beyond a level considered prudent after taking into account the capacity of their local markets to absorb external shocks without excessive volatility. - When local markets are at an early stage of development and there is limited room to adjust macroeconomic policies, authorities should proceed with caution when it comes to liberalizing portfolio inflows. - Countries with portfolio flow restrictions that intend to liberalize might consider a gradual approach by moving toward either quantitative limits or price-based restrictions (for example, taxes, reserve requirements) that could mitigate the risk of excessive inflows. ### Analytical and policy emphasis - Focus on building market capacity to absorb external shocks without excessive volatility before encouraging broad foreign investor participation. - Use macroprudential instruments proactively and consider maintaining them long term or permanently as a resilience-building measure. - Prefer gradual liberalization toward quantitative limits or price-based restrictions where appropriate. ### References and empirical literature (selected themes preserved from source) - The chapter draws on a broad empirical literature on capital flows, sovereign spreads, and local currency bond markets (selected authors and works listed in the source), underscoring factors that drive capital flows and the implications for emerging market bond yields and market stability. --- ### Bank profitability under prolonged low interest rates (excerpts from related chapter) - Profitability has been a persistent challenge for banks in several advanced economies since the global financial crisis; very low interest rates have compressed banks’ net interest margins. - A simulation exercise conducted for a group of nine advanced economies indicates that a large fraction of their banking sectors, by assets, may fail to generate profits above their cost of equity in 2025. - Once immediate challenges recede, banks could take steps to mitigate pressures on profits, including by increasing fee income or cutting costs, but it may be challenging to fully mitigate profitability pressures. - Over the medium term, banks may seek to recoup lost profits by taking excessive risks; authorities can implement policies to mitigate vulnerabilities, including: - removal of structural impediments to bank consolidation, - incorporation of a low-interest-rate-environment scenario on banks’ risk assessments and supervision, - use of macroprudential policies to tame banks’ incentives for excessive risk taking. ### Empirical scope and sample details (numeric fidelity preserved) - Econometric exercise relies on a sample of about 12,000 banks. - The estimation of the effective maturity profiles and the actual forward-looking simulation rely on 1,000 banks. - The figure-based analysis is based on a sample of more than 5,000 banks in nine advanced economies. - The nine advanced economies are grouped as: North Atlantic economies (Canada, United Kingdom, United States); large euro area economies (France, Germany, Italy); low-interest-rate economies (Japan, Sweden, Switzerland). ### Key diagnostic metrics and findings (exact figures preserved) - The market-implied cost of equity (median for each region) has ranged from 8 percent to 14 percent since 2013. - Four main channels through which a decline in interest rates can affect bank profitability: - Changes in net interest margins. - Declines in loan loss provisions. - Higher credit growth. - Higher noninterest income. - Historical dynamics (2013–18): compression in net interest margins contributed to lower median net interest income in most countries; this was partly offset by lower provisioning and, in some cases, higher noninterest income. Median return on assets rose in three economies, fell in four, and remained stable in two. ### Conceptual benchmark for insufficient profitability - Banks with a return on equity below the cost of equity are considered to have an insufficient level of profitability. - In this chapter, the cost of equity is measured as the ratio of a bank’s return on equity to the price-to-book ratio (formulation based on the Gordon growth model). ### Policy implications for the banking sector - Incorporate persistent low-interest-rate scenarios into supervisory and risk assessment frameworks. - Encourage revenue diversification (for example, fee income) and cost-efficiency measures, recognizing limits to fully offsetting low-rate pressures. - Use macroprudential policy to limit incentives for excessive risk-taking that could undermine resilience and credit supply. *International Monetary Fund | April 2020* ### 4. Change in Median Bank’s Return on Assets, 2013–18 ### 4. Change in Median Bank’s Return on Assets, 2013–18 ### Interest rate environment and observed bank performance - Bank deposit rates fell quickly but have stabilized near zero, while bank lending rates have continued to fall, which has squeezed bank net interest margins. - Lower net interest income has been partly offset by a cutback in provisioning and lower operating expenses. - Gains from securities have been shrinking, and this trajectory may continue. - Bank deposit rates are assumed to have a floor at zero in the simulation; relaxing this assumption and allowing the deposit rate to fall to a minimum of –50 basis points does not significantly change the results. ### Econometric results: sensitivities and nonlinearities - A 100 basis point decline in short-term interest rates reduces net interest margins (relative to assets) for the average bank in the sample by about 6 basis points in normal times (when short-term interest rates are positive). - When short-term interest rates are negative, a 100 basis point decline reduces net interest margins by 12 basis points, indicating a nonlinear relationship. - A 100 basis point fall in the