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### Chapter 1 — At a Glance: Global outlook and market backdrop
- Global financial stability risks have increased since the April 2022 GFSR and the balance of risks is skewed to the downside.
- The world economy is experiencing the highest inflation in decades amid extraordinary uncertainty from COVID-19 and Russia’s ongoing war in Ukraine.
- The global economic outlook has worsened materially since April 2022; crystallized downside risks include:
  - higher-than-anticipated inflationary pressures;
  - a worse-than-expected slowdown in China because of COVID-19 outbreaks, lockdowns, and a further deterioration in real estate;
  - additional spillovers from Russia’s invasion of Ukraine.
- Data cutoff date: September 28, 2022.

### Financial conditions, asset markets, and volatility
- Financial conditions:
  - Financial conditions have continued to tighten globally since April; in many advanced economies conditions are tight by historical standards and in some emerging markets have reached levels last seen during the height of the COVID-19 crisis.
  - Conditions eased somewhat in China as policymakers provided additional support.
- Systemic risk gauges:
  - Dollar funding costs and counterparty credit spreads have risen, raising risk of a disorderly tightening in financial conditions.
- Risk assets and liquidity:
  - Equity prices have fallen sharply; corporate bond spreads have materially widened.
  - Market liquidity has deteriorated markedly, including in benchmark sovereign bond markets.
  - Cross-currency-basis swap spreads widened to their highest level since March 2020 for the euro and the yen.
- Volatility:
  - Rate volatility remained very elevated—at levels not witnessed since March 2020.
  - After a midyear relief rally, volatility increased again when major central banks reaffirmed their resolve to fight inflation.

### Crypto markets and extreme segments
- Crypto market stress and outcomes:
  - Bitcoin lost over 50 percent of its value.
  - Terra (largest non-collateralized algorithmic stablecoin) experienced an investor run, fell below parity with the US dollar, and collapsed.
  - Tether briefly traded below parity and saw significant outflows.
  - Cash-backed and more transparent stablecoins received some inflows and were able to maintain parity during the volatile period.

### Emerging markets, sovereign spreads, and currencies
- Sovereign stress and defaults:
  - 20 countries are either in default or trading at distressed levels.
  - 14 sovereigns have spreads exceeding 1,000 basis points.
  - Six sovereigns have already defaulted or engaged in debt restructuring: Belarus, Lebanon, Sri Lanka, Suriname, Russia, and Zambia.
  - Spreads on high-yield and frontier market sovereign indices are above 900 basis points, approximately 500 basis points higher than their pre-pandemic levels.
- Currency and flows:
  - Large depreciations against the US dollar in some jurisdictions have partly tracked widening interest rate differentials related to faster Fed hikes.
  - Outside Latin America, emerging market currencies have broadly depreciated in 2022.
  - Several central banks (Chile, Czech Republic, Indonesia, Japan, Philippines, Malaysia, among others) have intervened in FX markets or signaled readiness to do so.

### China and housing-sector risks
- Property sector stress:
  - Presale transactions accounted for about 90 percent of total home sales in recent years.
  - The property downturn deepened after sharp declines in home sales during lockdowns, exacerbating pressures on developers.
- IMF staff analysis on developers and bonds:
  - 45 percent of property developers by assets might not be able to cover their debt obligations with earnings at prevailing market conditions.
  - 20 percent of developers by assets could become insolvent if inventory values are adjusted to current property prices.
  - About 70 percent of offshore real estate bonds trade at 40 cents on the dollar or less.
- Banking exposures:
  - 8 percent of total lending is to property developers.
  - 20 percent of total lending is to mortgage borrowers.
- Downside bank solvency scenario (IMF staff analysis):
  - If 10 percent of exposures to distressed property developers and 10 percent of mortgage exposures related to unfinished properties become nonperforming with very low recovery values, then 15 percent of banks in the sample, representing 10 percent of total banking system assets, would fail to meet minimum capital requirements.
  - Assumed minimum capital requirement: 10.5 percent CAR for other banks, plus additional buffers for DSIBs and GSIBs.
- Policy actions announced by authorities:
  - Property sector rescue fund authorized to raise up to RMB 300 billion.
  - RMB 200 billion in special loans through policy banks.
  - Credit guarantees offered by China Bond Insurance Co. to support bond issuance by property developers.
  - Reduction in the five-year loan prime rate, with the minimum first-home mortgage rate set at 20 basis points below the five-year loan prime rate.

### Banking sector, global stress tests, and corporate credit
- Global bank stress test (sample and coverage):
  - Sample: 262 banks from 28 countries accounting for 70 percent of global sector assets.
  - Aggregate capital outcomes: Global CET1 ratio increased from 12.5 percent in 2019 to 14.1 percent in 2021.
  - In the stress scenario, global CET1 ratio declines from 14.1 percent in 2021 to a minimum of 11.4 percent in 2023, barely recovering to 11.5 percent in 2024.
- Emerging market bank sensitivity:
  - Maximum drop in CET1 ratio from 2021 reaches 4.3 percentage points for emerging market banks, which is 1.7 percentage points larger than for advanced economy banks.
  - Under a severe downturn scenario, up to 29 percent of emerging market bank assets could breach minimum capital requirements; in advanced economies most banks would remain resilient.
- Distribution of distress and capital shortfalls:
  - More distressed cases account for 5 percent of total global assets in the sample and would require $77 billion to bring CET1 to 4.5 percent.
  - Banks accounting for 10 percent of total assets would fail to meet the 4.5 percent minimum CET1.
  - Among GSIBs, no bank would fall below 4.5 percent, but 11 percent of GSIBs (by assets) would need to dip into capital conservation buffers (CCBs).
  - Total capital rebuilding need (rebuilding CCB/GSIB buffers and shortfalls) amounts to about $214 billion.
- Corporate credit and leveraged finance:
  - Sub-investment-grade firms are more exposed to a turn in the credit cycle.
  - Corporate downgrades are increasing and corporate bond yields (cost of new funding) have risen materially.
  - Private credit reached $1.4 trillion at end-2021.
  - Almost one-third of new leveraged loans have ratios of debt to EBITDA greater than six times earnings.
  - In the United States, more than 50 percent of the leveraged finance market is now composed of firms with a B credit rating.
  - CLOs’ average holdings of B-rated loans have more than doubled over the past five years.
  - Almost half of lower-rated CCC credit is trading at distressed levels.
- IMF partial sensitivity analysis (interest coverage assumptions and outcomes):
  - Panel assumptions: volume of goods sold declines by 7.5 percent; price of unit of goods sold increases by 13.4 percent; cost of unit of goods sold increases by 20.5 percent.
  - Effective interest rate on firms’ total debt rises by 100 basis points for large firms, 312 basis points for medium firms, and 524 basis points for small firms.
  - Share of debt with interest coverage ratio below 0 rises quickly, exceeding 50 percent at small firms (averages across advanced and emerging markets).
  - Share of debt at firms with interest coverage ratio between 0 and 3 increases to more than one-third at both large and midsize firms, especially among emerging markets.
  - Firm size definitions: large firms = assets greater than $500 million; medium firms = assets between $500 million and $50 million; small firms = assets less than $50 million.

### Market liquidity, market structure, and funding stresses
- Market liquidity deterioration:
  - Bid-ask spreads widened significantly; market depth declined sharply; liquidity premiums increased.
  - Market liquidity has significantly worsened across asset classes, including advanced-economy government bond markets and standardized/exchange-traded products.
- Structural drivers:
  - Regulatory reforms reduced banks’ balance-sheet-intensive market-making capacity.
  - Technological shifts moved market-making toward principal trading firms that may pull back when volatility increases.
  - Passive investing: US S&P 500 index trackers and ETFs more than doubled assets to an almost 20 percent share of the market in less than a decade.
- Short-term international dollar funding stresses:
  - Three-month cross-currency basis swaps (euro and yen vs US dollar) surged to widest since March 2020.
  - FRA-OIS spreads have increased, signaling potential drops in supply of US dollar funding.
  - Dealers appear less willing to deploy balance sheets, reducing market depth.
- Quantitative tightening implications:
  - Reduced central bank demand for sovereign bonds could leave more bonds in private hands, implying higher liquidity premiums and lower market liquidity, all else equal.

