## CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEW: BRIDGE TO RECOVERY

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### Global outlook and near-term risks
- Near-term global financial stability risks have been contained for now due to unprecedented and timely policy response that has helped maintain the flow of credit and avoid adverse macro-financial feedback loops, creating a bridge to recovery.
- Expected rebound and risk distribution:
  - Expected rebound of 5.2 percent in global GDP growth next year implies the 2021 growth forecast distribution will shift back into positive territory.
  - The probability of global growth falling below zero in 2021 is close to 5 percent.
  - The 5th percentile (growth-at-risk) metric indicates risks are elevated by historical standards.

### Rising vulnerabilities across sectors
- Corporate and sovereign vulnerabilities:
  - Nonfinancial corporate sector: firms have taken on more debt to cope with cash shortages, increasing liquidity and future solvency risks.
  - Sovereign sector: fiscal deficits have widened to support the economy.
- Corporate solvency and default dynamics:
  - SMEs are more vulnerable than large firms with capital market access.
  - Corporate liquidity pressures could morph into insolvencies if the recovery is delayed.
  - Defaults have risen notably in high-yield bond issuers, leveraged loans, and middle-market loans; defaults remain significantly lower than in 2008–09 but speculative-grade defaults have risen quickly, particularly in the United States.
- Banking sector resilience and downside risks:
  - Banks entered the crisis with stronger capital and liquidity buffers than in the global financial crisis, but a weak tail of banks exists.
  - October 2020 WEO adverse scenario results:
    - Capital shortfall relative to minimum capital requirements is about $110 billion.
    - Overall capital shortfall relative to broad capital requirements could reach $220 billion, after accounting for policy support.
    - The average capital shortfall in the adverse scenario is close to 1 percent of GDP.
    - For comparison, the median government bank recapitalization during the global financial crisis was about 3.6 percent of GDP.
  - Global systemically important banks tend to fare better; banks in emerging markets appear less resilient than peers in advanced economies.
- Nonbank financial sector fragilities:
  - Asset managers entered the pandemic with elevated vulnerabilities, including sizable liquidity mismatches.
  - Fragilities in the nonbank financial sector aggravated market dislocations during the March sell-off and remain elevated.
- Emerging and frontier market financing challenges:
  - Some emerging and frontier market economies face financing challenges that may tip some into debt distress or lead to financial instability and may require official support.
  - IMF financing support provided to member countries during the COVID-19 crisis: 80 countries to date.

### Policy response, market effects, and market signals
- Unprecedented policy response:
  - Central bank interventions stabilized key markets by lifting investor risk appetite through anticipated and actual central bank demand for safe and risk assets.
  - Many emerging market central banks engaged in asset purchases to stabilize local currency bond markets or ease domestic financial conditions.
  - Policy support has lessened near-term financial stability risks and bought time to address the health crisis, but prolonged support may have unintended consequences (stretched asset valuations, increased vulnerabilities).
- Financial conditions and yields:
  - Since the June 2020 GFSR Update, global financial conditions have remained accommodative.
  - Low interest rates and risk asset recovery supported easing in financial conditions; central bank measures have driven real yields down to historic lows.
  - Market-implied inflation expectations recovered since the March sell-off but remain slightly below pre–COVID-19 levels.
  - Estimated impact of US policy actions on emerging markets: roughly one-quarter to one-half of the decline in emerging markets’ long-term interest rates attributable to US policy actions since the COVID-19 sell-off.
- Equity markets, concentration, and volatility:
  - Equity rebound accompanied by concentration: five tech giants (AAPL, AMZN, GOOG, FB, MSFT) account for about 25 percent of total US market capitalization and have significantly outperformed the rest of the index since June 2020.
  - Decomposition of S&P 500 performance: negative contribution from deteriorating corporate earnings outlook was more than offset by a lower risk-free rate and compression of the equity risk premium.
  - Option-implied volatility (VIX) and realized volatility declined sharply in late March–April despite elevated economic uncertainty, reflecting improved funding and liquidity conditions after interventions.
  - Retail participation increased (example: trading on Robinhood tripled in March 2020 compared with March 2019); margin trading outstanding in China increased sharply.

### Credit markets and spread misalignments
- Yields and spreads:
  - Yields in credit markets declined due to lower risk-free rates and compression in credit spreads driven by policy support.
  - Much of the decline in US investment-grade corporate bond yields since March has been driven by policy support (model includes Federal Reserve balance sheet size, policy measures, swap line usage, etc.).
  - Most bond spreads appear too compressed relative to economic fundamentals across advanced and emerging markets (misalignment defined as difference between market- and model-based values scaled by standard deviation of monthly changes in spreads).
- Fund behavior and fixed‑income market stress:
  - Fixed-income funds experienced large outflows in March 2020; subsequent reversals occurred as markets recovered.
  - Mutual funds suspended a total of $62 billion year to date (reported by Fitch for 2020), equivalent to 0.11 percent of the sector’s total assets.
  - Funds facing large redemptions reduced liquid assets first but also sold less-liquid assets, contributing to price dislocations; central bank interventions helped limit what could have been larger-scale fire sales.
  - Average bid-ask spreads in sample portfolios nearly doubled overall and more than tripled temporarily for the most affected portfolios (sample of 323 fixed-income funds).
  - Policy recommendation: consider wider adoption of swing pricing and harmonized measurement of fund leverage.

### Solvency pressures, corporate borrowing, and households
- Corporate borrowing and liquidity relief:
  - Firms stepped up bond issuance and bank borrowing to cope with cash shortages, refinance debt, or build precautionary cash buffers.
  - Rapid bank credit expansion in H1 2020 reflected credit line drawdowns, government guaranteed loans, and lending under government-supported programs.
  - The share of firms that had to raise new debt because they could not generate enough cash to cover debt service rose sharply.
- Solvency risks and dependence on policy trajectory:
  - Increased net borrowing reduced immediate liquidity pressures but may deteriorate repayment capacity over the medium term.
  - Future defaults and bankruptcies depend critically on the pandemic trajectory and policymakers’ capacity to maintain accommodative funding conditions and fiscal support to viable firms.
  - SMEs face acute vulnerability due to thin equity cushions, low liquidity buffers, limited financing options, nondiversified revenues, and concentration in contact-intensive sectors; in Europe, SMEs account for more than half of total output and about two-thirds of employment.
- Household sector strains:
  - Unprecedented job losses, especially in the United States and in some emerging markets, reduced personal income and increased household indebtedness.
  - Delinquencies on US credit cards started to accelerate in Q1 2020; mortgage delinquencies remained low.
  - Real house price growth was positive in most advanced economies in Q1 2020; year-over-year real house prices declined in China and India but rose in other major emerging market economies.

