## Global Financial Stability Report: Navigating the High-Inflation Environment (extracts) ## Source details **Canonical URL:** [Global Financial Stability Report: Navigating the High-Inflation Environment (extracts)](https://www.imf.org/-/media/files/publications/gfsr/2022/october/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2022/october/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2022/october/english/text.pdf.json) --- ### Preface — purpose, scope, contributors, conventions - Purpose and scope - The GFSR assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks. - Information current as of September 28, 2022; Executive Directors discussed the GFSR on September 29, 2022. - Coordination and contributors - Coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project direction and individual contributors listed (names preserved in source). - Key conventions and assumptions - “Billion” means a thousand million. - “Trillion” means a thousand billion. - “Basis points” refers to hundredths of 1 percentage point. - Symbols: ". . ." indicates data not available; — indicates zero or less than half the final digit shown; – denotes ranges; / indicates fiscal/financial year. - If no source listed on tables/figures, data are IMF staff estimates or calculations. - Further information - Digital editions and datasets available on IMF eLibrary; corrections incorporated into digital editions; print copies orderable via imfbk.st/523389. ### Foreword — high-level environment and policy implications - Macro-financial environment and risks - Inflation at multi-decade highs and broadly spread across countries. - Economic outlook deteriorating in many countries; geopolitical risks persist. - Central banks in advanced economies and many emerging markets have accelerated monetary policy normalization. - Global financial conditions tightened in most regions; market liquidity has deteriorated across key asset classes. - Heightened risk of rapid, disorderly repricing amplified by pre-existing vulnerabilities and poor liquidity. - Key stress findings - Global bank stress tests: up to 29 percent of emerging market banks would breach capital requirements in a severely adverse scenario. - Frontier markets face particularly severe pressures driven by tightening financial conditions and commodity price volatility. - Policy guidance - Central banks: act resolutely to bring inflation back to target; provide clear communication about policy reaction functions and further normalization. - Emerging markets: use a calibrated mix of tools per IMF’s Integrated Policy Framework—interest rate policy, macroprudential actions, FX intervention, capital flow measures. - Scale up private climate finance in EMDEs; involve MDBs to attract private investors and strengthen risk absorption capacity. - Reform nonbank financial institutions; consider liquidity management tools, including swing pricing. ### Executive Summary — global macro-financial environment and main findings - Global macro-financial environment - The world economy is experiencing stubbornly high inflation. - Central banks in advanced economies accelerating policy normalization; emerging markets tightened policy with regional differences. - Global financial conditions tightened notably in 2022; capital outflows from many emerging and frontier markets. - The balance of risks is skewed to the downside; the range of adverse GDP growth outcomes is in the worst 20th percentile of the last four decades. - Deterioration since April 2022 GFSR - Downside risks crystallized: higher-than-anticipated inflationary pressures; worse-than-expected slowdown in China; additional spillovers from Russia’s invasion of Ukraine. - Financial markets: volatility, liquidity, risk repricing - Interest rates and prices of risk assets extremely volatile since April 2022. - Emerging market sovereign spreads of high-yield issuers rose nearly to levels last seen in March 2020. - Crypto: Bitcoin lost over 50 percent at one point; Terra collapsed; Tether briefly traded below parity. - US Treasury bid-ask spreads widened significantly; market depth declined; liquidity premiums increased. - Regional developments and salient events - Europe: asset-price sell-off amid recession fears and natural gas shortages; ECB’s Transmission Protection Instrument helped contain fragmentation risk. - UK: after fiscal measures, pound depreciated and gilts plunged; Bank of England on September 28 announced temporary purchases of long-dated UK government bonds. - China: financial conditions eased somewhat following policy support addressing property-sector strains. - Emerging and frontier markets - Multiple risks: high external borrowing costs, stubborn inflation, volatile commodity markets. - Interest expenses on government debt continued to rise, increasing liquidity pressures and default risk. - Nonresident portfolio flows remain weak despite some stabilization. - Sovereign hard-currency issuance deteriorated sharply; many frontier issuers may need alternative funding or debt reprofiling/restructuring. - Corporate, leveraged finance, housing - Credit spreads widened; large firms reported profit margin contractions; small-firm bankruptcies started to increase. - Private credit reached $1.4 trillion at end-2021. - Housing: soaring borrowing costs and stretched valuations could lead to significant real house price declines in a worst-case scenario. - China property and banking spillovers - Presale-dependent funding: presales accounted for about 90 percent of total home sales. - IMF staff: 45 percent of property developers by assets might not be able to cover their debt obligations with earnings; 20 percent by assets could become insolvent if inventory values adjusted to current prices. - Offshore real estate bond prices: about 70 percent of offshore bonds trade at 40 cents on the dollar or less. - Bank exposures: 8 percent of total lending to property developers and 20 percent to mortgage borrowers. - Scenario: if 10 percent of exposures to distressed developers and 10 percent of mortgage exposures related to unfinished properties become nonperforming with very low recovery values, 15 percent of banks in the sample (representing 10 percent of total banking system assets) would fail to meet minimum capital requirements. - Banking-sector resilience and stress tests - Global CET1 ratio declines from 14.1 percent in 2021 to a minimum of 11.4 percent in 2023 under the IMF stagflation adverse scenario. - Emerging market banks: maximum drop in CET1 ratio reaches 4.3 percentage points from 2021. - Distressed cases account for 5 percent of total global assets in the sample and would require $77 billion to bring CET1 ratios back to 4.5 percent. - Overall capital need to rebuild CCB, GSIB buffers, and the shortfall below the 4.5 percent CET1 minimum would amount to about $214 billion. - Rebuilding buffers and covering capital shortfall would require over $200 billion (Executive Summary reference). - Sustainable finance and climate financing needs - Sustainable finance grown rapidly, but EMDEs disadvantaged. - MDBs/DFIs should emphasize equity financing to catalyze private investment. - IMF RST can provide affordable long-term financing and help catalyze private finance. - Open-end funds: liquidity mismatch and systemic risks - Liquidity mismatch in open-end funds with daily redemptions raises run risk and potential for asset fire sales; consider liquidity management tools including swing pricing. - Policy recommendations (summary) - Central banks: act resolutely to bring inflation back to target; provide clear communication and continue normalization. - Emerging markets: follow IMF’s Integrated Policy Framework where appropriate. - Scale up private climate finance; reform nonbank financial intermediation; strengthen liquidity management tools for funds. ### Chapter 1 — Financial stability in the new high-inflation environment (selected findings) - Financial conditions: tightening and heterogeneity - Financial conditions tightened rapidly in advanced economies; tighter in some emerging markets (central, eastern, southern Europe; Middle East and Africa). - Conditions eased somewhat in China due to policy support. - IMF financial condition index captures pricing of risk and includes real house prices; does not include balance sheet or credit growth metrics. - Market volatility, risk repricing, and liquidity - Equity prices fell sharply; credit spreads widened; rate volatility at levels not seen since March 2020. - US Treasury market: bid-ask spreads elevated and market liquidity worsened. - Cross-currency basis and short-term dollar funding stress: three-month cross-currency basis swaps surged to widest since March 2020. - FRA-OIS spreads widened; dealers less willing to hold inventory. - Sovereign spreads, defaults, and frontier markets - High-yield and frontier sovereign indices above 900 basis points, approximately 500 bps higher than pre-pandemic levels. - 14 sovereigns have spreads exceeding 1,000 bps; six more have defaulted or engaged in debt restructuring. - More than half of all low-income countries judged by IMF to be in, or have high probability of entering, debt distress. - UK gilt-market episode - Following large debt-financed fiscal measures, investors repriced monetary policy—expecting Bank of England to hike by about 240 basis points by year end (bringing policy rate to nearly 6 percent in 2023). - Bank of England announced temporary purchases of long-dated UK government bonds on September 28; will reduce APF gilts holding by 80 billion pounds over next 12 months; set gilt sales and auction details including selling GBP580MM per auction in each of three buckets. - Growth outlook and probabilities - Global economic growth for 2022 marked down to 3.2 percent, 0.4 percentage point lower than projected in the April 2022 WEO. - Probability of growth falling below zero about 10 percent for 2022. - Market evidence assigns significant probability to inflation outcomes being greater than 3 percent in coming years in euro area and UK. - For US, 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—nearly 300 basis points of real policy tightening implied by projections and market expectations. - Corporate and credit-cycle stress - Credit spreads widened; sub-investment-grade firms face tighter financing; almost half of lower-rated CCC credit trading at distressed levels. - IMF sensitivity analysis (interest coverage shock): share of debt with interest coverage ratio below 0 exceeds 50 percent at small firms. - Calibration details: volume of goods sold declines by 7.5 percent; price of unit increases by 13.4 percent; cost increases by 20.5 percent; effective interest rate rises by 100 bps for large firms, 312 bps for medium firms, 524 bps for small firms. - Firm size definitions: Large firms: assets greater than $500 million; Medium firms: assets between $500 and $50 million; Small firms: assets less than $50 million. - Housing risks and downside scenarios - Pandemic-era house price surge; price-to-income ratios highest in two decades in many countries. - Downside three-year horizon severe scenario: real house price declines nearly 25 percent in emerging markets; more than 10 percent in advanced economies. - Compared to October 2021 GFSR: implies a 2 percentage point larger decline for emerging markets and a 3 percentage point smaller decline for advanced economies. - China housing and banking spillovers (selected stats) - Presale transactions about 90 percent of home sales. - IMF staff: 45 percent of developers by assets might not cover debt with earnings; 20 percent by assets could become insolvent if inventory values adjusted. - Offshore real estate bond prices: about 70 percent trade at 40 cents on the dollar or less. - Bank exposures: 8 percent of total lending to property developers; 20 percent to mortgage borrowers. - Scenario: 15 percent of banks in sample (10 percent of system assets) would fail to meet minimum capital requirements under specified nonperforming exposures. - Global bank stress test (aggregate results) - Sample: 262 banks from 28 countries, 70 percent of global sector assets. - Aggregate CET1 falls from 14.1 percent in 2021 to min 11.4 percent in 2023; recovers to 11.5 percent in 2024. - Distressed cases = 5 percent of global assets; $77 billion to raise to 4.5 percent CET1; overall capital need about $214 billion. - Emerging market banks more affected: max CET1 drop 4.3 percentage points. - Market liquidity: structural drivers and amplification - Quantitative tightening and balance-sheet normalization reduce central bank demand for sovereign bonds, leaving more in private hands and raising liquidity premiums. - Dealer balance-sheet constraints, shift to principal trading firms, growth of passive investing (~20 percent share of US S&P 500 market by index trackers) exacerbate liquidity fragility. - Policy recommendations (Chapter 1 summary) - Continue monetary policy normalization; preserve central bank credibility and provide clear communication. - Tighter fiscal stance where inflation elevated to support price stability. - For EMDEs: use IMF Integrated Policy Framework guidance—FX interventions, capital flow measures, macroprudential tools where appropriate. - Strengthen bank provisioning, supervisory stress testing, and ensure capital buffers; enforce accurate asset classification and loan-loss provisioning. - Housing markets: deploy stringent stress tests; reconsider earlier macroprudential loosening. - China: central government actions to restore housing market stability, restructure distressed developers, ensure delivery of presold housing, and provide macroeconomic support and structural reforms. - Crypto: implement comprehensive regulation—“same activity, same risk, same regulation.” - Market liquidity: improve trade-level data availability and trading infrastructure robustness. ### Chapter 2 — Scaling up private climate finance in EMDEs (selected findings) - Market structure and issuance - Sustainable finance in EMDEs mainstreaming; 2021 breakout year. - Green bonds: 59 percent in 2022 to date of sustainable issuance in EMDEs. - Asia-Pacific: accounted for 60 percent of sustainable issuance in 2021 and 72 percent in 2022 to date. - Debt accounts for 60 percent of total climate finance; equity accounts for 32 percent. - Sovereign issuance absent in China; sovereign issuance shares: 10 percent in advanced economies (since 2008), 34 percent in emerging markets excluding China, 77 percent in developing economies. - Climate financing gaps and needs - Financing shortfalls larger for adaptation (water, sanitation, irrigation, flood protection). - Regions with greater aggregated vulnerability face larger financing gaps. - Meeting/exceeding the $100 billion annual climate finance goal to developing economies is critical; ensure sizable share to adaptation. - Supply–demand frictions - EMDE sustainable finance dominated by debt; equity needed for many mitigation technologies. - Project preparation bottlenecks and weak institutional capacity hamper investable project supply. - High share of foreign-currency issuance due to investor preferences and shallow local markets. - The triple challenge - Carbon pricing: EMDEs lag advanced economies; fossil fuel consumption subsidies act as negative carbon pricing. - Fossil fuel sector debt growth: - Coal sector outstanding debt grew more than 400 percent between Q1 2016 and Q2 2022. - Coal sector in Asia-Pacific: nearly 500 percent increase between Q1 2016 and Q2 2022. - Oil and gas sector outstanding debt grew 225 percent between Q1 2016 and Q2 2022; Asia-Pacific oil and gas debt grew more than 400 percent. - Debt of EMDE companies with coal expansion plans increased about 350 percent between 2016 and 2022; annual growth in Q2 2022 nearly 30 percent. - Instruments, MDB/DFI roles, and leverage metrics - Four instrument types summarized: structured finance/closed-end fixed-income funds; blended finance for infrastructure; outcome-based sustainable debt instruments; private finance for public-sector “pay-for-success.” - IFC-Amundi emerging market green bond fund example: IFC equity investment $125 million; fund total $2 billion; leverage multiple 16. - On average, MDBs attracted 1.2 times private finance relative to their own resources in 2020. - Share of MDB commitments in equity instruments: 1.8 percent. - Mitigation finance–outer circle: $24.7 billion total; Adaptation finance–inner circle: $13.3 billion total. - Climate information architecture, taxonomies, disclosures - EMDE data and disclosure gaps: sparse climate datasets, voluntary and nonstandard corporate disclosures in most countries. - Taxonomies: China and EU taxonomies have spurred EMDE national/regional taxonomies (examples: ASEAN; traffic-light approaches in Indonesia, Malaysia, Singapore). - ESG scores and EMDE firms: ESG scores systematically lower for EMDE firms; global ESG assets $35.3 trillion (~36 percent of global AUM). - International carbon markets (Article 6) - Completion of Article 6 rulebook at COP26 enables trade in ITMOs. - Estimates: Article 6 could generate $330 billion to $475 billion in net financial flows to EMDEs by 2030 and prevent up to 6 percent of these economies’ total energy-related emissions over same period. - Article 6.4 mechanism transfers a fixed share of traded carbon to an Adaptation Fund supporting adaptation finance in developing economies. - Policy recommendations (Chapter 2 summary) - Strengthen climate information architecture: improve data, disclosures, taxonomies. - Scale innovative structured finance and outcome-based instruments. - Develop transition taxonomies for hard-to-abate sectors. - Increase MDB/DFI emphasis on equity financing and crowd-in private capital. - Encourage sovereign participation in sustainable finance markets to deepen them. - Provide sufficient funding to specialized adaptation vehicles (e.g., Green Climate Fund with 50/50 mitigation/adaptation balance). - Use IMF RST to provide affordable long-term financing and catalyze private investments. - Continue advocacy and assistance for carbon pricing. ### Chapter 3 — Asset price fragility and open-end investment fund (OEF) vulnerabilities - Stylized facts and data - Sample: 17,000 OEFs domiciled in 43 countries holding over 450,000 bond and equity securities; sample period Q4 2013–Q2 2022. - Trends: funds increasingly invest in less liquid assets; total net assets and nonbank share rose (2002:Q1–2022:Q1 coverage). - Private credit reached $1.4 trillion at end-2021 (contextual cross-reference). - Asset-level vulnerability findings - Bonds held by less liquid funds show more volatile returns than those held by more liquid funds. - A one standard deviation increase in bond vulnerability raises return volatility by 23 percent relative to median. - Less liquid fixed-income assets (corporate high-yield and EM bonds) are most vulnerable. - Amplification in stress and herding - In periods of high VIX or monetary policy uncertainty, the same one standard deviation increase is associated with ~20 percent increase in bond return volatility relative to median. - Herding increases the effect by 3 percent to 5 percent. - Spillovers to emerging markets - A one standard deviation increase in vulnerability measure for EM corporate bonds held by advanced-economy funds is associated with a 23 percent increase in return volatility relative to median. - Impact magnified during stress: one standard deviation increase associated with 