### Regional strains: Europe and UK market stress
- European energy crisis and market functioning:
  - Skyrocketing energy prices and volatility led to large margin calls on utilities, forcing extra collateral postings and contributing to widened government bond swap spreads in the euro area.
  - Several European governments implemented emergency support schemes (liquidity lines, loan guarantees, freezing energy bills).
  - The ECB ended net asset purchases and raised key policy rates by 125 basis points; designed the Transmission Protection Instrument (TPI) to address fragmentation risk.
- United Kingdom gilt market stress and policy response:
  - After large debt-financed tax cuts and fiscal measures, the pound depreciated and UK sovereign yields rose sharply.
  - Bank of England announced on September 28 temporary and targeted purchases of long-dated UK government bonds to prevent dysfunction; purchases scheduled to end on October 14 and be unwound once risks subsided.
  - Following the announcement, the pound appreciated and yields reversed a portion of earlier increases.
  - Market-implied expectations: investors now expect the Bank of England to hike the policy rate by about 240 basis points by year end, bringing it to nearly 6 percent in 2023.

### Macroeconomic outlook, inflation expectations, and recession risk
- Growth and risks:
  - Global economic growth for 2022 downgraded to 3.2 percent, 0.4 percentage point lower than April 2022 WEO projection.
  - IMF growth-at-risk framework: downside risks are very high compared to historical norms; probability of growth falling below zero is currently about 10 percent for 2022.
- Inflation expectations:
  - Option-implied inflation probabilities show investors assign significant probability to inflation outcomes being greater than 3 percent in coming years, particularly in the euro area and the United Kingdom; investor disagreement has increased.
  - In the United States, the median September 2022 FOMC participant anticipates the federal funds rate to significantly exceed the FOMC projection of the nominal neutral rate over the entire forecast period.
  - In real terms, the federal funds rate is expected to climb from deeply negative levels in 2022 to more than 150 basis points in 2023, implying nearly 300 basis points of real policy tightening.
- Historical evidence:
  - Historically, when the Federal Reserve raised the federal funds rate close to or above measures of the neutral nominal rate, the US economy often entered recession soon thereafter (1994 tightening cycle is a notable exception).

### Central bank actions and interest-rate developments
- Since April 2022 GFSR:
  - The Federal Reserve has initiated balance sheet reduction and raised the federal funds rate target range by 275 basis points—including three 75 basis point increases.
  - The ECB ended net asset purchases, raised key policy rates by 125 basis points, and designed the TPI.
  - The Bank of England announced it will reduce its gilts holding in the Asset Purchase Facility (APF) by 80 billion pounds over the next 12 months.
  - Active gilt sales via auction originally scheduled for October 3, 2022, were postponed to October 31 following the Bank of England’s September 28 announcement.
- Forward guidance and expectations:
  - Given uncertainty, the Federal Reserve, the ECB, and the Reserve Bank of Australia indicated they would no longer provide precise forward policy guidance, moving to a meeting-by-meeting approach.
  - Market-implied expectations of policy rates have risen since the previous GFSR across most advanced economies.
  - Medium- and long-term interest rates have been volatile and ended the period higher in some countries; real yields have risen markedly.

### Macrofinancial scenarios, capital flows, and downside stress projections
- Capital flows and issuance:
  - Investors withdrew about $75 billion from local currency bonds in China between February and August 2022, including nearly 15 percent of foreign holdings of government bonds.
  - Bond funds dedicated to emerging markets (hard and local currency combined) saw record dollar outflows of over $60 billion through late-September 2022, nearly 10 percent of assets under management.
  - From January through September 2022, sovereign new issues declined 54 percent year over year, to $68 billion.
  - Corporate nonfinancial bond issuance declined to just under $60 billion over the same period, down 75 percent year over year.
  - Weighted-average maturity of new issuance declined; only 18 percent of bonds issued at maturities >15 years—the lowest since 2013.
- Risk metrics and stress projections:
  - IMF capital-flows-at-risk analysis: probability of outflows over the next three quarters has risen to over 40 percent, up from 30 percent in April 2022 GFSR.
  - Capital flows at risk increased to 3.2 percent of GDP for emerging markets (lowest fifth percentile of forward-looking distribution).
  - Historical-sensitivity stress scenario: distressed sovereigns (spreads >1,000 basis points) could rise from 20 to 31 under a sharp tightening of global financial conditions.
  - In that scenario, over 40 countries would have spreads exceeding 700 basis points; distressed issuers would account for 20 percent of the benchmark EM bond index (market cap) and barely 5 percent of global GDP; spreads would remain below 600 basis points for more than 60 percent of the index.

### Macroeconomic indicators, frontier markets, and reserves
- Currency composition and local markets:
  - Larger emerging markets shifted toward more local currency debt issuance; frontier markets have relied more on foreign currency debt.
  - Nonresident share of local debt declined in several large emerging markets by at least 10 percentage points since January 2020.
  - Cumulative inflows into local currency bond markets from January 2020 to March 2022 were less than 0.5 percent of GDP (compared with 2.8 percent in runup to 2013 taper tantrum and 1.9 percent in 2015–16 Fed hiking cycle).
- Reserve adequacy:
  - Reserves generally healthy but buffers have eroded and a weak tail of countries persists.
  - Reserves in the range of 100–150 percent of the IMF’s Assessing Reserve Adequacy (ARA) metric are considered broadly adequate for precautionary purposes.
- Frontier markets:
  - Over 40 percent of frontier bonds maturing through 2025 are trading at distressed spreads (above 1,000 basis points).
  - Close to 80 percent of frontier bonds are trading at spreads of more than 700 basis points.
  - Frontier issuance down 75 percent through September 2022, with only three issuances since early April.
  - Median debt-to-GDP ratio for frontier markets nearly doubled since 2010, though expected to decline somewhat in 2022.
  - Several defaulted/distressed frontier issuers owe more than one-third of external debt to private sector creditors.
  - Of the four frontier markets currently in default: Belarus, Sri Lanka, Suriname, Zambia.
  - Sixty-nine low-income countries eligible for the G20 Common Framework; eight low-income countries in debt distress and 30 at high risk of distress.
  - G20 Common Framework: only three requests (Chad, Ethiopia, Zambia) and no completed restructurings to date.

### Housing markets, house-price-at-risk, and downside scenarios
- House-price dynamics and risk:
  - House prices surged by more than 20 percent in some economies since pandemic onset.
  - Price-to-income ratios reached highest level in two decades in many countries.
- House-price-at-risk (severely adverse scenario, 5th percentile, three years ahead):
  - Emerging markets: –23.5 percent (cumulative real house price growth).
  - Advanced economies: –10.6 percent (cumulative real house price growth).
- Mitigating factors:
  - Stronger bank capital and more conservative underwriting since global financial crisis could limit contagion via banks.
  - Risks may be emerging where nonbank financial institutions play larger roles in securitized mortgage markets (for example, the United States).

