## Global Financial Stability Report—COVID-19, Crypto, and Climate: Navigating Challenging Transitions (October 2021) ## Source details **Canonical URL:** [Global Financial Stability Report—COVID-19, Crypto, and Climate: Navigating Challenging Transitions (October 2021)](https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2021/october/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2021/october/english/text.pdf.json) --- ### Preface and scope - Reflects information available as of September 27, 2021; benefited from comments following discussions on September 28, 2021. - Overarching thematic focus: COVID-19, Crypto, and Climate ("the 3Cs"). - Purpose: assess key vulnerabilities in the global financial system and highlight policies to mitigate systemic risks and support sustained economic growth. ### Macro-financial outlook and key risks - Financial conditions and yields: - Financial conditions eased further in advanced economies and remained easy on balance in emerging markets. - After declining through the summer, global long-term yields rose in late September, in some countries entirely reversing earlier moves. - US 10-year nominal yields rose more than 80 basis points through the end of March, then dropped as much as 55 basis points in the summer; through late September, US 10-year yields were only 27 basis points lower since the April 2021 GFSR. - The Federal Reserve’s end-2023 projection of the policy rate is at 1 percent. - Inflation and monetary policy: - Risks to the inflation outlook appear skewed to the upside in many countries. - Market-implied probability of US inflation being greater than 2 percent over the next five years is more than 80 percent. - Inflation has risen about 1.5 percentage points above the median emerging market central bank target. - Central banks should provide clear forward guidance and remain ready to act if price pressures prove persistent. - Vulnerabilities from prolonged easy conditions: - Prolonged extremely easy financial conditions may produce overly stretched asset valuations and fuel financial vulnerabilities; a sudden repricing of risk could tighten financial conditions and put medium-term growth at risk. - Corporate, banking, and nonbank sectors: - Corporate balance sheets have strengthened overall; revenues and profitability have risen in many economies. - With removal of fiscal and regulatory support, insolvency may rise in some countries. - Banks have remained resilient overall, with a weak tail in some countries. - Non-bank financial intermediary sector exhibits vulnerabilities exposed by the pandemic that need urgent attention. ### Executive-summary highlights and metrics - Overall assessment: - Financial stability risks contained so far due to policy support and economic rebound; investor concerns about recovery strength and rising infections increased over summer. - The balance of risks to growth in 2022 is expected to remain skewed to the downside. - The probability of growth falling below zero next year is estimated at about 4 percent. - Notable statistics and signals: - Sustainable fund sector AUM: $3.6 trillion at end-2020; climate funds: $130 billion. - Crypto market dynamics: 40% decline in May and 3× YTD increase until early May (Figure 12 referenced). - 90% confidence interval referenced in analyses of EM term premia response to the US real yield rise. ### Policy guidance summarized - Monetary policy: - Provide clear forward guidance to avoid unwarranted tightening and minimize market volatility; act decisively if inflation expectations unanchor. - Fiscal policy: - Continue support for vulnerable firms and individuals; where space exists, target measures and shift from emergency support toward transformation as recovery allows. - Financial regulation: - Prioritize establishing a sound regulatory framework for crypto assets and decentralized finance; level playing field and special attention to stablecoins. - Strengthen oversight and resilience of the nonbank financial sector, including investment funds and life insurers. - Climate finance and disclosure: - Strengthen data, disclosure, and sustainable finance classifications to assess transition risks and prevent greenwashing. - Mobilize public and private investment to achieve net-zero carbon emissions by 2050. ### Chapter 1 — Global financial conditions and systemic vulnerabilities - Financial conditions evolution: - Global financial conditions eased further since April 2021, driven by slightly lower interest rates and rising corporate and housing valuations, particularly in the United States. - Rates, term premia, and inflation signals: - Term premia have fallen, on net, since April 2021; five-year–five-year forward real yields in the United States are down 60 basis points. - Five-year inflation breakevens in the United States and euro area moved within a relatively tight range since April 2021. - Emerging markets and spillovers: - Local currency government bond yields for most emerging markets have risen year to date and remain elevated. - Market pricing: median two-year forward policy rate for emerging markets is currently at 4.7 percent compared with 3.3 percent at the time of the April 2021 GFSR. - IMF staff analysis: emerging market term premia could rise by almost 140 basis points over 16 weeks in the event of a 100 basis point rise in US 10-year real yields following a hawkish surprise. - Capital flows and China’s role: - Capital flows at risk (5th percentile) declined from 2.1 percent of GDP at end-2020 to 1.7 percent of GDP. - Emerging market sovereign hard currency issuance reached a record cumulative $250 billion. - Inclusion of China in global benchmark indices estimated inflows of $180 billion since 2020; cumulative local currency flows to China year to date: $50 billion. - Banking, loan growth, and credit supply: - Bank loan underwriting standards remain restrictive in many countries; consensus analyst loan growth forecasts are generally below “GDP-consistent” loan growth under the analysis assumptions. ### Key risks and sectoral findings (Chapter 1 excerpts) - Asset valuations and sectoral strains: - Equity price misalignments relative to fundamentals remain elevated in most markets; credit spreads narrowed to below pre-pandemic levels. - House prices rose rapidly in many countries; worst-case estimated house price declines over next three years: Advanced economies: −14 percent (5th percentile worst-case); Emerging markets: −22 percent (5th percentile worst-case). - Nonbank financial intermediaries and insurers: - Life insurers own about 20 percent of global bonds and 30 percent of credit investments; a stress scenario could induce mark-to-market losses of 30 percent for insurers in some jurisdictions. - Policy surrenders could force life insurers to liquidate investments; extreme liquidation could reach $1 trillion in the United States and Europe. - Fintech and leveraged finance: - Collateralized loan obligation issuance reached record highs in 2021. - Fintech lenders: assets for fintech banks increased by 18 percent over 2019–20; fintech nonbanks assets increased by 7 percent over 2019–20; nonperforming asset rates for fintech nonbanks increased more than traditional peers. ### China-specific findings and scenarios (Chapter 3 excerpts) - Total social financing (excluding government bonds) increased to about 230 percent of GDP as of June 2021, up 15 percentage points from end-2019. - Selected scenario figures: - If new credit is restricted to zero: investment expenditure would decline by RMB 5.4 trillion unless financed by fiscal support or asset sales. - Cash drawdowns up to RMB 0.5 trillion could fund part of operating cash deficit. - Leaving an operating cash flow shortfall of RMB 2.3 trillion to be funded by fiscal support or asset sales. - RMB 2.3 trillion = ~23 percent of local government fiscal revenues. - Policy recommendations for China: - Continue coordinated efforts to contain leverage and phase out implicit guarantees; accelerate restructuring of financially nonviable firms; improve governance of local governments’ public finances; enhance fiscal resource sharing between provinces. ### Chapter 2 — Crypto ecosystem: market developments and risks - Market size and volatility: - Market capitalization has grown by a factor of 10 and is comparable to some established asset classes (for example US high-yield bonds). - The market cap of stablecoins has quadrupled in 2021; Tether previously issued more than half the supply of stablecoins though its dominance has declined. - More than 16,000 tokens have been listed over time; around 9,000 exist today. - Trading, leverage, and DeFi: - Leverage on crypto exchanges has been as high as 125 times the initial investment. - DeFi collateral “locked” rose sharply, led by decentralized exchanges and credit platforms; most DeFi built on Ethereum. - DeFi experienced hacking and scams (example: record $0.6 billion hack of Polychain in August). - Stablecoin-specific findings: - Reserve panel headline figures: $6 bn; $12 bn; $27 bn; $63 bn (Tether: as of June 2021; USD Coin: as of August 2021; Binance USD: as of July 2021; DAI: as of August 2021). - DAI collateralization was more than 200 percent. - USD Coin consolidates cash and cash equivalents in its disclosure (about 60 percent of reserves); Circle announced that, as of September 2021, 100 percent of USD Coin reserves would be moved to cash and cash equivalents. - Tether disclosure indicates only one-third of its reserves are backed by cash and Treasury bills; about half is invested in commercial paper. - Algorithmic stablecoin failure example: IRON/TITAN episode — 25 percent