14 percent higher impact on bond return volatility when VIX high vs low. - Selling-pressure and event-study results - Event-study: abnormal return impacts up to –2.5 percentage points for some bond categories during March 2020 turmoil. - Estimated selling-pressure coefficient for high-yield corporate bonds equals 46 percent (visual truncation noted in source). - Liquidity-management tools and evidence - Liability-side tools: in-kind redemptions, redemption suspensions/gates, side pockets. - Price-based tools: redemption fees, antidilution levies, swing pricing. - Swing pricing: reduces adverse impact of fund vulnerabilities on bond-return volatility by about one-third where adopted (empirical proxy: funds domiciled in Luxembourg or UK). - Calibration challenges: optimal swing factor estimates range from 0 to 9 percent; many funds capped at much lower factors in prospectuses. - Adoption limited across jurisdictions; antidilution levies and swing pricing availability constrained. - Cash buffers: equity funds hold 0.5–4 percent of net assets; bond funds hold 1–9 percent. - Central bank backstops and moral hazard - Central bank interventions in severe stress (including corporate bond purchases) can prevent fire sales but may create moral hazard. - Funds lack access to central bank liquidity facilities and are not subject to same prudential rules as banks. - ETFs: differences and vulnerabilities - ETFs permit intraday trading and arbitrage; less vulnerable to run risk than OEFs but arbitrage can break down in stress. - During March 2020, ETF discounts rose: >5 percent across all bond ETFs, up to 27 percent for high-yield bond ETFs, up to 13 percent for investment-grade bond ETFs. - Bonds held by ETFs experienced smaller volatility increases than those held by OEFs in stress. - Policy recommendations (Chapter 3 summary) - Encourage wider adoption of ex ante price-based tools (swing pricing, antidilution levies) and eliminate caps that prevent full pass-through of transaction and price-impact costs to redeeming investors. - Improve disclosure of swing pricing practices and calibration methodologies. - Collect and publish aggregate fund flow data in real time to support calibration. - Consider mandating liquidity management tools and enhanced disclosure where voluntary adoption hampered by stigma/competition. - Strengthen global regulatory coordination to manage cross-border spillovers from OEF vulnerabilities. - Supervisors should monitor intraday activity, leverage of nonbank liquidity providers, and require robust liquidity risk management; consider minimum liquidity buffers and stress-testing for funds. - Encourage central clearing and greater transparency in bond trading; deepen domestic markets and diversify investor bases in recipient EMDEs. *Source: Global Financial Stability Report: Navigating the High-Inflation Environment, International Monetary Fund | October 2022 (information current as of September 28, 2022; Executive Board discussion concluded September 29, 2022).* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and seeks to play a role in preventing crises by highlighting policies that may mitigate systemic risks. - This GFSR reflects information available as of September 28, 2022. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussions of the GFSR on September 29, 2022. The analysis and policy considerations are those of the contributing staff and should not be attributed to the IMF, its Executive Directors, or their national authorities. ### Coordination and contributors - Coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project direction: Fabio Natalucci, Deputy Director; Ranjit Singh, Assistant Director; Nassira Abbas, Deputy Division Chief; Charles Cohen, Deputy Division Chief; Antonio Garcia Pascual, Deputy Division Chief; Mahvash Qureshi, Division Chief; Mario Catalán, Deputy Division Chief; Ananthakrishnan Prasad, Unit Chief. - Individual contributors: Sergei Antoshin, Yingyuan Chen, Fabio Cortes, Reinout De Bock, Andrea Deghi, Xiaodan Ding, Dimitris Drakopoulos, Torsten Ehlers (Chapter 2 co-lead), Zhi Ken Gan, Charlotte Gardes-Landolfini (Chapter 2 co-lead), Deepali Gautam, Marco Gross, Pierre Guérin, Sanjay Hazarika, Anna-Theresa Helmke, Frank Hespeler, Shoko Ikarashi, Tara Iyer, Phakawa Jeasakul, Esti Kemp, Johannes Kramer, Harrison Kraus, Peter Lindner, Sheheryar Malik, Junghwan Mok, Kleopatra Nikolaou, Natalia Novikova, Thomas Piontek, Silvia Ramirez, Patrick Schneider, Xinyi Su, Felix Suntheim (Chapter 3 lead), Jeffrey David Williams, Hong Xiao, Yanzhe Xiao, Dmitry Yakovlev, Akihiko Yokoyama, Xingmi Zheng. - Production and editorial support: Suellen Kelly Basilio, Javier Chang, Monica Devi, Olga Tamara Maria Lefebvre, Srujana Sammeta (word processing); Gemma Rose Diaz (Communications Department) led the editorial team with Denise Bergeron, David Einhorn, Harold Medina (and team), Lucy Scott Morales, Nancy Morrison, Grauel Group, TalentMEDIA Services. ### Key conventions and assumptions used throughout the GFSR - ". . ." to indicate that data are not available or not applicable; - — to indicate that the figure is zero or less than half the final digit shown or that the item does not exist; - – between years or months (for example, 2021–22 or January–June) to indicate the years or months covered, including the beginning and ending years or months; - / between years or months (for example, 2021/22) to indicate a fiscal or financial year. - “Billion” means a thousand million. - “Trillion” means a thousand billion. - “Basis points” refers to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point). - If no source is listed on tables and figures, data are based on IMF staff estimates or calculations. - Minor discrepancies between sums of constituent figures and totals shown reflect rounding. - As used in this report, the terms “country” and “economy” do not in all cases refer to a territorial entity that is a state as understood by international law and practice. - The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries. ### Further information, corrections, and distribution - Corrections and revisions: When errors are discovered, corrections and revisions are incorporated into the digital editions available from the IMF website and on the IMF eLibrary. All substantive changes are listed in the online table of contents. - Print copies can be ordered from the IMF bookstore at imfbk.st/523389. - Multiple digital editions, including ePub, enhanced PDF, and HTML, are available on the IMF eLibrary at www.elibrary.imf.org/OCT22GFSR. - A free PDF of the report and data sets for each chart are available from the IMF website at www.imf.org/publications/gfsr. - Information on terms and conditions for reusing contents: www.imf.org/external/terms.htm. ### Foreword — key messages and policy implications - The global environment is fragile with storm clouds on the horizon: inflation is at multi-decade highs and broadly spread across countries; the economic outlook continues to deteriorate in many countries; geopolitical risks persist. - Central banks in advanced economies and many emerging markets have moved to an accelerated path of monetary policy normalization to prevent inflationary pressures from becoming entrenched, and global financial conditions have tightened in most regions as an intended consequence. - Global financial markets have shown strains: asset prices have sold off due to energy market pressures, emerging stress in cross-currency funding, and stress in certain nonbank financial institution segments; market liquidity has deteriorated across key asset classes. - There is a heightened risk of rapid, disorderly repricing that could interact with and be amplified by pre-existing vulnerabilities and poor market liquidity. - Financial stability risks have increased; the balance of risks is tilted to the downside. Vulnerabilities are elevated in the sovereign and nonbank financial institution sectors, where rising interest rates have brought additional stress. - Global bank stress tests show relative resilience for advanced economy banks but indicate that, in a severely adverse scenario, up to 29 percent of emerging market banks would breach capital requirements. - Frontier markets face particularly severe pressures driven by tightening financial conditions, deteriorating fundamentals, and high exposure to commodity price volatility. - Policy guidance: - Central banks should act resolutely to bring inflation back to target, maintain credibility, and avoid market volatility through clear communication about policy decisions and the need to normalize policy further. - For many emerging markets, the IMF’s Integrated Policy Framework suggests a calibrated mix of tools including interest rate policy, macroprudential actions, foreign exchange intervention, and capital flow measures to mitigate monetary policy trade-offs and reduce financial stability risks. - Scale up private climate finance in emerging market and developing economies, including requiring new financing instruments for climate-related investments in infrastructure and involving multilateral development banks to attract private investors and strengthen risk absorption capacity. - Continue reform efforts for nonbank financial institutions; consider liquidity management tools, including swing pricing, to address vulnerabilities highlighted by the 2020 dash-for-cash episode. - Surveillance, timely action, and clear communication are crucial to mitigate the risk that further adverse shocks could trigger market illiquidity, disorderly sell-offs, or distress. *Preface and Foreword, Global Financial Stability Report: Navigating the High-Inflation Environment (information current as of September 28, 2022).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Global macro-financial environment - The world economy is experiencing stubbornly high inflation, a challenge not faced for decades. - Following the global financial crisis, interest rates were extremely low for years, contributing to a buildup of financial vulnerabilities that monetary normalization is now exposing. - Central banks in advanced economies are accelerating policy normalization; policymakers in emerging markets have continued to tighten policy with notable regional differences. - Global financial conditions have tightened notably in 2022, leading to capital outflows from many emerging and frontier market economies with weaker macroeconomic fundamentals. - The balance of risks is significantly skewed to the downside; the range of adverse GDP growth outcomes based on the probability distribution of future GDP growth is in the worst 20th percentile of the last four decades (Figure 2). ### Deterioration in outlook since April 2022 GFSR - The global economic outlook has deteriorated materially since the April 2022 Global Financial Stability Report. - Downside risks that have crystallized include: - Higher-than-anticipated inflationary pressures. - A worse-than-expected slowdown in China due to COVID-19 outbreaks and lockdowns. - Additional spillovers from Russia’s invasion of Ukraine. - Amid extraordinary uncertainty and stubbornly high inflation, central banks continue to normalize policy to restore price stability. ### Financial markets: volatility, liquidity, and risk repricing - Interest rates and prices of risk assets have been extremely volatile since April 2022. - Risk assets sold off sharply through June on fears of accelerated policy rate hikes; emerging market sovereign spreads of high-yield issuers rose nearly to levels last seen in March 2020 (Figure 3). - Crypto markets experienced extreme volatility, collapse of riskiest segments, and unwinding of some crypto funds. - A mid-year rally on hopes of an earlier end to normalization was undone as major central banks reaffirmed their resolve to fight inflation. - Market-implied probability distributions show heightened disagreement on inflation outcomes; in the euro area there are significant odds of both low- and high-inflation outcomes (Figure 4). - Market liquidity metrics have worsened across asset classes, including highly liquid markets and standardized/exchange-traded products: - US Treasury bid-ask spreads have widened significantly. - Market depth has declined sharply. - Liquidity premiums have increased (Figure 5). - There is a tangible risk of a disorderly tightening of financial conditions amplified by existing vulnerabilities and poor market liquidity. ### Regional developments and salient events - European markets: asset prices sold off amid recession fears, natural gas shortages, and reemergence of fragmentation risks in the euro area. - Spreads of southern European government bond yields over German yields tightened after the European Central Bank announced the Transmission Protection Instrument. - United Kingdom: investor concerns over fiscal and inflation outlook following large debt-financed tax cuts and fiscal measures caused abrupt pound depreciation and sharp sovereign bond price drops. - On September 28 the Bank of England announced temporary and targeted purchases of long-dated UK government bonds to prevent gilt market dysfunction posing material risk to UK financial stability. - China: financial conditions have eased somewhat due to policy support to offset deteriorating outlook and real estate sector strains. ### Emerging markets and frontier markets: vulnerabilities and flows - Emerging markets face multiple risks: high external borrowing costs, stubborn inflation, volatile commodity markets, uncertainty about global outlook, and spillovers from advanced economy policy tightening. - Frontier markets are particularly exposed due to tightening conditions, deteriorating fundamentals, and high commodity price exposure. - Interest expenses on government debt have continued to rise, increasing immediate liquidity pressures and elevating default risk in poor-fundamentals environments. - Investors have so far differentiated across emerging markets; many large emerging markets appear more resilient to external vulnerabilities. - Nonresident portfolio flows remain weak despite some stabilization after sizable first-half outflows (Figure 6). - Issuance of sovereign hard currency bonds has deteriorated sharply; without improved market access, many frontier market issuers may need alternative funding sources and/or debt reprofiling and restructurings. ### Corporate sector, leveraged finance, and housing risks - Global corporate pressures: - Credit spreads have widened substantially across sectors since April 2022. - Large firms report contraction in profit margins due to higher costs. - Downward revisions to global earnings growth forecasts are gaining momentum amid recession concerns. - Small-firm bankruptcies have started to increase in major advanced economies as these firms face higher borrowing costs and declining fiscal support. - Firms reliant on leveraged finance markets face tighter lending terms and standards; credit quality could be tested in a downturn with macro spillovers. - Housing markets: - Soaring borrowing costs, tighter lending standards, and stretched valuations could adversely affect housing markets. - In a worst-case scenario, real house price declines could be significant, driven by affordability pressures and deteriorating economic prospects (Figure 7). ### China property sector and banking spillover risks - China’s property sector downturn deepened as COVID-19 lockdowns caused a sharp decline in home sales, exacerbating liquidity stress for property developers and raising solvency concerns. - Property developer failures could spill over to the banking sector, affecting vulnerable small banks and domestic systemically important banks given lower capital buffers and higher property-related concentration risk (Figure 8). ### Banking sector resilience and stress-test findings - High levels of capital and ample liquidity buffers have bolstered global banking sector resilience. - IMF Global Bank Stress Test scenario: an abrupt and sharp tightening of financial conditions causing a 2023 recession amid high inflation could result in up to 29 percent of emerging market banks (by assets) breaching capital requirements, while most advanced economy banks would remain resilient. - Rebuilding buffers and covering the capital shortfall would require over $200 billion (Figure 9). ### Sustainable finance and climate-related financing needs - Emerging market and developing economies will need significant climate financing in coming years to reduce greenhouse gas emissions and adapt to physical climate risks. - Sustainable finance has grown rapidly, but emerging market and developing economies remain disadvantaged. - Significant challenges to scaling up private climate finance include lack of supportive climate policies (such as effective carbon pricing) and a still-weak climate information architecture (Figure 10). ### Open-end investment funds: liquidity mismatch and systemic risks - Open-end funds play an increasing role in financial markets; liquidity mismatch between assets and liabilities raises financial stability concerns. - Funds holding illiquid assets while offering daily redemptions can drive fragility by increasing the likelihood of investor runs and asset fire sales, with potential cross-border spillovers and tightening of domestic financial conditions (Figure 11). ### Policy recommendations - Central banks: - Must act resolutely to bring inflation back to target to prevent entrenchment of inflationary pressures and de-anchoring of expectations that would damage credibility. - Should provide clear communication about their policy reaction functions, commitment to mandated objectives, and the need to further normalize policy to preserve credibility and avoid unwarranted market volatility. - Emerging market economies: - Where appropriate, follow recommendations of the IMF’s Integrated Policy Framework (specific actions and country-by-country applicability detailed in the body of the report). *Source: Global Financial Stability Report: Navigating the High-Inflation Environment, International Monetary Fund | October 2022* ### eXeCUtIVe sUMMARY ### eXeCUtIVe sUMMARY ### Global outlook and risks - High inflation and extraordinary uncertainty have weakened global economic prospects; risks to the outlook are unusually high. - Prominent risks that tilt growth outcomes to the downside include: - policy divergence and cross-border tensions; - further energy and food price shocks; - an entrenchment of inflation dynamics and a de-anchoring of inflation expectations; - debt vulnerabilities in some emerging markets. - Recent shocks (including Russia’s war in Ukraine and lingering COVID-19 supply disruptions) heightened the likelihood of policy tradeoffs and increased the probability of policy mistakes. - The global economic outlook has worsened materially since the April 2022 Global Financial Stability Report. ### Monetary and fiscal policy guidance - Central banks should act decisively to bring inflation credibly back to target and avoid de-anchoring of inflation expectations; continuing to normalize policy is necessary in most advanced economies and EMDEs. - Maintaining central bank independence and policy credibility is essential to secure price stability. - Clear communication about policy functions and commitment to price objectives is crucial to preserve credibility and avoid unwarranted market volatility. - Fiscal policy: - Where inflation is elevated, a tighter fiscal stance would