### Policy priorities and recommendations
- Monetary policy:
  - Central banks must act resolutely to bring inflation back to target and avoid de-anchoring of inflation expectations.
  - Avoid a stop-go normalization path; rethink forward guidance as policy rates move away from effective lower bound; clear communication on objectives and trade-offs is essential.
- Fiscal policy:
  - Tighter fiscal policy can support monetary policy in achieving inflation objectives; governments should reprioritize spending to protect the most vulnerable within budget constraints.
- Euro area:
  - Ensure transmission across member states and counter fragmentation risks; the ECB’s TPI is noted as a step to address fragmentation.
- Emerging and frontier markets:
  - Continue country-specific rate increases as warranted; rebuild fiscal space and buffers; use IMF Integrated Policy Framework to manage tightening and a stronger US dollar.
  - Foreign exchange interventions may be appropriate if reserves suffice and do not impair credibility or substitute for needed macro adjustment.
  - Capital flow management measures may be used in crises as part of a comprehensive package and lifted once crisis conditions abate.
- Sovereign debt strategy:
  - Contain debt vulnerabilities via early creditor engagement, multilateral cooperation, and international support.
  - Use enhanced collective action clauses and majority voting provisions in syndicated loans to facilitate restructurings.
  - For countries near debt distress, coordinate preemptive restructuring; use G20 Common Framework where applicable.
  - Consider value recovery instruments (GDP- or commodity-linked warrants) to improve restructuring outcomes.
- Financial stability and macroprudential policy:
  - Contain further buildup of financial vulnerabilities via selected macroprudential adjustments while avoiding procyclicality and disorderly tightening.
  - Develop macroprudential tools for nonbank financial institutions; ensure adequate supervision and risk management.
  - Strengthen liquidity risk management practices across counterparties.
- Market liquidity, transparency, and crypto regulation:
  - Implement policies to mitigate market liquidity risks, monitor trading infrastructures, support market transparency, and improve trade-level data availability.
  - Strengthen counterparty liquidity risk management and enhance transparency and data availability for principal trading firms and hedge funds.
  - Implement comprehensive, consistent regulation and supervision of crypto asset markets under a “same activity, same risk, same regulation” principle.
  - Strengthen international cooperation for consistent implementation and to contain spillovers.
- Housing and China-specific recommendations:
  - Monitor housing markets; deploy stringent stress tests for house-price declines' impact on households and financial institutions.
  - In China, urgent central government action needed: credible, low-cost mechanisms to complete presold housing; restructure distressed developers; restore home-buyer confidence; contingency planning; macroeconomic support; and medium-term structural reforms.
- Bank supervision and data:
  - Ensure asset classifications and loan-loss provisions reflect credit risk; strengthen risk management, stress-testing, and data collection.
  - Maintain adequate capital buffers and require credible plans to restore capital after significant declines.
  - Enhance transparency in private debt markets and collect cross-border exposure data.
  - Restructuring and insolvency tools should facilitate orderly exit of nonviable firms; short-term fiscal support may be appropriate for viable firms subject to fiscal space.

*International Monetary Fund | October 2022 — Chapter 1 (ch1)*

### Chapter 1 at a Glance

### Chapter 1 at a Glance

### Global outlook and market backdrop
- Global financial stability risks have increased since the April 2022 Global Financial Stability Report and the balance of risks is skewed to the downside.
- The world economy is experiencing the highest inflation in decades amid extraordinary uncertainty stemming from the COVID-19 pandemic and Russia’s ongoing war in Ukraine.
- The global economic outlook has worsened materially since the April 2022 GFSR; a number of downside risks have crystallized, including:
  - higher-than-anticipated inflationary pressures;
  - a worse-than-expected slowdown in China because of COVID-19 outbreaks, lockdowns, and a further deterioration in real estate;
  - additional spillovers from Russia’s invasion of Ukraine.
- Unless otherwise stated, the data cutoff date is September 28, 2022.

### Financial conditions and asset markets
- Financial conditions have continued to tighten globally since April; in many advanced economies conditions are tight by historical standards and in some emerging markets have reached levels last seen during the height of the COVID-19 crisis.
- In contrast, conditions have eased somewhat in China as policymakers provided additional support.
- Key gauges of systemic risk, such as dollar funding costs and counterparty credit spreads, have risen with a risk of a disorderly tightening in financial conditions that could interact with preexisting vulnerabilities.
- Risk assets have declined sharply on balance in 2022:
  - Equity prices have fallen sharply; corporate bond spreads have materially widened.
  - Market liquidity has deteriorated markedly, including in benchmark sovereign bond markets.
  - Cross-currency-basis swap spreads have widened to their highest level since March 2020 for the euro and the yen.
- Volatility:
  - Rate volatility remained very elevated—at levels not witnessed since March 2020.
  - After a midyear relief rally, volatility increased again when major central banks reaffirmed their resolve to fight inflation.

### Crypto markets and extreme segments
- Crypto markets experienced extreme volatility amid rising correlation with equities and poor market liquidity:
  - Bitcoin lost over 50 percent of its value.
  - Terra, the largest non-collateralized algorithmic stablecoin, experienced an investor run, fell below parity with the US dollar, and collapsed.
  - Tether briefly traded below parity and saw significant outflows.
  - Cash-backed and more transparent stablecoins received some inflows and were able to maintain parity during the volatile period.

### Emerging markets, sovereign spreads, and currencies
- Rising rates, worsening fundamentals, and large outflows have pushed up borrowing costs notably for emerging markets; the impact has been especially severe for more vulnerable economies.
- Sovereign stress:
  - 20 countries are either in default or trading at distressed levels.
  - 14 sovereigns have spreads exceeding 1,000 basis points, a level commonly considered distressed and at high risk of default.
  - Six more sovereigns have already defaulted or engaged in debt restructuring (Belarus, Lebanon, Sri Lanka, Suriname, Russia, and Zambia).
  - Spreads on the high-yield and frontier market sovereign indices are above 900 basis points, approximately 500 bps higher than their pre-pandemic levels.
- Large emerging market issuers with stronger fundamentals have proved resilient thus far.
- Currency movements:
  - Large depreciations against the US dollar in some jurisdictions have partly tracked widening interest rate differentials related to faster Fed hikes.
  - Outside Latin America, emerging market currencies have broadly depreciated in 2022.
  - Several central banks (Chile, Czech Republic, Indonesia, Japan, Philippines, and Malaysia, among others) have intervened in FX markets or signaled readiness to do so.

### China and housing sector risks
- In China, the property downturn has deepened as sharp declines in home sales during lockdowns have exacerbated pressures on developers, with heightened risk of spillovers to the banking, corporate, and local government sectors.
- In many other countries, housing markets still show signs of overheating and there is a risk of a sharp fall in house prices as mortgage rates rise, affordability falls, and lending standards tighten.

### Banking, corporate credit, and stress tests
- Global stress tests for banks show that, under a severe downturn scenario, up to 29 percent of emerging market bank assets could breach minimum capital requirements; in advanced economies most banks would remain resilient.
- Corporate credit:
  - Sub-investment-grade firms are more exposed to a turn in the credit cycle and deteriorating investor risk appetite.
  - Corporate downgrades are increasing and corporate bond yields (cost of new funding) have risen materially.
  - Emerging market companies are particularly vulnerable given that balance sheet leverage has risen since the onset of the pandemic.

### Regional strains: Europe
- European financial markets have shown significant strains amid an unprecedented energy crisis, continued supply chain disruptions, and heightened concerns about the economic outlook.
- Energy prices reached record-high levels in the summer, amplifying stresses in the region.