of IRON’s collateral involved native token TITAN; algorithm failed and TITAN collapsed to 0. - Risks and transmission channels: - Operational, cyber, governance, market integrity, and data gaps create potential for runs and contagion. - Runs on stablecoins could trigger fire sales of reserve assets (commercial paper liquidity concerns highlighted). - Crypto adoption in some emerging markets may accelerate dollarization and erode effectiveness of exchange restrictions and capital controls. - Mining: Bitcoin network consumes about 0.36 percent of the world’s electricity; mining revenues in 2021 exceeded $1 billion a month, on average, for each of Bitcoin and Ethereum blockchains. - Policy recommendations (summary): - Implement global standards applicable to crypto assets; coordinate internationally to limit regulatory arbitrage. - For widely used stablecoins, ensure: effective risk management frameworks, enhanced disclosure, independent audit of reserves, fit and proper rules for administrators/issuers, and enhanced operational and cyber resilience. - Use existing tools interimly; agree on common minimum principles for data and a globally consistent taxonomy. - For emerging markets: strengthen macro policies, safeguard central bank independence, consider CBDCs where appropriate, and reassess capital flow restrictions in a digital world. ### Chapter 2 — Reserve, run, and cross-border implications (selected details) - Stablecoin reserve composition and disclosure: - Binance USD is issued in collaboration with Paxos; 4 percent of its reserves in Pax Dollar (USDP) with under $1 billion outstanding. - Disclosure gaps remain: many stablecoins lack audited reserve disclosures and details such as domicile and denomination of reserve holdings. - Run and contagion channels: - Run drivers include doubts about redeemability at a 1:1 peg and collateral value collapses (example IRON/TITAN). - Potential contagion: fire sales of commercial paper; cross-border spillovers via global exchanges; concentrated ownership by market makers. - Policy measures to mitigate FX and capital flow effects: - Capital flow management and crypto-specific measures can be somewhat effective but may leak to P2P channels; Korea example: Bitcoin premia as high as 50 percent in 2018 due to domestic demand and restricted arbitrage. ### Chapter 3 — Investment funds and the green transition - Market size, flows, and composition: - Sample covers more than 54,000 open-end funds over 2010:Q1–20:Q4; 36,500 funds active as of end-2020 totaling $49 trillion AUM. - Sustainable funds AUM: about $3.6 trillion at end-2020; climate-focused funds: $130 billion. - Net flows into sustainable funds rose to about 5 percent of lagged AUM in 2020:Q4; climate-labeled funds surged by 48 percent of AUM over four quarters of 2020. - As of September 1, 2021, year-to-date aggregate climate bond issuance amounted to $258.8 billion. - Transition metrics and portfolio characteristics: - Transition-opportunity score and carbon-intensity score constructed from firm- and fund-level data. - Average transition-opportunity scores (2020:Q4): Conventional funds mean = 31.4; Climate-labeled funds mean = 38.6. - Carbon-intensity scores (2020:Q4): Conventional funds mean = 238; Climate-labeled funds mean = 335 (tons CO2-equivalent per million US dollars of revenue). - Climate-themed funds hold larger exposure to transition-sensitive sectors (utilities, manufacturing, transportation, waste management, construction, fossil fuels). - Flows, stewardship, and stability implications: - Fund labels materially influence flows; labels are an important driver even after controlling for portfolio metrics. - Funds with sustainable/environment labels support climate-related shareholder resolutions more than conventional peers. - Flows to sustainable funds are less sensitive to past performance and more persistent; sustainable investing share is about 10 percent of AUM in surveyed firms. - Cash buffer findings: a fund with a 2.4 percent cash buffer (mean) will hold 13.5 basis points less cash if its transition-opportunity score increases by one standard deviation; same fund reduces buffer by 7 basis points for a one standard deviation increase in carbon-intensity score. - Cash buffer deciles (percent of fund assets): 1st: 0.13; 2nd: 0.14; 3rd: 0.40; 4th: 0.74; 5th: 1.16; 6th: 1.69; 7th: 2.40; 8th: 3.41; 9th: 5.25. - Policy recommendations for the transition: - Urgently strengthen the global climate information architecture: harmonized disclosure standards, high-quality comparable data (including Scope 3), and globally agreed sustainable finance classifications (climate taxonomies). - Enforce disclosure and classification standards to prevent greenwashing. - Conduct scenario analysis and stress testing of the investment fund sector to assess resilience to transition shocks. - Once architecture is in place, consider tools to channel savings toward transition-enhancing funds (for example, financial incentives for climate funds). ### Survey and empirical notes (selected numerical points) - Survey of asset managers: 26 portfolio managers and representatives from 11 asset management firms and one asset owner; more than $16 trillion combined AUM. - Use of third-party ESG databases: 82 percent of respondents. - Technological change/consumer-preference driver cited by 66 percent of respondents. - US 401(k) example: 3 percent of 401(k) plans had an ESG option in 2019, representing 0.1 percent of plan assets. - Signatories to Principles for Responsible Investment: about 1,400 in 2015; more than 3,000 in 2020. _Italic: Global Financial Stability Report—COVID-19, Crypto, and Climate: Navigating Challenging Transitions (information as of September 27, 2021). International Monetary Fund | October 2021._ ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks and support sustained economic growth. - This GFSR reflects information available as of September 27, 2021, and benefited from comments and suggestions from IMF staff and Executive Directors following their discussions on September 28, 2021. - The report’s overarching thematic focus: COVID-19, Crypto, and Climate ("the 3Cs"). ### Macro-financial outlook and key risks - Financial conditions: - Financial conditions eased further in advanced economies and remained easy on balance in emerging markets. - After declining through the summer, global long-term yields rose in late September, in some countries entirely reversing earlier moves. - Inflation and monetary policy: - Risks to the inflation outlook appear to be skewed to the upside in many countries. - In emerging markets, inflation pressures have led many central banks to hike policy rates. - Higher financing costs for domestic debt in emerging markets (except China) have been observed since last year. - Central banks should provide clear guidance about the future stance of monetary policy to avoid an unwarranted tightening of financial conditions and minimize market volatility. - Monetary authorities should remain vigilant and—if price pressures turn out to be more persistent than anticipated—act swiftly to counter any possible unmooring of inflation expectations. - Vulnerabilities from prolonged easy conditions: - A prolonged period of extremely easy financial conditions may result in overly stretched asset valuations and fuel financial vulnerabilities. - A sudden repricing of risk could interact with these vulnerabilities, leading to tighter financial conditions and putting growth at risk in the medium term. - Corporate and banking sector: - Credit conditions have improved in the corporate sector, though they remain uneven across sectors and countries. - With gradual removal of fiscal and regulatory support measures, insolvency may rise in some countries. - Banks have remained resilient through the pandemic with the exception of a weak tail of banks in some countries; banks remain cautious about the credit outlook in most countries. - The non-bank financial intermediary sector has exhibited vulnerabilities exposed by the pandemic that need urgent attention. ### Crypto-related findings and policy priorities - Market developments and risks: - Crypto asset markets are growing rapidly and remain highly volatile. - The volume of crypto asset transactions has reached macro critical levels in some emerging markets, often as high as those of domestic equities. - Some stablecoin business models have been subject to the risk of sudden and severe liquidity pressures. - Policy implications and recommendations: - A sound regulatory framework for crypto assets, and decentralized finance markets more generally, must be a priority on the global policy agenda. - Ensuring a regulatory level playing field is a key priority. - Stablecoins, given their vulnerabilities, require particular regulatory attention to address liquidity and systemic risks. ### Climate transition and financial stability - Role of finance: - The forthcoming 26th United Nations Climate Change Conference of the Parties (COP26) is presented as a pivotal opportunity to speed up the transition and global climate actions. - Achieving net-zero carbon emissions by 2050 requires substantial additional global investment by both the public and private sectors. - The global financial sector can play a crucial role in catalyzing private finance and accelerating the transition. - Investment fund developments: - Climate finance is growing rapidly, particularly among asset managers. - Assets under management in climate-themed investment funds remain relatively small, but inflows have surged. - There is promise of cheaper funding costs for climate-friendly firms and