send a powerful signal that policymakers are aligned in the fight against inflation and would help keep borrowing costs lower. - Fiscal support to address the surge in cost of living should primarily focus on targeted support to the most vulnerable segments to preserve price incentives for energy conservation. - Some Directors considered that additional but temporary energy policies may be needed in countries with exceptionally high and volatile energy prices owing to Russia’s war in Ukraine. - Governments should invest in social safety nets and develop policy strategies and tools that can be readily deployed under various scenarios. - A sound and credible medium-term fiscal framework, including spending prioritization and efforts to raise revenues, can help manage urgent needs, rebuild fiscal buffers, and support long-term development needs such as renewable energy and health care. ### Financial conditions and systemic risks - Financial conditions have tightened globally since April 2022; in many advanced economies conditions are tight by historical standards, and in some emerging markets they have reached levels last seen during the height of the COVID-19 crisis. - Key gauges of systemic risk, such as dollar funding costs and counterparty credit spreads, have risen; there is a risk of a disorderly tightening that may interact with preexisting vulnerabilities. - Specific vulnerabilities and stress points: - In emerging markets, rising rates, worsening fundamentals, and large outflows have pushed up borrowing costs notably. - 20 countries are either in default or trading at distressed levels. - Unless market conditions improve, there is a risk of further sovereign defaults in frontier markets. - In China, the property downturn has deepened, with heightened risk of spillovers to the banking, corporate, and local government sectors. - In many other countries, housing markets 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. - Global stress tests 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 faces increased risk of default, with sub-investment-grade firms more exposed. ### Policy recommendations to preserve financial stability - Policymakers should contain further buildup of financial vulnerabilities by: - adjusting selected macroprudential tools as needed to tackle pockets of elevated vulnerabilities while avoiding procyclicality and a disorderly tightening of financial conditions; - implementing policies to mitigate market liquidity risks to avoid amplification of shocks; - monitoring the robustness of trading infrastructures and supporting transparency in markets; - improving availability of data at the trade level to enable timely assessment of liquidity risks. - Given the importance of nonbank financial institutions, counterparties should: - carefully monitor intraday activity and leverage exposures; - strengthen liquidity risk management practices; - enhance transparency and data availability. - For open-end investment funds: - price-based liquidity management tools such as swing pricing can lower asset price fragilities, but policymakers should provide further guidance on implementation; - additional tools could include linking the frequency of redemptions to the liquidity of funds’ portfolios; - tighter monitoring of funds’ liquidity risk management practices, additional disclosures by open-end funds, and measures to bolster the provision of liquidity are warranted. ### Cross-border and multilateral actions - Directors reiterated the urgent need for global cooperation and dialogue to defuse geopolitical tensions, avoid economic and trade fragmentation, and respond to interconnected challenges. - Multilateral actions called for include: - responding to humanitarian crises and ending Russia’s war in Ukraine; - safeguarding global liquidity and managing debt distress; - mitigating and adapting to climate change; - addressing pandemic inequities in access to health care and vaccinations. - Directors called for greater debt transparency and better mechanisms to produce orderly debt restructurings, including a more effective Common Framework where insolvency issues prevail. - Multilateral institutions should stand ready to provide emergency liquidity to safeguard essential spending and contain financing crises. ### Climate finance and IMF role - Scaling up private climate finance requires new finance instruments and the involvement of multilateral development banks to attract private investors, leverage private investment, and strengthen risk absorption capacity. - A larger share of equity financing and additional resources for climate finance from multilateral development banks would help countries achieve climate objectives. - The IMF can support members by undertaking financial stability risk assessments, lending through its new Resilience and Sustainability Trust, and advocating for closing data gaps and disclosures. ### Operational guidance for EMDEs and sovereign borrowers - Sovereign borrowers in developing economies and frontier markets should enhance efforts to contain risks associated with high debt vulnerabilities, including through early contact with creditors, multilateral cooperation, and international community support. - Enacting credible medium-term fiscal consolidation plans after recent shocks could help contain borrowing and refinancing costs and alleviate debt sustainability concerns. - According to the IMF’s Integrated Policy Framework, where appropriate, some emerging market economies 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, reduce financial stability risks, and maintain appropriate monetary policy transmission—guided when appropriate by the Integrated Policy Framework and in line with the Institutional View on the Liberalization and Management of Capital Flows and without substituting for exchange rate flexibility and warranted macroeconomic adjustments. ### Financial markets and monetary transmission - Ensuring effective transmission of monetary policy is crucial during policy normalization; the Transmission Protection Instrument announced by the European Central Bank is noted as a welcome step to address euro area fragmentation risks. - The high uncertainty about the outlook hampers policymakers’ ability to provide explicit and precise guidance about the future path of monetary policy, increasing the importance of clear communication. *Published October 2022; data cutoff date September 28, 2022; Executive Board discussion remarks concluded September 29, 2022.* ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### Financial conditions: tightening and heterogeneity - Financial conditions have tightened rapidly in advanced economies and are now above historical averages in most countries; higher interest rates and lower corporate valuations are the key drivers. - Financial conditions are even tighter in some emerging markets; in central, eastern, and southern Europe, as well as in the Middle East and Africa, conditions are at levels last seen during the height of the COVID-19 crisis. - Conditions have eased somewhat in China where policymakers provided additional support to offset rising corporate credit borrowing costs from strains among property developers. - The IMF financial condition index captures pricing of risk and incorporates various pricing indicators, including real house prices; balance sheet or credit growth metrics are not included. ### Market volatility and risk-asset sell-off - Risk assets sold off sharply through June on fears of accelerated central bank rate hikes, then experienced a midyear relief rally, and deteriorated again as major central banks reaffirmed resolve to fight inflation. - Equity prices have fallen sharply; credit spreads have materially widened; market liquidity has deteriorated markedly, including in benchmark sovereign bond markets. - Rate volatility has remained very elevated—at levels not witnessed since March 2020. - Crypto markets: Bitcoin lost over 50 percent of its value; Terra (largest non-collateralized algorithmic stablecoin) experienced an investor run and collapsed; Tether briefly traded below parity and saw significant outflows; cash-backed and more transparent stablecoins received some inflows and maintained parity. ### Drivers of equity declines and credit-market stress - According to IMF staff models, the fall in equity prices has been driven by both rising rates and expectations of lower earnings growth, particularly over the medium term. - Large firms reported contractions in profit margins due to higher costs; downward revisions to global earnings growth forecasts are gaining momentum amid recession concerns. - Corporate bond spreads in advanced economies have been close to two-year highs, including for investment-grade bonds. - Access to credit has become more challenging, especially for sub-investment-grade firms; 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. ### Sovereign spreads, defaults, and frontier markets - Spreads on foreign-currency debt for frontier markets and other emerging markets with high-yield sovereign ratings have risen nearly to levels last seen in March 2020. - High-yield and frontier market sovereign indices are above 900 basis points (bps), approximately 500 bps higher than their pre-pandemic levels. - Currently, 14 sovereigns have spreads exceeding 1,000 bps (a level at which they are commonly considered distressed and at high risk of default). - Six more have already defaulted or engaged in debt restructuring. - The frontier market classification comprises 43 countries included in the J.P. Morgan NEXGEM index or low-income countries with international bond issuance not part of the index. ### Currency moves, dollar appreciation, and policy responses - Large currency depreciations against the US dollar have occurred in some jurisdictions, particularly in Europe and Japan, partly tracking widening interest rate differentials related to the faster pace of Fed hikes. - Outside Latin America, emerging market currencies have broadly depreciated in 2022; Latin America benefited from proactively raising rates in 2021 and earlier commodity-price rises. - Ongoing US dollar appreciation presents a challenge for advanced and emerging central banks; several have resorted to FX intervention or signaled readiness to do so (Chile, Czech Republic, Indonesia, Japan, Philippines, Malaysia, among others). ### European energy crisis, fragmentation risk, and market stress - The unprecedented energy crisis triggered by Russia’s war in Ukraine, supply-chain disruptions, and growth concerns have led to record-high energy prices in the summer and large swings in gas and electricity prices. - High energy price volatility raised concerns about funding conditions and possible cash shortages at some European utility companies, contributing to large margin calls on derivatives positions and the need to post extra collateral. - Government bond swap spreads in the euro area widened, and concerns about fragmentation risk resurfaced as investors focused on fiscal vulnerabilities in some member states. - The ECB’s asset reinvestment policy and the announcement of the “Transmission Protection Instrument” helped contain disorderly spreads so far. ### UK gilt-market dysfunction and Bank of England intervention - Following announcement of large debt-financed tax cuts and fiscal measures to address energy prices, UK market sentiment deteriorated in late September: the British pound depreciated abruptly while yields on UK sovereign bonds rose sharply. - The scale and speed of yield increases had a significant impact on levered positions held by UK institutional investors, particularly pension funds, through mark-to-market losses and margin calls. - To prevent market dysfunction posing a material risk to UK financial stability, the Bank of England announced on September 28 temporary and targeted purchases of long-dated UK government bonds, scheduled to end on October 14, with purchases to be unwound smoothly once market-functioning risks subsided. - The Bank of England emphasized purchases were on financial stability grounds and reiterated that it would not hesitate to hike interest rates by as much as needed to achieve its 2 percent target in the medium term; following the announcement, the pound appreciated and gilt yields reversed a portion of their increase. *Source: CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT, October 2022.* ### 1. European Energy Prices (One-Year Forward) and Euro Area ### 1. European Energy Prices (One-Year Forward) and Euro Area Swap Spreads ### Market reactions and immediate developments - Investor concerns about fragmentation risk have resurfaced. - Investors repriced the expected path of UK monetary policy, now expecting 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. - The pound depreciated sharply amid concerns over fiscal deterioration and higher inflation. - Yields on UK sovereign debt rose sharply and the curve inverted. - With investors aggressively pulling back from risk taking, there is a danger of a disorderly repricing of risk that could be amplified by preexisting financial vulnerabilities. ### UK-specific events and market interventions - The Bank of England announced temporary and targeted purchases of long-dated UK government bonds following market stress. - The Bank of England also 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, 2022, following the BoE’s bond purchase announcement. - The BoE set its gilt sales auction schedule on a quarterly basis and announced plans to sell GBP580MM per auction in each of three buckets (short, medium, and long-term). ### Central bank actions and policy path - The Federal Reserve has initiated the process of 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, a magnitude not seen since 1994. - 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. - Given the uncertain growth and inflation 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 advanced-economy central banks, including the Bank of England, Bank of Canada, Reserve Bank of New Zealand, and Swiss National Bank, have taken significant steps toward policy normalization. ### Balance sheet vulnerabilities and market liquidity - The IMF staff’s indicator-based framework shows balance sheet vulnerabilities are currently most prominent in the sovereign sector. - In most jurisdictions, the public sector cushioned some pandemic impacts on households and nonfinancial firms at the cost of deterioration of the fiscal position and a large increase in sovereign debt. - Balance sheet vulnerabilities are elevated in the nonbank financial intermediation sector, reflecting high liquidity and maturity transformation, exposure to credit and duration risk, and interconnectivity with the banking sector. - In the nonfinancial corporate sector, vulnerabilities have declined for large firms due to easy financing conditions and ample liquidity, but some sectors and lower-rated firms have started to see deterioration and a pickup in credit rating downgrades. - Housing-sector vulnerabilities remain elevated in emerging markets and some advanced economies; the house-price-to-income ratio has reached its highest level in two decades in many countries amid rising mortgage rates and tighter lending standards. - Market liquidity has significantly worsened across asset classes, even in typically highly liquid markets such as advanced-economy government bond markets, stocks, foreign exchange, and exchange-traded futures, creating a potential shock amplifier. ### Growth outlook, risks, and probability assessments - 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, and global financial stability risks have materially worsened since the April 2022 GFSR. - The IMF growth-at-risk framework indicates downside risks are very high relative to historical norms. - The probability of growth falling below zero is currently about 10 percent for 2022. - Evidence based on inflation options suggests 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 most likely outcomes is more notable than at the end of last year. - Fears that central banks may raise policy rates well above neutral levels have raised investor concerns about a possible recession in advanced economies. - For the United States, 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—nearly 300 basis points of real policy tightening implied by projections and market expectations. ### Emerging markets: policy space and market pressures - Emerging market and frontier market central banks have continued to tighten policy, with regional differences: Latin American central banks hiked earlier and more aggressively; central and eastern Europe tightened later but accelerated; Türkiye is an outlier that continued to cut rates despite rising inflation and currency weakness; Asian central banks began hiking only recently and more modestly. - Markets are pricing in an end to rate hikes in most emerging market 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. - Conditions in local currency bond markets have worsened materially in many emerging and frontier markets; sovereign bond term premiums have increased sharply, especially for central and eastern Europe. - Volatility in local bond market yields has risen globally and has approached peak historical levels in some emerging markets. - Local currency bond markets have seen large net portfolio outflows from nonresident investors in 2022; in China, investors withdrew about $75 billion from local currency bonds between February and August 2022, including nearly 15 percent of foreign holdings of government bonds. - Nonresident portfolio flows into local currency debt for emerging markets excluding China have been stagnant in recent years. - More than half of all low-income countries are judged by the IMF to be already in, or to have a high probability of entering, debt distress. - A disorderly restructuring of global supply chains (higher trade barriers and increased trade policy uncertainty) would disproportionately harm emerging markets by amplifying macroeconomic and capital flow volatility and reducing access to international capital markets. *Italic: Source — Global Financial Stability Report: Navigating the High-Inflation Environment, Chapter 1 (text extracted from the October 2022 GFSR).* ### 1. US Monetary Policy Tightening Cycles, 1960 onward ### 1. US Monetary Policy Tightening Cycles, 1960 onward ### Key historical finding - Historically, each time the Federal Reserve has raised the federal funds rate close to, or above, the neutral nominal rate, the US economy has entered a recession soon thereafter. - The figure summarizing this relationship covers a 60-Year Record. ### Measurement and construction notes - Measurement of the neutral rate is subject to uncertainty, with different approaches proposed in the literature. - The nominal neutral rate estimate shown is constructed based on the real neutral rate measure proposed by Holston, Laubach, and Williams (2017), in which the former is equal to the real neutral rate plus inflation expectations. - The inflation expectations series used corresponds to the five-year, five-year forward horizon and is published by the Federal Reserve Board going back to the mid-1980s; it is based on the model by D’Amico, Kim, and Wei (2018). ### Data and labeling conventions in the figure - Gray shaded areas indicate National Bureau of Economic Research recession periods. - Consumer price inflation (CPI) corresponds to headline inflation (urban consumers). - Abbreviations used: FOMC = Federal Open Market Committee; y/y = year over year. *Sources: Bloomberg Finance L.P.; Federal Reserve; US Bureau of Labor Statistics; and IMF staff calculations.