### Policy priorities and recommendations
- Central banks must act resolutely to bring inflation back to target, to keep inflationary pressures from becoming entrenched, and to avoid de-anchoring of inflation expectations that would damage credibility.
- Given high uncertainty, explicit precise guidance on the future path of monetary policy is hampered; nonetheless, clear communication about policy function, unwavering commitment to mandated objectives, and the need to further normalize policy is crucial to avoid unwarranted market volatility.
- Ensuring effective transmission of monetary policy is crucial during normalization:
  - The Transmission Protection Instrument announced by the European Central Bank is noted as a welcome step to address euro area fragmentation risks.
- For emerging markets, per the IMF’s Integrated Policy Framework, where appropriate some countries managing the global tightening cycle could consider using some combination of targeted foreign exchange interventions, capital flow measures, and/or other actions to help smooth exchange rate adjustments to reduce financial stability risks and maintain appropriate monetary policy transmission.
- Policymakers should contain a further buildup of financial vulnerabilities by adjusting selected macroprudential tools as needed, while striking a balance to avoid procyclicality and a disorderly tightening of financial conditions.
- Implementation of policies to mitigate market liquidity risks is key; counterparties should strengthen their liquidity risk management practices.

*International Monetary Fund | October 2022 — Chapter 1 at a Glance*

### 1. S&P 500 Equity Index Returns

### 1. S&P 500 Equity Index Returns

### Equity and Credit Market Developments
- Decomposition (Percent; cumulative returns since Oct 2021): lower equity risk premiums, lower risk-free rates, and higher earnings contribute positively to stock market returns, and vice versa. (EU = European Union; GFSR = Global Financial Stability Report; HY = high yield; IG = investment grade; US = United States.)
- Corporate credit spreads have continued to widen since the April 2022 GFSR.
- Global corporate bond and leveraged loan spreads (Basis points) have widened; emerging market credit spreads have widened sharply on net, with differentiation by rating.
- Emerging market sovereign spreads (Basis points) have widened on net.

### European Energy Crisis and Market Functioning
- Skyrocketing energy prices and high volatility have led to large margin calls on derivatives positions used by utilities to lock in future electricity price sales, forcing companies to post extra collateral and contributing to a widening of government bond swap spreads in the euro area.
- Several European governments implemented emergency support schemes: short-term liquidity lines and loan guarantees; measures such as freezing energy bills were implemented to support households and energy-intensive businesses.
- Several European countries have set up new schemes to provide liquidity support for energy companies, including Finland, Germany, Sweden, and the United Kingdom. The United Kingdom also introduced the Energy Price Guarantee to limit energy prices.
- Euro area: ECB started to normalize policy; concerns about fragmentation risk resurfaced as investors focused on fiscal vulnerabilities in some member states. Spreads of southern European government bond yields over similar-maturity German yields have widened, on net, since April. The ECB’s active use of asset reinvestment policy and the announcement of the new “Transmission Protection Instrument” have helped contain a disorderly widening of spreads.

### United Kingdom Market Stress and Policy Actions
- After announcement of large debt-financed tax cuts and fiscal measures, investor concerns about the fiscal and inflation outlook weighed heavily on market sentiment in late September: the British pound depreciated abruptly, while yields on UK sovereign bonds rose sharply.
- Large mark-to-market losses and associated margin calls raised concerns of fire sales and further yield increases.
- Bank of England announced on September 28 temporary and targeted purchases of long-dated UK government bonds to prevent dysfunction in the gilt market; purchases were scheduled to end on October 14 and to be unwound in a smooth and orderly fashion once risks subsided. The Bank also indicated it would not hesitate to hike interest rates as much as needed to achieve its 2 percent target in the medium term.
- Following the announcement, the British pound appreciated and yields on UK government debt reversed a portion of their earlier increases, particularly at the long end.
- Market-repriced expectations: investors now expect the Bank of England to hike the policy rate by about 240 basis points by year end, bringing it to nearly 6 percent in 2023.

### Market Liquidity and Balance Sheet Vulnerabilities
- Market liquidity has significantly worsened across asset classes and is an important shock amplifier; deterioration observed even in typically highly liquid markets (advanced economy government bond markets) and standardized/exchange-traded products (stocks, foreign exchange, exchange-traded futures).
- IMF indicator-based framework shows balance sheet vulnerabilities currently most prominent in the sovereign sector.
- Public sector balance sheets have cushioned pandemic impacts on households and nonfinancial firms at the cost of fiscal deterioration and large increases in sovereign debt.
- Nonbank financial intermediation sector vulnerabilities are elevated, reflecting high liquidity and maturity transformation, exposure to credit and duration risk, and interconnectivity with the banking sector.
- Nonfinancial corporate sector vulnerabilities have declined overall, but some sectors and lower-rated firms are seeing deterioration and a pickup in credit rating downgrades that could presage a rise in default rates from below-average levels.
- Housing sector vulnerabilities remain elevated in emerging markets and some advanced economies; house-price-to-income ratio has reached its highest level in two decades in many countries amid rising mortgage rates and tighter lending standards.

### Macroeconomic Outlook and Risks
- Global economic growth for 2022 has been marked down to 3.2 percent, 0.4 percentage point lower than projected in the April 2022 WEO.
- The balance of risks is squarely skewed to the downside; global financial stability risks have materially worsened since the April 2022 GFSR.
- IMF growth-at-risk framework: downside risks are very high compared to historical norms. The probability of growth falling below zero is currently about 10 percent for 2022.

### Central Bank Actions and Interest Rate Developments
- Since the April 2022 GFSR:
  - The Federal Reserve has initiated balance sheet reduction (quantitative tightening) and raised the target range for the federal funds rate by 275 basis points—including three 75 basis point increases.
  - The ECB has ended its net asset purchases, raised its key policy rates by 125 basis points (after eight years of negative rates on the deposit facility), and designed a new tool to prevent fragmentation in the euro area.
  - The Bank of England announced it will reduce its gilts holding held in the Asset Purchase Facility (APF) by 80 billion pounds over the next 12 months.
- Active sales of gilts via auction originally scheduled to commence on October 3, 2022, were postponed to October 31 following the Bank of England’s September 28 announcement of temporary and targeted purchases.
- Given the uncertain outlook, the Federal Reserve, the ECB, and the Reserve Bank of Australia indicated they would no longer provide precise forward policy guidance, moving to a meeting-by-meeting approach based on incoming data. Several other advanced economy central banks have also taken significant steps toward policy normalization (Bank of England, Bank of Canada, Reserve Bank of New Zealand, Swiss National Bank).
- Market-implied expectations of policy rates have risen since the previous GFSR across most advanced economies.
- Medium- and long-term interest rates have been volatile and ended the period higher in some countries. Real yields have risen markedly due to a higher expected path of short-term real rates and rising real term premiums. Inflation breakevens have generally declined across tenors, with temporary increases in five-year breakevens in the euro area and the United Kingdom as the energy crisis intensified.

### Inflation Expectations and Recession Risks
- Inflation options evidence: investors assign significant probability to inflation outcomes being greater than 3 percent in coming years, particularly in the euro area and the United Kingdom; disagreement among investors around likely outcomes has increased since the end of last year.
- In the United States, the median September 2022 FOMC participant anticipates the federal funds rate to significantly exceed the FOMC projection of the nominal neutral rate over the entire forecast period.
- In real terms, the federal funds rate is expected to climb from deeply negative levels in 2022 to more than 150 basis points in 2023, implying nearly 300 basis points of real policy tightening.
- Historical evidence: every time the Federal Reserve has raised the federal funds rate close to, or above, measures of the neutral nominal rate, the US economy has entered a recession soon thereafter, with the 1994 tightening cycle as a notable exception.

Sources: Bloomberg L.P.; ICE Bond Indices; JPMorgan Chase & Co.; PitchBook Leveraged Commentary and Data; Refinitiv Datastream; IMF staff calculations; IMF GDS database; IMF World Economic Outlook; IMF staff analysis.