greater climate stewardship by funds. - Sustainable fund flows appear more resilient to adverse shocks, suggesting climate-friendly investors might be relatively stickier. - Policy priorities for the transition: - Further improvements in data, disclosure, and sustainable finance classifications remain key policy objectives to facilitate assessment of transition-related risks and prevent greenwashing. ### Guidance to policymakers - Monetary policy: - Provide clear forward guidance to avoid unwarranted tightening of financial conditions and to minimize market volatility. - Remain ready to act swiftly if inflation pressures become more persistent than anticipated. - Financial regulation: - Prioritize establishing a sound regulatory framework for crypto assets and decentralized finance, with special attention to stablecoins and the need for level playing fields. - Address vulnerabilities in the non-bank financial intermediary sector urgently. - Climate finance and disclosure: - Strengthen data, disclosure, and sustainable finance classifications to better assess transition-related risks and to reduce the potential for greenwashing. - Mobilize public and private investment to meet the substantial additional financing needed to achieve net-zero carbon emissions by 2050. *Source: Preface and Foreword, Global Financial Stability Report—COVID-19, Crypto, and Climate: Navigating Challenging Transitions (information as of September 27, 2021).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Overall assessment: where do we stand? - Financial stability risks have been contained so far, reflecting ongoing monetary and fiscal policy support and the rebound of the global economy this year. - Financial conditions have eased further, on net, in advanced economies; optimism that propelled markets in the first half of the year faded somewhat over the summer. - Investors have become increasingly concerned about the economic outlook amid rising virus infections and greater uncertainty about the strength of the recovery, particularly in emerging markets. - In late September, concerns that inflationary pressures may be more persistent than initially anticipated pushed nominal yields higher, in some countries entirely reversing earlier moves. - Financial vulnerabilities remain elevated in a number of sectors, masked in part by massive policy stimulus. - Policymakers face a trade-off: maintain near-term support for the global economy while preventing unintended consequences and medium-term financial stability risks. - A prolonged period of extremely easy financial conditions may result in overly stretched asset valuations and could fuel financial vulnerabilities. - Warning signs include increased financial risk-taking and rising fragilities in the nonbank financial institutions sector; if left unchecked, these vulnerabilities may become structural legacy problems that put medium-term growth at risk and test the resilience of the global financial system. ### Progress since the April 2021 Global Financial Stability Report - Financial conditions: - Eased further, on net, in advanced economies, buoyed by expectations of continued accommodative monetary policy and rising risk asset valuations. - Changed little, on balance, in emerging markets as monetary policy tightening in response to inflation pressure in some countries offset gains in risk asset prices. - Corporate sector: - Corporate balance sheets have strengthened overall. - A feared substantial pickup in bankruptcies has not materialized, thanks to targeted fiscal support and unprecedented monetary policy support. - Revenues have risen, with profitability surpassing pre-pandemic levels in several economies. - Credit quality in speculative-grade bond markets has continued to strengthen, with default rates expected to remain low. - Households: - Household financial positions have improved and appear stronger than during the global financial crisis. - Households benefited from lower interest rates and support for income and interest costs, including debt payment moratoria in some countries. - Debt service ratios have fallen in many countries, reducing the risk of defaults on mortgage and other consumer loans. - Emerging and frontier market economies: - Outlook for portfolio flows has improved, boosted by the ongoing economic recovery and robust global risk sentiment, even though local currency debt flows have not recovered from the first-quarter weakness. - Hard currency issuance has rebounded strongly, with many lower-rated issuers returning to capital markets. - Banking sector: - With a solid global capital position, the global banking sector has continued to play a crucial role in supporting the flow of credit to the economy. - Banks have remained resilient, reflecting years of capital buildup following global financial crisis reforms and ongoing unprecedented policy support, with the exception of a weak tail in some countries. - Sustainable finance and climate-related investment: - The investment fund sector can play a crucial role in catalyzing private investment for a low-carbon transition (Chapter 3). - Flows into sustainable funds, and into climate funds in particular, have surged since early 2020. - The sustainable fund sector remains small: $3.6 trillion in assets under management at the end of 2020, of which only $130 billion is in climate funds. - Sustainable investors may offer financial stability benefits as they tend to be less sensitive to short-term returns. ### Risks remain amid still-elevated financial vulnerabilities - Yields and inflation expectations: - After declining through the summer, global long-term yields rose in late September, in some cases entirely reversing earlier moves, on concerns that price pressures may be more persistent. - Investors still expect recent price pressures to moderate and gradually subside, but concerns about inflation risks have intensified recently. - Contributing factors include the rise in energy and commodity prices and potential persistence of supply chain disruptions and shortages of labor and materials that could feed into wage dynamics and unmoor inflation expectations. - Asset valuations and sectoral strains: - Asset valuations appear stretched in some market segments. - Equity prices have risen further, on net, since the April 2021 GFSR, boosted by accommodative monetary policy and strong earnings; equity price misalignments (relative to fundamentals-based values) have remained elevated in most markets. - Credit spreads have narrowed to below pre-pandemic levels. - House prices have risen rapidly in many countries, reflecting the improved outlook, policy support, and shifting household preferences. - Emerging and frontier markets: - Continue to face large financing needs. - Local currency government bond yields have increased in many countries due to higher inflation and fiscal concerns. - The late-September increase in US Treasury yields may exert additional pressure, raising funding costs. - Inflation pressure has led many central banks to adopt a tighter monetary policy stance. - Monetary conditions remain broadly accommodative, with deeply negative real rates, but there is a risk that real rates may rise significantly in coming years. - A sudden change in the monetary policy stance of advanced economies may sharply tighten financial conditions and adversely affect capital flows, exacerbating pressures in countries with debt sustainability concerns. - Nonfinancial firms: - Recovery remains uneven across countries, sectors, and firm sizes. - Solvency risks continue to be elevated in sectors hit hardest by the pandemic (for example, transportation and services) and in small firms. - In China, credit conditions have tightened, particularly for firms with weak credit ratings and in provinces with weaker public finances. - Nonbank financial institutions and investment funds: - Vulnerabilities unmasked by the “dash for cash” in March 2020 remain. - Risks are rising at some other nonbank financial institutions as they reach for yield to meet nominal return targets. - Life insurance companies face elevated asset-liability duration mismatches in many jurisdictions and have increased their share of lower-quality bonds. - Greater use of financial leverage in the current environment could prompt volatility in financial markets. - Banking sector lending: - Loan underwriting standards remain restrictive in many countries; bank loan officer surveys indicate this posture is expected to persist, with risks to the credit outlook as the main constraint to loan growth. - A slowdown in international bank lending may pose additional downside risks to many emerging market economies. - Crypto ecosystem: - Continues rapid growth, presenting opportunities and challenges (Chapter 2). - Crypto asset exchanges pose operational and financial integrity risks through cross-border operations. - Investor protection risks loom large for crypto assets and decentralized finance. - Stablecoins generally have poor disclosures and can be subject to runs if their reserves come into question. - In emerging markets, crypto assets may accelerate dollarization and erode the effectiveness of exchange restrictions and capital control measures; increased trading of crypto assets by emerging market users can potentially lead to destabilizing capital flows. - Policymakers in emerging market and developing economies should prioritize strengthening macro policies and consider benefits of issuing central bank digital currencies. - Globally, policymakers should work together through the G20 Cross Border Payments Roadmap to make cross-border payments