### Commercial real estate, property markets, and sectoral shifts
- Commercial real estate developments:
  - CMBS issuance exceeded $100 billion in 2019.
  - Over 2009–19, commercial property asset valuations rose, on average, 4.5 percent a year.
  - COVID-19 impacts in 2020:
    - Global commercial property transactions slumped by about 50 percent in 2020:Q2 relative to 2019:Q2.
    - Retail and hospitality sales fell by 60 percent and 80 percent, respectively (panel 3).
    - Retail sector price index fell by about 18 percent and 23 percent in July year over year in the European Union and the United States, respectively (panel 4).
    - Funding costs increased sharply in mid-March 2020; spreads on BBB-rated CMBS and CMBS indices remained much higher in June relative to pre-pandemic levels.
    - Syndicated commercial real estate lending dropped by about 50 percent in North America, 70 percent in Europe, and 40 percent in Asia in 2020:Q2, year over year.
    - In the United States, 5.8 percent of CMBS loans were delinquent in 2020:Q2, an increase of more than 200 basis points relative to the previous year.
  - Rating agencies project CMBS default rates to more than double in 2020:Q3.

### Sovereign debt, fiscal impacts, and emerging market access
- Sovereign debt and fiscal outcomes:
  - COVID-19 is expected to push global public debt above 100 percent of GDP in 2020.
  - Public debt reached historic highs in most systemically important economies at end‑Q1 2020.
  - In 2020, headline fiscal deficits in advanced economies are expected to be five times higher than in 2019.
  - In the baseline scenario, public debt ratios are generally expected to stabilize in 2021, except in the United States and China.
  - Emerging markets will face greater fiscal challenges as debt service to tax revenue ratios are projected to rise.
  - Bank holdings of government debt have increased in most countries, tightening sovereign–bank linkages.
- Emerging and frontier market spreads and access:
  - COVID-19 pushed spreads of lower-rated economies to prohibitive levels, spotlighting large refinancing needs.
  - Country market-access indicator values (as shown):
    - Zambia: 136
    - Ethiopia: 112
    - Pakistan: 102
    - Angola: 57
    - Mozambique: 52
    - Kenya: 41
    - Cameroon: 36
    - Ghana: 34
    - Senegal: 24
    - Uganda: 15
    - Nigeria: 8
  - IMF staff capital-flows-at-risk findings:
    - Probability of outflows over the next three quarters fell from about 60 percent at the peak of market turmoil to about 25 percent in September.
    - Capital flows at risk (5th percentile) stands at –1.9 percent of GDP according to the latest assessment, compared with –3.3 percent of GDP on March 23 and realized portfolio outflows of almost 2 percent of GDP in 2020:Q1.
  - Frontier market economies face considerable financing challenges; the Group of Twenty debt service suspension initiative sought to help some 73 countries by temporarily stopping debt payments to official creditors.

### China: local government debt, LGFVs, and systemic linkages
- Key metrics and exposures:
  - Direct borrowing by local governments rose quickly to 24 percent of GDP.
  - Entities identifying as LGFVs in bond prospectuses have outstanding debt equivalent to 39 percent of GDP.
  - Net new credit to household and corporate sectors in 2020:H1 was equivalent to 18.26 percent of 2019 GDP.
  - Roughly 75 percent (RMB 26 trillion) of outstanding LGFV debt is likely unserviceable (net-debt-to-earnings ratio of more than 15 or negative earnings).
  - Local SOEs owe another RMB 10 trillion in similarly defined unserviceable debt.
- Implications:
  - If local governments assume unserviceable LGFV and SOE debt, it will more than double existing debt loads and increase by tenfold the debt owed by provinces with debt-to-revenue ratios above 400 percent.
  - Banks, as primary creditors to LGFVs and local SOEs, face potential asset quality deterioration and nonperforming loans, creating spillover risks to the banking sector.
- Policy priorities for China:
  - Strengthen intergovernmental fiscal coordination.
  - Introduce bank and corporate restructuring frameworks in line with international best practices.
  - Address gaps in financial supervision and regulation.

### Policy priorities, road map, and recommended focus
- Overarching policy emphasis:
  - Maintain accommodative monetary and financial conditions, credit availability, and targeted solvency support to sustain the recovery, facilitate structural transformation, and support transition to a greener economy.
  - As economies reopen, shift focus from liquidity provision to managing gradual reopening and supporting recovery while preparing exit strategies.
- Monetary and liquidity guidance across phases (Great Lockdown; Gradual Reopening under Uncertainty; Pandemic under Control):
  - Ease and then maintain monetary accommodation; withdraw or adjust unconventional measures and liquidity support gradually as conditions improve; maintain monetary policy accommodation until objectives are achieved.
  - Maintain liquidity support to markets and institutions during reopening but adjust pricing to incentivize market return; gradually withdraw support when pandemic is under control.
  - Provide liquidity support to alleviate stress and support credit flows; encourage banks to continue lending while maintaining prudential standards and timely recognition of loan losses (IFRS 9 expected credit loss framework).
- Fiscal, solvency, and restructuring measures:
  - Use targeted fiscal measures to help most vulnerable firms and individuals; tighten eligibility criteria over time to avoid debt overhang.
  - Extend repayment moratoria only if necessary; facilitate debt restructuring that reduces debt overhang or adjusts repayment schedules; provide solvency support to viable systemic firms and grants for smaller firms.
  - Prepare for medium-term fiscal costs of prolonged policy support and develop credible medium-term fiscal strategies.
- Financial sector reform and macroprudential priorities:
  - Strengthen regulatory frameworks for nonbank financial sector and step up prudential supervision to contain excessive risk taking in a lower-for-longer rate environment.
  - Consider adjustments to CCP operational frameworks to address procyclicality in margin calls.
  - Adopt more robust liquidity risk management for investment funds; consider wider adoption of swing pricing and harmonized leverage measures.
  - Create macroprudential space (releasable buffers) and consider loan-to-value and debt-to-income limits to prevent excessive risk taking in property markets.
- Preparations for exit and longer-term risks:
  - Central banks should consider unintended consequences of prolonged support (stretched valuations, increased vulnerabilities) and ensure strategies to manage exit risks.
  - Policymakers should plan for recapitalization, restructuring, or resolution of unviable firms and prepare for implications for banks, nonbank financial institutions, and sovereigns.
  - Adopt policies to manage climate-change-related risks (gradual carbon taxes, better disclosure, climate stress tests) and encourage digital investment and considered regulation of digital currencies.

_International Monetary Fund | October 2020_

### Chapter 1 at a Glance

### Chapter 1 at a Glance

### Global outlook and near-term risks
- Near-term global financial stability risks have been contained for now due to unprecedented and timely policy response that has helped maintain the flow of credit and avoid adverse macro-financial feedback loops, creating a bridge to recovery.
- Looking ahead, the expected rebound of 5.2 percent in global GDP growth next year implies the 2021 growth forecast distribution will shift back into positive territory.
- Nonetheless, significant downside risks remain:
  - The probability of global growth falling below zero in 2021 is close to 5 percent.
  - The 5th percentile (growth-at-risk) metric indicates risks are elevated by historical standards.