*Source: ch1 - 1. S&P 500 Equity Index Returns (chapter excerpt), GLOBAL FINANCIAL STABILITY REPORT: NAVIGATING THE HIGH-INFLATION ENVIRONMENT, International Monetary Fund | October 2022*

### 1. Option-Implied Probability of Various Inflation Outcomes

### 1. Option-Implied Probability of Various Inflation Outcomes

### Option-implied inflation probabilities and investor disagreement
- Option-implied probability distributions are shown for the United Kingdom, Euro area, and United States over five years (panels indicate percent, over five years).
- Visual ranges on charts span numeric tick marks: 0, 20, 40, 60, 80, 100 (panel axes for probability percent).
- Commentary in the chapter notes: "... but with notable disagreement among investors."
- Note: “Latest” refers to the time of the October 2022 GFSR.

### United States: probability density of inflation outcomes
- Probability density chart axis labels preserve numeric scale: 0.0, 0.1, 0.2, 0.3, 0.4, 0.5, 0.6 and percent ticks 1 2 3 4 (as displayed on figure).
- The chapter highlights divergence in investor views implied by option prices for US inflation.

### Euro area: probability density of inflation outcomes
- Probability density chart axis labels preserve numeric scale: 0.0, 0.1, 0.2, 0.3, 0.4, 0.5, 0.6 and percent ticks 1 2 3 4 (as displayed on figure).
- The Euro area distribution is presented alongside US and UK distributions to illustrate cross-market differences in implied inflation risks.

### Broader context and related quantitative findings in Chapter 1
- Market and policy environment context:
  - Markets are pricing in an end to rate hikes in most countries by the end of this year or early next year (excluding Asia) and substantial rate cuts by some emerging market central banks in 2023 (Figure 1.12, panel 1).
  - Sovereign bond term premiums have increased sharply, especially for central and eastern Europe (Figure 1.12, panel 2).
  - Volatility in local bond market yields has risen globally and has approached peak historical levels in some emerging markets (Figure 1.12, panel 3).
- Capital flows and market pressures:
  - Investors withdrew about $75 billion from local currency bonds in China between February and August 2022, including nearly 15 percent of foreign holdings of government bonds.
  - Bond funds dedicated to emerging markets (hard and local currency combined) have seen record dollar outflows of over $60 billion through late-September 2022, nearly 10 percent of assets under management.
  - From January through September 2022, the volume of sovereign new issues declined 54 percent year over year, to $68 billion.
  - Corporate nonfinancial bond issuance declined to just under $60 billion over the same period, down 75 percent year over year.
  - The weighted-average maturity of new issuance has declined, with only 18 percent of bonds issued at maturities of more than 15 years—the lowest since 2013.
- Risk metrics and projections:
  - IMF staff analysis using capital-flows-at-risk methodology indicates the probability of outflows over the next three quarters has risen to over 40 percent, up from 30 percent in the April 2022 GFSR.
  - Capital flows at risk have increased to 3.2 percent of GDP for emerging markets (defined as the lowest fifth percentile of the forward-looking distribution for capital flows).
  - Historical-sensitivity stress scenario suggests the number of distressed sovereigns (with spreads of more than 1,000 basis points) could rise from 20 to 31 under a sharp tightening of global financial conditions.
  - In that scenario, over 40 countries would have spreads exceeding 700 basis points; distressed issuers would account for only 20 percent of the benchmark emerging market bond index (based on market capitalization) and barely 5 percent of global GDP; spreads would remain below 600 basis points for more than 60 percent of the index.

### Data and sources
- Sources cited in the figures: Bloomberg Finance L.P.; and IMF staff calculations.
- GFSR = Global Financial Stability Report.

*Sources: Bloomberg Finance L.P.; and IMF staff calculations. Note: “Latest” refers to the time of the October 2022 GFSR.*

### 1. Macroeconomic Indicators

### 1. Macroeconomic Indicators

### Currency composition of public debt and local markets
- Larger emerging markets have shifted toward more local currency debt issuance, while frontier markets have relied more on foreign currency debt.
- Nonresident share of local debt has declined in several large emerging markets by at least 10 percentage points since January 2020.
- Cumulative inflows into local currency bond markets from January 2020 to March 2022 were less than 0.5 percent of GDP, compared with 2.8 percent of GDP in the runup to the 2013 taper tantrum and 1.9 percent of GDP in the 2015–16 Federal Reserve hiking cycle.
- Foreign participation in local currency debt markets has declined, providing some insulation from shifts in external risk sentiment (panel labels use ISO country codes).

### Reserve adequacy
- Reserves appear generally healthy but buffers have eroded and a weak tail of countries persists.
- Reserves in the range of 100–150 percent of the IMF’s Assessing Reserve Adequacy (ARA) metric are considered broadly adequate for precautionary purposes, though country-specific considerations may apply.
- Panel 3 is based on 10-year zero coupon yields.

### Sovereign spreads, market access, and downside risks
- Emerging market sovereign bond spreads display a wide distribution; many frontier markets face poor prospects for market access, with potential for debt distress to spread if conditions worsen.
- Over 40 percent of frontier bonds maturing through 2025 are trading at distressed spreads (above 1,000 basis points).
- Close to 80 percent of frontier bonds are trading at spreads of more than 700 basis points.
- Frontier issuance has dropped sharply in 2022, with total volume down 75 percent through September and only three issuances since early April.
- Without substantial improvement in market conditions, many issuers may need new bilateral or multilateral financing (including IMF-supported programs), debt reprofiling and restructuring, and structural reforms to improve fiscal balances.

### Frontier markets: debt dynamics and creditor complexity
- The median debt-to-GDP ratio for frontier markets has nearly doubled since 2010, although it is expected to decline somewhat in 2022.
- Interest expenses on government debt have continued to rise, increasing immediate liquidity pressures and potentially crowding out public investment.
- Frontier markets have increasingly relied on private sector creditors (Eurobonds and syndicated loans); several countries that traded at distressed levels or are already in default owe more than one-third of their external debt to the private sector.
- Of the four frontier markets currently in default: Belarus, Sri Lanka, Suriname, Zambia.
- Sixty-nine low-income countries are eligible for the G20 Common Framework (an IMF-supported program is a precondition); eight low-income countries are in debt distress and 30 are at high risk of distress (out of 69 countries considered low-income).
- The G20 Common Framework has had only three requests (Chad, Ethiopia, Zambia) and no completed restructurings to date.

### Local currency yields and investor base
- Domestic local currency yields have surged to the highest in a decade, but adjusted for one-year-ahead inflation expectations, the rise appears more manageable for core emerging markets.
- The financing burden has shifted to domestic markets, with banks and non-bank financial institutions taking on an increased financing role since the COVID-19 shock.
- This shift has created a sovereign–bank nexus that is a key vulnerability (see related analysis in Chapter 2 of the April 2022 GFSR).

### China — property sector stress and banking spillovers
- Presale transactions have accounted for about 90 percent of total home sales in recent years, making presale receipts a major source of funding for developers.
- The property sector downturn deepened after declines in home sales during lockdowns, increasing liquidity stress for property developers and reducing their ability to complete construction.
- IMF staff analysis findings:
  - 45 percent of property developers by assets might not be able to cover their debt obligations with earnings at prevailing market conditions.
  - 20 percent of developers by assets could become insolvent if their inventory value is adjusted to current property prices.
  - About 70 percent of offshore real estate bonds trade at 40 cents on the dollar or less.
- Banking sector exposures:
  - 8 percent of total lending is to property developers.
  - 20 percent of total lending is to mortgage borrowers.
- Downside bank solvency scenario (IMF staff analysis):
  - If 10 percent of exposures to distressed property developers and 10 percent of mortgage exposures related to unfinished properties become nonperforming loans with very low recovery values, then 15 percent of banks in the sample, representing 10 percent of total banking system assets, would fail to meet minimum capital requirements.
  - The minimum capital requirement assumed is a 10.5 percent CAR for other banks, plus additional required buffers for DSIBs and GSIBs.
- Local government and regional risks:
  - Large stocks of unfinished presold housing and limited fiscal space in some regions could generate macro-financial spillovers.
  - Presold unfinished houses are estimated from cumulative home presales and housing construction since 2010; risky debt of LGFVs is debt issued by LGFVs with EBIT lower than net interest expense for the past three years.