faster, cheaper, more transparent, and inclusive. - Notable metrics and signals highlighted in the report: - 90% confidence interval referenced in analyses of EM term premia response to the US real yield rise. - Crypto market dynamics noted: 40% decline in May and 3× YTD increase until early May (Figure 12). ### Policy recommendations - Tailor policy support to country circumstances, given the mixed pace of the economic recovery across countries. - Monetary policy: - Central banks should provide clear guidance about their future policy stance to prevent an abrupt tightening of financial conditions. - If price pressures prove more persistent than currently expected, monetary authorities should act decisively to prevent an unmooring of inflation expectations. - Fiscal policy: - Fiscal policy should continue to support vulnerable firms and individuals. - Given policy space, fiscal measures should be targeted and tailored to country characteristics and needs. - Addressing unintended consequences of prolonged support: - In light of the possible need for prolonged policy support to ensure a sustainable and inclusive recovery, policymakers should act decisively to address potential unintended consequences of unprecedented measures taken during the crisis. - Nonbank and market resilience: - Strengthen oversight and resilience of the nonbank financial sector, including investment funds, life insurers, and other institutions reaching for yield. - Emerging market priorities: - Strengthen macro policies; consider central bank digital currencies where appropriate; monitor and manage risks from crypto adoption and capital flow volatility. - Cross-border cooperation: - Advance the G20 Cross Border Payments Roadmap to improve speed, cost, transparency, and inclusion of cross-border payments. *GLOBAL FINANCIAL STABILITY REPORT—COVID-19, CRYPTO, AND CLIMATE: NAVIGATING CHALLENGING TRANSITIONS — International Monetary Fund | October 2021* ### eXeCUtIVe sUMMARY ### eXeCUtIVe sUMMARY ### Key risks and outlook - Global financial stability risks have been contained so far, reflecting ongoing monetary and fiscal policy support and the rebound of the global economy this year. - Investors have become increasingly concerned about the economic outlook amid rising virus infections and greater uncertainty about the strength of the recovery. - After declining through the summer, global long-term yields rose in late September, in some countries entirely reversing their earlier moves, on concerns that price pressures may be more persistent than initially anticipated. - The balance of risks to growth in 2022 is expected to remain skewed to the downside. - The probability of growth falling below zero next year is estimated at about 4 percent. - A year and a half into the COVID-19 pandemic, policymakers face a trade-off between maintaining near-term support and preventing unintended medium-term financial stability risks. ### Financial conditions and sectoral vulnerabilities - Financial conditions in advanced economies have eased further, on net, since the April 2021 GFSR, buoyed by expectations that monetary policy will remain accommodative. - Equity prices have risen and credit spreads have continued to narrow, producing stretched valuations in segments of financial markets. - House prices have risen rapidly in many countries, boosted by policy support and shifting preferences. - Financial conditions in emerging and frontier market economies are little changed, with local currency yields remaining elevated amid increased local currency issuance and inflation pressure in some countries. - Credit conditions have improved in the corporate sector, albeit unevenly: - Corporate balance sheets have generally strengthened, and profitability has improved. - Defaults and bankruptcies have declined, but solvency risks remain elevated in sectors hit hardest by the pandemic and for small firms. - In China, credit conditions have tightened, particularly for firms with weak credit ratings and in provinces with weaker public finances. - Banks have supported credit flow during the pandemic, but loan underwriting standards remain restrictive in many countries, raising questions about banks’ willingness to contribute to the recovery once support measures are withdrawn. - Nonbank financial institutions, nonfinancial corporates, and the housing market show elevated vulnerabilities masked in part by very substantial policy stimulus. - Life insurance companies face significant asset-liability duration mismatches in many jurisdictions. ### Policy recommendations — macroprudential, fiscal, monetary - Policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a broad tightening of financial conditions. - Due to possible lags between activation and impact, they should take early action. - If tools are unavailable (for example, in the nonbank financial intermediary sector), policymakers should urgently develop them. - Given challenges designing and operationalizing macroprudential tools, policymakers should consider building buffers elsewhere to protect the financial system. - Policymakers should act preemptively to address vulnerabilities and avoid a buildup of legacy problems. - Monetary policy: - Should remain accommodative where there are output gaps, inflation pressures are contained, and inflation expectations are consistent with central bank targets. - Central banks should be prepared to act quickly if the recovery strengthens faster than expected or if inflation expectations are rising. - Transparent and clear communication about the future stance of monetary policy is critical to avoid de-anchoring of inflation expectations and prevent financial instability. - Fiscal policy: - Should remain supportive but be well-targeted, carefully calibrated, and tailored to country-specific circumstances. - In countries with high vaccination and low funding costs, fiscal policy should gradually shift from emergency measures toward promoting transformation to more resilient and inclusive economies. - In countries with lower vaccination rates and tighter financing constraints, health-related spending and protecting the most vulnerable remain top priorities. - As countries converge back to precrisis GDP trends, focus should shift toward ensuring fiscal sustainability, including establishing credible medium-term fiscal frameworks to promote fiscal transparency and sound governance. - For emerging and frontier markets: - Rebuild buffers as appropriate and implement structural reforms to insulate from capital flow reversals and abrupt increases in funding costs. - Leverage the general special drawing rights allocation to provide international liquidity and support buffer rebuilding. ### Investment funds, crypto, digital dollarization, and climate-related finance - Policymakers should urgently address vulnerabilities in investment funds through enhanced prudential supervision and regulation to raise ex ante resilience against liquidity risks. - The global nature of the investment fund business requires internationally coordinated reform through the Financial Stability Board. - Conduct scenario analysis and stress testing of the investment fund sector to mitigate potential financial stability risks from the transition to a green economy. - Digital dollarization: - Emerging markets must address digital-dollarization challenges by strengthening the credibility of monetary policy, safeguarding central bank independence, and maintaining a sound fiscal position. - Effective legal and regulatory measures are necessary to disincentivize foreign currency use. - Adequate frameworks for crypto asset service providers must be established with coordination among national regulators. - Countries should reconsider capital flow restrictions in a more digital world and pursue cross-border collaboration to address technological, legal, regulatory, and supervisory challenges (see Chapter 2). - To foster growth of the sustainable fund sector and mitigate transition-related financial stability risks, policymakers should urgently strengthen the global climate information architecture (data, disclosures, sustainable finance classifications). - Once this architecture is in place, consider tools to channel savings toward transition-enhancing funds (such as financial incentives for investment in climate funds). ### IMF Executive Board discussion — priorities and multilateral actions - Executive Directors broadly agreed with staff’s assessment of the global economic outlook, risks, and policy priorities. - Directors welcomed the continuing recovery but noted divergences, especially between advanced economies and low-income countries, reflecting differentiated vaccine access and early policy support. - Directors highlighted the importance of global cooperation to ensure universal access to vaccines and a strong financial safety net. - Multilateral efforts remain essential to avoid international trade and supply chain disruptions, speed up global vaccine access, provide liquidity and debt relief to constrained economies, and mitigate and adapt to climate change. - Directors highlighted the expected contribution of the recent General Allocation of Special Drawing Rights in providing much-needed international liquidity. - Directors noted that higher debt levels and large government financing needs in many countries are sources of vulnerability, especially if global interest rates rise faster than expected. - For financially constrained countries, Directors emphasized ensuring continued essential spending while meeting other obligations and noted that further efforts are needed, including debt relief in the context