term spread leads to a decline in net interest margins (relative to assets) on average; in a period of low spreads (when the spread between the 10-year and 3-month rates is below 1 percent) this effect is nearly 21 basis points. - A 100 basis point decline in the term spread is estimated to lead to a 15 basis point fall in provisions (relative to assets) in a low-spread environment. - A 1 percent increase in economic growth is associated with a 1.2 basis point reduction in the ratio of loan loss provisions to assets. - The decomposition indicates that, for the average bank in the large euro area and low-interest-rate economies in the sample, lower short-term rates and a tightening in term spreads can account for a sizable part of the fall in net interest margins over 2013–18; the role of the interest rate environment is relatively lower in North Atlantic economies over this period. ### Repricing, effective maturities, and simulation inputs - Effective repricing maturities estimated from a model of bank interest income dynamics over 2005–18: - Loans are repriced every three to six years, on average, across the nine economies. - Deposits are repriced every two to three years, on average, across the nine economies. - Simulation starting point and inputs: - For data availability reasons, the simulation uses December 2018 as the starting point. - Simulated values for 2019 use realized growth rates and interest rate data. - For the rest of the simulation period, growth forecasts correspond to those of the April 2020 World Economic Outlook. - Interest rates correspond to effective rates until the first quarter of 2020 and to forward market rates for the 1-month, 3-month, and 10-year benchmark bonds of each sample country prevailing at April 6, 2020. - The simulation incorporates four channels affecting bank profitability: 1. Changes in net interest margins from repricing of maturing loans and deposits. 2. Changes in loan-loss provisions resulting from the interest rate and economic environment. 3. Changes in credit growth associated with economic growth. 4. Noninterest income. ### Profitability simulation: 2020–25 projections and scenarios - Market expectations used: short-term interest rates remain at very low levels for a while and term spreads recover gradually over the next few years, albeit to levels below historical norms and with different trajectories across countries. - Phases in simulated interest-rate pass-through to banks: - Phase 2: New loans are issued at lower rates than maturing loans while funding costs remain relatively unchanged, reducing net interest margins. - Phase 3: Deposit rates fall further until they hit the zero lower bound, reflecting easing of monetary policy. - Phase 4: Another round of net interest margin compression as loan rates continue to fall while deposit rates remain around zero. - Phase 5: Interest rates on loans start to increase gradually, as do deposit rates in some countries. - Credit growth is derived from a Bayesian vector autoregression model used to estimate effective repricing maturities, capturing downside pressure on credit growth from the near-term economic outlook and compensating effects of declining interest rates. - Potential gains on securities investments are kept constant relative to assets in the simulation due to lack of portfolio data; this likely overstates simulated profits in the medium term as rates remain low and then move up. - Simulation results and trajectories: - The sharp economic contraction in 2020 leads to higher provision expenses based on historical relationships; provisioning then declines as economic growth recovers. - Medium-term dynamics of profitability are dominated by further compression in net interest income. - Across country groups, even after the contraction in profitability in 2020–21 fades, most banks see a reduction in return on assets by 2025 relative to their recent levels. - Banks in low-interest-rate economies benefit less from the future economic recovery because provisioning and net interest margins are already very low and rates are not expected to rise by much. - In large euro area economies, a cutback in provisions and a small increase in noninterest income enable a fraction of banks (by assets) to increase profits relative to 2018 levels; nonetheless, return on assets in 2025 remains below current levels for most banks in the region. - Banks in North Atlantic economies also face profitability pressures largely driven by net interest margin compression. - Return on equity (ROE) outcomes: - The simulated distribution of ROE in 2025 is markedly to the left of 2018 and similar to the one simulated for 2020, indicating persistent profitability pressures. - A large fraction of banks in the sample generate a ROE below 8 percent—the lower end of current estimates for the cost of equity. - Simulated ROE at global systemically important banks (GSIBs) in 2025 is somewhat better than in 2020 but still deteriorates relative to 2018. - Note on uncertainty and policy measures: - The simulation does not explicitly consider direct measures targeting the banking sector or borrower relief; these measures could materially affect provisions, credit flows, and near-term funding costs. - Historical relationships driving provisions may weaken due to large fiscal and other support measures; loan loss guarantees and regulatory flexibility could dampen near-term provisioning increases. ### Key implications and outlook - Bank profitability is likely to remain under pressure over the next five years, driven primarily by sustained net interest margin compression amid a low-rate, low-spread environment. - Offsetting channels—lower provisioning and lower operating expenses—have been partly exhausted and are increasingly unlikely to remediate margin pressure going forward. - Policy and supervisory considerations should account for: - Potential nonlinear effects of negative short-term rates on margins. - The interaction between term spreads, provisioning, and credit growth when assessing bank resilience. - The heterogeneous impact across regions, with large euro area and low-interest-rate economies showing particular vulnerability. - The simulation underscores the importance of monitoring banks’ ability to generate ROE commensurate with cost of equity, given a sizable share of banks projected to have ROE below 8 percent in 2025. *Sources: Bloomberg Finance L.P.; European Central Bank; Fitch Connect; Haver Analytics; S&P Market Intelligence; SNL Financial; and IMF staff calculations.* ### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS? ### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS? ### Earnings shortfall and key drivers - The sharp economic downturn from COVID-19 will likely hurt bank earnings through mark-to-market and credit losses; banks’ earnings challenges emerged prior to COVID-19 and will extend to at least 2025. - Banks’ ability to mitigate structural profitability pressures from low interest rates depends on increasing noninterest income or cutting operating costs amid rising competition from fintech and nonbank financial intermediaries. - Gains on securities holdings will likely decline further when interest rates stabilize, so improvement in noninterest income must derive largely from generating more fee income. ### Noninterest income: historical patterns and outlook - From 2013 to 2018, fee income (relative to assets) was fairly flat across advanced economy banks, on aggregate. - Fee income fell in Canada, Germany, Sweden, the United Kingdom, and the United States over 2016–18, and rose in France, Italy, and Japan (different degrees). - Significant fee income pools appear structurally mature (capital markets sales and trading revenue have shrunk steadily over the past decade) or subject to technology-based market erosion (payments and transaction banking). - Analysts are forecasting falling fee income relative to assets. ### Cost reductions: historical impact and forecasts - From 2013 to 2018, cost savings delivered about a 15 basis point improvement to median return on assets. - Analysts expect cost-to-assets ratios to continue to decline in some countries, generally in the order of another 5–25 basis points of assets by 2021. ### What is required to restore profitability (return on equity) - The chapter examines combinations of cost reduction and additional fee income improvement required for an “average” bank in each country group to deliver return on equity of 8 percent, holding other earnings drivers and capital structure at industry-average levels. - Findings by country group: - North Atlantic economies: a fair proportion of banks expected to generate adequate returns by 2025; for the rest, a range of feasible cost and revenue improvements could suffice. - Large euro area economies: virtually all banks would need to improve both costs and noninterest income, sometimes significantly; for some banks, cutting costs to zero would not suffice in absence of an increase in noninterest income. - Low-interest-rate economies: many banks show little scope for further cost improvement—costs are already quite low—and would require noninterest income rising from very low current levels. ### Hedging, bank size, and sensitivity to rates - Large banks have much larger overall interest rate swap books (notional) relative to total assets, suggesting more hedging activity. - Available data for the United States suggest smaller banks are more sensitive to a decline in rates than larger banks; econometric analysis corroborates that small banks are less resistant than larger domestic peers to margin and earnings compression in a negative interest rate environment. - US banks’ net interest income has become more sensitive to changes in policy rates in recent years, with risk increasingly skewed to the downside, perhaps reflecting increasing difficulty of mitigating net interest margin pressures as deposit rates approach zero. ### Evidence of risk-taking responses to prolonged low rates - Before COVID-19, some banks modestly shifted exposures from short-term instruments and marketable securities toward less liquid loans, raising loans as a percentage of total assets and taking additional liquidity risk. - From 2013 to 2018, estimated average loan maturity across reporting banks lengthened, particularly in countries where low interest rates exacerbated pressures on net interest margins. - Econometric analysis confirms that banks in a negative rate environment have tended to increase the maturity of their loans, in contrast to their behavior in normal times. - Studies suggest banks may respond to low interest rates by shifting loan portfolio composition toward riskier borrowers; some evidence indicates increased origination of riskier syndicated loans is rapidly ceded to nonbank financial intermediaries, passing credit risk to other parts of the financial system. - Some banks have increased overseas exposures, potentially raising currency and liquidity risks; this is most evident in Canada and Japan and appears available primarily to large banks with extensive international footprints. ### Policy discussion and recommendations - Near term: maintain balance between preserving financial stability, maintaining soundness of financial institutions, and supporting economic activity by: - Adequate provision of liquidity by central banks. - Clear supervisory guidance on prudent renegotiation of loan terms. - Use of flexibility in existing regulatory frameworks to account for expected credit losses. - Use of existing buffers to absorb costs. - Medium term: incorporate low-interest-rate environment into decisions and risk assessments: - Supervisory