*Source: Chapter 1 — "Macroeconomic Indicators" (Global Financial Stability Report).*

### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT

### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT

### Real estate stress and local government vulnerabilities
- Local governments face the delivery of unfinished presold houses and handling distressed property developers amid falling revenues from land sales.
- Elevated debt levels, increased fiscal burdens, and contingent liabilities from financially weak local government financing vehicles may constrain capacity to support the sector.
- The stock of unfinished presold houses is sizable in a number of provinces with relatively low income and high public debt.
- Authorities announced several policies to support the real estate sector, including:
  - a property sector rescue fund authorized to raise up to RMB 300 billion,
  - RMB 200 billion in special loans through policy banks,
  - credit guarantees offered by China Bond Insurance Co. to support bond issuance by property developers,
  - a reduction in the five-year loan prime rate, with the minimum first-home mortgage rate set at 20 basis points below the five-year loan prime rate.
- If local governments cannot support the real estate sector, adverse spillovers to the broader corporate sector are possible, where vulnerabilities are already high.

### Poor market liquidity as a shock amplifier
- The global move toward an aggressive tightening monetary cycle to fight high inflation has substantially increased market volatility and contributed to a deterioration in market liquidity conditions.
- Market liquidity metrics have worsened across asset classes recently:
  - bid-ask spreads have widened significantly,
  - market depth has declined sharply,
  - liquidity premiums have increased.
- Examples of market stress and transmission channels:
  - The recent dramatic stress in the gilts market illustrates how sudden price moves combined with forced selling and deleveraging can lead to disorderly conditions that threaten market functioning and stability.
  - As central banks tighten and shrink balance sheets, investors have pulled back from risk taking, increasing holdings of cash and cash-equivalents and driving liquidity into US short-term funding markets.
- Quantitative tightening implications:
  - Reduced central bank demand for sovereign bonds could leave more bonds in private hands, implying higher liquidity premiums and lower market liquidity, all else equal.
  - Future liquidity conditions will depend on sovereign bond supply volumes and maturity profiles, risk management practices, and investor risk appetite.

### Market structure, dealer capacity, and passive investing effects
- Structural shifts since the global financial crisis may affect market liquidity provision:
  - Regulatory reforms led banks to reduce capital allocated to balance-sheet-intensive market-making, contributing to liquidity disappearing in volatile conditions.
  - Technological innovations shifted market-making from bank dealers to principal trading firms, which may automatically pull back when volatility increases, exacerbating illiquidity.
- Passive investing has grown materially:
  - US S&P 500 index trackers and exchange-traded funds have more than doubled their assets, to an almost 20 percent share of the market in less than a decade.
  - The growing role of passive investing with daily redemptions, increased herding and concentration, and constrained arbitrage capacity can make market liquidity more vulnerable to rapid sentiment changes.
- Constraints on arbitrageurs:
  - Restrictions in leverage available from prime brokers and investor demands for tighter risk management and greater transparency may limit hedge funds’ ability to act as liquidity providers.

### Short-term international dollar funding stresses
- Indicators of strain in international short-term dollar funding markets have risen:
  - Three-month cross-currency basis swaps (for the euro and yen vs the US dollar) surged to their widest level since March 2020.
  - FRA-OIS spreads, a measure of interbank credit risk, have increased, signaling potential drops in the supply of US dollar funding.
- Demand- and supply-side drivers:
  - Strengthening of the US dollar reduces the repayment capacity of (unhedged) borrowers outside the US, increasing demand for synthetic US dollar funding.
  - A persistent funding strain could trigger activation of central bank international liquidity facilities such as the Federal Reserve’s swap lines, the Foreign and International Monetary Authorities Repo Facility, and existing IMF precautionary credit lines.
- Market-making and dealer positioning:
  - Dealers appear less willing to deploy balance sheets in a highly uncertain and volatile environment, contributing to reduced market depth and liquidity.

### Corporate sector pressures and potential credit-cycle turning
- Profitability and earnings:
  - Corporate profit margins have started to contract from highs supported by the economic reopening; all major sectors (excluding energy) have revised earnings forecasts downward.
- Credit spreads and issuance:
  - Credit spreads have widened substantially across sectors, especially recently as investor risk appetite declined amid poor liquidity and elevated volatility.
  - Spreads on sub-investment-grade credit such as high-yield bonds and leveraged loans have widened to levels not seen since the spring of 2020.
  - New issuance of risky debt, particularly high-yield bonds, has pulled back materially.
- Distress indicators and defaults:
  - Almost half of lower-rated CCC credit is trading at distressed levels.
  - Major credit rating agencies have revised high-yield default outlooks and expect US defaults to rise in the next few months.
- Small firms and bankruptcies:
  - Bankruptcies have already started to increase this year in major advanced economies among small firms, which are more affected by rising borrowing costs, declining fiscal support, and higher input costs that are hard to pass on to consumers.
- IMF partial sensitivity analysis (interest coverage focus):
  - The analysis centers on the interest coverage ratio (earnings before interest and taxes divided by interest expense).
  - The share of debt with an interest coverage ratio below 0 (indicating firms with negative profitability) rises quickly across firm types, exceeding 50 percent at small firms (based on averages across advanced and emerging markets).
  - The share of debt at firms with an interest coverage ratio between 0 and 3 increases to more than one-third at both large and midsize firms, especially among emerging market economies.
  - Countries included in the analysis: China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Türkiye, the United Kingdom, and the United States.
- Policy implication:
  - Temporary and targeted government support may be needed to prevent a wave of small-firm bankruptcies and avoid spillovers to the financial system.

### Leveraged finance under pressure
- Leveraged finance market conditions have deteriorated materially:
  - Spreads have widened sharply and issuance in the US leveraged loan market plunged in the third quarter to post-global-financial-crisis lows.
- Risk amplification channels:
  - Depending on private lenders’ funding structures, investor horizons, holdings concentration, and linkages to the banking sector (for example, through lines of credit), a tightening in leveraged finance could crystallize balance-sheet liquidity and credit risks and amplify the shock.
- Firms shut out of high-yield and leveraged loan markets:
  - Firms that are smaller, have weaker liquidity, or high debt levels have found financing more difficult to obtain in the high-yield bond and leveraged loan markets amid the challenging growth backdrop and elevated market volatility.

*IMF — CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT (October 2022) — ch1 - CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT*

### 1. Corporate Profit Margins

### ch1 - 1. Corporate Profit Margins

### Corporate profit margins and credit spreads
- Corporate credit spreads have continued to widen since the April 2022 GFSR to reach about half the pandemic peaks.
- New issuance has slowed as risky firms face tighter financial conditions.
- Panel assumptions (interest coverage shock analysis):
  - Volume of goods sold declines by 7.5 percent.
  - Price of the unit of goods sold increases by 13.4 percent.
  - Cost of the unit of goods sold increases by 20.5 percent.
  - Effective interest rate on firms’ total debt rises by 100 basis points for large firms, 312 basis points for medium firms, and 524 basis points for small firms.
  - Firm size definitions: large firms = assets greater than $500 million; medium firms = assets between $500 million and $50 million; small firms = assets less than $50 million.