of early and timely implementation of multilateral initiatives such as the G20 Common Framework. ### Chapter 1 — At a Glance (key takeaways) - Financial stability risks contained so far due to policy support, but investor concerns have risen amid rising infections and uncertainty about recovery strength. - Financial conditions in advanced economies have eased further; equity prices rose and credit spreads narrowed; house prices rose rapidly in many countries. - Financial vulnerabilities remain elevated across several sectors; a sudden repricing of risk could lead to tighter financial conditions and put growth at risk in the medium term. - Emerging and frontier markets face risks from uneven vaccine access and potential sudden changes in advanced-economy monetary policy; local currency yields remain elevated in some countries. - Corporate credit conditions improved overall but unevenly; solvency risks persist for sectors hardest hit and small firms; tailored support to viable firms remains crucial. - Banks have supported credit flows but underwriting standards are restrictive in many countries, which may constrain banks’ contribution to recovery when support measures end. - Monetary and fiscal support should be more targeted and tailored to country circumstances; central banks should provide clear guidance about the future stance of monetary policy to avoid unwarranted tightening. - Policymakers should take early action and tighten selected macroprudential tools to target pockets of elevated vulnerabilities while avoiding broad tightening of financial conditions. - Emerging and frontier markets should rebuild buffers and implement structural reforms to cushion the adverse impact of capital flow reversals and abrupt increases in financing costs. *Source: eXeCUtIVe sUMMARY, text - eXeCUtIVe sUMMARY (October 2021).* ### 1. Global Financial Conditions Indices ### 1. Global Financial Conditions Indices ### Financial conditions: recent evolution - Global financial conditions have eased further, on net, since the April 2021 GFSR. - Easing has been driven by slightly lower interest rates and rising corporate valuations and housing prices, particularly in the United States. - A significant downgrade of economic prospects could trigger a sharp decline in risk asset prices and tighten financial conditions, with particularly difficult implications for a number of emerging markets with limited monetary and fiscal policy space. ### Global rates and yield dynamics - US 10-year nominal yields rose more than 80 basis points through the end of March, then dropped as much as 55 basis points in the summer on concerns about the strength of the recovery. - Through late September, US 10-year yields were only 27 basis points lower since the April 2021 GFSR. - The Federal Reserve’s end-2023 projection of the policy rate is at 1 percent. - Term premia have fallen, on net, since the April 2021 GFSR; safe-haven flows into US Treasury securities have coincided with this decline. - Five-year–five-year forward real yields in the United States are down 60 basis points, reflecting concerns about long-term-growth prospects. - Real yields have declined significantly across most major advanced economies; in the United States the decline has been at the back end of the curve, whereas in other advanced economies the decline has been more evident at the five-year maturity. ### Inflation signals and market-implied expectations - Five-year inflation breakevens in the United States and euro area moved within a relatively tight range since the April 2021 GFSR. - The rise in five-year forward inflation breakevens since the beginning of the pandemic has been considerably more contained, pointing to well-anchored long-term inflation expectations. - The forward one-year inflation breakeven curve is downward sloping, consistent with expectations that price pressures will moderate and then gradually subside. - Market-implied probability of US inflation being greater than 2 percent over the next five years is more than 80 percent. - Inflation has risen about 1.5 percentage points above the median emerging market central bank target. - Five-year-ahead survey expectations for many emerging markets remain well anchored and forward survey estimates show inflation anticipated to start trending down over the next 6–12 months. ### Emerging market local assets and bond markets - Local currency government bond yields for most emerging market economies have risen year to date and remain elevated despite recent declines in US Treasury yields. - In the first quarter of 2021 the rise in bond yields for many emerging market economies was mostly because of higher term premia; changes since the April 2021 GFSR have been driven primarily by an upward shift in policy expectations reflecting tighter monetary policy in some countries. - Increased local currency issuance and broader fiscal risks, amid weak nonresident flows, are likely contributing to upward pressure on yields and term premia. - Overall stress in local currency bond markets has declined, but conditions in some countries (mostly in Latin America) remain tense. - Hard currency emerging market bond spreads have been relatively stable this year after recovering from the COVID-19 sell-off; frontier-economy spreads have changed little, on net. - Emerging market hard currency bond issuance is running at a record pace this year (surpassing the record in 2020); corporate issuance has outperformed 2020 by almost 20 percent. - An exception is China, where corporate issuance has been weak, reflecting tighter credit conditions in certain segments. ### Managing a gradual withdrawal of monetary accommodation - Central bank balance sheets in advanced economies increased to close to 60 percent of GDP, almost double the level prevailing before the pandemic. - Domestic monetary authorities and the foreign official sector now account for close to 40 percent of securities outstanding, even after increased government bond supply to finance fiscal responses. - Investors anticipate the Federal Reserve will commence policy normalization in coming months; other advanced-economy central banks have already started and more are likely to follow this year or next. - A key financial stability challenge during normalization is avoiding an unwarranted tightening of financial conditions that may hurt the recovery. - Historical precedents may not be a helpful guide given the large size of central bank balance sheets and compressed term premia; a sudden reassessment of the outlook for monetary policy could trigger a spike in volatility and a sharp upward move in term premia (as in the 2013 “taper tantrum”), though prior episodes have differed in outcomes. *Source: IMF staff calculations and analysis, Global Financial Stability Report—October 2021.* ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEw: A DELICATE BALANCING ACT ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEw: A DELICATE BALANCING ACT ### Global market conditions and asset valuations - Unprecedented easing in global financial conditions during the pandemic led to a collapse in volatility across asset classes and encouraged investors to take on more risk. - Equity prices have risen further on net since the April 2021 GFSR, helped by extremely low and declining real rates and strong earnings, but equity price misalignments (relative to fundamentals-based values) have remained elevated in most markets. - Sectoral equity valuations have diverged since late March 2021. - Corporate credit spreads have remained tight, reflecting investors’ benign view of the credit outlook amid ample liquidity and continued policy support. - Investors have become somewhat more cautious recently, demanding more protection against large declines in risk markets; elevated equity valuations and increased sensitivity of equity prices to government bond prices imply that equity markets may reprice substantially in the event of a sudden reassessment of the economic outlook or unexpected policy changes. ### Volatility, term premia, and central bank balance sheets - Cross-asset volatility declined before the recent market reversal; demand for downside protection increased (higher SKEW and other implied volatility measures). - Central bank balance sheets expanded to unprecedented levels in response to the COVID-19 pandemic; many asset purchase programs have ended or are winding down, but central banks still hold a significant amount of assets on their balance sheets. - Historical episodes show term premia and volatility reacted differently during past taper episodes. - There is a risk that real rates may rise significantly in coming years; market-implied paths suggest term real rates may return to prerecession levels fairly quickly in some countries and even rise to historic highs in some cases. ### A tough act for emerging market monetary policy - Price pressures in some emerging markets reflect higher commodity and food prices and weaker nominal exchange rates; inflation surveys indicate the increase in inflation in emerging markets is expected to be temporary. - Since the April 2021 GFSR, the central banks of Angola, Brazil, Chile, Colombia, Hungary, Mexico, Peru, and Russia, among others, have hiked policy rates. - Market pricing: the median two-year forward policy rate for emerging markets is currently at 4.7 percent compared with 3.3 percent at the time of the April 2021 GFSR. - Despite recent hikes, monetary conditions remain broadly stimulative, with real rates deeply negative. - Considerable slack persists in some economies, with output gaps persisting through 2024 according to IMF staff