## EXECUTIVE SUMMARY

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### Global financial conditions and near-term outlook
- Global financial conditions have tightened notably and downside risks to the economic outlook have increased as a result of the war in Ukraine.
- The tightening has been particularly pronounced in eastern Europe and Middle East countries with close ties to Russia, reflecting lower equity valuations and higher funding costs.
- The tightening has occurred as most of the world was slowly bringing the pandemic under control and the global economy was recovering from COVID-19.
- Near-term growth forecast densities shifted lower amid greater tail risks (figure referenced).

### Financial stability risks and monetary policy trade-offs
- Financial stability risks have risen on several fronts, though so far no global systemic event affecting financial institutions or markets has materialized.
- A sudden repricing of risk from an intensification of the war and escalation of sanctions could expose vulnerabilities built up during the pandemic, leading to a sharp decline in asset prices.
- Sharp rise in commodity prices is anticipated to add to preexisting inflation pressure, creating a trade-off for central banks between fighting record-high inflation and safeguarding the post-pandemic recovery.
- Bringing inflation back down to target and preventing an unmooring of inflation expectations requires removing accommodation while preventing a disorderly tightening of financial conditions.
- Incoming inflation data suggest more decisive tightening of monetary policy is necessary in many countries.
- After rising early in the year on inflation concerns, advanced economy nominal bond yields increased further since the invasion amid heightened volatility of rates. Inflation break-evens have risen significantly on the back of sharply higher commodity prices.

### Direct and indirect financial exposures to Russia and Ukraine
- Banks’ direct exposures to Russia are relatively small except for some non-systemic European banks.
- Indirect exposures are more difficult to identify and assess because they are less well known and lack detailed and consistent disclosures; indirect exposures could be meaningful and surprise investors, raising counterparty risk and risk premia.
- Foreign non-bank financial intermediaries have sizable investments in Russian assets, with US and European investment funds accounting for most exposures; however, as a share of total assets their exposure to Russia is small.
- Dedicated emerging market funds reduced their share of Russian debt from more than 10 percent before 2014 to just over 4 percent in 2022.
- Funds benchmarked to global indices had an average 0.2 percent of their assets invested in Russian debt in 2022.

### Commodity markets, trade finance, and dealer bank roles
- Severe disruptions in commodity markets and supply chains have caused extreme volatility in commodity prices, amplified by pressures in commodity trade finance and derivatives markets.
- Dealer banks play a crucial role with significant exposures, including by providing liquidity and credit to a small group of large energy trading firms that operate globally, are largely unregulated, and are mostly privately owned.
- Pressures in commodity markets, often magnified by poor liquidity, have led to lower risk appetite and rising counterparty risk concerns, with implications for funding conditions.

### Emerging markets and capital flows
- Emerging and frontier markets face tighter financial conditions and higher risks of capital outflows.
- Since the war began, emerging market (EM) hard currency yields increased rapidly, akin to earlier episodes of EM stress, before retracing some in mid-March.
- The number of issuers trading at distressed levels has surged to nearly 25 percent of issuers, surpassing pandemic-peak levels.
- The deterioration in spreads, combined with the increase in US yields, has pushed financing costs well above pre-pandemic levels for many borrowers, though markets remain open for issuance at those higher funding cost levels.
- Flows in local currency bonds and equities experienced the largest weekly redemptions since March 2020; tighter external financial conditions from US monetary policy normalization and heightened geopolitical uncertainty are likely to increase downside risks for portfolio flows.

### China and emerging-market sovereign-bank linkages
- In China, a recent equity sell-off (particularly in the tech sector) and an increase in COVID-19 cases have raised concerns about a growth slowdown, with possible spillovers to emerging markets.
- Ongoing stress in China’s real estate sector has increased financial stability risks and added to growth pressures; extraordinary financial support measures may be necessary but could add to medium-term debt vulnerabilities.
- The interlinkages between emerging market sovereigns and domestic banks intensified over the past two years as additional government financing needs were largely met by banks; bank holdings of domestic sovereign debt surged to historic highs in 2021.
- Distress in emerging markets could trigger an adverse feedback loop between sovereigns and banks—the sovereign-bank nexus—potentially reducing bank soundness and lending.

### Medium-term structural risks and energy transition implications
- The war highlighted medium-term structural issues: risks to the geopolitics of energy security that may put climate transition at risk; potential fragmentation of capital markets and implications for the role of the US dollar; potential fragmentation in payment systems and creation of central bank digital currency blocs; increased crypto asset usage in emerging markets; and more complex bespoke asset allocations to preempt sanctions.
- The urgency to cut dependency on carbon-intensive energy and accelerate renewables is evident, but growing energy security concerns may set back the energy transition for some time.
- The current energy crisis may alter the speed of phasing out fossil fuel subsidies in emerging market and developing economies, and rising inflation pressure may lead authorities to resort to subsidies or other fiscal support for households or firms.
- Figure-related data point: Russia’s share in global production and price changes are measured for the period February 23 to March 23, 2022 (figure referenced).

### Crypto assets, fintech, and decentralised finance (DeFi)
- Crypto asset trading volumes against some emerging market currencies spiked following sanctions against Russia and the use of capital restrictions in Russia and Ukraine, compounding a longer-term increase in cross-border crypto transactions.
- Rapid growth of risky fintech business segments can be a cause for financial stability concern when fintech firms are subject to less stringent regulation.
- Value of DeFi assets and stablecoins rose significantly (figure referenced); stablecoins cited include USDC and USDT.

### Policy recommendations (explicit)
- Central banks should act decisively to prevent inflation pressure from becoming entrenched and avoid an unmooring of inflation expectations.
  - To avoid unnecessary volatility, central banks in advanced economies should provide clear guidance about the normalization process while remaining data dependent.
- Emerging market central banks: Many have already significantly tightened policy. Further rate increases, or policy normalization with respect to other pandemic-era measures (such as asset purchases), should continue as warranted according to the country-specific inflation and economic outlook to anchor inflation expectations and preserve policy credibility.
- Policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a disorderly tightening of financial conditions; striking a balance against procyclicality is important given economic uncertainty, monetary policy normalization, and fiscal limits after the pandemic.
- While addressing energy security concerns, policymakers should intensify efforts to implement the 2021 United Nations Climate Change Conference (COP26) road map to achieve net-zero targets:
  - Increase availability and lower cost of fossil fuel alternatives and renewables and improve energy efficiency.
  - Scale up private finance in the transition to a greener economy.
  - Continue to strengthen the climate finance information architecture.
- Policymakers should develop comprehensive global standards for crypto assets across the activity and risk spectrum.
  - Strengthen oversight of fintech firms and DeFi platforms to capture benefits while mitigating risks.
  - Preserve effectiveness of capital flow management measures amid growing crypto usage via a multifaceted policy strategy.
- Regulators should examine broader implications of recent market and exchange measures taken in response to commodity price volatility, including exchange governance mechanisms, resiliency of trading systems, concentration of risk, margin setting, and trading transparency in exchange and over-the-counter markets.

*International Monetary Fund | April 2022 — Executive Summary (Global Financial Stability Report: SHOCKWAVES FROM THE WAR IN UKRAINE TEST THE FINANCIAL SYSTEM’S RESILIENCE)*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2022/april/english/execsum.pdf_