capital planning and stress testing should include lower-for-longer scenarios; evaluate strength of business models in such an environment. - Supervisors should remain vigilant to prevent excessive risk buildup through regulatory arbitrage that could reduce banking sector resilience. - If banks take excessive risks once the emergency recedes, deploy macroprudential tools: - Counter-cyclical capital buffer could be used in time to enhance resilience as systemic risk builds during loose financial conditions. - Borrower-based measures could limit rapid mortgage portfolio growth if banks shift aggressively into mortgages to sustain margins. - For systems expanding foreign operations, macroprudential authorities should ensure foreign exposures remain adequately diversified and monitor liquidity mismatches in banks’ foreign currency balance sheets. - Monetary policy: remain data dependent and set to meet central banks’ macroeconomic targets; keep in place policy tools that offset some adverse effects of negative interest rates (for example, tiering schemes) while policy rates are negative. - Structural measures: assess benefits of domestic and cross-border bank consolidation while ensuring adequate competition and addressing potential too-big-to-fail issues. - Encourage banks to improve operating efficiencies through branch reduction where warranted, upgrades of information technology systems, and process outsourcing. - Balance cost-reduction efforts against policy concerns: - Ensure broad access to financial services and financial inclusion for households and small- and medium-sized enterprises. - Technology upgrades should guarantee adequate data protection and privacy. - Efforts to expand non-fee income should ensure financial consumers are adequately informed and protected. - Potential consequences for local communities and employment should be properly assessed. ### Box summary: Negative interest rate policies (selected points) - Since 2014 several central banks, mostly in Europe, set policy rates below zero for extended periods when conventional stimulus room was exhausted. - Negative rates transmit to the economy by lowering cost of capital, raising attractiveness of current consumption over saving, and weakening the exchange rate, and may support credit growth. - Money market rates have tracked policy rates closely as they moved below zero; longer-term yields have fallen too, especially following initial cuts below zero. - Deposit rates and lending rates have also fallen; deposit rate falls have been more pronounced for corporate deposits. - Evidence on macroeconomic effects is sparse and confounded by other policies; negative rates in the euro area seem to have had small but positive effects on inflation and growth; negative rates may have supported Japan via the exchange rate channel. - There is a limit—the effective lower bound—beyond which deeply negative rates could trigger wholesale moves into cash, causing bank profits to decline and reversing positive impacts on bank lending. *International Monetary Fund | April 2020* ### Box 4.1. The Experience with Negative Interest Rate Policies ### Box 4.1. The Experience with Negative Interest Rate Policies ### Deposit rate pass-through and bank profitability - After policy rate cuts, euro area corporate deposit rates have fallen, but pass-through has diminished over time. - Euro area retail deposit rates have also fallen, but less so. - Swedish retail deposit rates show the same behavior. - In Sweden, corporate deposit rates have also fallen, with diminishing pass-through. - Note: Figures document changes in new short-term deposit rates for households and corporations up to 12 months following each 10 basis point cut (ECB since June 2014; Swedish Riksbank since February 2015). NFC = nonfinancial corporation; repo = repurchase agreement. ### Tiered reserve systems introduced by central banks - Several central banks have introduced tiered reserve systems to help counter the negative effects of low rates on banks’ profitability. - Jurisdictions with some form of tiering system include Denmark, the euro area, Japan, Norway, Sweden, and Switzerland. - Tiering delivers two benefits to banks: - Banks are exempted from paying interest (or receiving a less negative rate) on a portion of the reserves they maintain at the central bank. - Banks have scope to arbitrage the difference between the negative rate and the exempted rate by trading liquidity (possibly across countries). - Example arbitrage mechanism described: a German bank charged –0.50 percent on excess reserves could pay –0.30 percent to an Italian bank for holding liquidity; both banks could benefit. ### Estimated savings from tiering - The introduction of the two-tier system by the European Central Bank at the end of 2019 is estimated to generate total savings for euro area banks of about €4.7 billion per year relative to a counterfactual scenario where tiering is not introduced. - In Switzerland, savings from the recent change in tiering introduced in November 2019 are estimated at about $0.7 billion per year. - Caveat: These savings, equivalent to a few basis points of return on assets, are unlikely to fully offset the impact of low interest rates on profitability. ### Selected central bank deposit tiering schemes (Table 4.2.1, as reported) - Euro Area - Description: Bank deposits below the exemption threshold pay no interest. Reserves above the threshold pay the deposit rate. - Exemption Threshold: Six times the minimum reserve requirement. - Interest Rate Applied to Nonexempt Reserves (percent): –0.50 - Date Tiering Implemented: Nov. 2019 - Date Negative Rates Implemented: Jun. 2014 - Japan - Description: Three-tier system at 0.1 percent rate for the basic balance, 0.0 percent rate for the macro add-on balance, and -0.1 percent rate for the policy rate