## CHAPTER 1 FINANCIAL FRAGILITIES ALONG THE LAST MILE OF DISINFLATION ## Source details **Canonical URL:** [CHAPTER 1 FINANCIAL FRAGILITIES ALONG THE LAST MILE OF DISINFLATION](https://www.imf.org/-/media/files/publications/gfsr/2024/april/english/ch1.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2024/april/english/ch1.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2024/april/english/ch1.pdf.json) --- ### Key findings and near-term outlook - Expectations that global disinflation is entering its “last mile” and monetary policy will be easing have driven up asset prices worldwide since the October 2023 Global Financial Stability Report. - Many emerging markets have shown resilience, and some frontier economies have taken advantage of buoyant risk appetite to issue international debt. - The global economy appears increasingly likely to achieve a soft landing, and cracks in the financial system exposed by high interest rates have not ruptured further. - Near-term global financial stability risks have receded according to the IMF’s growth-at-risk framework. - Stress in the commercial real estate (CRE) sector has become more acute; more borrowers likely in trouble and a number of banks are being scrutinized by investors over CRE-related loan losses. - Financial market volatility appears too low relative to elevated macroeconomic and geopolitical uncertainty; valuation of many risk assets is increasingly stretched, premised on investor expectations for relatively brisk monetary easing. - Stalling disinflation could surprise investors, prompting a repricing of assets and a resurgence of financial market volatility that would tighten financial conditions and hasten credit-cycle deterioration. - Both public and private debt continue to accumulate in advanced economies and emerging markets, creating medium-term vulnerabilities; servicing historically high sovereign debt could become difficult if real economic growth falls below market expectations for real long-term interest rates. - Elections in a record number of countries in 2024 may lead to fiscal “slippages,” increasing sensitivity of interest rates to sovereign issuance and central bank quantitative tightening. - Investor sentiment in China remains weak and may continue to weigh on the property and local government sectors. ### Monetary policy and financial market developments - Market pricing suggests multiple policy rate cuts in major advanced economies during the year: - Market pricing currently indicates up to two rate cuts by the Federal Reserve, expected over the second half of the year. - Around three European Central Bank cuts by October. - One Bank of England cut by August. - Japan remains an outlier; markets price a gradual increase in the policy rate following the Bank of Japan’s exit from negative interest rate policy and other unconventional measures. - At its March meeting, the Bank of Japan hiked the short-term policy rate band to above zero (between 0 to 0.1 percent) for the first time since 2016, abolished yield curve control, halted purchases of exchange-traded funds and Japanese real estate investment trust shares, and announced that gross Japanese government bond purchases will be conducted at broadly the same amounts as in the recent past while commercial paper and corporate bond purchases will be gradually reduced before being discontinued in about one year’s time. - As inflation has slowed, expectations of future inflation have fallen in the euro area but have risen some for the United States. - Core inflation remains above central bank targets in most countries, leaving the global economy susceptible to inflationary shocks. - Option prices and survey forecasts signal elevated uncertainty and increased disagreement about future US inflation levels and US growth relative to the euro area. - Global long-term interest rates have declined, on net, since the October 2023 GFSR, driven by a lower expected path of policy rates and compression of the term premium. - The 10-year US Treasury yield approached 5 percent at one point in September–October 2023, driven by a term premium increase of around 70 basis points. - Current levels of real risk premiums across future horizons remain elevated compared with the end of the previous tightening cycle in January 2019 and to the average after the global financial crisis. ### Asset prices, leverage, and credit conditions - Global equity markets have experienced broad-based rallies since the October 2023 GFSR, with largest gains in Japan and the United States; Chinese stocks have significantly underperformed (a 45 percent decline since the peak in 2021 for Chinese equities noted elsewhere). - European and US corporate bond markets have rallied with narrower borrowing spreads for both investment-grade and high-yield issuers. - Reaching for yield is reemerging: corporations, including lower-rated ones, find financing easier through corporate