### Rising vulnerabilities
- Vulnerabilities have increased in:
  - The nonfinancial corporate sector, as firms have taken on more debt to cope with cash shortages.
  - The sovereign sector, as fiscal deficits have widened to support the economy.
- Corporate liquidity pressures could morph into insolvencies if the recovery is delayed:
  - SMEs are more vulnerable than large firms with access to capital markets.
  - The future path of defaults will be shaped by the extent of continued policy support and the pace of the recovery, which may be uneven across sectors and countries.
- While the global banking system is well capitalized overall, there is a weak tail of banks; some banking systems may experience capital shortfalls in the October 2020 World Economic Outlook adverse scenario even with currently deployed policy measures.
- Some emerging and frontier market economies face financing challenges that may tip some into debt distress or lead to financial instability and may require official support.

### Unprecedented policy response and effects on markets
- Central banks’ interventions have stabilized key markets by lifting investor risk appetite through both anticipated and actual central bank demand for safe and risk assets.
- Many emerging market central banks have, for the first time, engaged in asset purchases to stabilize local currency bond markets or to ease domestic financial conditions.
- Unprecedented policy support has lessened risks to financial stability and bought time for authorities to address the health crisis and contain its economic fallout, but these policies may have unintended consequences if maintained for an extended period (for example, contributing to stretched asset valuations or fueling financial vulnerabilities).
- Since the June 2020 GFSR Update, global financial conditions have remained accommodative on the back of continued policy support.
  - In advanced economies, low interest rates and a recovery in risk asset markets have supported further easing in financial conditions.
  - With nominal yields already at low levels, central bank measures have driven real yields down to historic lows.
  - Market-implied inflation expectations for the near to medium term have recovered since the March sell-off but remain slightly below pre–COVID-19 levels.
- In China, financial conditions have remained broadly stable over the summer; authorities initially cut policy rates and increased bank credit, then scaled back expectations for further interest rate reductions in May, leading to a rebound in bond and money market yields.

### Differentiation across sectors and markets
- The pandemic has hit some sectors harder than others:
  - More affected: airlines, hotels, energy, financials, and commercial real estate (notably through remote work reducing demand).
  - Less affected / outperforming: information technology, communications.
- Market signals:
  - Equity market indices with a larger share of less contact-intensive sectors have seen a stronger rebound.
  - Certain sectors—consumer services (hotels, restaurants, leisure), industrials (capital goods), and financials (banks)—have experienced large swings in their 2020–21 earnings per share forecasts, wide dispersion across analysts, and significant downgrades of long-term earnings per share growth forecasts.
- Stock market dynamics:
  - The disconnect between rising market valuations and weak economic activity persists despite the September correction in equity markets.
  - A decomposition of S&P 500 year-to-date performance shows a sharp deterioration in corporate earnings outlook contributed negatively, but this was more than offset by:
    - A lower risk-free rate (reflecting policy rate cuts).
    - A compression of the equity risk premium (boosting risk sentiment).
  - Sectoral composition and technical factors have driven differential performance; in the US, five tech giants (AAPL, AMZN, GOOG, FB, MSFT) account for about 25 percent of total market capitalization and have significantly outperformed the rest of the index since June 2020.

### Policy priorities and recommendations
- Continued policy support remains critical as economies reopen:
  - Accommodative monetary and financial conditions, credit availability, and targeted solvency support will be essential to sustain the recovery, facilitate necessary structural transformation, and support the transition to a greener economy.
- Post-pandemic financial reform agenda should prioritize:
  - Addressing fragilities unmasked by the COVID-19 crisis.
  - Strengthening the regulatory framework for the nonbank financial sector.
  - Stepping up prudential supervision to contain excessive risk taking in a lower-for-longer interest-rate environment.
- As central banks plan for eventual withdrawal of support, they should consider potential unintended consequences of prolonged policies (stretched asset valuations, increased vulnerabilities) and ensure strategies to manage exit risks.

*International Monetary Fund | October 2020*

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEW: BRIDGE TO RECOVERY

### Global equity markets: rebound, concentration, and valuation risks
- Markets rebounded on strong policy support, with clear differentiation across countries and sectors.
- A few large firms—Alphabet (Google), Amazon, Apple, Facebook, and Microsoft—have significantly outperformed the rest of the US stock market since the COVID-19 outbreak and dominate certain sectors (information technology, telecommunications, consumer discretionary) and have large international exposures.
- Decomposition and drivers:
  - Falling risk-free rates and equity premium compression supported equity performance despite drag from a weaker earnings outlook.
  - The S&P 500 decomposition uses a three-stage dividend discount model (Panigirtzoglou 2002).
- Valuation and misalignment signals:
  - IMF staff equity valuation models suggest overvaluations are at historically high levels in some countries (see Figure 1.6, panel 6).
  - Misalignment measure: difference between market- and model-based values scaled by the standard deviation of weekly returns; positive values indicate overvaluation.
  - Model relies on 12-month- and 18-month-ahead earnings forecasts and does not capture longer-term earnings growth expectations.
- Retail activity:
  - Retail participation increased in recent months in several markets; e.g., trading on Robinhood tripled in March 2020 compared with March 2019.
  - In China, margin trading outstanding increased sharply since last year.
- Key temporal anchors and indices referenced:
  - Price changes measured since February 19, 2020.
  - Indices: S&P 500, S&P 500 ex. top five, Russell 2000.

### Market volatility, uncertainty, and drivers of compressed volatility
- Despite elevated economic uncertainty, option-implied volatility (VIX) and realized market volatility declined sharply in late March–April, reflecting improved funding and liquidity conditions after policy interventions.
- Drivers of volatility dynamics:
  - VIX model includes macroeconomic fundamentals, funding and liquidity conditions, corporate performance, and external factors.
  - EPS dispersion is the standard deviation of EPS forecasts across analysts.
- Interpretation:
  - The disconnect between elevated economic uncertainty and compressed volatility narrowed during the September sell-off.
  - The extent of equity price misalignments can be interpreted as the portion of the equity risk premium unexplained by expected corporate earnings (mean EPS forecasts), EPS dispersion, term spreads, and interest rates.

### Credit markets: yields, policy support, and spread misalignments
- Yields in credit markets declined since the start of the pandemic due to lower risk-free rates and compression in credit spreads on the back of policy support.
- US investment-grade corporate bond yields decomposition (Figure 1.8, panel 1):
  - Model based on four groups of explanatory variables: economic (firm value) factors, uncertainty measures, leverage metrics, and policy support factors.
  - Policy support factors include: size of the Federal Reserve’s balance sheet; number of announced policy measures; dummy (0 before March 2020 and 1 thereafter); amount of the Federal Reserve US dollar swap lines used (flow); outstanding amount of the Federal Reserve US dollar swap lines (stock).
  - Estimates based on extreme bound analysis (Durham 2002).
  - Much of the decline in US investment-grade corporate bond yields since March has been driven by policy support.
- Bond spread misalignments:
  - Most bond spreads appear too compressed relative to economic fundamentals across both advanced and emerging markets.
  - Misalignment defined as difference between market- and model-based values scaled by the standard deviation of monthly changes in spreads; negative values indicate overvaluation.
  - Historical data go back to 1995 or earliest available; latest data through September 29, 2020.
- Emerging market transmission:
  - Rough estimates suggest US policy actions since the COVID-19 sell-off account for about one-quarter to one-half of the decline in emerging markets’ long-term interest rates.
  - In local currency bond markets, both conventional and unconventional policies, including asset purchases by emerging market central banks, helped push short rates and long-term yields lower.