balance. - Exemption Threshold: Amount of reserves charged at the policy rate varies in line with the Bank of Japan’s monetary base target. - Interest Rate Applied to Nonexempt Reserves (percent): –0.10 - Date Tiering Implemented: Feb. 2016 - Date Negative Rates Implemented: Jan. 2016 - Switzerland - Description: Negative interest is charged on the portion of banks’ sight deposits at the central bank exceeding the exemption threshold. - Exemption Threshold: Twenty-five times the minimum reserve requirement (revised up from 20 times exemption in Nov. 2019). - Interest Rate Applied to Nonexempt Reserves (percent): –0.75 - Date Tiering Implemented: Jan. 2015 - Date Negative Rates Implemented: Dec. 2014 ### European Central Bank tiering impacts (Table 4.2.2, end of 2019) - Reported figures (columns: Minimum Reserve Requirement (MRR); Bank Deposits with Eurosystem (Billions of euro); Exempted Reserves (MRR * Multiple); Cost Savings for Banks (Billions of euro); Impact on Banks’ Return on Assets (percentage points)): - Euro Area: 135 | 1,818 | 807 | 4.0 | 0.01 - Germany: 375 | 622 | 241 | 1.1 | 0.01 - France: 275 | 261 | 60 | 0.8 | 0.01 - Italy: 181 | 021 | 100 | 0.4 | 0.01 *Author of the box: Juan Solé. Sources: European Central Bank; national central banks; IMF staff calculations and estimates.* ### CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES ### CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES ### Overview and conceptual channels - Two channels link climatic disasters to the financial sector: - Channel 1 (Current Climatic Disasters): current climatic disasters affect credit, underwriting, market, operational, and liquidity risks. - Channel 2 (Future Climatic Disasters): shifts in expectations and attention about future climatic disasters can affect asset values today. - Equity markets are suited to analyze both channels because they provide high-frequency information on investor perceptions and are perpetual claims on firms’ cash flows. ### Sample, scope, and key questions - Sample: - 68 economies with aggregate stock market data. - 34 advanced and 34 emerging market and developing economies. - Covers the past 50 years. - Disaster sample includes more than 6,000 disasters; about 60 percent occurred in emerging market and developing economies. - Key questions the chapter addresses: 1. Trend in frequency and severity of climatic disasters in the 68 economies. 2. How have aggregate equity prices, bank equity prices, and insurance equity prices reacted to large climatic disasters historically? 3. Can better insurance coverage and sovereign financial strength enhance resilience of equity markets and financial institutions? 4. Are climate change risks reflected in equity prices as of 2019 (do valuations correlate negatively with predicted changes in physical risk)? 5. Are equity investors paying attention to temperature as an observable climate variable? ### Stylized facts on climatic disasters and damages - Frequency and types: - Annual number of disasters increased from slightly more than 50 in the early 1980s to about 200 since 2000; it has been stable over the past 20 years. - Floods and storms constitute about 80 percent of the sample. - Damage distribution and magnitudes: - Median disaster damage amounts to 0.01 percent of GDP. - The 95th percentile of the damage-to-GDP distribution corresponds to about 0.5 percent of GDP. - Only large disasters cause sizable damages relative to domestic GDP. (Definition: a disaster is “large” if the rate of affected population is greater than 0.5 percent or the damage is greater than 0.05 percent of GDP.) - Advanced economies (AE) vs emerging market and developing economies (EMDE): - Average damage relative to GDP: EMDE 0.13 percent of GDP; AE 0.07 percent of GDP. - For the 10 largest disasters over 1970–2018: - EMDE damages range from 2.9 percent of GDP to 10.1 percent of GDP. - AE damages range from 1.0 percent of GDP to 3.2 percent of GDP. - Number of people affected tends to be much higher in EMDEs than in AEs. - Aggregate annual damages (absolute and relative): - Total annual average damage (constant 2018 US dollars) rose nearly sixfold: surpassing $120 billion in 2010–18 compared with $22 billion in 1980–89. - As a share of world GDP, total annual damages have remained broadly constant at about 0.2 percent over the past 30 years. ### Equity market reactions to large climatic disasters - Average market response: - Cumulative average abnormal returns (actual returns minus returns predicted by a pricing model with a global stock market factor, averaged over disasters) are about −1 percent from 21 trading days before the disaster to 40 trading days after the disaster. - Reactions vary considerably across disasters. - Notable disaster examples: - US Hurricane Katrina (2005): - Damage about 1 percent of US GDP. - Nearly 2,000 lives lost. - Half a million people affected. - Triggered only a modest stock market reaction, with no discernible drop in the US stock market index. - Thai floods (2011): - Damage 10.1 percent of GDP (largest damage in sample relative to economy size). - 813 deaths. - 9.5 million affected people. - Thai stock market index dropped more than 8 percent soon after onset and about 30 percent cumulatively after 40 trading days. - Financial sector-specific impacts: - Among financial sector firms, large disasters have a statistically significant effect on the returns of non–life insurance firms (the chapter notes a statistically significant effect for non–life insurers). - Banks face credit risk, market risk, operational risk, and liquidity risk from disasters; insurers face underwriting risk, market risk, credit risk, and operational risk (and may see increased underwriting volumes and premiums post-disaster). ### Pricing of future physical risk and investor attention - Pricing challenges