### Leveraged finance and private credit developments
- Private credit has grown rapidly over the past decade, reaching $1.4 trillion at the end of 2021 and surpassing the size of the US institutional leveraged loan market.
- Leverage metrics on new loans in the leveraged loan market have hit new highs:
  - Almost one-third of new loans have ratios of debt to EBITDA greater than six times earnings.
- Credit quality deterioration in leveraged finance:
  - In the United States, more than 50 percent of the leveraged finance market is now composed of firms with a B credit rating.
  - CLOs’ average holdings of B-rated loans have more than doubled over the past five years.
- Concentration risks:
  - Nearly 50 percent of the loan market is composed of exposures to sectors such as technology, health care, and business services.
- Market and issuance dynamics:
  - Leveraged buyout volumes are down 30 percent from 2021 in 2022 to date.
  - A decline in CLO issuance and lower returns for equity and lower-rated CLO investors could reduce funding available to sub-investment-grade firms.
- Investor exposures:
  - Asset managers and hedge funds remain the most exposed to riskier tranches of collateralized loan obligations (CLOs).
- Opacity and risk assessment:
  - Most private lending remains very opaque, making it hard for investors and regulators to assess credit risk until the credit cycle has already turned.

### Housing markets: valuation, affordability, and downside risk
- House prices have surged by more than 20 percent in some economies since the onset of the pandemic.
- Price-to-income ratios have reached their highest level in the past two decades in many countries, indicating a deterioration in housing affordability.
- Monetary policy transmission and mortgage rates:
  - The average fixed-rate 30-year mortgage in the United States hit highs last seen in 2008, before declining somewhat in midyear 2022.
- House-price-at-risk (severely adverse scenario, 5th percentile, three years ahead):
  - Emerging markets: –23.5 percent (cumulative real house price growth).
  - Advanced economies: –10.6 percent (cumulative real house price growth).
- Regional and driver decomposition (projected contribution, latest):
  - Affordability pressures and deteriorating economic prospects are key drivers of downside risk to house prices across most regions.
- Mitigating factors and vulnerabilities:
  - Stronger bank capital positions and more conservative loan underwriting standards since the global financial crisis could limit contagion through the banking sector compared with previous recessions.
  - Risks may be emerging elsewhere in the housing sector, particularly where nonbank financial institutions play a larger role in the securitized mortgage market (for example, the United States).

### Global Bank Stress Test: stagflation scenario and banking resilience
- Stress scenario design:
  - Assumes a pandemic resurgence and continuation of geopolitical tensions resulting in persistent global supply chain disruptions, including disruption in Russian gas exports to Europe.
  - Calibrates de-anchoring of inflation expectations and a disorderly tightening of financial conditions, with spillovers sending the global economy into recession in 2023.
  - Baseline corresponds to the October 2022 WEO.
- Sample coverage:
  - The IMF Global Bank Stress Test examined 262 banks from 28 countries accounting for 70 percent of global sector assets.
  - The 28 countries in the sample are Australia, Austria, Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Greece, India, Indonesia, Ireland, Italy, Japan, the Republic of Korea, Mexico, The Netherlands, Norway, Portugal, Saudi Arabia, South Africa, Spain, Sweden, Switzerland, Türkiye, the United Kingdom, and the United States.
- Aggregate capital outcomes:
  - Global CET1 ratio increased from 12.5 percent in 2019 to 14.1 percent in 2021.
  - In the stress scenario, the global CET1 ratio declines from 14.1 percent in 2021 to a minimum of 11.4 percent in 2023, barely recovering to 11.5 percent in 2024.
  - Positive contributions to CET1 from higher interest income on performing loans are offset by negative contributions from higher loan impairments and larger other expenses.
- Cross-country-group outcomes:
  - Emerging market banks face greater losses than advanced economy banks.
  - The maximum drop in the CET1 ratio, from 2021, reaches 4.3 percentage points for emerging market banks, which is 1.7 percentage points larger than for advanced economy banks.

*Italic: International Monetary Fund | October 2022 — Chapter 1 (ch1 - 1. Corporate Profit Margins)*

### 1. Lending Standards and Demand for Corporate Credit

### 1. Lending Standards and Demand for Corporate Credit

### Macrofinancial scenario and calibration
- Scenario calibration is based on the Global Macrofinancial Model (Vitek 2018).
- The adverse stress scenario is considerably more severe than the October 2022 WEO downside scenario.
- Scenario variables shown include:
  - Real GDP growth trajectories for 2021–2024 for AE (advanced economy), EM (emerging market), and Global.
  - Inflation trajectories for 2021–2024 for AE, EM, and Global.

### Impact on global banks under the stress scenario
- Sample and data:
  - Weighted average global sample of 262 underlying banks from 28 countries.
- Change in CET1 ratios:
  - Under the stress scenario, the global weighted average CET1 ratio stands 5.5 percentage points below the baseline.
  - For advanced economy banks the difference is 2.5 percentage points below the baseline.
- Drivers of capital ratio changes (difference between stress and baseline; contributions shown separately for AE and EM banks):
  - Impairment (loan losses)
  - NII = net interest income (declines)
  - NFCI = net fee and commission income
  - NTI + OCI = net trading income plus other comprehensive income (mark-to-market losses)
  - Other (residual of pretax income and expense flows, including administrative expense)
  - Tax
  - Dividend
  - ΔRWA = change in risk-weighted assets

### Distribution of distress and capital shortfalls
- No country banking system would fail to meet the minimum 4.5 percent CET1 ratio under the stress scenario, but several individual institutions would fall below that threshold.
- More distressed cases:
  - These more distressed cases account for 5   percent of total global assets in the sample and would require $77 billion to bring the CET1 ratio back to 4.5 percent.
  - The majority of these cases are emerging market banks, representing 29 percent of emerging market bank assets in the sample.
- GSIBs and buffers:
  - Among GSIBs, no bank would fall below the minimum 4.5 percent threshold.
  - However, 11 percent of GSIBs (by bank assets) would need to dip into their capital conservation buffers (CCBs).
- Non-GSIBs:
  - Banks accounting for 10 percent of total assets would fail to meet the 4.5 percent minimum threshold.
- Total capital rebuilding need:
  - To rebuild the CCB and GSIB buffers, as well as the capital shortfall below the 4.5 percent minimum CET1 ratio, the overall capital need would amount to about $214 billion.

### Key features explaining EM bank sensitivity
- Emerging market banks face larger stress losses due to:
  - Greater sensitivity to macrofinancial shocks.
  - Higher loan impairment.
  - Larger declines in net interest income.
  - Higher mark-to-market losses on trading books (NTI + OCI), reflecting sharper increases in short-term interest rates and a higher share of government securities in portfolios.
  - Additional vulnerabilities where corporate or sovereign sectors have a high share of foreign-currency-denominated debt.