* ### 1. Frontier Debt-to-GDP and Interest-to-Revenue Ratios ### 1. Frontier Debt-to-GDP and Interest-to-Revenue Ratios ### Frontier market debt and rollover risks - Market access has dropped sharply this year as financial conditions have tightened. - Frontier markets face significant bond maturities in 2023–25, which will be hard to roll over at current spreads. - External debt to private creditors accounts for more than one-third of external debt for many issuers that have traded at distressed levels this year. - In panel grouping, the >1,000 bps category comprises those that have traded above 1,000 bps for an extended period at some point in 2022. - Debt sustainability snapshot for low-income countries: eight low-income countries are in debt distress and 30 are at high risk of distress (out of 69 countries considered low-income countries). - Ukraine: In August 2022, Ukraine’s foreign creditors backed its request for a two-year freeze (deferral) on debt service payments. Ukraine is not classified as a frontier market elsewhere. ### Key statistics and observations - Composition and data notes: Public and publicly guaranteed external debt primarily from World Bank International Debt Statistics (as of 2020) or World Bank Quarterly External Debt Statistics where not available. Zambia’s external debt numbers comprise only foreign-currency-denominated debt. - In panel visualizations, spreads and maturities are presented in: Billions of US dollars (issuance and maturities) and basis points (spreads). --- ### China: Housing Risks Could Spread to the Banking Sector ### Funding shock and developer liquidity - 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. - As access to market financing becomes increasingly difficult and presale receipts plummet, property developers face self-reinforcing liquidity pressure that diminishes their ability to complete ongoing construction. - Local governments have tightened control over presale receipts in escrow accounts to ensure completion of presold properties, amplifying liquidity strains. ### Developer solvency and bond market distress - IMF staff analysis: 45 percent of property developers by assets might not be able to cover their debt obligations with earnings. - IMF staff analysis: 20 percent of developers by assets could become insolvent if their inventory value is adjusted to current property prices. - Offshore real estate bond prices have dropped sharply: about 70 percent of offshore bonds trade at 40 cents on the dollar or less. - Many property developers have defaulted on their debt after building up leverage to raise turnover and expand inventories. ### Bank exposures and potential losses - The banking sector’s exposure to the property sector is large: 8 percent of total lending to property developers and another 20 percent to mortgage borrowers. - Scenario analysis (IMF staff): - Assumptions underlying panels: (1) 70 percent of net new mortgages each year are associated with presold houses; (2) 10 percent of unfinished presold houses fail to be delivered; (3) loans to risky developers as a share of total real estate exposures are at 5 percent for GSIBs, 10 percent for DSIBs, and 15 percent for other banks. - Under a scenario in which 10 percent of the exposures to distressed property developers and 10 percent of the mortgage exposures related to unfinished properties become nonperforming loans with very low recovery values, 15 percent of banks in the sample, representing 10 percent of total banking system assets, would fail to meet minimum capital requirements. - Minimum capital requirement reference: a 10.5 percent CAR for other banks, plus additional required buffers for DSIBs and GSIBs. - The weak tail of bank failures consists mostly of small banks and some domestic systemically important banks; large banks, including all global systemically important banks (GSIBs), appear to be resilient. ### Fiscal and local government risks - With constrained fiscal capacity, local governments face elevated debt levels and contingent liabilities from financially weak local government financing vehicles (LGFVs), complicating their ability to ensure delivery of unfinished houses and handle distressed developers. - Regional indicators: the stock of unfinished presold houses is sizable in a number of provinces with relatively low income and high public debt. - Policy measures announced by authorities include: 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, and 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. --- ### Poor Market Liquidity: A Shock Amplifier ### Deterioration in liquidity amid tightening cycle - After more than a decade of abundant liquidity and compressed volatility, aggressive tightening by central banks 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, especially in recent weeks amid deteriorating risk appetite: bid-ask spreads have widened significantly, market depth has declined sharply, and liquidity premiums have increased. ### Specific market stress indicators - US Treasury market: the US Treasury bid-ask spread is elevated and market liquidity conditions have worsened; markets need to keep absorbing sizable Treasury issuances as central banks reduce their purchases. - US Treasury supply: Ten-year-equivalent issuance and projections are shown net of Federal Reserve purchases; issuance projections use primary dealers’ marketable borrowing estimates and past auction data for maturity composition. - Cross-currency and hedged returns: - Excess yield spreads of hedged US Treasury yields over local government bonds have increased, suggesting foreign demand for US Treasuries could decrease as foreign-exchange-hedged returns become less attractive. - Cross currency basis swap (3 month) and other basis measures show stress; given Libor transition, cross currency basis spreads are Libor-index-based before January 1, 2022, and OIS-based on and after that date. - Short-term dollar funding and interbank risk: - The costs of international dollar short-term funding have increased, reflecting precautionary demand amid high uncertainty. - FRA-OIS spreads (a proxy of interbank credit risk) have been wider recently, indicating banks appear less willing to deploy balance sheets in a highly uncertain and volatile environment. - Market structure indicators: primary dealer positions and OIS-implied volatility signal reduced willingness of dealers to hold inventory and higher implied volatility. ### Data notes and cutoff - Market liquidity indicators and panels draw on sources including Bloomberg Finance L.P., Haver Analytics, JPMorgan, MarketAxess, Federal Reserve Bank of New York, and IMF staff calculations. - Data cutoff for panels 5 and 6 (cross-currency basis and FRA-OIS) is October 4, 2022. *Source: IMF Global Financial Stability Report: Navigating the High-Inflation Environment (October 2022), Chapter 1.* ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### International short-term dollar funding and market stress - Recent investor risk aversion has driven larger cash holdings and more liquidity into US short-term funding markets. - Three-month cross-currency basis swaps (for the euro, and yen vs the US dollar) surged to their widest level since March 2020. - Seasonal technical factors (the three-month contract capturing the year-end) combined with global liquidity concerns have increased demand for US dollars. - Supply-side risks: - Increase in FRA-OIS spread (a measure of interbank credit risk) and heightened currency volatility could reduce the supply of US dollar funding. - Demand-side risks: - Strengthening US dollar reduces repayment capacity of unhedged borrowers outside the US, increasing demand for synthetic US dollar funding. - Persistent strains 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. ### Quantitative tightening, sovereign bond markets, and liquidity - Central banks tightening and balance sheet normalization imply reduced demand for sovereign bonds, potentially leaving more sovereign bonds in private hands and translating into higher liquidity premiums and lower market liquidity. - The supply of long-dated Treasuries is anticipated to remain large next year. - Foreign-exchange-hedged yields may become increasingly less attractive to foreign investors as central bank demand declines. - Structural factors that could tighten liquidity during stress include: - More constrained dealer balance sheets. - Technological innovations shifting market making to nontraditional players. - A greater share of passive investors. ### Market structure, market making, and passive investing - Regulatory reforms have led banks to reduce capital allocated to market-making, causing liquidity to disappear at times, particularly during volatile market conditions. - Shift of market-making from bank dealers to principal trading firms: - Algorithmic principal trading firms in fixed-income interdealer markets can automatically pull back during sharp volatility, exacerbating illiquidity. - Rise of passive investing: - 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. - Growing passive investing with daily redemptions, increased herding and concentration, has made market liquidity more vulnerable to rapid changes in sentiment. - Arbitrage capacity constraints: - Restrictions in leverage from prime brokers and investor demands for tighter risk management and greater transparency may limit hedge funds’ ability to conduct arbitrage and act as liquidity providers. ### Corporate sector stress and credit cycle assessment - Macro and policy environment pressures: - Earnings in large publicly traded firms remain strong but higher labor and input costs are weighing on profitability. - Corporate profit margins have started to contract from reopening-supported highs; all major sectors excluding energy revised earnings forecasts downward. - Credit spreads: - Credit spreads have widened substantially across sectors, especially recently as investor appetite declined amid poor liquidity and elevated volatility. - Spreads on sub-investment-grade credit (high-yield bonds and leveraged loans) widened to a degree not seen since spring 2020. - Issuance and distress: - Pullback in new issuance of risky debt, particularly high-yield bonds. - Almost half of lower-rated CCC credit is trading at distressed levels. - Major credit rating agencies revised high-yield default outlooks and expect US defaults to rise in the next few months. - Small firms: - Bankruptcies have already started to increase this year in major advanced economies; small firms are more affected by rising borrowing costs, declining fiscal support, and higher labor and input costs. - Small firms are defined as having assets of less than approximately $50 million. - IMF partial sensitivity analysis (interest coverage ratio focus): - Share of debt with an interest coverage ratio below 0 rises quickly at all firm types, exceeding 50 percent at small firms (based on averages across advanced and emerging markets). - 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. - This increase in debt-at-risk could result in losses at bank and nonbank financial institutions with significant exposures to highly indebted nonfinancial firms, amplifying the shock. - Temporary and targeted government support may be needed to prevent a wave of bankruptcies at small firms and avoid spillovers to the financial system. ### Leveraged finance and private credit risks - Recent developments: - Conditions in leveraged finance deteriorated materially with spreads widening sharply and US leveraged loan issuance plunging in the third quarter to post-global-financial-crisis lows. - Private credit expansion: - Private credit reached $1.4 trillion at the end of 2021, surpassing the size of the US institutional leveraged loan market. - Private credit is often referred to as “direct lending” and is provided by dedicated funds outside regulated bank markets. - Leveraged loan quality and concentration: - Almost one-third of new leveraged loans have debt-to-EBITDA ratios greater than six times earnings. - In the United States, more than 50 percent of the leveraged finance market is composed of firms with a B credit rating. - Concentration risks: nearly 50 percent of the loan market composed of exposures to sectors such as technology, health care, and business services. - CLOs and investor base: - CLOs’ average holdings of B-rated loans more than doubled over the past five years. - Asset managers and hedge funds remain the most exposed to riskier CLO tranches; banking sector exposures are mostly concentrated in senior AAA tranches and thus less likely to face credit losses. - Private equity and leveraged buyouts: - Private equity sponsors increasingly use private credit lenders in highly leveraged deals. - Leveraged buyout volumes in 2022 to date are down 30 percent from 2021. - Credit quality of these assets may be tested in a recession; opacity of private lending may hinder risk assessment until the credit cycle turns. - Risks if asset quality deteriorates: - Increase in assets rated CCC or below could reduce returns for equity and lower-rated CLO investors. - Underperformance could reduce new CLO issuance and lead to a credit crunch in the leveraged loan market, reducing funding for sub-investment-grade firms. ### Housing markets and downside scenarios - Pandemic-era house price surge: - Since the onset of the pandemic, house prices surged by more than 20 percent in some economies. - Price-to-income ratios reached highest level in past two decades in many countries, signaling deteriorated housing affordability. - Monetary tightening and mortgage markets: - Pass-through of policy tightening has been swift in the United States; the average fixed-rate 30-year mortgage hit highs last seen in 2008 before declining somewhat in midyear 2022. - Rapidly rising policy and mortgage rates and cessation of MBS purchases by the Federal Reserve since March 2022 (excluding reinvestments) led to a sharp drop in refinancing rates, a decline in MBS repayment rates, and a notable widening in MBS spreads. - Regional house price developments: - Real house price growth about 11 percent (year over year) in central and eastern Europe in Q4 2021; considerably lower in emerging Asia, Latin America, and the Middle East and North Africa. - Downside scenarios (three-year horizon): - In a severely adverse scenario, real house price declines could be nearly 25 percent in emerging markets. - In advanced economies, real house prices could fall more than 10 percent in such a scenario. - Compared to October 2021 GFSR estimates, current downside scenario implies a 2 percentage point larger price decline for emerging markets and a 3 percentage point smaller decline for advanced economies. - Median real house price growth is estimated to be about 5 percent over the next three years in some regions (scenario implies global house price boom will slow with a 50 percent probability). - Key drivers of downside risk to house prices: - Affordability pressures and deteriorating economic prospects. - Mitigating factors: - Stronger capital position of banks and (text truncated at source). ### Calibration details from IMF analysis (interest coverage shock assumptions) - 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, - 524 basis points for small firms. - Firm size definitions: - Large firms: assets greater than $500 million. - Medium firms: assets between $500 and $50 million. - Small firms: assets less than $50 million. - Country coverage for corporate analysis follows the April 2021 GFSR framework: China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Türkiye, the United Kingdom, and the United States. *Source: CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT (text - CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT).* ### 1. Real Residential Property Price Developments ### 1. Real Residential Property Price Developments ### Real house price developments and affordability - Panel data show cumulative real residential property price growth (nominal house prices adjusted for inflation using the consumer price index) with wide cross-country dispersion (ISO country codes used in panels). - Key observations from panels: - Housing affordability "has come under intense pressure" (text excerpt). - Price-to-Income Ratio shown for 2000:Q1–2021:Q4 (Index, 2015 = 100) indicates notable increases in many countries. - Note on terminology: AEs = advanced economies; EMs = emerging markets. ### House Price-at-Risk (PaR) analysis and downside risks - The house-prices-at-risk model: - Predicts house price growth in a severely adverse scenario (lower tail of future distribution). - Estimates probability densities for three-year-ahead (cumulative) house price growth across advanced economies and emerging markets. - Filled circles indicate the price decline in the severely adverse scenario with a 5 percent probability (5th percentile). - Panel 3 statistics (illustrative density points and tail values from text): - Example lower-tail declines include: –23.5% and –10.6% (density axis shown with Real house price growth (percent) spanning –40–30–20–10 0 10 20 30). - Panel 4 decomposes projected contributions (percent, latest) of key drivers of house-price-at-risk by region: - Regions listed: Africa; Asia and Pacific; Europe; Western Hemisphere. - "Misalignment" defined as deviation of house-price-to-GDP per capita from an estimated trend (used as a simple measure of deviation from fundamentals, i.e., overvaluation). - Conclusion in text: "downside risks remain significant, especially in emerging markets." ### Banking-sector context and implications for housing risk transmission - Post-global financial crisis underwriting: - "More conservative loan underwriting standards since the global financial crisis" have limited potential contagion via banks, but nonbank exposures (notably in the United States securitized mortgage market) may pose risks. - Banking-sector metrics and trends: - Global CET1 ratio increased from 12.5 percent in 2019 to 14.1 percent in 2021. - Banks are rebuilding loan-loss reserves for the first time since the pandemic. - Liquidity and funding conditions remain healthy; cash and reserves are still above pre-pandemic levels, though cash balances have declined from high levels starting in 2021. - Loan growth has rebounded and is at pre-pandemic levels. ### Global Bank Stress Test (stagflation adverse scenario) — design and aggregate results - Scenario assumptions: - Pandemic resurgence and continuation of geopolitical tensions with persistent global supply chain disruptions, including disruption in Russian gas exports to Europe. - De-anchoring of inflation expectations and disorderly tightening of financial conditions leading to a global recession in 2023. - Baseline corresponds to the October 2022 WEO. - Sample coverage: - 262 banks from 28 countries accounting for 70 percent of global sector assets (countries listed in footnote). - Aggregate capital impact: - 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 banks suffer larger losses than advanced economy banks: - Maximum drop in CET1 ratio from 2021 reaches 4.3 percentage points for emerging market banks, 1.7 percentage points larger than for advanced economy banks. - By end-2024, CET1 for emerging market banks stands 5.5 