and empirical findings: - Pricing future climate risks is extremely challenging due to large uncertainties in climate science projections and the economic cost of predicted hazards. - Economy-level equity valuations as of 2019 are generally not statistically significantly associated with currently available proxies of future changes in physical risk. - Equity investors do not seem to have paid full attention to temperature, an observable climate variable, which could suggest they do not pay full attention to climate change either. - Potential financial stability channel: - A sudden shift in investors’ perception of future physical risk could lead to a drop in asset values, generating ripple effects on investor portfolios and financial institutions’ balance sheets. ### Policy implications and recommendations (from the chapter) - To protect domestic financial stability under a baseline scenario in which climate change mitigation policies are projected to remain weak globally: - Preserve or enhance government financial strength. - Reduce barriers to non–life insurance penetration while ensuring adequate capital in the insurance sector. - Encourage adaptation. - Additional measures to address informational challenges and improve risk pricing: - Better measurement and increased disclosure of exposure and vulnerability to climatic hazards. - Implementation caveats and constraints: - Preserving or enhancing financial strength appears challenging as public debt ratios continue to increase. *Source: CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES, Global Financial Stability Report: Markets in the Time of COVID-19, International Monetary Fund, April 2020.* ### 2. Cumulative Market Returns in the United States around Hurricane ### 2. Cumulative Market Returns in the United States around Hurricane ### Impact of large climatic disasters on aggregate and sector stock prices - The impact of large climatic disasters on aggregate stock prices has been modest. - Following a disaster, stock prices of non–life insurers in advanced economies trend down for about 50 trading days after a large disaster and reach a trough of about −2 percent. - In emerging market and developing economies, there is no significant reaction of insurers’ stock prices. - Stocks of global reinsurance companies react negatively to disasters happening in both advanced economies and emerging market and developing economies. - For banks in both groups of economies, there is a small negative contemporaneous stock market reaction; cumulative average abnormal returns of banks reach a trough of about −1.5 percent 25 trading days after the onset of a disaster. - Cumulative average abnormal returns are relative to 21 trading days before the start day to incorporate potential anticipation effects. Abnormal returns are computed based on estimates from a one-factor model (global factor) using daily returns of one year before the disaster. Dashed lines represent the 90 percent confidence intervals. ### Role of insurance penetration and sovereign financial strength - Insurance penetration is measured by the ratio of non–life insurance premiums to GDP, with the ratio ranging from 0 to 5 across economies. - The protection gap for climatic disasters varies widely; even in advanced economies, only two-thirds of losses related to climate disasters are covered by insurance. - Econometric analysis (focusing on cumulative abnormal returns 40 trading days after disaster onset relative to 20 trading days before) finds: - A 1 percentage point increase in non–life insurance penetration improves banking and industrial sector returns by about 1.5 percentage points on average. - In the left tail (when returns are particularly low), the improvement is about 3–4 percentage points. - A one-notch improvement in sovereign rating (on a scale of 1 to 21) boosts aggregate market returns by 0.2 percentage point, and banking and industrial sector returns by 0.3 percentage point on average. - When returns are low, the improvement is about 0.6–1.0 percentage point for the aggregate market and these two sectors, and 1.6 percentage points for the non–life insurance sector. - These effects are large relative to the size of cumulative average abnormal returns around disasters (between 1 percent and 2 percent). - The correlation between insurance penetration and sovereign financial strength is high; when considered jointly, sovereign financial strength appears more robust. ### Equity pricing of future climate change physical risk - Financial market participants have started to focus more on physical risk as a potential source of financial vulnerability. - Only a very small proportion of global stocks are held by sustainable funds; the share of assets under management by sustainable equity funds relative to overall market capitalization has been increasing but remains small. - Empirical pricing of future physical risk is challenging due to: - Difficulty in creating time-varying measures of future physical risk. - Scarcity of firm disclosures about present and future exposures. - Investment horizons of many investors potentially shorter than the horizons over which physical risk unfolds. - A stylized asset-pricing model suggests market-implied equity risk premiums observed in 2019 are in line with those under a no-further-warming scenario, and significantly smaller than premiums under a high-warming scenario—implying equity valuations should be lower if the high-warming scenario materializes. - Cross-country econometric analysis using World Bank Climate Change Knowledge Portal projections (changes between 1986–2005 and 2020–39 for extreme heat days, drought likelihood, heat wave likelihood, and extreme precipitation days; scenarios RCP 2.6, RCP 4.5, RCP 6.0, and RCP 8.5) and measures of projected sea level rise and a Climate Change Hazard