### Policy recommendations and supervisory priorities
- Monetary policy:
  - Central banks should continue to normalize policy to prevent inflationary pressures from becoming entrenched and to preserve credibility.
  - Policymakers should avoid a stop-go normalization path that could undermine price stability and trigger disorderly tightening of financial conditions.
  - Forward guidance modalities and objectives should be rethought as policy rates move away from the effective lower bound; clear communication on objectives, trade-offs, and steps to bring inflation back to target is essential.
- Fiscal policy:
  - Tighter fiscal policy can support monetary policy in achieving inflation objectives; fiscal consolidation would ease aggregate demand pressure on prices.
  - Governments should reprioritize spending to protect the most vulnerable from rising food and energy prices, within budget constraints.
- Euro area:
  - Ensure monetary policy transmission across member states and counter fragmentation risks; the Transmission Protection Instrument is noted as a step to address fragmentation.
- Emerging and frontier markets:
  - Continue country-specific rate increases as warranted to preserve credibility and anchor inflation expectations.
  - Rebuild fiscal space and buffers; utilize IMF Integrated Policy Framework to manage tightening and a stronger US dollar.
  - Foreign exchange interventions may be appropriate if reserves suffice and intervention does not impair credibility or substitute for needed macroeconomic adjustment.
  - Capital flow management measures may be used in crises as part of a comprehensive policy package and lifted once crisis conditions abate.
- Sovereign debt strategy:
  - Sovereign borrowers in developing and frontier markets should contain debt vulnerabilities via early creditor engagement, multilateral cooperation, and international support.
  - Use enhanced collective action clauses and majority voting provisions in syndicated loans to facilitate restructurings.
  - For countries near debt distress, coordinate preemptive restructuring; use the G20 Common Framework where applicable.
  - Consider value recovery instruments (GDP- or commodity-linked warrants) to improve restructuring outcomes.
  - Countries with moderate debt-distress risk but elevated liquidity risks should consider liability management through debt exchanges or refinancing.
- Financial market depth and nonbank sector:
  - Promote depth of local currency markets in emerging markets by establishing sound legal and regulatory frameworks, developing efficient money markets, enhancing transparency and predictability of issuance, bolstering market liquidity, and developing robust market infrastructure.
  - Contain further buildup of financial vulnerabilities via selected macroprudential adjustments while avoiding procyclicality and disorderly tightening of conditions.
  - Develop macroprudential tools for nonbank financial institutions where missing; ensure adequate risk management and supervision for nonbank intermediaries.
- Housing markets and China:
  - Monitor housing markets; deploy stringent stress tests for house-price declines' impact on households and financial institutions.
  - In China, urgent central government action is needed to restore housing market stability: credible, low-cost mechanisms to complete presold housing, restructure distressed developers, restore home-buyer confidence, contingency planning, macroeconomic support, and medium-term structural reforms.
- Bank supervision and data:
  - Ensure bank asset classifications and loan-loss provisions accurately reflect credit risk and losses.
  - Strengthen bank risk management, stress-test capacity, and adequacy.
  - Maintain adequate capital buffers and credible capital conservation plans; require credible plans to restore capital after significant declines.
  - Ensure authorities have sufficient and reliable data to assess vulnerabilities from origination practices and intermediation chains in corporate debt markets; enhance transparency in private debt markets and collect cross-border exposure data.
  - Restructuring and insolvency tools should facilitate orderly exit of nonviable firms; short-term fiscal support may be appropriate for viable firms facing market access failure and subject to available fiscal space.
- Market liquidity and crypto regulation:
  - Swiftly implement policies to mitigate market liquidity risks, monitor trading infrastructures, support market transparency, and improve trade-level data availability.
  - Counterparties should monitor intraday activity and leverage exposures of principal trading firms and hedge funds, strengthen liquidity risk management, and enhance transparency and data availability.
  - Implement comprehensive, consistent regulation and supervision of crypto asset markets; regulate crypto asset service providers delivering core functions (storage, transfer, exchange, custody of reserves, etc.) with a “same activity, same risk, same regulation” principle.
  - Strengthen international cooperation to guide consistent implementation and contain spillover risks.

*Source: IMF Global Financial Stability Report: Navigating the High-Inflation Environment, Chapter 1 (October 2022).*

### 1. Proportion of Economies with Elevated Vulnerabilities, by Sector

### 1. Proportion of Economies with Elevated Vulnerabilities, by Sector

### Overview and key statistics
- Percent of countries with high and medium-high vulnerabilities, by GDP (assets of banks, asset managers, other financial institutions, and insurers); number of vulnerable countries in parentheses.
- Sectoral counts reported in the source:
  - Nonfinancial firms (11)
  - Asset managers (6)
  - Insurers (14)
  - Banks (5)
  - Households (1)
  - Sovereigns (12)
  - Other financial institutions (12)
- Chart axis markers shown in the source: 100%, 80, 60%, 40%, 20%.

### Financial vulnerabilities by region and sector (high-level takeaways)
- The source presents a cross-region, cross-sector assessment of vulnerabilities including: United States, Advanced Economies, Emerging Market Economies, Euro area, Other advanced, China, and Other emerging economies.
- Vulnerabilities are attributed across sectors: Sovereigns, Nonfinancial Firms, Banks, Households, Asset managers, Insurers, and Other financial institutions.

### Box 1.2 — ECB Transmission Protection Instrument (TPI) and fragmentation risk
- Context:
  - As the European Central Bank (ECB) proceeds to normalize monetary policy, fragmentation risk has returned to focus and may impair the effective transmission of monetary policy across euro area countries.
- Role of PEPP:
  - The first line of defense against transmission risks related to the COVID-19 pandemic is the reinvestment flexibility of purchases of maturing assets under the Pandemic Emergency Purchase Programme (PEPP).
  - PEPP reinvestments are anticipated to continue only until 2024.
  - PEPP reinvestments appear to be smaller than the expected gross sovereign debt issuance from southern European countries.
- Fiscal and market dynamics:
  - With net asset purchases having come to an end in the first half of 2022, the fiscal deficit in the euro area is, for the first time in several years, set to exceed ECB reinvestments going forward.
  - Southern European countries referenced: Greece, Italy, Portugal, and Spain.
- Transmission Protection Instrument (TPI) design and activation:
  - The TPI involves purchases of public sector securities issued in jurisdictions where disorderly and unwarranted market dynamics threaten monetary policy transmission.
  - The ECB stated that it may consider purchases of private sector securities, if appropriate.
  - The TPI will be activated by the ECB’s Governing Council based on a comprehensive assessment of market and transmission indicators and an evaluation of eligibility criteria.
- Implication:
  - Flexible PEPP reinvestments are unlikely to fully offset gross sovereign debt issuance by southern European countries, motivating the TPI as an additional tool to contain fragmentation risk.

### Box 1.3 — Historical perspective on US monetary policy tightening cycles and financial markets
- Historical pattern:
  - Over the past six decades, monetary policy tightening cycles in the United States have often been followed chronologically soon after by a recession.
  - Noted exceptions with no recession following the tightening cycle include: 1965, 1984, and 1994 (the 1994 cycle is cited as a soft landing).
- Evolution of tightening cycles:
  - Cumulative increases in the policy rate have generally become more limited over each tightening cycle beginning with the 1988 episode, with a progressively lower terminal rate.
  - The pace of the current policy tightening to date is more comparable to episodes before 1988, as the Federal Reserve has moved aggressively to tackle inflation at decades-high levels.
- Interest rates and markets:
  - Longer-term interest rates have generally moved upward across tightening cycles, although less so since the early 2000s; the pace of increase in the 10-year yield this time is more comparable to cycles before 1988.
  - The evolution of 30-year mortgage rates appears similar to that of the 10-year yield.
  - Investment-grade corporate spreads have typically compressed relative to the beginning of tightening cycles, even though corporate bond yields have increased in sync with risk-free yields; the magnitude of compression has varied across cycles.
  - Risk assets such as equities and investment-grade corporate bonds have generally performed well during tightening cycles, with exceptions (for example, the 1977–80 episode and the current cycle).
- Financial conditions and vulnerabilities:
  - Financial conditions (as summarized by the IMF US financial conditions index) in the current cycle have tightened significantly compared to recent cycles, reflecting in part historically easy levels ahead of the tightening cycle.
  - Financial vulnerabilities have emerged in some sectors in the wake of the COVID pandemic, and financial market volatility has notably risen after having remained relatively compressed over the preceding protracted period of low rates.
- Policy and communication:
  - With real rates still negative, and financial conditions still around neutral levels by historical standards, clear communication about the Federal Reserve’s policy function—objectives, intertemporal trade-offs, and steps required to bring inflation credibly down to target—and the need to continue to normalize monetary policy remain crucial to avoid unwarranted market volatility and a disorderly tightening of financial conditions.

*International Monetary Fund | October 2022 — Chapter content excerpt*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2022/october/english/ch1.pdf_