estimates; a rapid tightening of domestic financial conditions could adversely affect nascent recoveries and raise debt sustainability concerns, especially for low-income countries. - Almost 60 percent of low-income countries are already in or near high debt distress. ### Spillover risk from US real yields and emerging market term premia - IMF staff analysis shows emerging market term premia could rise by almost 140 basis points over 16 weeks in the event of a 100 basis point rise in US 10-year real yields following a hawkish surprise (proxied by an S&P 500 equity fall while real rates rise). - Recent increases in emerging market bond yields relative to equivalent-maturity US Treasuries have been driven primarily by domestic developments (higher inflation and fiscal concerns); the late-September increase in US Treasury yields has potential to add to this pressure. ### Capital flows: patterns, divergence, and the role of China - The outlook for portfolio flows has improved, buoyed by the economic recovery and robust global risk sentiment; capital flows at risk (5th percentile) have declined from 2.1 percent of GDP at the end of 2020 to 1.7 percent of GDP. - A two-speed pattern persists: - Hard currency issuance has rebounded strongly; many lower-rated issuers (including Cameroon, Mongolia, and Pakistan) returned to capital markets since the April 2021 GFSR. - Local currency debt flows to China have been strong, with cumulative flows of $50 billion year to date. - Emerging market (excluding China) local currency debt flows have not recovered from first-quarter weakness and remain a weak spot: cumulative local currency debt flows (excluding China) since January 2020 remain negative, down by more than $20 billion. - Emerging market sovereign hard currency issuance reached a record cumulative $250 billion. - China’s role: - Inclusion in global benchmark indices has led to significant inflows, estimated at $180 billion since 2020. - China’s sovereign credit rating is significantly higher than that of other emerging markets and has remained stable through the pandemic, unlike other emerging markets that experienced record credit rating downgrades. - China’s earlier recovery has resulted in a sharp divergence in domestic growth and fiscal pressures compared with other emerging markets. - Behind aggregate flows there is wide variation: Colombia and Malaysia saw strong inflows in 2021; Mexico, Poland, and South Africa were notable laggards. - The changing investor base in emerging markets presents risks but also an opportunity to strengthen domestic local capital markets; domestic investors have become increasingly important marginal investors in local currency bond markets amid elevated fiscal needs and weak nonresident flows. ### Policy implications and considerations - The stance of monetary policy should be informed by country-specific circumstances, including pandemic evolution, available policy space, inflation and economic outlook, risk of cross-border spillovers, and financial stability considerations. - A preemptive tightening of monetary policy may help prevent a possible unanchoring of inflation expectations and safeguard central bank credibility. - Policymakers should weigh the trade-off that rapid tightening could jeopardize nascent recoveries and raise debt sustainability concerns, particularly for low-income countries and economies with significant slack. - Managing normalization will be complicated by prior asset purchases and large central bank balance sheets; careful communication and sequencing of normalization measures are important to limit adverse spillovers. *International Monetary Fund | October 2021* ### 3. Hard Currency Issuance in Frontier Emerging Markets ### 3. Hard Currency Issuance in Frontier Emerging Markets ### Hard-currency issuance and capital flows - Hard currency bond issuance in frontier market economies continues. - The capital flows outlook has improved, based on the benign risk sentiment and return of growth. - Emerging market (excluding China) local bond flows remain weak. - Local currency debt flows vary significantly across countries. - Probability of outflows has declined from 25% to 20%. - Capital flows at risk have improved from –2.1% of GDP to –1.7% of GDP. ### Financial-sovereign nexus and investor composition - Financial institutions, more recently, have absorbed an increasing portion of domestic debt across major emerging markets, highlighting the risk of the financial-sovereign nexus in some countries. - Flows to emerging markets driven by environmental, social, and governance factors have grown significantly, even during the pandemic, though they remain relatively small as a share of total flows. - Transition finance—for example, sustainability-linked debt focusing on environmental, social, and governance targets—could become a source of capital for issuers looking to fund long-term improvement strategies. ### Corporate sector credit conditions and risks - Corporate revenues have risen and profitability prospects have brightened, surpassing pre-pandemic levels in several economies. - Recovery is uneven; near-term solvency and liquidity risks remain elevated in sectors hit most by the pandemic, such as transportation and services in advanced economies. - By firm size, solvency risk has fallen more for large firms; solvency risk has risen in some advanced and emerging market economies, especially among small firms. - Credit quality in the speculative-grade bond market has continued to strengthen, with credit rating upgrades exceeding downgrades this year. - US speculative-grade default rates are anticipated to remain low. - A substantial pickup in bankruptcies has not materialized so far, aided by targeted fiscal support and unprecedented monetary policy. - Private debt funds have accumulated close to $400 billion in dry powder, representing a potential funding source for distressed and smaller firms. ### China: rising financial vulnerabilities and credit dynamics - Total social financing, excluding government bonds, had increased to about 230 percent of GDP as of June 2021, up 15 percentage points from the end of 2019. - State-owned entities accounted for about half of total onshore corporate bond defaults in 2020–21, up from about 10 percent in 2017–19, while the bond default rate is still very low at 0.7 percent. - Since the state-owned-enterprise bond defaults in late 2020, nearly all of the net increase in bond issuance has occurred at firms with a history of negative operating cash flows, most of which are local government-owned entities. - Selected indicators and scenarios: - If new credit is restricted to zero: investment expenditure would decline by RMB 5.4 trillion unless financed by fiscal support or asset sales. - Cash drawdowns of up to RMB 0.5 trillion could be used to fund part of the operating cash deficit. - Leaving an operating cash flow shortfall of RMB 2.3 trillion to be funded by fiscal support or asset sales. - RMB 2.3 trillion = ~23 percent of local government fiscal revenues. - In 2020, of about 7 trillion renminbi in new external financing, about 4.9 trillion was used to fund investment expenditures; the remaining 2.1 trillion covered operating cash flow deficits. - Concerns: - Financially weak state-owned entities in provinces with relatively strong public finances have retained access to additional bond financing, potentially exacerbating credit misallocation. - Credit conditions have become more challenging for firms in provinces with weaker public finances, private firms, and firms with lower credit ratings. - Debt of financially weak local government financing vehicles is substantial in many provinces and could become contingent liabilities that strain local government balance sheets. ### Policy recommendations for China - Continue coordinated efforts across agencies to contain leverage and phase out implicit guarantees. - Accelerate restructuring of financially nonviable firms. - Improve governance of local governments’ public finances. - Enhance sharing of fiscal resources between financially weaker and stronger provinces (for example, through conditional central government transfers). - Avoid restricting credit in ways that would adversely affect investment and local government balance sheets without accompanying restructuring and reform. ### Market exuberance, leverage, and potential volatility - Merger and acquisition activity and leveraged buyouts have increased, with financial risk-taking and corporate releveraging potentially exacerbating vulnerabilities. - Use of equity-linked derivatives has increased, though the ratio to market capitalization has declined. - Dealers report elevated demand for securities financing to purchase equities. - Issuance of collateralized loan obligations has been on a record-setting pace in 2021, and current CLOs have less embedded leverage than pre-global financial crisis structures. - Rising financial leverage and pockets of market exuberance could prompt additional volatility. *International Monetary Fund | October 2021* ### 1. Global Institutional Leveraged-Loan M&As and Leveraged Buyout ### 1. Global Institutional Leveraged-Loan M&As and Leveraged Buyout ### Financial risk-taking, releveraging, and financial leverage - Releveraging reemerged through debt-funded leveraged buyouts. - The growing use of equity-linked derivatives suggests a rising degree of financial leverage. - Collateralized loan obligation issuance has reached record highs. - Surveys indicate elevated demand for borrowing to fund equity positions. - Note: In panels reported, 2021 data are annualized to estimate full-year