Index finds: - Overall, there is no evidence that equity valuations in 2019 were negatively associated with projected changes in hazard occurrence. - The association between predicted changes in hazard occurrence and price-to-earnings ratios is positive across five of six hazard measures and climate scenarios; the association is negative only for change in drought likelihood but not statistically significant. - The analysis controls for the damage-to-GDP ratio and, when examining equity valuations, controls for mean annual growth rate of earnings per share, standard deviation of annual growth of earnings per share, and the three-month Treasury bill rate. ### Key statistics and parameters preserved from the analysis - Trough for non–life insurers in advanced economies: about −2 percent (about 50 trading days after disaster). - Trough for banks: about −1.5 percent (25 trading days after disaster). - Insurance penetration ratio range: 0 to 5 (non–life insurance premium, percent of GDP). - Coverage in advanced economies: only two-thirds of losses related to climate disasters are covered by insurance. - Effect of 1 percentage point increase in non–life insurance penetration: improves banking and industrial sector returns by about 1.5 percentage points on average; 3–4 percentage points in the left tail. - Effect of one-notch sovereign rating improvement (scale of 1 to 21): boosts aggregate market returns by 0.2 percentage point; banking and industrial returns by 0.3 percentage point; left-tail improvements about 0.6–1.0 percentage point for aggregate/banking/industrial and 1.6 percentage points for non–life insurance. - Size of cumulative average abnormal returns around disasters: between 1 percent and 2 percent. - Climate projection comparison period: changes between 1986–2005 and 2020–39. - Emission scenarios used: RCP 2.6, RCP 4.5, RCP 6.0, RCP 8.5. *Sources: Emergency Events Database (EM-DAT); Refinitiv Datastream; World Bank; and IMF staff calculations.* ### 1. Price-to-Earnings Ratio (in logs; y-axis) and Climate Change Hazard ### 1. Price-to-Earnings Ratio (in logs; y-axis) and Climate Change Hazard Index (x-axis) ### Empirical findings on equity valuations and physical climate risk - There is no association between measures of predicted changes in climatic hazard occurrence and equity valuations. - A greater projected increase in hazard risk combined with a greater sensitivity to climate change is not associated with lower valuations. - A greater projected increase in hazard risk combined with a lower capacity to adapt to climate change is not associated with lower valuations. - None of the coefficients in panels 2–4 is significant and has a sign consistent with pricing of climate change physical risk. - Panel 1 index range: 0 to 10. - Projections and indices used: - Extreme heat exposure, extreme precipitation, drought likelihood, and heat wave likelihood are projections for the horizon 2020–39. - The sea level rise index is based on projections for the year 2100 under RCP 8.5. - The Climate Change Hazard Index is based on projections up to 2050 under RCP 8.5. - Representative Concentration Pathway scenarios considered: RCP 2.6, RCP 4.5, RCP 6.0, and RCP 8.5 (IPCC emission scenarios; higher number = higher level of emissions). ### Regression evidence and interaction-index results - Regressions: cross-sectional regressions of the price-to-earnings ratio on climate change physical risk indicators, each controlling for expected future earnings, the equity risk premium, and interest rates. - Interaction tests: - Interaction between predicted changes in climatic hazard occurrence and the Climate Change Sensitivity Index: association generally positive and not statistically significant when negative (no evidence of expected negative association). - Interaction between predicted changes in climatic hazard occurrence and the Climate Change Adaptive Capacity Index: association is the opposite of expectations regardless of climate change scenario (no evidence of expected positive association). - Augmenting regressions with interactions between proxies of changes in physical risks and insurance penetration or sovereign financial strength yields equally inconclusive results. ### Temperature sensitivity and evidence of mispricing - Analysis extends Kumar, Xin, and Zhang (2019) to a sample of 27 economies over 1998–2017. - Firm temperature sensitivity: - Defined as the absolute value of the “temperature beta,” measuring comovement of firms’ stock returns with temperature extremes. - Sensitivity measured over rolling windows of 60 months. - Temperature anomaly defined as the difference between the temperature in a given month and the average temperature over the preceding 30 years in the same month. - Key results: - The analysis confirms the U.S. finding and documents a temperature-related pricing anomaly in more than half of the economies considered. - In 10 economies, a portfolio composed of the top 20 percent of stocks most sensitive to temperature underperformed by at least 0.5 percent a month, on average, over the sample period, controlling for standard risk factors. - Interpretation: presence of such abnormal returns indicates equity investors in many economies have not paid enough attention to temperature-related variables and may not be paying sufficient attention to climate change risk either. - Presentation details: - Figure 5.9 shows abnormal equity returns of firms with the highest sensitivity to temperature (Percent, 1998–2017). - Black diamonds indicate differences between firms with high temperature sensitivity (top quintile) and all other firms; red and green bars show 90 percent confidence intervals; solid bars indicate significance at the 10 percent level or less. ### Comparative evidence across asset classes and possible explanations - Bonds and municipal