percentage points below the baseline, compared to 2.5 percentage points for advanced economy banks. ### Distributional outcomes and capital shortfalls - No country banking system would fail to meet the minimum 4.5 percent CET1 ratio under the stress scenario in aggregate, but several individual institutions would: - Distressed cases account for 5 percent of total global assets in the sample and would require $77 billion to bring CET1 ratios back to 4.5 percent. - Majority of these distressed cases are emerging market banks, representing 29 percent of emerging market bank assets in the sample. - Among GSIBs, no bank would fall below the minimum 4.5 percent CET1 ratio; however, 11 percent of GSIBs (by bank assets) would need to dip into their capital conservation buffers (CCBs). - For non-GSIBs, banks accounting for 10 percent of total assets would fail to meet the 4.5 percent minimum threshold. - 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. ### Drivers of larger EM bank losses (stress decomposition) - Emerging market banks exhibit greater sensitivity to macrofinancial shocks resulting in: - Higher loan impairment (loan losses). - Larger declines in net interest income (NII). - Higher mark-to-market losses on trading books ("NTI + OCI" components). - Higher other expenses. - Contributing factors include sharper increases in short-term interest rates and a higher share of government securities in EM portfolios, plus additional vulnerabilities from high shares of foreign-currency-denominated debt in corporate or sovereign sectors. ### Policy recommendations (monetary policy and communication) - With inflation climbing to highs not seen in decades and broadening beyond food and energy, policymakers should: - Continue to normalize monetary policy; the pace of tightening is accelerating in many countries, particularly in advanced economies. - Recognize that tightening financial conditions is necessary to restore price stability, though it cannot resolve pandemic-related supply bottlenecks or commodity market disruptions from the war in Ukraine. - Act resolutely to bring inflation back to target to avoid de-anchoring inflation expectations and preserve central bank credibility. - Heed historical lessons (US monetary policy in the 1970s and early 1980s): moving too slowly to restrain inflation requires more costly subsequent tightening and more disruptive economic adjustments. - Forward guidance: - As policy rates move away from the effective lower bound, policymakers should rethink modalities and objectives of forward guidance. - High uncertainty hampers the ability of central banks to provide explicit and precise guidance about future policy paths; clear communication about policy function, objectives, intertemporal trade-offs, and steps required to bring inflation down to target is critical. *International Monetary Fund | October 2022* ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT ### Global monetary policy normalization and financial stability - Clear communication and preservation of central bank credibility are crucial during policy normalization to avoid unwarranted volatility and disorderly tightening of financial conditions. - Risk: financial conditions may tighten sharply and economic growth may slow more than anticipated in coming months, prompting calls for a pause in policy normalization; authorities should be wary of such calls and consider deploying appropriate tools in case of market dysfunction. - Stop-go policy normalization could undermine price stability and produce a disorderly tightening of financial conditions that interacts with existing financial vulnerabilities and risks economic growth and financial stability down the road. - Monetary policy can be supported by tighter fiscal policy in achieving inflation objectives; fiscal consolidation would ease aggregate demand pressure on prices and moderate the extent of policy normalization required to rein in inflation. - Governments should, within budget constraints, reprioritize spending to protect the most vulnerable from the sharp rise in food and energy prices. ### Euro area: fragmentation risks and the Transmission Protection Instrument (TPI) - The euro area faces differing inflation, economic prospects, and funding needs across member states; ensuring smooth monetary policy transmission across all countries is essential. - The Transmission Protection Instrument (announced July 2022) is intended to address fragmentation risk that could impair effective transmission of monetary policy across euro area countries. - PEPP (Pandemic Emergency Purchase Programme) reinvestment flexibility is the first line of defense against transmission risks related to the COVID-19 pandemic, but: - PEPP reinvestments are anticipated to continue only until 2024. - Projected monthly PEPP reinvestments appear to be smaller than expected gross sovereign debt issuance by southern European countries. - With net asset purchases having come to an end in the first half of 2022, the fiscal deficit in the euro area is set to exceed ECB reinvestments going forward. - 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. - The ECB may consider purchases of private sector securities if appropriate. ### Emerging and frontier market vulnerabilities and policy guidance - Emerging and frontier markets remain vulnerable to a sharp tightening in global financial conditions and capital outflows. - Central banks in many countries have continued to tighten monetary policy to address inflationary pressures; rate increases should proceed as warranted based on country-specific circumstances to preserve policy credibility and anchor inflation expectations. - Countries with highly vulnerable financial sectors, limited or no fiscal space, and significant external financing needs are under strong pressure and could face further severe challenges in the event of a disorderly tightening of conditions. - Countries with credible medium-term fiscal plans, clearer policy frameworks, and stronger financing arrangements will be better positioned to manage tightening; there is a need to rebuild fiscal space and buffers. - The IMF’s Integrated Policy Framework provides an architecture to manage risks from the global tightening cycle and the stronger US dollar; depending on exchange rate flexibility, FX market depth, FX mismatches, and the anchoring of inflation expectations, different actions may be called for. - Foreign exchange interventions may be appropriate in the presence of frictions if reserves are sufficient and intervention does not impair macroeconomic policy credibility or substitute for necessary adjustment. - In case of crises or imminent crises, capital flow management measures may be an option for some countries to lessen outflow pressures; any such measures should be part of a comprehensive policy package that tackles underlying macroeconomic imbalances and should be lifted once crisis conditions abate. ### Sovereign debt vulnerabilities and restructuring tools - Sovereign borrowers in developing economies and frontier markets should enhance efforts to contain risks associated with high debt vulnerabilities through early contact with creditors, multilateral cooperation, and international community support. - Continued use of enhanced collective action clauses in international sovereign bonds and development of majority voting provisions in syndicated loans would help facilitate future debt restructurings. - For countries near debt distress, bilateral and private sector creditors should coordinate on preemptive restructuring to avoid costly hard defaults and prolonged market access loss; where applicable, the G20 Common Framework should be utilized. - Value recovery instruments, such as GDP—or commodity—linked warrants, could play an important role in improving restructuring outcomes during high economic uncertainty. - Countries with moderate risk of debt distress but elevated liquidity risks should consider liability management operations through debt exchanges or refinancing operations. ### Deepening local-currency markets and investor base in emerging markets - Policymakers should promote the depth of local currency markets and foster a stable and diversified investor base. Measures should strive to: 1. establish a sound legal and regulatory framework for securities, 2. develop efficient money markets, 3. enhance transparency of both primary and secondary markets as well as the predictability of issuance, 4. bolster market liquidity, and 5. develop a robust market infrastructure. ### Containing financial vulnerabilities and macroprudential policy - Policymakers should continue to contain further buildup of financial vulnerabilities while considering country-specific circumstances and near-term economic challenges. - Adjust selected macroprudential tools as needed to tackle pockets of elevated vulnerabilities while avoiding a disorderly tightening of financial conditions. - If macroprudential tools are not available (for example, in the nonbank financial institution sector), policymakers should urgently develop them. - Balance is needed between containing the buildup of vulnerabilities and avoiding procyclicality given heightened uncertainty, policy normalization, and limited fiscal space after the pandemic. ### Housing markets and China-specific recommendations - Developments and risks in global housing markets during monetary tightening should be carefully monitored; national authorities should deploy stringent stress tests to estimate the impact of a sharp fall in house prices on household balance sheets and financial institutions. - Policymakers who previously tightened macroprudential tools (such as stressed debt-service and loan-to-value ratios) should consider whether to revisit those decisions to prevent severe macroeconomic implications from sharp repricing in housing markets. - In China, further action led by the central government is urgently needed to restore stability in the housing market, including: - credible policy mechanisms at minimum taxpayer cost to ensure completion of presold housing, - restructure distressed developers, - restore home buyer confidence, - contingency planning to safeguard financial stability, - macroeconomic policy support, and - medium-term structural reforms for an orderly transition to a sustainable financial model for property developers. ### Banking system resilience and supervisory priorities - Global Bank Stress Test results suggest the global banking system would remain resilient in a severe stagflation scenario; however: - Some advanced economy banks and 29 percent of the largest emerging market banks (by assets) would need additional capital. - Authorities should ensure bank asset classifications and loan-loss provisions accurately reflect credit risk and losses. - Supervisors should ensure banks have risk management systems commensurate with their risk profiles, including strengthening stress testing capacity and adequacy. - Adequate capital buffers are essential; financial institutions should have adequate capital conservation plans, and any significant decline in capital ratios should be accompanied by a credible plan to restore capital. ### Corporate and nonbank credit markets, data, and restructuring - Authorities should ensure sufficient and reliable data to analyze vulnerabilities from origination practices and intermediation chains in the corporate debt market; transparency in the growing private debt market should be enhanced, including collection of data on cross-border exposures. - Given the prominent role of nonbank financial institutions in global credit intermediation, ensuring adequate risk management practices and supervision by prudential authorities is vital. - To deal with private debt overhang, restructuring and insolvency tools should enable efficient and orderly exit of nonviable firms facing structural challenges; some firms and sectors facing credit constraints may need short-term fiscal support limited to viable firms and only where fiscal space and clear market access failure exist. ### Market liquidity, trading infrastructure, and nonbank liquidity providers - Swift implementation of policies to mitigate market liquidity risks is paramount to avoid shock amplification during monetary policy normalization. - Supervisory authorities should monitor trading infrastructure robustness and support market transparency. - Improving availability of trade-level data would help public and private sectors with timely assessment of liquidity risks. - Counterparties should carefully monitor intraday activity and leverage exposures of nonbank liquidity providers (such as principal trading firms and hedge funds), strengthen liquidity risk management, and enhance transparency and data availability. ### Crypto assets and regulatory imperatives - The correction in crypto asset markets adds urgency to comprehensive and consistent regulation and adequate supervision. - Policymakers need to address risks to users and investors, market and financial integrity, and macro-financial stability. - Regulatory frameworks should cover all critical activities and entities; crypto asset service providers that deliver core functions and generate key risks (including entities related to storage, transfer, exchange, and custody of reserves) should be licensed, registered, or authorized and subject to regulation similar to financial service providers (principle: “same activity, same risk, same regulation”). - Strong international cooperation is essential to provide guidance, ensure consistent implementation, and contain spillover risks. ### Historical perspective on US tightening cycles and recessions - Over the past six decades, US monetary tightening cycles have often been followed soon after by a recession; notable exceptions include the 1965, 1984, and 1994 cycles (the 1994 cycle is a well-cited soft landing). - The magnitude of decline in economic activity has varied considerably across recessionary periods. - Starting with cumulative increases in the policy rate, the magnitude has become more limited over tightening cycles beginning with the 1988 episode, with a progressively lower terminal rate, reflecting in part a more muted inflationary environment compared to the 1970s and early 1980s. - The 2022 tightening cycle is ongoing. *Source: CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT (text - CHAPTER 1 FINANCIAL STABILITY IN ThE NEw hIGh-INFLATION ENvIRONMENT), International Monetary Fund | October 2022.* ### Box 1.3. Financial Markets and US Monetary Policy Tightening Cycles: A Historical Perspective ### Box 1.3. Financial Markets and US Monetary Policy Tightening Cycles: A Historical Perspective ### Overview of the current tightening cycle - The pace of 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 (Figure 1.3.1 and Figure 1.3.2, panel 1). - Real rates remain negative, and financial conditions are around neutral levels by historical standards (as shown in Figure 1.1). - The Federal Reserve benefits from inflation-fighting credibility built over the past several decades, helping long-term inflation expectations remain much better anchored. ### Historical patterns across key financial indicators during tightening cycles (1967–2022) - Federal funds (effective rates): - Panel 1 shows the total increase in the federal funds rate over each tightening cycle and the average monthly change (labeled “average change”) denoted by yellow markers. - The 2022 tightening pace resembles pre-1988 episodes. - Ten-year US Treasury (UST) yields: - Longer-term interest rates have generally moved upward across tightening cycles, although less so since the early 2000s. - The 10-year yield trended down to record-low levels in the early 2000s, but the pace of increase in the 10-year yield this time is more comparable to cycles before 1988 (Figure 1.3.2, panel 2). - 30-year mortgage rates: - The evolution of 30-year mortgage rates appears similar to that of the 10-year yield (Figure 1.3.2, panel 3). - Panel 3 shows percentage point changes in 30-year fixed-rate mortgages from Freddie Mac’s Primary Mortgage Market Survey. - Investment-grade corporate spreads: - Spreads shown are Moody’s Aaa corporate yields relative to 10-year US Treasury yields (panel 4). - Investment-grade corporate spreads have typically compressed relative to the beginning of the tightening cycle, even though corporate bond yields increased in sync with risk-free yields. The magnitude of compression has tended to vary across cycles. - Equity returns: - Panel 5 shows the range of returns and average returns of the S&P 500 Index since the start of each cycle. - Risk assets such as equities and investment-grade corporate bonds have generally performed well during tightening cycles, even as the economy in many cases ended up in a recession afterward. Exceptions include the 1977–80 episode and the current cycle. - Financial conditions: - Financial conditions (as summarized by the IMF US financial conditions index) this time have tightened significantly compared to recent cycles, likely reflecting, in part, historically easy levels ahead of the tightening cycle (Figure 1.3.2, panel 6). - Data are not available for all tightening cycles considered for the financial conditions index and mortgage rates. ### Inflationary context and historical comparisons - A key difference between the 1994 episode (which resulted in a soft landing) and the current tightening cycle is the inflationary environment: inflation during 1994 was significantly lower (Figure 1.3.1). - In terms of inflation levels, the current period resembles more closely the 1970s and early 1980s, when recessions following tightening cycles were characterized by high inflation and low growth (stagflation). In those episodes: - A substantial rise in the policy rate was necessary to tame inflation, followed by significant economic downturns. - The COVID-19 shock is unprecedented, and the policy framework today differs from the 1970s/early 1980s: - The Federal Reserve’s credibility and anchored long-term inflation expectations differ from those earlier episodes. - The financial and regulatory architecture has evolved considerably since the global financial crisis, and policymakers have risk management tools to address potential systemic fallout from a disorderly tightening. ### Financial vulnerabilities and market behavior - Financial vulnerabilities have emerged in some sectors in the wake of the COVID pandemic. - Financial market volatility has notably risen after having remained relatively compressed over the preceding protracted period of low rates. - During economic downturns, prices of risk assets have typically posted losses. - The behavior of the US dollar across tightening cycles is harder to generalize because external factors also influence it. ### Policy implications and communications - 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. - Policymakers today have at their disposal a number of risk management tools, supported by an evolved financial and regulatory architecture, to manage potential adverse systemic fallout. *Sources: Bloomberg L.P.; Federal Reserve Economic Data; Freddie Mac; Moody’s; and IMF staff calculations. International Monetary Fund | October 2022.* ### CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES ### CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES ### Key findings on market structure and recent momentum - Sustainable finance markets in emerging market and developing economies (EMDEs) have become progressively more mainstream; 2021 was a breakout year. - Green bonds remain the main instrument in the sustainable finance ecosystem in EMDEs: 59 percent in 2022 to date. - Other sustainable finance debt instruments (social, sustainability, and sustainability-linked loans and bonds) have gained prominence since 2018, especially outside of China. - The Asia-Pacific region accounted for 60 percent of sustainable issuance in 2021 and 72 percent in 2022 to date. - Issuance of sustainable debt in EMDEs remains a small share of GDP and lower than that of advanced economies. - Maturities have generally shrunk as issuance has grown—except for sustainability bonds. - Sovereign issuance patterns: - Sovereign issuance has been absent in China. - Sovereign issuance accounted for 10 percent of all issuances (since 2008) in advanced economies. - Sovereign issuance accounted for 34 percent in emerging markets excluding China. - Sovereign issuance accounted for 77 percent in developing economies. - Issuance by other entities (mainly government agencies and local authorities) totaled 64 percent in China and 39 percent in advanced economies. - Private sector issuance share: - Private sector issuance in developing economies: 23 percent. - Private sector issuance in other emerging markets: 43 percent (comparable to the share in advanced economies and China). - Sustainable finance instrument composition: - Debt accounts for 60 percent of total climate finance. - Equity accounts for 32 percent of total climate finance. ### Climate finance needs, gaps, and regional vulnerability - Infrastructure financing for mitigation (mainly transport and energy) falls short of needs across all regions. - The relative financing gap is greater for adaptation (water and sanitation, irrigation, flood protection), where investment is almost nonexistent. - The greater a region’s aggregated vulnerability to climate change (measured by exposure, sensitivity, and ability to adapt), the greater the financing gap. - International community objectives and targets: - It is critical to meet or even exceed the goal of providing $100 billion in climate finance to developing economies each year and to ensure a sizable amount goes to adaptation. - Financing needs for mitigation and adaptation are large relative to GDP across all regions; needs are specifically significant in Central Asia and Eastern Europe and in Middle East and Africa. ### Supply–demand mismatch and market frictions - The mismatch between EMDE climate financing needs and current investment flows has produced a large financing gap. - Instrumental and investor structure constraints: - Sustainable finance markets are largely dominated by debt instruments. - Different financing instruments and investors have varying horizons, scale needs, and risk profiles; all need to be mobilized for mitigation and adaptation. - Renewable energy infrastructure and low-carbon technologies (carbon capture and storage, batteries, low-carbon hydrogen) will largely require equity finance. - Project and country constraints holding back supply and demand: - Lack of investable projects and bottlenecks in project preparation and development. - Deficiencies in policy and regulatory frameworks and weaker institutional capacity (contract enforcement, property rights, fiscal risk management, public investment management). - Need for high-quality, reliable, and comparable data. - Currency and market depth issues: - High share of foreign currency issuance in EMDEs reflects demand from investors based in advanced economies who prefer hard currency. - Lack of depth in domestic capital markets and small scale of local currency bond markets contribute to foreign currency issuance. - Developing economies often lack corporations large enough to issue bonds in global markets. ### The triple challenge: carbon pricing, fossil fuel investment, and climate information architecture - Carbon pricing: - EMDEs lag advanced economies in implementing carbon pricing. - Nascent initiatives—mainly carbon taxes—fall short in emission coverage and prices compared with advanced economies. - Consumption subsidies for fossil fuels in some EMDEs act as a persistent form of negative carbon pricing. - Fossil fuel sector financing trends: - Coal sector: growth of outstanding debt (bonds and loans) was more than 400 percent between Q1 2016 and Q2 2022. - Coal sector in Asia-Pacific: nearly 500 percent increase between Q1 2016 and Q2 2022. - Oil and gas sector: outstanding debt grew 225 percent between Q1 2016 and Q2 2022. - Oil and gas sector in Asia-Pacific: more than 400 percent increase over the same period (primarily via bank loans). - Debt of companies in EMDEs with coal power expansion plans increased about 350 percent between 2016 and 2022; annual growth in Q2 2022 was nearly 30 percent. - Climate information architecture: - Data, disclosures, and taxonomies to align investments with climate goals require strengthening. - ESG scores and fund features can disadvantage EMDEs unless information architecture improves. ### Opportunities and institutional roles to scale up private climate finance - Innovative instruments and market enablers: - Deploy innovative structured finance and outcome-based financial instruments at larger scale and improve them where necessary. - Develop transition finance taxonomies to better signal current and future climate benefits—even for industries with currently high emissions. - Strengthen the climate information architecture (data, disclosures, taxonomies). - Public sector and multilateral roles: - Multilateral development banks (MDBs), development finance institutions (DFIs), and other international financial institutions must play a key role in crowding in private climate financing in EMDEs. - Public institutions should place more emphasis on equity rather than debt financing to catalyze private investment. - Sovereign issuers, currently latecomers or absent from sustainable finance markets, can boost market development. - United Nations Framework Convention on Climate Change (UNFCCC) carbon markets could generate significant investment flows to EMDEs for mitigation if fully implemented. - Specialized vehicles (for example, the Green Climate Fund) will need sufficient funding to support adaptation finance. - The Green Climate Fund maintains a 50/50 balance between mitigation and adaptation finance. - Role of the International Monetary Fund: - The IMF can help strengthen the climate information architecture and support EMDEs with the design and implementation of supportive climate policies, including carbon pricing. - The IMF’s new Resilience and Sustainability Trust (RST): - RST financing could help eligible and qualifying EMDEs tackle longer-term structural challenges from climate change by providing affordable long-term financing and helping catalyze (public and) private financing. - The RST could be tapped to develop a conducive investment climate by promoting reform measures to improve the regulatory environment and increase the resilience of infrastructure needed to address climate change. - Complementarity of policy and finance: - Implementing necessary and appropriate climate policies remains crucial; climate policies and finance are complementary. - Carbon pricing is an effective tool to make high emitters pay for climate costs and channel investment toward projects that emit less. - Climate policies and commitments (for example, Nationally Determined Contributions under the Paris Agreement) send a strong signal to investors and can help direct investment flows to support the transition. ### Policy recommendations and priority actions - Strengthen climate information architecture: improve data, disclosures, and taxonomies to align investments with climate goals. - Scale innovative structured finance and outcome-based instruments to overcome project- and investor-level barriers. - Develop and adopt transition finance taxonomies to signal alignment with emission-reduction goals, including for high-emission industries undergoing transition. - Increase public-sector emphasis on equity financing and use MDBs/DFIs to crowd in private capital. - Encourage sovereign participation in sustainable finance markets to deepen and broaden market development. - Provide sufficient funding to specialized adaptation vehicles (for example, Green Climate Fund) to address adaptation finance shortfalls. - Use IMF instruments such as the RST to provide affordable, long-term financing and promote reforms that improve the investment climate and infrastructure resilience. - Implement and expand carbon pricing initiatives in EMDEs to provide the price signals needed to redirect investment toward low-carbon projects. *International Monetary Fund, GLOBAL FINANCIAL STABILITY REPORT: NAVIGATING THE HIGH-INFLATION ENVIRONMENT, October 2022 — Chapter 2* ### 1. Total Debt of Companies Operating in the Oil and Gas Industry ### 1. Total Debt of Companies Operating in the Oil and Gas Industry ### Debt levels and samples - Total debt includes bonds and loans. - Panel 1 (oil and gas): Data are based on a sample of roughly 80 companies for which debt statistics are available from 2016 onward, out of 250 identified companies headquartered in EMDEs. - Panel 2 (thermal coal value chain): Data are based on a sample of 106 parent companies and subsidiaries for which debt statistics are available from 2016 onward, out of roughly 2,200 identified that are headquartered in EMDEs. - The coal sample represents roughly 25 percent of the installed coal power capacity of companies headquartered in EMDEs. - Companies with expansion plans are those planning to develop new coal-fired power capacity of at least 100 megawatts. - Observation: Debt levels of companies pursuing expansion plans have increased, notably in Asia. ### Key statistics (as presented) - Sample sizes: roughly 80 companies (oil and gas sample) and 106 parent companies and subsidiaries (coal sample). - Universe sizes: 250 identified oil and gas companies headquartered in EMDEs; roughly 2,200 identified coal-related companies headquartered in EMDEs. - Coal sample coverage: roughly 25 percent of installed coal power capacity. - Expansion threshold: at least 100 megawatts. _Italicized sources line: Sources: Bloomberg Finance L.P.; Urgewald; and IMF staff calculations._ --- ### Climate information, taxonomies, and disclosure gaps - Climate information architecture in emerging market and developing economies remains underdeveloped. - Data gaps: Lack of granular, quality climate data; datasets on climate variables and carbon intensity are sparse, especially for Africa, small island developing states, and regions in high-mountain Asia. - Corporate disclosures: Improved recently in Asia, Chile, Peru, South Africa, and Türkiye, but disclosures remain voluntary in most countries and lack standardization, consistency, and reliability because of an absence of auditing requirements. - Consequence: Current disclosures cannot give a consistent picture of financial sector exposure to climate-related risks and opportunities because of the lack of high-quality, consistent, and comparable climate data. - Taxonomy developments: Chinese and European taxonomies have propelled several EMDEs—primarily in Asia and Latin America—to develop regional or national taxonomies. - Examples: ASEAN taxonomy; Indonesia, Malaysia, and Singapore using a “traffic light” approach. - Purpose: Identify improvements in emissions over time and across sectors, including within most carbon-intensive sectors, to support the transition to a low-carbon economy. - Limitations: Most taxonomy projects have not been tested for robustness to meet long-term temperature goals or for impacts on financial markets (including potential diversion of investment from carbon-intensive activities or complex-transition companies). - Global initiatives: International Platform on Sustainable Finance’s Common Ground Taxonomy and advanced-economy regulations (Europe, United States) may serve as benchmarks; impact on EMDEs is unclear. --- ### ESG scores, fund allocations, and implications for EMDE firms - Global ESG assets: $35.3 trillion, or about 36 percent of global assets under management (GSIA 2020). - Asset allocation within ESG funds: 52 percent allocated to equities (at the end of the second quarter of 2022). - Finding: ESG scores are systematically lower for EMDE firms than for advanced economy firms. - Data basis: Panels 1 and 2 use listed firms only—more than 6,200 in total, of which more than 1,300 are from EMDEs. - Panel 1 excludes US firms for Refinitiv ESG scores due to bias; a higher score implies better ESG performance. - Determinants: Firm size is one determinant, but EMDE firms in the listed sample are, on average, not significantly smaller than advanced economy firms. - Regression evidence: Industry composition, firms’ financial performance, and other unobserved firm characteristics cannot fully account for the lower ESG scores of EMDE firms. - Consequences for capital flows: - Allocations to EMDEs by ESG investment funds (equities and bonds) are lower than those by non-ESG funds. - One partial cause: limited size and number of ESG funds dedicated to EMDEs. - Panel data include values up to the end of the second quarter of 2022. - Caveats: Which ESG characteristics explain lower EMDE scores is difficult to pinpoint because ESG scores are constructed from many data points that vary by provider and industry; scoring methodologies and weights differ substantially across providers. - Research note: Recent IMF research finds limited scope for investment strategies based on ESG indicators to meaningfully help mitigate climate change. --- ### Harnessing private climate finance: instruments and MDB/DFI roles - Principle: No single instrument or approach suffices; a set of feasible and complementary tools is needed for different use cases and country circumstances. - Four distinct instrument types and approaches (summary of Table 2.1): 1. Structured finance and EMDE (closed-end) fixed-income funds - Examples: Green bond funds (IFC-Amundi; Axa’s Blue Like an Orange (in progress)). - Description: Green bonds issued by EMDE banks (against green loans) are securitized into green bonds with public sector providing credit risk reduction. - Use case: Emerging markets with existing bank loans to green projects. - Fundamental challenges addressed: Reduction in credit risk (through elevation to investment-grade finance), scaling, diversification, potential currency risk reduction through pooling. - Targeted investors: Institutional investors, including pension funds and insurance companies. - Climate-benefit mechanism: Selection of eligible bank loans; usual green bond certification. - Public sector/MDB role: De-risking (purchase equity tranche/provide first-loss guarantee); technical assistance. - Design issues: Requires existing bank loans and technical assistance for banks to issue green bonds. - Potential to scale up: High. 2. Blended finance for infrastructure and other complex projects - Examples: Equity, mezzanine/first-loss finance for infrastructure projects. - Description: MDBs or the public sector make an equity or mezzanine investment, or provide a guarantee to de-risk and crowd in private investors. - Use case: New infrastructure projects (for example, in the energy sector); use of new types of technologies with potentially higher risks; agriculture. - Fundamental challenges addressed: Mitigation of credit and political risks; mitigation of information asymmetry problems. - Targeted investors: Specialist investors and investment funds; local investors. - Climate-benefit mechanism: Project selection and technical assistance. - Public sector/MDB role: Own resources for equity/mezzanine investment and guarantees; provide specialized expertise for project design. - Design issues: Complex contractual agreements; extensive equity/mezzanine investment and guarantees can create moral hazard; limits returns for other equity investors. - Potential to scale up: Limited by public sector MDB resources. 3. Outcome-based sustainable debt instruments - Examples: Sustainability-linked instruments (bonds, loans, commercial paper, etc.); environmental impact “bonds”. - Description: Issuer receives a bonus (pays a penalty) if sustainability target agreed on in advance is met (missed). - Use case: Support firm-level or government-level alignment with sustainability targets (such as greenhouse-gas-emission reductions). - Fundamental challenges addressed: Information asymmetry (“greenwashing”). - Targeted investors: All. - Climate-benefit mechanism: Bonus (or penalty) provides incentive to fulfill sustainability target. - Public sector/MDB role: None. (Sovereigns could issue to support market development and set standards.) - Design issues: Sustainability targets may not be sufficiently ambitious; penalties need to be high enough to motivate issuer to achieve target. - Potential to scale up: Limited by issuer characteristics. 