issuance; in panel measures, the right scale shows the percentage of all leveraged buyouts (LBOs) for which the issuer of the leveraged loan has leverage greater than six times debt to EBITDA. Acronyms preserved: CLO = collateralized loan obligation; EBITDA = earnings before interest, taxes, depreciation, and amortization; HY = high-yield; IG = investment-grade; M&A = merger and acquisition. ### Vulnerabilities at nonbank financial intermediaries and life insurers - While financial vulnerabilities have generally declined at nonbank financial intermediaries, in several advanced economies and China, nonbank financial intermediaries still feature elevated leverage, credit risk exposures, and/or liquidity mismatches. - Vulnerabilities have increased for life insurers; the sector owns about 20 percent of global bonds and 30 percent of credit investments. - A stress scenario of a large and sudden increase in bond yields and corporate spreads could induce mark-to-market losses of 30 percent for insurers in some jurisdictions. - Policy surrenders could force life insurers to liquidate investments, which, in the extreme, could reach $1 trillion in the United States and Europe. ### Housing market surge and downside risks - House prices have been exceptionally strong during the pandemic, buoyed by accommodative monetary policy, shifting household preferences, and limited supply. - In some countries (Luxembourg, New Zealand, Turkey) real house prices have risen more than 15 percent since the end of 2019. - Sustained rapid growth in house prices can encourage excessive risk-taking and rising vulnerabilities. - Worst-case estimated house price declines over the next three years: - Advanced economies: –14 percent (5th percentile worst-case) - Emerging markets: –22 percent (5th percentile worst-case) - The house-prices-at-risk model defines downside risks as the forecast house price growth at the 5th percentile of the house price distribution and controls for past growth in house prices, financial conditions, real GDP growth, presence of credit booms, and an overvaluation indicator. ### Household balance sheets and mortgage lending - Household financial positions appear stronger than before the global financial crisis based on household net worth and owners’ real estate equity. - Debt service ratios have fallen in many countries, helped by lower interest rates and policy measures, reducing the risk of mortgage and consumer debt default. - Mortgage delinquencies have remained low during the pandemic, largely due to forbearance; loans in forbearance have started to diminish as households bring payments up to date. - Nonbank mortgage lenders have become more prominent in the US mortgage origination market, notably during the pandemic in refinancings. - Nonbank lenders usually sell mortgages to government-sponsored enterprises within one quarter and thus have limited credit risk exposure on retained balances. - Nonbank lenders do not hold deposits, obtain liquidity from banks, and fund themselves in wholesale markets, making them vulnerable to a sharp tightening in funding market conditions. - High concentration among nonbank lenders raises exit risk by key lenders, potentially resulting in a decline in credit. - Nonbank mortgage originators often act as mortgage servicers, exposing them to credit risk from several months of missed payments. ### Banks, credit supply, and implications for the recovery - Global banking sector has remained resilient through the pandemic, supported by capital buildup after post–global-financial-crisis reforms and continuing monetary and fiscal support. - Restrictions on capital distributions have been removed or relaxed in several jurisdictions; in some countries, notably the United States, banks have begun to bolster capital by writing back precautionary reserves. - Banks’ loan underwriting standards remain restrictive in most countries, and bank credit officers expect this posture to persist. - Analysis assumptions: - The credit intensity of growth remains at the 2010–19 average. - Bank loans will grow at the same pace as total credit over the next few years. - Under these assumptions, consensus estimates of loan growth (based on analyst forecasts for listed banks) are generally below loan growth consistent with the IMF 2022 GDP forecast (“GDP-consistent” loan growth) in most countries, pointing to potential downside risks to the IMF’s GDP forecasts unless the credit intensity of growth or bank loan share changes. - Structural shifts: - In most countries, bank loans have grown at a slower pace than total credit over 2010–19, reflecting a rise in credit extension outside of the banking sector due to market structure changes, regulatory reforms, and technology advances. - Economic growth appears to be more closely related to overall credit growth than to bank loan growth, suggesting capital markets may play an important role in supporting the recovery. - Policy trade-offs: - There are trade-offs between incentivizing credit extension to support economic growth and the potential risks to financial stability. - Nonbank lenders may have different risk appetites and funding vulnerabilities compared with banks. *Source: IMF staff analysis (excerpts from Chapter 1, GLOBAL FINANCIAL STABILITY REPORT—COVID-19, CRYPTO, AND CLIMATE: NAVIGATING CHALLENGING TRANSITIONS, October 2021).* ### 4. System CET1 Ratio and Consensus Minus GDP-Consistent Loan Growth ### 4. System CET1 Ratio and Consensus Minus GDP-Consistent Loan Growth in 2022 ### Key findings on loan growth and credit intensity - Bank loan growth has been slower than the growth of total credit in many countries. - Countries vary in credit intensity of growth and in bank loan growth relative to total credit growth. - Loan growth associated with the GDP forecast falls short of market forecasts in many countries (consensus minus GDP-consistent loan growth is often negative). - “GDP-consistent” loan growth in the analysis assumes: - the total credit intensity of GDP growth remains at the same level observed over the last 10 years, and - the loan share of total credit remains at 2020 levels. - Consensus estimates of loan growth are based on analyst forecasts for listed banks. - Data labels use ISO country codes. CET1 = common equity tier 1. ### Bank capital and the loan-growth gap - The capital position of banks does not appear to explain the gap between consensus and GDP-consistent loan growth. - According to loan officer opinion surveys, bankers cite uncertainties around the economic and credit risk outlook rather than their own internal risk factors as the main constraints on loan growth. - Expiration and runoff of support policies (guarantees, moratoria, and other measures) could drive defaults higher and require banks to increase provisions; in some cases the negative impact on capital could exceed 100 basis points of CET1 ratios. - Implication: lending appetite may be more sensitive to policies that improve the credit quality environment (for example, support for borrower solvency and policies to improve credit information and bad debt recoveries) than solely to considerations related to capital positions. ### International bank credit: risks to emerging markets - A slowdown in international bank credit extension could be a source of a credit shortfall in emerging markets. - Trends and magnitudes: - Banks have cut back international lending to emerging markets in recent years. - Emerging market banks’ market share in global cross-border lending tripled (to 15 percent) between 2008 and 2018. - Close to 40 percent of cross-border lending to emerging markets is from banks based in other emerging markets. - Stability by provision channel: - Pure cross-border lending (lender has no presence in borrower country) is the least stable. - Lending through foreign bank branches (relying mainly on wholesale and intragroup funding) is relatively prone to outflows during stress. - Lending by foreign bank subsidiaries (incorporated, capitalized, and mainly funded locally) is the most stable. - Historical evidence: countries with higher foreign bank participation experienced larger and faster outflows under stress, with particular weakness where foreign bank branch participation was higher. - Simulation result: a one standard deviation shock to both lender and borrower factors could drive a 5 percent decline in international lending. - Regional vulnerability: Emerging market Asia (excluding China), where the COVID-19 Delta variant is spreading rapidly (at the time of the analysis), is particularly vulnerable. - Emerging market banks are expected to cut back more than advanced economy banks in such scenarios. ### Policy recommendations to secure recovery and limit financial stability risks - General guidance: - Monetary and fiscal policy support remains crucial but should be tailored to country-specific circumstances given uneven recoveries. - Normalization and removal of unprecedented policy support must be well telegraphed, gradual, tailored, and recalibrated as recovery evolves. - Central bank guidance: - Central banks should provide clear guidance about the future stance of monetary policy and progress toward policy normalization to avoid unnecessary market volatility. - If price pressures become persistent, monetary authorities should act decisively to avoid an unmooring of inflation expectations. - For emerging market central banks that implemented asset purchase programs during the pandemic, transparency and clear communication on objectives are crucial; asset purchase programs should generally be limited in time and scale and linked to clear