### Rising global financial vulnerabilities and channels of risk
- Pre-existing vulnerabilities were elevated across several sectors—including asset management companies, nonfinancial firms, and sovereigns—across 29 jurisdictions with systemically important financial sectors (S29).
  - The S29 comprise: euro area economies (Austria, Belgium, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Finland, Spain); other systemically important advanced economies (Australia, Canada, Denmark, Hong Kong SAR, Japan, Korea, Norway, Singapore, Sweden, Switzerland, the United Kingdom, the United States); and systemically important emerging market economies (Brazil, China, India, Mexico, Poland, Russia, Turkey).
- Since the COVID-19 outbreak, vulnerabilities have continued to rise and may interact with triggers (new virus outbreaks, policy missteps, other shocks) to tip the economy into a more adverse scenario (see October 2020 WEO).
- Potential adverse macro-financial feedback loops:
  - Widespread bankruptcies could lead to repricing of credit risk, tightening of bank lending standards, and renewed sharp tightening of financial conditions.
  - Credit losses could deplete banks’ capital buffers; although the global banking system is well capitalized, a weak tail of banks exists and some banking systems may experience capital shortfalls in the adverse WEO scenario even with current policy measures.
  - Fragilities in the nonbank financial sector aggravated market dislocations during the March sell-off; central bank support limited fallout but did not eliminate fragilities.
  - Shrinking policy space could call into question public-sector capacity to backstop the private sector, especially where vulnerabilities are high and rising across several sectors.
  - External financing challenges for emerging and frontier markets may tip some into debt distress or financial instability.

### Solvency risks in the nonfinancial sector and policy mitigation to date
- Nonfinancial firms in many systemically important economies entered the COVID-19 recession with elevated vulnerabilities: the share of S29 economies with high or medium-high corporate sector vulnerabilities was already close to 80 percent (by GDP) before the pandemic (Figure 1.9).
- Cash flow shock:
  - After the outbreak, cash flows declined sharply; more vulnerable firms—those with weaker solvency and liquidity positions and smaller size—experienced greater financial stress in early stages of the crisis.
- Policy role to date:
  - Large and frontloaded policy support has so far avoided widespread bankruptcies.
  - However, borrowing to cope with cash shortages has shifted some solvency risks into the future; SMEs, especially in contact-intensive industries, are more vulnerable than large firms with capital markets access.

*Italic: International Monetary Fund | October 2020*

### Chapter 3). Taking advantage of the massive easing in

### Chapter 3). Taking advantage of the massive easing in

### Corporate borrowing, liquidity relief, and rising debt
- Firms in advanced and emerging market economies stepped up bond issuance and increased borrowing from banks to cope with cash shortages, refinance debt, or build precautionary cash buffers.
- Rapid expansion of bank credit in the first half of this year partly reflects sizable credit line drawdowns (especially in the United States), government guaranteed loans, and lending under government-supported programs.
- The share of firms that had to raise new debt because they could not generate enough cash to cover their debt service costs rose sharply.
- Without policy support facilitating such borrowing, nonfinancial firms would likely have faced a sharp rise in bankruptcies.
- The further expansion of corporate debt has added to already high debt levels in several economies.

### Corporate solvency, defaults, and credit quality
- Increased net borrowing reduced immediate liquidity pressures and mitigated an otherwise larger increase in defaults for now, but rising debt may deteriorate repayment capacity over the medium term, putting solvency at risk.
- Credit rating downgrades initially spiked and year-to-date speculative-grade defaults have risen quickly, particularly in the United States.
- Missed debt payments were reported as the leading cause of defaults in 2020 to date.
- Sectors most affected by the pandemic—air travel, retail, hospitality, and energy—have seen higher default rates.
- Largest increases in defaults have been among:
  - high-yield bond issuers,
  - leveraged loans,
  - middle-market loans.
- Defaults remain significantly lower than in 2008–09.
- The pace of defaults has recently slowed in the United States and remained relatively subdued in Europe.
- The range of speculative-grade default forecasts for 2021 by credit rating agencies is fairly wide, reflecting uncertainty about the pandemic and corporate credit quality.
- Credit market pricing suggests a more sanguine picture, likely reflecting expectations of continued policy support.

### Dependence on pandemic trajectory and policy support
- Future defaults and bankruptcies will critically depend on:
  - the evolution of the pandemic,
  - policymakers’ capacity to maintain accommodative funding conditions,
  - continued fiscal support to viable firms (see the October 2020 Fiscal Monitor).
- Large firms with access to capital markets can likely avoid significant erosion of equity positions unless funding conditions tighten significantly.
- SMEs are much more vulnerable because they tend to have:
  - thin equity cushions,
  - low liquidity buffers (lack of precautionary credit lines and liquid and noncore assets),
  - limited financing options,
  - nondiversified revenues,
  - concentration in contact-intensive sectors (hotels, restaurants, entertainment).
- Widespread insolvencies among SMEs could have significant direct macroeconomic impact and adverse implications for banking sector health; in Europe, SMEs account for more than half of total output and about two-thirds of employment.
- Because SMEs rely almost entirely on bank financing, they could be a source of vulnerability, especially for regional and small banks.

### Household sector strains
- The COVID-19 pandemic resulted in unprecedented job losses, especially in the United States and in some emerging market economies with more limited unemployment support.
- With sharply reduced personal income, household indebtedness has risen to cover lost income, weakening future debt servicing capacity.
- The new buildup of debt is occurring on top of already elevated household leverage in a number of major economies.
- Historically, higher unemployment portends more delinquencies and larger bank losses on unsecured consumer credit.
- Delinquencies on US credit cards started to accelerate in the first quarter of this year, whereas mortgage delinquencies remain low.
- Real house price growth was positive in most advanced economies in the first quarter, supported by lower mortgage rates and moratoriums on interest payments, foreclosures, and evictions.
- In emerging market economies, year-over-year real house prices declined in China and India but continued to rise in other major economies.