4. Private finance for public sector projects (“Pay for Success”) - Examples: Environmental impact “bonds”. - Description: Contract with a public sector authority that pays if predefined environmental outcomes are achieved. - Use case: Adaptation finance, nonbankable transition finance. - Fundamental challenges addressed: Capacity limits in developing complex green projects (such as infrastructure); potential inefficiencies in public sector investment. - Targeted investors: Specialized funds, donor funds, MDBs. - Climate-benefit mechanism: Project selection; due diligence. - Public sector/MDB role: Direct investment; technical assistance. - Design issues: High financial and political risks for private investors. - Potential to scale up: Limited by fiscal resources. - Role of MDBs and DFIs: - Public sector institutions can reduce risks associated with EMDE financial assets (credit, foreign exchange, macroeconomic, governance, political risks) to attract private capital. - MDBs/DFIs can absorb risk, provide technical assistance and capacity development, lend reputation and expertise, and crowd in private investors. - Risk: These public-sector interventions entail risks for the public sector that need appropriate management. ### Examples and leverage metrics - IFC-Amundi emerging market green bond fund (AP EGO) example: - IFC purchased a first-loss/equity tranche. - IFC’s equity investment: $125 million. - Fund total: $2 billion. - Leverage multiple: 16. - Effect: Reduced credit risk to “investment-grade level,” allowing pension funds to invest. - MDB leverage statistics: - On average, MDBs attracted only 1.2 times the amount of private finance (equity and debt) relative to commitments of their own resources in 2020. - Equity constituted about 1.8 percent of total MDB commitments to private climate finance in EMDEs. --- _Italicized source attribution: International Monetary Fund | October 2022 — CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES (extracts)._ ### 1. MDB Climate Finance from Their Own Resources and ### 1. MDB Climate Finance from Their Own Resources and Private Investors (Private Finance), 2020 ### MDB instruments, allocations, and key statistics - Mitigation finance–outer circle: $24.7 billion total. - Adaptation finance–inner circle: $13.3 billion total. - Share of MDB commitments in equity instruments: 1.8 percent. - Private finance currently equals 1.2 times MDBs’ own resources. - Selected instrument shares and related figures as presented: - 1.8, 5.2, 5.5, 1.6, 8.4, 3.0, 1.0, 1.8, 15.1, 1.9, 0.4, 17.5, 1.5. - Note on commitments: Commitments include the nominal value of guarantees, which may or may not lead to use of a multilateral development bank’s own resources. ### Use of instruments and operational roles of MDBs - MDBs’ core contributions: supporting complex infrastructure project development (including technical assistance) and providing financing. - MDBs can: - Undertake long-term initiatives to build local currency bond markets. - Provide guarantees, subsidize issuance costs, and take first-loss positions in funding vehicles and securitizations. - Assist in issuance of climate bonds via technical assistance to improve governments’ institutional capacity. - For less developed economies, green infrastructure projects remain central; MDBs can increase their capital base and reconsider risk appetite via private-sector partnerships with governance oversight. - Recommendation: MDBs could make greater use of equity finance (currently about 1.8 percent of their commitments to climate finance in emerging market and developing economies) to draw in much larger amounts of private finance. ### Sustainability-linked bonds and outcome-based instruments - Sustainability-linked bonds: feature a contractually agreed sustainability performance target based on a key performance indicator; issuers may use proceeds freely. - Dominant performance indicators among EMDE issuers: emissions and other environmental goals (mainly energy efficiency and water consumption). - Potential uses: - Transition financing if targets align with net-zero-emission pathways. - Suitable for emerging market firms with scope to improve emission intensity. - Practical challenges: - Sustainability targets sometimes seen to lack ambition. - Penalty for missing targets often low—less than 25 basis points for most emerging market issuance. - Penalty typically implemented as a coupon step-up; penalty event date typically occurs several years after issuance, further reducing dollar-value incentive. - Coupon penalty distribution (by share of issuance amount) as presented across bp categories: - 29.2, 12.2, 4.4, 1.9, 34.4, 1.4, 3.0. - Recommendation: For material climate impact, sustainability targets should be linked to emission-reduction targets in line with the Paris Agreement and penalties should be set sufficiently high to incentivize compliance. ### Pay-for-success / environmental impact bonds - Pay-for-success instruments (environmental impact bonds) originated for social projects but can be applied to environmental projects, notably adaptation finance. - Potential advantages: - Mobilize private sector participation for innovative green technologies. - Incentivize efficient implementation if payments to private investors increase with performance. - Practical constraints: - Contractual arrangements are bespoke and complex. - Require technical assistance and assurance against political risks—a potential role for MDBs. ### Role of the IMF and the Resilience and Sustainability Trust (RST) - IMF catalytic roles: - Policy advice, surveillance, capacity development, and mitigating macroeconomic risk via Article IV consultations and Financial Sector Assessment Programs. - Advocating carbon pricing and providing the Climate-Public Investment Management Assessment framework. - Strengthening climate information architecture, identifying data gaps, promoting corporate climate-related disclosure, and developing guidance for taxonomies to ensure interoperability. - Publishing a Climate Change Indicators Dashboard. - RST specifics: - Focus: longer-term structural changes including climate change and pandemic preparedness that entail macroeconomic risk. - Role: provide affordable long-term financing to support macro-critical reforms, improve policy frameworks with clear timelines, create predictability, and catalyze private-sector investments. - RST can help develop a conducive investment climate through regulatory reforms, improved data and disclosures, and support for making infrastructure more resilient. - Recommendation: Capacity building (aligned with Article 6.8 of the Paris Agreement) and interoperable sustainable finance taxonomies and climate disclosures are essential. ### Transition taxonomies and sovereign issuance - Transition taxonomies: - Useful for sectors difficult to abate (cement, steel, chemicals, heavy-duty transport). - Help promote corporate and financial institutions’ disclosure of transition plans and inform temperature ratings. - Can incentivize private investment informed by climate change targets rather than excluding carbon-intensive industries. - Sovereign sustainable debt issuance: - Sovereigns generally issued sustainable debt after the private sector; EMDE sovereigns have been faster to follow the private sector. - Average lag: less than 2 years for EMDEs versus close to 4.5 years for advanced economies. - Sovereign issuance has tended to positively affect private issuance; sovereign frameworks set high standards (e.g., second-party opinions and impact reports for green bonds). ### International carbon markets and Article 6 ITMOs - COP26 outcomes: completion of the rulebook to implement Article 6, enabling issuance of carbon credits and international trade in ITMOs. - Potential benefits: - Estimates show potential to generate $330 billion to $475 billion in net financial flows to emerging market and developing economies by 2030. - Potential to prevent up to 6 percent of these economies’ total energy-related emissions over the same period. - Limitations and challenges: - Limited potential for adaptation finance. - Risks of double counting of emission reductions by buyer and seller. - Measurement, reporting, and verification can be complicated and costly. ### Conclusion and policy implications (summarized recommendations) - Scaling up private climate finance in EMDEs requires a multipronged approach across MDBs, IMF, and public sector interventions. - Recommendations include: - Replicate and scale up investment funds that draw institutional investors through public markets. - Use outcome-based instruments (with Paris-aligned targets and sufficiently large penalties) to reduce greenwashing and create material climate impact. - Bolster issuance of sustainable bonds by private sector, local governments, and agencies; MDBs to support market development and facilitate access for small and medium-sized firms. - Channel more climate financing through MDBs—by increasing capital and use of equity finance—to attract larger private finance pools. - Strengthen the climate information architecture: improve data availability, quality, and comparability; develop methodologies to assess infrastructure funding gaps; ensure internationally interoperable taxonomies and disclosures. - Shift ESG scores and fund labeling toward sustainability impact through regulatory and supervisory intervention across jurisdictions. - Continue advocacy and assistance for carbon pricing as a means to redirect private finance to greener investments. - Use the IMF RST to provide predictable, long-term finance and co-funding that catalyzes official and private climate investments. *Italic: Source — GLOBAL FINANCIAL STABILITY REPORT: NAVIGATING THE HIGH-INFLATION ENVIRONMENT, International Monetary Fund | October 2022* ### CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES ### CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES ### Asset-level approaches, taxonomies, and portfolio alignment - Asset-level approaches can enhance data collection regarding decarbonization options and characteristics in hard-to-abate and carbon-intensive sectors across value chains. - Such asset-level approaches can: - Inform transition plans at a corporate level. - Be useful to develop portfolio-level alignment methodologies. - Provide a clear signal by emerging market and developing economy issuers about the climate benefits of their assets, including in sectors with ample scope for emission reductions. - Shared common and operationalized principles for taxonomies and other alignment approaches would: - Avoid fragmentation and misalignment. - Foster comparability and consistency across jurisdictions. - Need to take into consideration these economies’ specific industrial structure, as well as decarbonization and adaptation priorities. ### International carbon markets (Article 6 of the Paris Agreement) - The international carbon market envisioned under Article 6 could foster climate finance in emerging market and developing economies—particularly adaptation finance. - Momentum from COP26 should be leveraged to fully implement the international carbon market mechanisms, since there is agreement on the key rules and modalities for their implementation. - Both implementation pathways could materially reduce costs of achieving Paris temperature goals: - Bilateral trade of carbon emission reduction among nations (Article 6.2). - Global trading of carbon emission reductions (Article 6.4, similar to the Clean Development Mechanism). - The global market under Article 6.4 will directly support adaptation finance in emerging market and developing economies by transferring a fixed share of traded carbon to a fund to finance adaptation projects and programs in developing economies (the “Adaptation Fund”). - This mechanism has the potential to provide a very significant increase in much-needed adaptation finance. - Recommendation: Parties to the UNFCCC as well as MDBs should provide as much support as possible toward timely and full implementation of the UNFCCC international carbon markets. ### Specialized public climate funds and adaptation finance - Specialized public climate funds, such as the Green Climate Fund (also under the auspices of the UNFCCC), should receive sufficient resources to fill the adaptation financing gap. - Advanced economies should allocate to such funds a significant share of their annual financing pledges to developing economies under the Paris Agreement. - Rationale: - Adaptation finance often cannot generate returns for private investors, but it can yield very large social benefits for the countries most affected by climate change. *Source: CHAPTER 2 SCALING UP PRIvATE CLIMATE FINANCE IN EMERGING MARKET AND DEvELOPING ECONOMIES (text - CHAPTER 2), International Monetary Fund.* ### 1. Total Net Assets and Share of the Nonbank ### 1. Total Net Assets and Share of the Nonbank ### Trends in fund size, domicile, and asset allocation - Time coverage shown: 2002:Q1–2022:Q1. - Most of these funds are domiciled in advanced economies. - Funds have been increasingly investing in less liquid assets. - Total net asset value is defined as the difference between the total value of a fund’s assets and liabilities. - AE = advanced economy; EM = emerging market; NBFI = nonbank financial intermediation. ### March 2020 market turmoil and subsequent outflows - In March 2020, open-end investment funds experienced larger outflows than in previous market stress episodes. - Monthly net flows shown over 2002:Q1–2022:Q1 (percent of lagged total net assets) include ranges depicted between –6 and 2 percent on the vertical axis for panel 1 and between –6 and 6 percent for panel 2. - Outflows were especially pronounced from relatively less liquid funds such as high-yield bond funds. - Cumulative fund flows into open-end bond funds and into emerging market open-end investment funds are shown for July 2021–July 2022 (percent), indicating that outflows from open-end bond funds increased sharply in sync with the tightening of monetary policy by the Federal Reserve and that outflows were pronounced from emerging market bond and equity funds. - Cumulative flows are calculated based on US dollar flows as a percent of beginning of period’s total net asset values. ### Policy and liquidity-management measures for funds - Liability-side tools discussed: in-kind redemptions, redemption suspensions or gates, side pockets. - Price-based measures discussed: redemption fees, antidilution levies, “swing pricing”. - Definitions and roles: - In-kind redemptions: a fund’s portfolio assets are distributed to redeeming investors on a pro rata basis. - Suspensions: temporarily prevent investors from withdrawing capital from a fund. - Redemption gates: restrict investors’ ability to redeem when total redemptions exceed a certain level. - Side pockets: subfunds that typically hold less liquid assets and have longer redemption periods. - Redemption fees: charges imposed on investors redeeming their shares to discourage short-term trading. - Antidilution levies: fees imposed on redeeming investors to compensate remaining investors for transaction costs caused by redemptions. - Swing pricing: allows funds to adjust their net asset value based on transactions of redeeming investors so that trading costs are borne by exiting investors. - Studies point to the potential effectiveness of price-based measures such as swing pricing, redemption fees, and antidilution levies in reducing investors’ incentive to run on funds (see, for example, Jin and others (2022) and Emter, Fecht, and Peia (2022)). - Price-based measures: - Ensure trading costs are borne only by exiting investors (for example, by adjusting the net asset value when facing outflows or by imposing a fee on redeeming investors). - Prevent dilution of shares of remaining investors. - Damp investor incentives to redeem ahead of others, thereby reducing the risk of investor runs. - Do not restrict funds’ ability to provide daily liquidity (unlike less frequent redemptions/gates). - Adoption issues: - To date, these measures have been adopted only by funds in certain jurisdictions. - Questions remain about calibration and effectiveness, especially in severe market stress (Lewrick and others 2022). ### Central bank backstops and moral hazard concerns - In the absence of adequate liquidity management by funds, central banks have stepped in during episodes of severe market stress to provide liquidity backstops to the financial sector, including to OEFs. - Such interventions have included purchases of a range of risky assets, including corporate bonds, to ease strains on liquidity and help prevent asset fire sales by funds. - While sometimes warranted to prevent systemic crises, these interventions may lead to moral hazard and systematic underpricing of risk by funds. - Investment funds generally: - Do not have access to central bank liquidity facilities or deposit insurance. - Are not subject to the same intensity of prudential oversight, capital, and liquidity requirements imposed on banks. - It is essential to work toward a policy and regulatory framework that addresses vulnerabilities associated with OEFs, mitigates potential risks to financial stability, and minimizes the need for central bank intervention. ### Conceptual framework: liquidity mismatch and run risk - OEFs that hold illiquid assets but offer daily redemptions face an asset-liability “liquidity” mismatch. - The mismatch creates vulnerability to sudden and large redemptions (runs on funds) because investors can redeem at current net asset value without bearing full transaction costs—costs that are then borne by remaining investors. - This externality creates a “first-mover advantage,” incentivizing investors to redeem ahead of others, especially from funds holding less liquid assets (Chen, Goldstein, and Jiang 2010; Goldstein, Jiang, and Ng 2017). - Funds facing outflows may be forced to sell assets, depressing prices—particularly of less liquid assets—thus amplifying redemptions and potentially tightening overall financial conditions. - Herding by funds can exacerbate selling pressure and cause asset prices to diverge from fundamentals. - Depressed asset values can lower fund performance, induce further redemptions and asset fire sales, and adversely affect balance sheets of other financial and nonfinancial entities, potentially leading to broad-based tightening of financial conditions and threatening macro-financial stability. ### Data sample, measurement, and empirical focus - Sample: 17,000 open-end investment funds domiciled in 43 countries holding more than 450,000 bond and equity securities. - Sample period for empirical measures: fourth quarter of 2013 to second quarter of 2022. - Vulnerabilities of OEFs are defined mainly in terms of illiquidity of asset holdings. - Illiquidity measure: value-weighted average of the bid-ask spreads of the securities held by the fund (bid-ask spreads are the difference between “sell” and “buy” prices quoted by market participants). - Asset-level “vulnerability measure” constructed to capture the illiquidity of portfolios of funds holding each asset; follows Jiang and others (2022) and captures the weighted-average liquidity of funds holding the assets, with liquidity defined as the value-weighted quoted bid-ask spread of funds’ portfolios and weights reflecting the share of a fund’s ownership of the asset. ### Stylized facts on fund and asset vulnerabilities - Illiquidity by fund type: - Illiquidity tends to be much higher for bond funds than for equity funds. - Among bond funds, those holding corporate high-yield bonds and emerging market bonds tend to be the most illiquid; funds investing in sovereign bonds are the most liquid. - Time evolution of fund-level liquidity: - Fund portfolio liquidity was relatively stable for several years before the COVID-19 pandemic. - Liquidity deteriorated dramatically in March 2020 amid heightened uncertainty; deterioration was particularly severe for funds invested in less liquid assets such as high-yield and emerging market bonds. - Redemptions from these funds reached record levels in March 2020. - The liquidity of funds’ portfolios worsened again in the first half of 2022, especially for high-yield and emerging market bond funds; for EM bond funds, liquidity reached levels similar to those observed in March 2020. - Asset vulnerability patterns: - Less liquid assets (bonds) are generally held by more illiquid funds and are therefore more vulnerable to selling pressure than equities. - Corporate high-yield and emerging market bonds are more likely to be held by more illiquid funds and hence are highly vulnerable to fund redemptions. - The vulnerability of these assets increased dramatically during the COVID-19 crisis and has risen again in 2022, in some cases close to early-pandemic levels. ### Asset-price impacts during stress episodes - More vulnerable assets experienced sharper price declines in periods of market stress: - March 2020: fixed-income securities held by more illiquid funds experienced a sharper drop in prices (lower returns) than those held by liquid funds. - First half of 2022: the same pattern repeated as global asset markets declined in response to monetary policy tightening by major central banks and the war in Ukraine. - For equities, no meaningful difference is found between returns of those held by more vulnerable funds versus less vulnerable funds, consistent with the notion that liquidity mismatches play a less important role in more liquid markets such as equities. *Sources: Financial Stability Board (2021); Morningstar; FactSet; Refinitiv; Emerging Portfolio Fund Research; and IMF staff calculations.