bond markets and private credit markets that are opaque to policymakers. - Leveraged trading strategies and open-end bond fund inflows have increased liquidity transformation risks; illiquid assets such as private credit are being marketed to retail investors. - Faster private credit growth could stimulate aggregate demand and make disinflation more challenging. - Many frontier and low-income countries remain under financing stress with limited rollover options; more businesses and households globally are set to default as they grapple with high interest rates and tighter bank lending standards. - Corporate sector vulnerabilities: - As of Q3 2023, the share of small firms with a cash-to-interest expense ratio below 1 was around 33 percent in advanced economies and 55 percent in emerging markets. - If interest expense rises in line with current market yields, these shares would rise to 38 percent and 59 percent, respectively. - Mortgage originations in the United States are 21 percent lower than one year ago. - Monthly US home prices have risen by 6.1 percent since the beginning of last year; 30-year mortgage rates declined from a peak of 7.8 percent to 6.8 percent but remain around 3 percentage points above pandemic lows. - Corporate credit growth is recovering quickly in this hiking cycle relative to prior cycles, and substantial corporate debt will mature at higher interest rates. ### Commercial real estate (CRE) stress and banking exposures - CRE price and sector stress: - Global private and institutional CRE prices declined by 12 percent globally over the past year in real terms. - US office sector prices declined by 23 percent; Europe declined by 17 percent. - Asia‑Pacific (excluding China) CRE prices remained relatively stable on aggregate. - Vacancy rates continued to rise in 2023; absorption rates have been negative. - Severely adverse scenario (5 percent probability): three-year real CRE price declines could reach: - 20 percent in the Europe, Middle East, and Africa region, - 23 percent in North America, - more than 25 percent in the office sector. - US CRE debt and refinancing: - US CRE debt is estimated at almost $6 trillion. - Of the $1 trillion of US CRE debt maturing in 2024 and 2025, the refinancing gap exceeds $300 billion (analyst estimates). - CMBS issuance down 45 percent from the previous year; CMBS delinquencies for office-specializing securities reached 6.1 percent, up from 1.5 percentage points a year ago. - Bank net charge-off rates for CRE loans rose briskly. - Bank exposures and indicators (United States): - CRE loans make up about 18 percent of total bank loans. - An estimated $277 billion in CRE loans will mature in 2024, $82 billion of which are backed by office properties. - The nonperforming CRE loan rate by end-2023 doubled from a year earlier to 0.81 percent from 0.40 percent at end-2022. - The CRE coverage ratio (loan-loss reserves to nonperforming loans) fell to 154 percent from 200 percent for the banking sector. - 15 percent of REITs specializing in the office sector are potentially in debt distress, a 10 percentage point increase from the previous year. - Banking sector concentration of CRE risk: - One-third of US banks, mainly small and medium banks with $3.7 trillion in total assets, reported CRE exposures exceeding 300 percent of their Tier 1 capital plus the allowance for credit losses. - More than 100 banks (about 3 percent of banking system assets) have the combination of: CRE exposure above 300 percent of capital plus allowance for credit losses; unrealized losses greater than 25 percent of Tier 1 capital; ratio of uninsured deposits to total deposits greater than 25 percent. - Unrealized losses remained elevated at $477 billion in the fourth quarter of 2023. ### Market functioning, volatility, and funds - Volatility and correlations: - Volatility has declined to multiyear lows for most asset classes; volatility risk premium has fallen across maturities since the October 2023 GFSR. - Shorter‑dated volatility risk premiums are now deeply in negative territory, similar to levels just before the start of the tightening cycle in 2022. - Average correlation across advanced economy and emerging market equities, bonds, credit, and commodity indices is high, exceeding the 90th historical percentile. - Open-end funds and liquidity mismatches: - Funds investing in less-liquid assets while permitting daily redemptions create liquidity mismatch risks—particularly high-yield corporate bond, leveraged-loan, and emerging market hard currency bond funds. - Investment-grade US corporate bond funds received close to 70 percent of their prepandemic net asset value in inflows since the pandemic onset. - Fund flow at risk (5 percent) used as a metric of potential peak outflows. - Leveraged positions and basis trades: - Hedge funds have increased Treasury basis trade activity by at least $317 billion since Q1 2022 (Federal Reserve Board