### Banking sector resilience and downside risks
- Banks entered the COVID-19 crisis with significantly stronger capital and liquidity buffers than at the time of the global financial crisis.
- Policies supporting borrowers and encouraging use of regulatory flexibility have likely supported banks’ willingness to provide credit.
- Some banks in certain countries have started tightening lending standards in response to deteriorating economic and borrower conditions.
- A forward-looking bank solvency analysis (Chapter 4) based on the October 2020 WEO baseline and adverse scenarios, accounting for announced policies, indicates:
  - In the baseline scenario, most banks can absorb losses and maintain capital buffers above minimum regulatory capital requirements.
  - In the adverse scenario (deeper recession and weaker recovery), there is a sizable weak tail of banks whose capital falls below regulatory minimum.
  - Global systemically important banks tend to fare better; banks in emerging markets appear less resilient than peers in advanced economies.
- In the October 2020 WEO adverse scenario:
  - Capital shortfall relative to minimum capital requirements is about $110 billion.
  - Overall capital shortfall relative to broad capital requirements could reach $220 billion, after accounting for policy support.
  - The average capital shortfall in the adverse scenario is close to 1 percent of GDP.
  - For comparison, the median government bank recapitalization during the global financial crisis was about 3.6 percent of GDP.
- The full fiscal cost of ensuring adequate bank capitalization must include direct fiscal support to firms and households, which reduced ex ante bank recapitalization needs but may limit future fiscal capacity.
- A more severe adverse scenario with larger banking losses cannot be ruled out given uncertainty about the recession’s depth and duration.
- Regulatory reference: the regulatory minimum cited is the “Pillar 1” requirement—4.5 percent of risk-weighted assets—plus mandatory buffers required of each global systemically important bank (GSIB buffer).

### Fragilities in nonbank financial institutions
- Asset managers in advanced economies entered the pandemic with elevated vulnerabilities, including sizable liquidity mismatches.
- After the outbreak:
  - Asset managers faced increased credit risk and became more interconnected with banks.
  - Exposures through investment positions (including bank deposits and money market fund shares) have risen.
  - Borrowing from banks increased as funds tapped credit lines.
- Increased credit risk and higher leverage in other financial institutions could lead to larger potential losses in renewed market stress.
- During the March sell-off, fixed-income funds experienced surge in redemptions, creating selling pressures and revealing weaknesses in market infrastructures and dealers’ intermediation capacity; jurisdictions with swing pricing saw less price pressure from redemptions.
- Fund flows have broadly recovered with the asset market rebound supported by policy action.
- Insurance companies and pension funds experienced portfolio losses in the March sell-off but have seen portfolio values recover.
- Risks from nonbank financial institutions looking forward include:
  - portfolio rebalancing in response to investor redemptions and market losses,
  - pulling back from certain markets,
  - sizable credit losses in riskier credit market segments (leveraged loans and private debt) that could lead nonbank institutions to step back from providing credit, exacerbating borrower strains and worsening macro-financial outcomes.
- Existing fragilities could have significant implications for the financial system if market stress is prolonged or policy support proves insufficient.
- Noted elevated liquidity mismatches in the asset management sector, especially in some fragile segments.

_International Monetary Fund | October 2020_

### Box 1.2) shows that fixed-income funds facing large

### ch1 - Box 1.2) shows that fixed-income funds facing large

### Fund liquidity dynamics and market effects
- Fixed-income funds facing large redemptions reacted primarily by reducing liquid assets, but also by selling less-liquid assets.
- The sell-off of riskier assets contributed to price dislocations in the underlying markets and could have resulted in larger-scale fire sales had central banks not intervened quickly to backstop the key segments of the financial system.
- Central bank interventions have masked but not eliminated the pressure points; a more prolonged liquidity shock in the future could potentially lead to larger-scale fire sales.
- During the March 2020 sell-off, fixed-income funds experienced large outflows, which have subsequently reversed (panel evidence referenced).

### Leverage, volatility-targeting strategies, and investor behavior
- Volatility-targeting investors that were reportedly forced to liquidate their positions during the March turmoil may have already started to releverage as equity and bond volatility normalized following central bank interventions.
- Volatility-targeting strategies seek to keep expected portfolio volatility to a specific target level. Lower market volatility then means that greater financial leverage is needed to meet volatility targets.
- Among volatility-targeting related investors, variable annuity funds are the largest, at an estimated $0.5 trillion in assets under management, and are more likely to deleverage quickly when volatility spikes.
- A rapid increase in financial leverage could contribute to asset price misalignments and increase the risk of a sharp unwinding of positions by leveraged investors during volatility spikes, amplifying asset price declines.

### Cross-asset correlations and diversification
- Correlations across risk assets remain well above the 2008–09 levels (Figure 1.15, panel 2).
- Higher correlations tend to reduce portfolio diversification opportunities and could therefore increase contagion risk and propagate losses across investor portfolios during abrupt price corrections.
- Increased central bank presence in a number of markets may be partly driving rising correlations.

### Nonbank financial sector fragilities and linkages
- Asset managers’ vulnerabilities remain elevated in China, the euro area, and the United States, and grew in OFIs in other advanced economies.
- Fragilities in the nonbank financial sector remain elevated and may lead to larger-scale distress and fire sales in a more prolonged episode of market stress.
- Increased linkages between nonbank financial institutions and banks imply that fragilities could spread more easily through the financial system.
- Looking ahead, a prolonged period of low interest rates and high cross-asset correlations may pose further challenges for institutional investors, whereas a widely held belief that central banks will continue to suppress volatility may incentivize investors to take on more risk and increase financial leverage to boost their returns.

### Sovereign debt, fiscal impacts, and sovereign-linked vulnerabilities
- The COVID-19 crisis is expected to push global public debt above 100 percent of GDP in 2020, the highest ever.
- Public debt reached historic highs in most systemically important economies at the end of the first quarter of 2020.
- In 2020, headline fiscal deficits in advanced economies are expected to be five times higher than in 2019.
- In the baseline scenario, public debt ratios are generally expected to stabilize in 2021, except in the United States and China.
- Emerging market economies will face greater fiscal challenges, as their ratios of debt service to tax revenue are projected to rise.
- Because private sector financing costs are linked to the sovereign risk premium, central banks in emerging market economies where sovereign debt levels are already high may face greater challenges in easing financial conditions when they need to cushion the impact of an adverse shock.
- Sovereigns may be facing a sharp rise in contingent liabilities; 6 out of S29 jurisdictions now show elevated vulnerabilities in the corporate, banking, and sovereign sectors.
- Bank holdings of government debt have increased in most countries, tightening sovereign-bank linkages.