* ### chapter investigates the strength of the relationship ### How Open-End Investment Fund Vulnerabilities Can Contribute to the Fragility of Asset Prices ### Asset‑level vulnerability: bonds versus equities - Individual fixed-income securities held by less liquid funds exhibit more volatile returns than those held by more liquid funds, after controlling for security characteristics including liquidity, rating, and maturity. - Fixed-income securities are on average more vulnerable than equity securities; less liquid securities such as high-yield and EM bonds are generally held by more illiquid funds and have vulnerabilities that "have reached levels almost as high as in March 2020." - A one standard deviation increase in the vulnerability measure of an average bond increases its return volatility by 23 percent relative to the median return volatility of the bond (first bar on the left). - By contrast, the volatility of returns of relatively more liquid assets, such as sovereign bonds and equities, does not appear to be strongly affected by the liquidity of the funds that hold them. ### Amplification by market stress and herding - Sensitivity of asset price fragility to fund vulnerabilities increases in periods of market stress, measured by: - Chicago Board Options Exchange Volatility (VIX) Index, and - US monetary policy uncertainty (textual measure). - A one standard deviation increase in the vulnerability measure is associated with about a 20 percent increase in bond return volatility (relative to median volatility) when the VIX Index or monetary policy uncertainty is high (at the 75th percentile) relative to when they are low (at the 25th percentile). - Herding amplifies the effect: a one standard deviation increase in the vulnerability measure has a 3 percent to 5 percent larger effect on return volatility (relative to the median) for securities exposed to sell‑herding compared with those that are not. ### Spillovers to emerging markets - Fund‑level vulnerabilities in advanced economies spill over to asset prices in emerging market economies, particularly to corporate bond prices. - A one standard deviation increase in the vulnerability measure of emerging market corporate bonds held by funds domiciled in advanced economies is associated with a 23 percent increase in their return volatility relative to their median volatility. - The impact is magnified during market stress: a one standard deviation increase in vulnerability is associated with a 14 percent higher impact on bond return volatility in periods when the VIX Index is high compared with periods when it is low. ### Transmission channels from OEF vulnerabilities to asset price fragility - Vicious circle mechanism: investor redemptions → forced liquidations by less liquid funds → selling pressures → lower market values → further redemptions. - Empirical findings supporting the mechanism: - Less liquid funds tend to face larger outflows, particularly when the VIX Index is elevated. - Outflows from funds lead to selling pressure; bonds with higher vulnerability (held by less liquid funds) are more likely to be liquidated when funds experience large outflows, with effects particularly pronounced for high‑yield bonds. - During periods of market stress (for example, the COVID‑19 market turmoil), funds appear to follow a pecking order of liquidation, selling relatively more liquid assets within their portfolio first (horizontal slicing/liquidation rank). - Selling pressures induced by fund outflows lead to significant price movements and negative abnormal returns for bonds; the event‑study results indicate abnormal return impacts on the order of up to –2.5 percentage points for some bond categories during the COVID‑19 market turmoil. - Quantitative highlights from selling‑pressure analysis: - The estimated selling‑pressure coefficient for high‑yield corporate bonds is equal to 46 percent (the y‑axis in the figure is truncated for visual clarity). - Panel evidence shows effects of fund illiquidity on outflows measured in percent of fund size across VIX percentiles, and liquidation‑adjusted outflows on abnormal returns measured in percentage points (see figures for the distribution of these effects). ### Synthesis of implications - Vulnerabilities associated with funds’ liquidity mismatches generate fragility in asset markets, especially fixed‑income markets. - Fragility is amplified when macro‑financial uncertainty is high and when funds engage in herding or follow similar liquidation pecking orders. - Advanced‑economy fund vulnerabilities can transmit materially to emerging market corporate bond markets, raising EM return volatility substantially during stressed periods. *International Monetary Fund | Global Financial Stability Report: Navigating the High‑Inflation Environment, October 2022 (chapter investigating fund‑level vulnerabilities and asset‑level fragility).* ### CHAPTER 3 ASSET PRICE FRAGILITY IN TIMES OF STRESS: ThE ROLE OF OPEN-END INvESTMENT FUNDS ### CHAPTER 3 ASSET PRICE FRAGILITY IN TIMES OF STRESS: ThE ROLE OF OPEN-END INvESTMENT FUNDS ### Spillovers to Financial Markets from Vulnerabilities in Open-End Investment Funds - Investor redemptions from funds lead to selling pressure that increases market volatility and depresses asset prices, which can tighten financial conditions and create macro-financial stability risks. - Empirical findings: - Average financial conditions across countries are correlated with average asset-level vulnerability (extent to which assets are held by illiquid funds). - An increase in the vulnerability measure for less liquid assets such as bonds is associated with a significant tightening of financial conditions in the next period. - No similar effect is visible for more liquid equity securities. - The adverse effect of bond-related vulnerabilities on financial conditions is amplified as financial conditions tighten (estimated with panel quantile regressions). - Cross-border spillovers: - Increased holdings of domestic assets by nonresident advanced economy illiquid funds are associated with significant tightening in domestic financial conditions of recipient countries in the period that follows. - Spillover effects are present for the full sample of countries but are much stronger for emerging market economies. ### Liquidity Management Tools: Availability and Usage - Wide range of liquidity management tools exist across jurisdictions; most widely available tools are those that can limit investors’ ability to redeem during severe outflows: - Redemption suspensions - Redemption fees - Redemption gates - In-kind redemptions - These tools are generally deployed only in periods of extreme market stress, and funds are concerned about reputational stigma associated with their use (example: during COVID-19 at least 215 funds suspended redemptions and subsequently experienced larger outflows than comparable funds). - Antidilution levies and swing pricing can reduce vulnerabilities ex ante by passing transaction costs to exiting investors but: - Are available only in a limited number of jurisdictions. - Utilization remains limited. - Mandatory requirements on holding minimum liquidity buffers appear to be the least-used tools across jurisdictions. ### Cash Buffers and Fund Behavior - Cash buffers vary across and within fund types: - Equity funds: cash buffers range from 0.5 percent to 4 percent of net assets. - Bond funds: cash buffers range from 1 percent to 9 percent of net assets. - Funds holding relatively illiquid securities (measured by bid-ask spread) on average hold larger cash buffers. - No meaningful difference in cash holdings between funds that use swing pricing and those that do not. - Fund responses to flows: - In normal times, funds facing outflows deplete cash buffers to pay investors. - In times of severe market stress (when VIX is above its 90th sample percentile in the analysis), funds appear to preserve portfolio liquidity and do not deplete cash buffers as much. ### Swing Pricing: Effectiveness and Calibration - Swing pricing is an ex ante tool that imposes transaction costs associated with redemptions on redeeming investors, thereby eliminating first-mover advantages if properly calibrated. - Empirical results: - The adverse impact of fund vulnerabilities on the volatility of bond returns is reduced by about one-third if more funds implement swing pricing. - Swing pricing funds in the empirical proxy are defined as funds domiciled in Luxembourg or the United Kingdom. - Statistical significance denoted at the 10 percent level or lower in the regressions. - Limitations and calibration challenges: - Swing factors must reflect the full cost of outflows, including price impact of asset liquidations; this is difficult for highly illiquid assets and during extreme stress when price impact assessment is challenging. - Studies estimating optimal swing factors to fully eliminate run risks find a range of 0 to 9 percent, with the higher end relevant in periods of stress and for funds with investors highly sensitive to performance. - Many funds are constrained by maximum swing factors set substantially below 9 percent and typically capped in prospectuses. - Caps are often based on direct trading costs (commissions, bid-ask spreads) and may not account for indirect costs such as price impact, reducing effectiveness. - Competitive pressure may lead funds to set low caps because some investors prefer funds with low caps on swing factor size. - Net effect: - Swing pricing mitigates vulnerabilities from OEFs but may not fully offset increased return volatility induced by illiquid funds’ bond holdings if swing factors are set too low. ### Conclusion and Policy Recommendations (Summary) - Open-end investment funds (OEFs) can transmit shocks to financial conditions domestically and across borders. - Reducing vulnerabilities associated with OEFs could help mitigate asset price fragility and macro-financial stability risks. - Policy implications highlighted by the chapter: - Wider consideration of ex ante tools (for example, swing pricing and antidilution levies) that pass transaction costs to redeeming investors could reduce first-mover advantages. - Attention to calibration of swing factors is critical — factors should account for full transaction costs including price impact, particularly for highly illiquid assets and in stressed markets. - Given limited use and variability of liquidity buffers, policymakers should weigh trade-offs (liquidity buffers can provide flexibility but may constrain fund capacity and have ambiguous effects on run dynamics). - Transparency, jurisdictional differences in tool availability, and potential stigma associated with ex post tools (gates, suspensions) are important considerations for regulatory design. *Source: CHAPTER 3 ASSET PRICE FRAGILITY IN TIMES OF STRESS: ThE ROLE OF OPEN-END INvESTMENT FUNDS — International Monetary Fund | October 2022.* ### Annex 3.2 for a description of the empirical methodology. ### Annex 3.2 for a description of the empirical methodology ### Direct effect of swing pricing on bond price volatility - Results reported capture only the direct effect from funds’ adoption of swing pricing on the price volatility of bonds in their portfolio. - Introduction of swing pricing at the fund level likely offers additional benefits by reducing run risks for other funds holding similar assets, thereby stabilizing the fund market segment as a whole. - In most jurisdictions where swing pricing is permitted, funds are required to publish the maximum swing factors they may apply in their prospectus and cannot apply a larger swing factor without changing the prospectus. ### Calibration approaches and limitations - Capponi, Glasserman, and Weber (2020) calibrate the optimal swing factor as a function of the direct price impact on assets that would result from funds’ transactions following investor redemptions. - Anadu and others (2022) derive optimal swing factors using ETF premiums and discounts for funds investing in short-term corporate bonds. - Limitation: ETF premiums and discounts may also be driven by factors such as the ability of authorized participants to provide liquidity. - Limitation: ETF investors may differ (have different liquidity preferences) from OEF investors. ### OEF growth, liquidity mismatch, and systemic implications - The share of assets held by OEFs has grown dramatically over the past two decades. - Vulnerabilities associated with the liquidity mismatch between OEF asset holdings and liabilities can subject some funds to investor run risk that can lead to severe dislocations in financial markets and amplify the adverse macro-financial impact of exogenous shocks. - Empirical findings: - OEFs holding illiquid assets that offer daily redemptions are a key driver of asset price fragility. - The most affected assets are those in less liquid markets, such as corporate bonds. - The volatility of returns for these assets increases significantly—especially in times of market stress—if these assets are held by more illiquid funds. - Fund vulnerabilities can have significant cross-border spillover effects and lead to greater asset price volatility in emerging market economies. - System-wide implications include tightening of domestic financial conditions and reinforcement of the vicious cycle between redemptions, fund asset sales, and the price impact of these sales. ### Policy tools: types, trade-offs, and effectiveness - Broad categories of liquidity management tools: - Tools that limit vulnerabilities ex ante by reducing the risk of investor runs (preferable). - Tools that mitigate impact once runs are underway (less desirable). - Examples and trade-offs: - Redemption suspensions or gates: - Limit investors’ ability to redeem. - Do not address the intrinsic first-mover advantage problem. - Typically adopted by funds already facing significant outflow pressures, which may limit systemic effectiveness. - Such tools could even exacerbate run risks because investors may try to redeem before the measures are applied by the fund. - Holding cash and other liquidity buffers: - May give funds flexibility to respond to shocks. - Do not necessarily reduce the risk of investor runs and may be insufficient to address systemic risks. - Price-based tools (swing pricing, antidilution levies): - Can reduce investors’ incentives to front-run others by passing on transaction costs to redeeming investors. - Protect remaining investors and mitigate systemic risks. - Widespread adoption and appropriate calibration are key to effectiveness. - Operational and implementation considerations: - Fund-imposed caps on swing factors could constrain funds’ ability to fully pass on transaction costs to redeeming investors and may limit effectiveness as a macroprudential tool in times of stress. - In periods of extreme stress when market liquidity is very poor, swing factors or antidilution levies may be very large or difficult to calibrate; redemption suspensions or gates may be an alternative, easier-to-implement tool. - IMF (2021) proposes a “waterfall” approach of progressively more aggressive liquidity management tools (example sequence: redemption deferrals for moderate shocks → in-kind redemption for moderate to large shocks → market-wide fees or gates for large shocks). - For very illiquid assets (for example, real estate) or where price-based tools cannot be effectively implemented for operational reasons, linking redemption frequency to portfolio liquidity or offering early redemption in exchange for a calibrated redemption fee may be suitable. ### Policy recommendations and supervisory measures - Require funds to eliminate caps on swing factors and calibrate swing factors such that they fully reflect the price impact of a fund’s asset sales. - Encourage disclosure of swing pricing practices and calibration methodologies. - Improve the availability of aggregate fund flow data in real time to help funds determine appropriate swing factors, especially during times of stress. - Consider tighter monitoring of liquidity risk management practices by supervisors and regulators to ensure appropriate implementation of liquidity management tools. - Collect additional data on funds’ liquidity risks where necessary. - Consider mandating the adoption of liquidity management tools and enhanced disclosure, given competitive pressure and concerns about stigma that may prevent voluntary implementation. - Given global operations of funds and cross-border spillovers, deploy liquidity management practices consistently at the global level and enhance international regulatory coordination. - Recipient countries should: - Be mindful of volatility of capital flows originating from funds in advanced economies. - Emphasize continued deepening of domestic markets. - Use debt management tools and macroeconomic, prudential, capital flow management, and foreign exchange intervention tools in line with the IMF’s Institutional View to address risks from surges and sharp reversals in portfolio investments by OEFs (IMF 2012, 2022). - Bolster provision of liquidity and market resilience: - Encourage central clearing and greater transparency in bond trading to reduce risks from liquidity mismatch in OEFs and to support functioning of securities markets in periods of stress. ### Exchange-Traded Funds (ETFs): differences, empirical findings, and vulnerabilities - Structural differences: - ETFs allow intraday trading at market prices and do not guarantee redemption at fund NAV; they are not vulnerable to investor runs in the same way as OEFs. - Arbitrage by authorized participants links ETF prices to NAV, but this mechanism can break down when market liquidity deteriorates. - Empirical findings: - Bonds held by ETFs experience a smaller increase in volatility during periods of stress than comparable bonds held by OEFs. - Regression setup: return volatility regressed on asset ownership and interaction with a stress dummy equal to 1 when the Chicago Board Options Exchange Volatility (VIX) Index is above its 90th sample percentile and zero otherwise. “Mutual fund owned” refers to the total amount of an asset held by OEFs, but not by ETFs, as a percentage of its market capitalization. Effects are based on weekly asset price volatilities; regression includes asset and issuer fixed effects; standard errors clustered at the asset and quarter levels; solid bars indicate statistical significance at 10 percent or lower. - ETF mispricing and March 2020 stress: - During March 2020 stress episode, when liquidity conditions were poor, discounts on ETFs increased dramatically: - Reaching more than 5 percent across all bond ETFs. - Up to 27 percent for high-yield bond ETFs. - Up to 13 percent for investment-grade bond ETFs. - ETF mispricing is calculated at daily frequency as the difference between the ETF closing price and the fund NAV divided by the fund NAV. - ETF vulnerabilities: - ETF discounts reflect market liquidity costs and the practical limits of arbitrage when dealer balance sheets are constrained. - Intraday liquidity provision attracts short-term liquidity traders; together with authorized participant arbitrage, this can transmit nonfundamental shocks to securities markets. - Evidence that ETFs can increase nonfundamental volatility in asset markets and amplify sensitivity of cross-border capital flows to global financial conditions. - Leveraged and inverse ETFs that rely on derivatives and short sales can introduce additional volatility due to end-of-day rebalancing needs. *Italic: Source — text - Annex 3.2 for a description of the empirical methodology.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2022/october/english/text.pdf_