staff estimate). - Repo volumes and futures shorts have increased; concentration is high with nearly half of two‑year futures positions held by fewer than eight traders. - A spike in repo rates could render basis trades unprofitable and trigger forced selling of Treasury securities. ### Sovereign debt, term premiums, and demand base for government bonds - Term premium dynamics and spillovers: - Spillovers from US term premiums to other advanced economies and emerging markets have risen; co-movements among global long-term interest rates could remain pronounced. - Between mid‑September and end‑October 2023, term premiums exerted upward pressure on yields reflecting US fiscal concerns and higher real risk premiums. - Advanced-economy issuance and quantitative tightening (QT): - Net US and EU Treasury duration supply relative to GDP projected through Dec. 2025 shows elevated issuance needs to fund deficits and service higher-rate debt. - Federal Reserve shrinking Treasury holdings by $60 billion per month; BoE ~£100 billion reduction; ECB redemptions estimated approximately €260 billion in 2024 plus €45 billion PEPP redemptions. - QT withdraws liquidity, reduces commercial banks’ central bank reserves, and could lead to reserve scarcity and higher interbank borrowing costs. - Buyer composition shift: - Since Sep. 2019, net issuances of US Treasuries increasingly absorbed by nonbank sector (households and hedge funds); banks have been net sellers. - New marginal buyers (hedge funds, households, asset managers) are more price sensitive and attuned to debt sustainability. ### Emerging markets, frontier economies, and China - Emerging markets: - On average, emerging-market central banks raised policy rates by 780 basis points from trough to peak after the pandemic, versus 400 basis points for advanced economies. - Early tightening widened the average nominal interest rate differential between emerging markets and the United States to over 6 percentage points. - Estimated likelihood of capital outflows across all emerging markets over the next year declined from 32 percent to 27 percent; the 5th percentile of one-year-ahead capital outflows fell to 2.3 percent of GDP. - Averaged across emerging markets, net domestic local currency bond issuance is nearly 1 percentage point of GDP higher than in prepandemic years. - Frontier issuers have a combined US$30 billion in foreign currency bonds coming due in 2024 and 2025—the same amount as aggregate debt that matured in 2019–2023. - Market-implied default rates over the next five years remain higher than in 2019 for some sovereigns even after recent rating changes. - China: - Housing market downturn shows few signs of bottoming out; declines in new home prices moderate but existing home prices and activity measures (starts, sales, investments) have dropped sharply. - Limited new home price adjustment and extended forbearance restrained negative spillovers to banks but disincentivized necessary debt restructuring. - Recent support policies (mortgage rate cuts, easing of purchase restrictions, promises for affordable housing and urban redevelopment) have had limited success restoring homebuyer confidence; financing conditions for property sector remain tight. - Presale revenue declines depressed land-sale proceeds to local governments while LGFVs face large debt repayments over next two years; frontier of LGFV vulnerability: high debt-to-earnings ratios and high financing costs in weaker provinces. - Chinese equity market: sharp declines with Chinese and Hong Kong SAR stock prices down as much as 11 percent and 14 percent, respectively, since October 2023 GFSR; 45 percent decline since 2021 peak noted. - Structured products: estimated US$45 billion outstanding of “snowball products” sold by banks and securities firms; related offshore products include an estimated US$20 billion of equity-linked investments in Korean markets. - Asset management industry: total assets ¥110 trillion or nearly 90 percent of GDP as of 2023; wealth management products and investment funds focused on public sector debt are three times as large as trust funds and are retail‑focused, posing run risks. ### Growth‑at‑Risk scenarios and credit growth trade-offs (United States) - Framework uses IMF growth-at-risk model with credit growth scenarios calibrated on historical tightening cycles. - Scenario calibrations and outcomes: - Scenario 1: household credit grows about 1.8 percent per quarter; corporate credit growth equal to 2.3 percent per quarter. - Under Scenario 1: near-term downside risk improves, whereas medium-term risks may remain elevated at around the baseline; corporate credit growth improvement leads to more than proportionate deterioration in medium-term risk. - Scenario 2: household credit growth calibrated to −0.5 percent (minimum quarterly credit growth). - Under Scenario 2: households’ near-term risks deteriorate considerably