### Emerging and frontier market financing conditions
- Local currency government bond issuance picked up pace as the global backdrop improved and domestic financial conditions in many economies eased; several emerging market economies (Chile, Colombia, Thailand) have managed to fund large portions of their projected deficits for 2020–21, but many other economies still face significant financing requirements.
- Concerns about future debt supply and weak domestic fundamentals have curtailed demand by nonresident investors, and portfolio flows into local currency bond funds remain weak since the COVID-19 sell-off.
- Many emerging markets (India and Mexico, among others) have delayed new local debt issuance to the second half of the year; some have increased reliance on foreign currency debt, whereas elsewhere (Indonesia, Poland) central banks have purchased bonds in the secondary market.
- Aggregate portfolio flows to emerging markets have recovered since February–April 2020, driven primarily by hard currency bond issuance, though more than half of emerging market economies have continued to experience outflows over the past three months.
- IMF staff analysis based on the capital-flows-at-risk methodology shows an improvement in the short- and medium-term outlook:
  - The probability of outflows over the next three quarters fell from about 60 percent at the peak of market turmoil (black line in Figure 1.17, panel 3) to about 25 percent in September (red line in Figure 1.17, panel 3), though still above the pre–COVID-19 level.
  - The capital flows at risk (measured as the 5th percentile of the distribution) stands at –1.9 percent of GDP according to the latest assessment, which compares with –3.3 percent of GDP on March 23 and realized portfolio outflows of almost 2 percent of GDP in 2020:Q1.
- Frontier market economies face considerable financing challenges; the COVID-19 shock pushed borrowing costs for many of these economies to prohibitive levels.
- The Group of Twenty debt service suspension initiative sought to help some 73 countries deal with financing pressures by allowing them to temporarily stop debt payments to official creditors.
- Many low-income countries with marketable debt have large rollover needs despite recent improvements in market conditions.

### Policy priorities and recommended focus
- As the economic recovery takes hold, the policy focus should shift from dealing with liquidity pressures to managing a gradual reopening of the economy and supporting the recovery.
- Policy Priorities during Gradual Reopening Under Uncertainty:
  - The priority is to ensure that policy support is maintained for the recovery to take hold and become sustainable.
  - Monetary accommodation should be maintained. After aggressively cutting policy rates early in the crisis, most advanced economies are now facing effective lower bounds for conventional monetary policy, though there is still room for further policy cuts in many emerging markets.
- Swift policy actions have mitigated risks to nonbank financial institutions during the March sell-off, but fragilities remain elevated and may require continued vigilance and targeted policy measures to prevent amplification into broader financial stress.

*Source: IMF staff summary of text in the October 2020 Global Financial Stability Report chapter content provided.*

### 1. Hard Currency Bond Spreads

### 1. Hard Currency Bond Spreads

### Emerging and Frontier Market Spreads and Market Access
- Figure referenced: Figure 1.18. Emerging and Frontier Market Economy Spreads and Market Access (Jan. 2020–Oct. 20).
- Data sources: Bloomberg Finance L.P.; World Bank Debtor Reporting System; and IMF staff calculations.
- Note: EMBI = JP Morgan Emerging Markets Bond Index; IG = investment grade.
- Country market-access indicators listed (numbers as shown):
  - Zambia: 136
  - Ethiopia: 112
  - Pakistan: 102
  - Angola: 57
  - Mozambique: 52
  - Kenya: 41
  - Cameroon: 36
  - Ghana: 34
  - Senegal: 24
  - Uganda: 15
  - Nigeria: 8

### Key Observations on Spreads and Refinancing Needs
- The COVID-19 pandemic pushed spreads of lower-rated economies to prohibitive levels, bringing into focus the large refinancing needs of several frontier market economies.

### Monetary and Financial Policy Road Map (Policy Areas across Phases)
- Table referenced: Table 1.1. Monetary and Financial Policy Road Map
- Phases: Great Lockdown; Gradual Reopening under Uncertainty; Pandemic under Control.
- Monetary Policy:
  - Great Lockdown: Ease monetary policy, including use of unconventional monetary policy tools.
  - Gradual Reopening under Uncertainty: Maintain monetary policy accommodation.
  - Pandemic under Control: Maintain monetary policy accommodation until the policy objectives (for example, inflation target) are achieved.
- Liquidity Support to Core Funding Markets:
  - Great Lockdown: Provide support to maintain market functioning and liquidity.
  - Gradual Reopening: Maintain support, but adjust pricing as appropriate to incentivize and prepare the ground for exit from use of central bank facilities.
  - Pandemic under Control: Gradually withdraw support, as warranted.
- Liquidity Support to Financial Institutions:
  - Great Lockdown: Provide support to alleviate liquidity stress and support monetary policy accommodation.
  - Gradual Reopening: Maintain support, but adjust pricing as appropriate to incentivize the return to normal market funding.
  - Pandemic under Control: Maintain liquidity support only as required to support monetary policy accommodation.
- Measures to Maintain the Flow of Credit:
  - Great Lockdown: Release macroprudential buffers, allow the use of capital and liquidity buffers, and apply regulatory flexibility as appropriate.
  - Gradual Reopening: Continue allowing the use of capital and liquidity buffers; suspend distribution of banks’ profits (dividend payouts and share buybacks); provide financing support to households and businesses.
  - Pandemic under Control: Rebuild capital and liquidity buffers gradually over time while ensuring continued financial institutions’ capacity to extend credit.
- Measures to Address Problem Assets:
  - Great Lockdown: Provide guidance on asset classification and provisioning.
  - Gradual Reopening: Maintain prudential standards to incentivize the recognition and handling of problem assets.
  - Pandemic under Control: Require banks to develop credible plans to reduce problem assets over an appropriate period of time; handle weak banks that experience significant credit losses; foster the development of markets for distressed assets.
- Financing Support to Business:
  - Great Lockdown: Provide credit guarantees (or other risk mitigation) and term funding to support new lending.
  - Gradual Reopening: Maintain financing support if containment measures are reintroduced, but tighten eligibility criteria to better target illiquid but solvent firms.
  - Pandemic under Control: Withdraw unwarranted support.
- Debt Restructuring for Businesses and Households:
  - Great Lockdown: Introduce repayment moratoria.
  - Gradual Reopening: Extend repayment moratoria only if necessary to prevent widespread insolvencies; facilitate debt restructuring that reduces debt overhang and/or adjust repayment schedule; provide solvency support to viable systemic firms; grants for smaller firms; ensure efficient out-of-court agreements with fast-track procedures.
  - Pandemic under Control: Facilitate debt restructuring that reduces debt overhang.

### Liquidity Support, Central Bank Actions, and Bank Lending
- Some emerging market central banks launched asset purchase programs to stabilize local markets and ease financial conditions; in some cases purchases facilitated financing of government deficits—transparency and clear communication are crucial to minimize risks to central bank credibility and perceptions of monetary financing.
- The necessary liquidity support to financial markets and institutions should be maintained; a number of backstops remain in place.
- Many central bank programs were designed to provide support at prices attractive in stressed markets but at a premium in normal conditions, creating incentives for financial institutions to return to markets as funding conditions normalize.
- Banks should be encouraged to continue lending while maintaining prudential and accounting standards for loan classification and provisioning.
  - Timely and reliable recognition of loan losses based on the expected credit loss framework (under International Financial Reporting Standard 9) is essential.
  - Country authorities may want to delay the impact of additional provisions on regulatory capital, with adequate disclosure of fully loaded capital positions.
  - Supervisors should provide guidance on treatment of restructured loans, including those resulting from moratoria on loan repayments.
  - Guidance should address the usabiliy of bank buffers and the optimal pace of rebuilding buffers once recovery becomes sustainable.