objectives. - Preemptive actions to address vulnerabilities: - Act decisively to address potential unintended consequences of pandemic-era measures to avoid building legacy problems. - Tighten selected macroprudential tools early to tackle pockets of elevated vulnerabilities while avoiding broad tightening of financial conditions. - If macroprudential tools are unavailable (for example, in the nonbank financial intermediary sector), urgently develop them. - Consider building buffers elsewhere to protect the financial system where designing and operationalizing macroprudential tools is challenging. - Fiscal policy: - Tailor the type and size of fiscal support to the stage of recovery and country-specific needs. - Prioritize the most vulnerable households and businesses where fiscal space is limited. - As recovery takes hold, concentrate targeted support on borrowers deemed temporarily distressed but likely viable. - Emerging and frontier market measures: - Rebuild buffers and implement long-standing structural reforms to boost structural growth prospects and insulate against capital flow reversals and increased financing costs. - Recent allocation of special drawing rights by the IMF will provide liquidity relief and help ease policy space constraints. - Use selected macroprudential policies and prudent macro-financial risk management where vulnerabilities are building. - Deepen local currency markets and diversify investor bases by: - establishing sound legal and regulatory frameworks for securities; - developing efficient money markets; - enhancing transparency of primary and secondary markets and predictability of issuance; - bolstering market liquidity; and - developing robust market infrastructure. - Support for nonfinancial corporates: - Tailor support to viable firms; encourage firms with market access to seek private funding. - Strengthen insolvency frameworks (for example, via fast-track processes) to facilitate orderly exits of nonviable firms and enable orderly debt restructuring. - Housing market and macroprudential action: - Activate appropriate macroprudential measures to lean against rapid house price increases, including reviewing stressed debt service and loan-to-value ratios and deploying stringent stress tests. - Nonbank financial intermediation: - Urgently address vulnerabilities via enhanced prudential supervision and regulation. - Reduce run and liquidity risks in investment funds by increasing the value of waiting to sell fund shares and deploying liquidity management tools of increasing intensity sequentially. - Use market-based liquidity backstops first and central bank emergency liquidity support for tail episodes; international coordination of reforms is imperative. - Monitor risks in the life insurance sector from the need to meet high-return targets in a low-yield environment; conduct stress tests on sudden yield increases and encourage more homogeneous disclosure standards. *Sources: Bank for International Settlements; Bloomberg Finance L.P.; CEIC; Haver Analytics; national authorities; and IMF staff calculations.* ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEw: A DELICATE BALANCING ACT ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEw: A DELICATE BALANCING ACT ### Global overview and cross-sector vulnerabilities - With the recovery gaining traction, global financial vulnerabilities have declined somewhat on balance across most sectors. - Advanced economies: vulnerabilities have lessened, in particular among nonfinancial firms, but remain elevated in some sectors, such as sovereigns and insurers. - Emerging markets: improvement has been less evident; vulnerabilities remain high in a number of sectors. - Sovereigns: debt levels have risen further—and at a faster pace in advanced economies relative to emerging markets—driven by aggressive fiscal policy during the pandemic. - External financing: accommodative financial conditions have helped many emerging markets meet external financing needs, but domestic concerns around inflation, COVID-19, and vaccine availability have weakened nonresident capital flows and kept external vulnerabilities elevated. - Data scope: focus restricted to on-balance-sheet vulnerabilities; most current data points are through the fourth quarter of 2020. ### Nonfinancial firms and households - Nonfinancial firms: - Balance sheet fundamentals continued to improve as strong earnings have outpaced debt growth. - Leverage (measured as debt to earnings) has declined across most advanced and emerging market economies, reflecting the rebound in earnings. - Corporate liquidity buffers have dipped as firms increased dividends, started to invest again, and used cash for mergers and acquisitions, but liquidity ratios remain well above historical averages and near record highs in some regions. - Households: - Net financial asset position has improved, particularly in the euro area and the United States. - Household debt-to-GDP ratio has edged higher in the United States but remains close to the lows reached after the global financial crisis; debt servicing capacity remains resilient. - Debt levels have continued to rise in a number of major economies where liquid assets held by households have declined, increasing liquidity mismatches. - In emerging markets, household vulnerabilities have stayed elevated. ### Banking and broader financial sector - Global banking system: continued recovery from the initial pandemic shock; more than half of bank assets in systemically important economies now in low-risk categories. - Banks in advanced economies: leverage and capital measures have continued to improve. - Emerging markets: better liquidity measures driven by ample deposit inflows have reduced vulnerabilities in some jurisdictions. - Asset managers and other nonbank financial institutions: - Insurance sector vulnerabilities intensified in many jurisdictions (particularly the United States and the euro area), driven by deterioration in credit and leverage indicators. - Outside insurers, vulnerabilities have generally decreased. - Asset managers: decline in leverage and credit exposures led to marginal improvements in most advanced and other emerging market economies. - Chinese entities: vulnerabilities remain elevated due to rising maturity mismatches and financial interconnectedness with banks; recent Evergrande market reverberations highlighted such vulnerabilities. - Euro area: improvements at other financial institutions due to lower interconnectedness risks and reduced liquidity and maturity mismatches. ### Box 1.2 — Challenges for life insurers and yield scenarios - Market role: - Insurance industry holds about 20 percent of outstanding global bonds and about 30 percent of outstanding global corporate bonds. - Life insurers represent a critical source of demand for long-maturity bonds given long-dated liabilities; life insurers account for almost half of global insurance premiums. - Key balance-sheet features and trends: - Life insurers face elevated asset-liability-duration mismatches in some jurisdictions. - Spreads of investment yields to guaranteed policy returns remain negative and at historically wide levels despite reductions in average guaranteed policy returns in recent years. - US and European life insurers increased share of lower-quality bond investments; in Japan, life insurers increased share of higher-yielding foreign investments. - Sensitivity to yield increases and corporate stress: - A gradual yield increase would help mitigate long-term challenges by reducing duration mismatches and negative spreads. - A rapid and disorderly increase in bond yields—especially if coupled with wider corporate bond spreads—could hurt life insurers significantly. - Life insurers with longer durations and greater shares of riskier corporate bonds would be hit hardest by a sudden increase in yields. - US and UK life insurers are particularly sensitive: estimated losses exceed 30 percent of their assets in the worst-case yield increase and wider corporate spread scenario, versus less than 10 percent in the more modest yield increase scenario. - Policyholder surrenders and market impact: - Most life insurance policies have protections (exit penalties, accumulated bonuses embedded in guarantees, tax disincentives), making a sharp increase in surrenders unlikely in most scenarios. - A scenario of bond yields increasing 200 basis points or more could be associated with a significant increase in lapse rates as policyholders may surrender policies for new products offering higher yields. - EIOPA estimate: surrender volumes could increase to €372 billion in Europe in its most stressed scenario, generating a shortfall of about €340 billion, which could be covered through asset sales. - Assuming similar lapse rates in the United States: surrenders could amount to over $550 billion in the United States, about $1 trillion in combined surrenders. - While combined surrenders would be less than 2 percent of the total market value of US and European fixed-income markets, their impact could be significant if coinciding with selling pressure from other investors in a stressed scenario. - Simulation scenarios applied to aggregate life-insurer balance sheets (Europe and United States as of December 2020; Japan as of February 2021): - Benign yield increase scenario shocks: - Equity: −5 percent - Real estate: −2 percent - All sovereign and corporate bond yields: +100 basis points regardless of credit rating - Yield increase and corporate stress scenario shocks: - Equity: −10 percent - Real estate: −6 percent - Sovereign bond yields: AAA-A (+100 basis points), BBB (+150 basis points),