debt: - Some evidence that other asset classes price climate change physical risk: in the United States, counties projected to be adversely affected by rising sea level face higher costs when issuing long-term municipal bonds. - Sovereigns facing greater projected change in physical risk pay higher spreads for long-term bonds relative to short-term bonds (for some proxies). - Possible reasons for difference between equity and bond pricing: - Closer geographic match between climatic disasters and sovereigns’ assets and sources of income reduces informational challenges for bond investors. - Investors’ investment horizon differences — long-term government bond investors may discount less and pay more attention to long-term risks than equity investors. - Expectation that governments will bear a greater share of costs of future climatic disasters than listed firms. ### Stress testing, FSAP experience, and case example - FSAP stress testing: - The IMF pioneered use of stress tests for assessing financial stability in the FSAP 20 years ago. - Over the past decade, one in five FSAPs contained an examination of physical climate risks; most related to small island states and other economies prone to climatic disasters. - Stress tests have evolved from non–life insurance focus to incorporating broader macro-financial feedback effects; future assessments may consider slow-moving consequences (e.g., migration from water shortages and crop failures). - Case: The Bahamas FSAP (2019) - Historical context: The country was hit by 11 hurricanes with average costs of 4.3 percent of GDP in the 20 years before the FSAP. - Findings: financial sector effects are nonlinear and dependent on macroeconomic context; a US recession combined with a hurricane would significantly amplify macro-financial losses. - Outcome: after Hurricane Dorian, the financial sector appeared to have weathered the hurricane well due to limited exposures to uninsured assets and adequate reinsurance abroad, though insurance penetration—especially residential—remains low. ### Policy implications and recommendations - Key conclusion: notwithstanding data and measurement limitations, evidence does not indicate that equity investors are pricing climate change physical risk. - Short- and medium-term measures to improve pricing and resilience: - Strengthen climate change literacy by enhancing visibility of findings in climate science, climate economics, and climate finance. - Improve granular, firm-specific information on current and future exposure and vulnerability to climate change physical risk for lenders, insurers, and investors. - Promote voluntary disclosures in line with the Taskforce on Climate-related Financial Disclosures (TCFD); consider developing global mandatory disclosures on material climate change risks: - Short term: mandatory disclosure could be based on globally agreed principles. - Longer term: incorporate climate change risk disclosure standards into financial statements compliant with International Financial Reporting Standards. - Anchor standards and disclosures in proper measurement of financial exposure to climate risk and adequate taxonomies. - For financial firms, use climate change stress testing and scenario analysis to better assess exposures at a granular level. - Strengthening financial resilience and reducing vulnerability: - Non–life insurance increases economies’ ability to recover from disasters; addressing the protection gap is especially important in emerging market and developing economies. - Support measures: sound legal and regulatory systems, mandating coverage for some assets, subsidizing climatic disaster insurance, enabling insurer-of-last-resort solutions, increasing financial and risk literacy, establishing risk-sharing arrangements such as Protection Gap Entities. - Sovereign financial strength matters: build fiscal buffers, establish contingent lines of credit, develop sound public financial management systems, and consider state contingent debt instruments to allow greater policy flexibility in bad times. - Adaptation and risk reduction measures: enhance early warning systems, manage population density in at‑risk areas, implement land-use regulation, invest in infrastructure and “build back better” programs. - Transition risk: strong mitigation policy must be managed to avoid abrupt and unanticipated repricing of portfolios and economic dislocation; gradual, ambitious, clear, and predictable mitigation policies help smooth the transition path. *Sources: Refinitiv Datastream; Verisk Maplecroft; World Bank Group, Climate Change Knowledge Portal; and IMF staff calculations.* ### Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program ### Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program ### References cited in the box - Baldauf, Markus, Lorenzo Garlappi, and Constantine Yannelis. 2020. “Does Climate Change Affect Real Estate Prices? 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IMF.org/COVID19lendingtracker - These notes are produced by IMF experts to provide guidance and help members address the economic effects of COVID-19. IMF.org/COVID19notes - Latest news, blogs, Factsheets, Podcasts, and all the information on the IMF’s response to the crisis IMF.org/COVID19 - The IMF and COVID-19 crisis: The IMF has responded to the COVID-19 crisis by quickly deploying financial assistance, developing policy advice, and creating special tools to assist member countries. Visit IMF.org/COVID19 to access the latest analysis and research from IMF staff in response to the pandemic. - Quotation: “A global crisis like no other needs a global response like no other.” —Kristalina Georgieva *Source: Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program — text extracted from the specified PDF.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/text.pdf_