### Solvency, Debt Restructuring, and Official Support
- Policymakers should develop effective strategies to deal with corporate and household solvency pressures; liquidity support can provide only temporary relief.
- Financing support increases indebtedness; firms and households may still face financing difficulties after moratoria are lifted.
- Solvency support examples:
  - Support for firms deemed strategic or systemic to mitigate macro-financial consequences.
  - Grants for SMEs in some countries to protect employment and support viable firms.
- Emerging and frontier market economies facing financing difficulties may require official support given deteriorating public finances and shallow domestic markets.
  - IMF has proactively provided financing support to member countries during the COVID-19 crisis (80 countries to date).
  - Public debt may become unsustainable in some countries, requiring debt restructuring with international creditors to safeguard macro-financial stability.

### Policy Responses if Recovery Is Delayed
- Be prepared to scale up liquidity support in a more targeted manner if the economic outlook deteriorates (for example, due to new outbreaks).
- Targeted fiscal measures should be used to help the most vulnerable firms and individuals; eligibility criteria should be gradually tightened to target viable firms and avoid debt overhang.
- Moratoria on repayments should be extended only if necessary to prevent widespread insolvencies.
- Monetary policy may have to be eased further as needed to support credit flow; emergency lending and unconventional monetary policy easing may be reactivated or expanded depending on country circumstances.
- Policymakers should provide solvency support (targeted transfers, tax relief, scaled-up support to viable systemic firms).

### Policy Priorities Once Pandemic Is Under Control
- Monetary policy accommodation should be maintained until central bank objectives are achieved; expectations of continued low inflation and a pronounced decline in real interest rates may prompt adjustments to monetary policy frameworks and communications.
- Liquidity support should be withdrawn as warranted once conditions improve; term funding to banks may be maintained as needed to support credit flows.
- Prolonged central bank support may distort price discovery, encourage excessive risk taking, and delay necessary business restructuring and balance-sheet correction.
- Banks should be encouraged to proactively clean up nonperforming loans; banks with high levels of nonperforming loans should develop and implement credible action plans. Supervisors may consider suspending automatic triggers for corrective actions and require credible capital-restoration plans instead.
- Policymakers should develop strategies to deal with private debt overhang:
  - Recapitalization for viable firms (equity-like support may be preferable to liquidity support).
  - Restructuring for firms facing structural challenges; develop simplified, standardized procedures to facilitate out-of-court restructuring agreements.
  - Resolution for unviable firms; foster development of markets for distressed assets to facilitate disposal.
- Prepare for implications of corporate and household insolvencies for banks, nonbank financial institutions, and sovereigns:
  - Ensure banks have credible recovery strategies and contingency plans.
  - Use resolution tools as necessary.
  - Develop credible medium-term fiscal strategies to ensure debt sustainability given potential fiscal costs of prolonged policy support.
- Adopt policies to manage climate-change-related risks: gradual and well-communicated implementation of carbon taxes, better disclosure, and increased use of climate stress tests.
- Encourage greater digital investment to enhance financial sector efficiency and inclusion; digital currencies could offer efficiency gains in cross-border payments but must be carefully regulated.

### Post-Pandemic Financial Reform Agenda
- Strengthen the regulatory framework for the nonbank financial sector and step up prudential supervision to curb excessive risk taking in a lower-for-longer interest rate environment.
  - Adjust operational frameworks for central counterparty clearing houses (CCPs) to address procyclicality in margin calls and ensure counterparties can anticipate and prepare for them.
  - Adopt a more robust liquidity risk management framework for investment funds (International Organization of Securities Commissions 2018); consider tools to manage redemptions and identify risks early.
  - Consider the usability of liquidity buffers in crisis times for nonbank sectors.

*Source: IMF staff; excerpted from Chapter 1, Global Financial Stability Report: Bridge to Recovery, International Monetary Fund | October 2020.*

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY

### Commercial real estate: recent developments and risks
- CMBS issuance recovered since the global financial crisis, with the total volume exceeding $100 billion in 2019.
- Over 2009–19, commercial property asset valuations rose, on average, 4.5 percent a year to reach historical highs in several economies.
- Capitalization rates fell to their lowest levels in recent years.
- COVID-19 impacts in 2020:
  - Global commercial property transactions slumped by about 50 percent in 2020:Q2 relative to 2019:Q2.
  - Within the sector, retail and hospitality sales fell by 60 percent and 80 percent, respectively (panel 3).
  - The retail sector price index fell by about 18 percent and 23 percent in July year over year in the European Union and the United States, respectively (panel 4).
  - Funding costs increased sharply in mid-March 2020; spreads on BBB-rated CMBS and CMBS indices remained much higher in June relative to pre-pandemic levels (panel 5).
  - Syndicated commercial real estate lending dropped by about 50 percent in North America, 70 percent in Europe, and 40 percent in Asia in 2020:Q2, year over year.
  - In the United States, 5.8 percent of CMBS loans were delinquent in 2020:Q2, an increase of more than 200 basis points relative to the previous year.
- Outlook and vulnerabilities:
  - Rating agencies project CMBS default rates to more than double in 2020:Q3, indicating continued pressure.
  - Structural shifts (increased e-commerce, work-from-home) may reduce demand for retail and office space and induce sustained volatility.
  - Given banks’ exposure—commercial real estate loans constituting large shares of lending in some jurisdictions—these developments could amplify macro-financial instability.

### Investment funds and fixed‑income fund behavior during March 2020 market turmoil
- Liquidity and flows:
  - Fixed-income and nongovernment money market funds experienced intense withdrawals in March 2020; market liquidity of securities held by fixed-income funds deteriorated substantially.
  - Average bid-ask spreads of securities in sample portfolios nearly doubled overall and more than tripled temporarily for the most affected portfolios (based on a sample of 323 fixed-income funds).
  - Mutual funds suspended a total of $62 billion year to date (Fitch reported for 2020), equivalent to 0.11 percent of the sector’s total assets.
- Fund responses to outflows:
  - Afflicted funds used liquidity buffers and sold liquid assets such as cash, cash equivalents, and US Treasuries to cover redemptions.
  - Funds receiving inflows hoarded cash and delayed investments.
  - Some funds purchased assets at high bid-ask spreads, using cash reserves to take advantage of illiquidity discounts.
  - Funds anticipating more redemptions reduced corporate bond exposures.
- Market impact of fund sales:
  - Assets sold most heavily by funds facing large redemptions saw larger increases in bid-ask spreads and larger cumulative returns declines in March 2020 than assets not facing such selling pressure.
  - Funds’ sales of liquid assets likely contributed to price pressures and liquidity strains in fixed-income markets; sales of corporate bonds may have amplified credit market dislocations.
  - Some funds—even those with large outflows—absorbed relatively illiquid assets and thus mitigated price pressures.
- Fragilities revealed:
  - Selling liquid assets first can intensify liquidity mismatch if market conditions do not improve.
  - Weakened liquidity profiles of funds facing outflows make them more susceptible to future redemption or valuation shocks.
  - Feedback loops between fund redemptions, asset sales, price dislocations, and investor sensitivity to performance could have led to larger-scale fire sales absent rapid central bank asset purchases and liquidity facilities.
- Policy and regulatory recommendations:
  - Consider a comprehensive review of prudential tools in the investment fund sector.
  - A wider adoption of swing pricing would be advisable to help contain redemptions, particularly in jurisdictions with sizable asset management sectors; implementation will likely need to be phased in over time and require modifications to operational infrastructure.
  - An internationally harmonized measurement of leverage in investment funds (International Organization of Securities Commissions 2019) should help timely recognition and mitigation of financial stability risks.
  - Data limitations prevented granular analysis of swing pricing effectiveness for March 2020; existing evidence (Jin and others 2019) supports effectiveness in stress periods for some funds.

### Macroprudential policy to curb excessive risk taking
- Rationale:
  - With market participants anticipating interest rates to remain very low for the foreseeable future, investor search for yield is likely to resume and may lead to excessive risk taking.
  - Existing balance sheet weaknesses mean a further buildup of leverage in the post-pandemic world should be contained.
- Recommended measures:
  - Strengthen macroprudential frameworks to ensure adequate capital and liquidity buffers in banking systems.
  - Contain excessive risk taking in the nonbank financial sector.
  - Create macroprudential space (releasable buffers) that can be used to cushion adverse shocks; prudential authorities could implement measures such as loan-to-value ratio and debt-to-income ratio limits to prevent excessive risk taking that could inflate property prices, including in commercial real estate.
  - The ECB emphasized creating macroprudential space in the form of releasable countercyclical capital buffers (CCyBs) to help sustain credit in a downturn.

### China: local government debt, LGFVs, and systemic linkages
- Recent trends and exposures:
  - Direct borrowing by local governments was first permitted in 2015 and has risen quickly to 24 percent of GDP, significantly outpacing growth in local government tax revenues.
  - Entities identifying as LGFVs in bond prospectuses have outstanding debt equivalent to 39 percent of GDP.
  - Direct borrowing growth accelerated during the COVID-19 crisis as a key funding source for macroeconomic countercyclical measures, including investment, spending, and bank recapitalization.
- Market sensitivity and spillovers:
  - Bond market credit spreads for LGFVs and lower-rated non-LGFVs are sensitive to provinces’ direct government indebtedness; LGFVs in provinces with weaker finances have seen credit spreads widen and overall debt growth slow or contract.
  - Province-level bond market credit spreads for lower-rated non-LGFV firms showed sharply increased differentiation based on government direct debt loads in 2019.
  - Net new credit to the household and corporate sectors in H1 2020 was equivalent to 18 percent of 2019 GDP, but 40 percent of that increase occurred in just three provinces; provinces with worse debt-to-revenue ratios saw significantly weaker credit impulses than the national average.
- Debt sustainability concerns:
  - Roughly 75 percent (RMB 26 trillion) of outstanding LGFV debt is likely unserviceable, defined as owed by LGFVs with a net-debt-to-earnings ratio of more than 15 or negative earnings.
  - Local SOEs owe another RMB 10 trillion in similarly defined unserviceable debt.
  - If local governments assume this unserviceable debt, it will more than double existing debt loads and increase by tenfold the debt owed by provinces with debt-to-revenue ratios above 400 percent.
- Financial stability risks and policy priorities:
  - A large proportion of LGFV and local SOE debt being unserviceable implies significant further deterioration in local fiscal backstops.
  - Banks, as primary creditors to LGFVs and local SOEs, face potential asset quality deterioration and nonperforming loans, which could generate large negative spillovers to the banking sector.
  - Key priorities include:
    - Strengthen the intergovernmental fiscal coordination framework.
    - Introduce bank and corporate restructuring frameworks in line with international best practices.
    - Address remaining gaps in financial supervision and regulation.

*Source: CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY, International Monetary Fund | October 2020*

### Box 1.3. Interlinkages among Local Government, Corporate, and Bank Vulnerabilities in China

### Box 1.3. Interlinkages among Local Government, Corporate, and Bank Vulnerabilities in China

### Key findings and observed linkages
- Direct local government debt has been rising faster than indirect debt incurred via local government financing vehicles (LGFVs), outpacing growth in local tax revenues.
- Bigger government debt loads may weaken backstops for local firms, resulting in increased credit risk premiums and deleveraging for firms with weaker stand-alone debt servicing capacity.
- Policy-driven credit growth acceleration in response to the COVID-19 pandemic has disproportionately benefited provinces with more manageable government debt loads.
- Much of the LGFV and local SOE debt local governments are exposed to is unserviceable, implying significant further deterioration in backstops.

### Definitions and measurement notes
- LGFV debt in panel 1 is based on financial statements of 1,852 firms with bonds designated as urban investment vehicle bonds.
- 2020:H1 LGFV total borrowing is estimated as the 2020:Q1 level multiplied by the 2020:Q1 quarterly growth rate.
- In the top chart of panel 2, each line is a quintile of provinces based on equally weighted ranking of fiscal deficit and debt-to-GDP ratio.
- Borrowing cost measures are based on weighted average bond coupons.
- In the bottom-right chart of panel 2, change is the 2019 average minus the 2018 average.
- In panel 4, unserviceable debt is defined as debt held by firms with a net debt to EBIT ratio above 15 (or negative earnings). Consolidated firm earnings are added to local government revenues.
- Abbreviations: EBIT = earnings before interest and taxes; LG = local government; LGFV = local government financing vehicle; SOE = state-owned enterprise.

### Quantitative signals and chart annotations (preserved exactly as shown)
- Total 2020:H1 new credit/2019 GDP: 18.26%
- Regression/equation shown: y = –0.0219x + 19.893
- R-squared values shown: R^2 = 0.3473; R^2 = 0.3808; R^2 = 0.1885
- Label: Debt/GDP (2019, percent)

### Implications for financial stability
- Rising direct local government borrowing relative to indirect LGFV borrowing, combined with taxation growth lagging, increases sovereign–corporate vulnerability transmission channels.
- High shares of unserviceable LGFV and local SOE debt (per the net debt to EBIT > 15 or negative earnings definition) indicate significant contingent liabilities for local governments and potential stress for banks and bond markets exposed to those issuers.
- The asymmetric allocation of 2020:H1 policy-driven credit extension toward provinces with lower debt burdens may temporarily mitigate stress in those provinces but could leave higher-debt provinces with deteriorating firm backstops and wider credit spreads.

*Source: IMF staff calculations and underlying data as presented in Box 1.3, Chapter 1.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/ch1.pdf_