relative to baseline with negligible improvement in medium-term risks. - Model notes: medium term calculated as average between years 4 and 8; credit data from BIS. ### Policy recommendations (selected and organized) - Monetary and market‑functioning: - Central banks should reflect country-specific circumstances, avoid premature easing in economies with persistent inflation, push against overly optimistic market expectations for policy easing, and gradually move to a more neutral stance where disinflation is sustainable. - Monitor market functioning and funding rates; be ready to address market stresses and clearly communicate liquidity removal steps and emergency liquidity frameworks. - Fiscal and sovereign debt management: - Rebuild buffers to support the last mile of disinflation, lower term premiums, and contain debt rises; pace and composition depend on aggregate demand and fiscal space. - Promote depth of local-currency markets and a diversified investor base via sound legal/regulatory frameworks, efficient money markets, greater transparency, predictable issuance, bolstered liquidity, and robust market infrastructure. - Sovereign borrowers in EMs, frontier economies, and LICs should strengthen efforts to contain debt vulnerabilities; countries near debt distress should enhance early creditor contact and consider preemptive restructuring where appropriate. - Financial-stability and macroprudential actions: - Conduct stress tests that incorporate large CRE price declines; review CRE valuation assumptions and ensure provisioning adequacy. - Enhance corporate governance, raise countercyclical or sectoral buffers where feasible, and ensure nonbank financial institutions face effective liquidity management and data reporting requirements. - Consider liquidity- and frequency-related reforms for CRE funds (longer notice/settlement periods, closed-end structures) and tighter reporting/supervision for private credit given growth and retail participation. - Prioritize full, timely, and consistent implementation of internationally agreed prudential standards. - Country-specific guidance: - China: deploy accommodative macroeconomic policies, structural and pro-market reforms, complete housing market adjustments and timely restructuring of troubled developers, consider additional monetary easing, reorient public expenditures toward households, phase out forbearance, and enforce prudential policies to restructure weak banks. - Emerging markets: avoid overly aggressive policy easing, use IMF Integrated Policy Framework where relevant, and consider FX intervention or capital flow measures only as part of broader policy packages. - Resolution, coordination, and crypto monitoring: - Advance recovery and resolution frameworks for banks and large nonbank institutions; strengthen cross-jurisdictional coordination and data-sharing for timely crisis management. - Enhance monitoring of linkages between traditional financial institutions and the crypto ecosystem after approval of spot Bitcoin ETPs; supervise risks from growing crypto exposures and the potential for portfolio reallocations to amplify systemic stress. *Source: Chapter 1 at a Glance and Chapter 1 excerpts, Global Financial Stability Report (April 2024).* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Key findings and near-term outlook - Expectations that global disinflation is entering its “last mile” and monetary policy will be easing have driven up asset prices worldwide since the October 2023 Global Financial Stability Report. - Many emerging markets have shown resilience, and some frontier economies have taken advantage of buoyant risk appetite to issue international debt. - The global economy appears increasingly likely to achieve a soft landing, and cracks in the financial system exposed by high interest rates have not ruptured further. - Near-term global financial stability risks have receded according to the IMF’s growth-at-risk framework. - Stress in the commercial real estate (CRE) sector has become more acute, with more borrowers likely in trouble and a number of banks being scrutinized by investors over CRE-related loan losses. - Financial market volatility appears too low relative to elevated macroeconomic and geopolitical uncertainty; valuation of many risk assets is increasingly stretched, premised on investor expectations for relatively brisk monetary easing. - Stalling disinflation could surprise investors, prompting a repricing of assets and a resurgence of financial market volatility that would tighten financial conditions and hasten credit-cycle deterioration. - Both public and private debt continue to accumulate in advanced economies and emerging markets, creating medium-term vulnerabilities; servicing historically high sovereign debt could become difficult if real economic growth falls below market expectations for real long-term interest rates. - Elections in a record number of countries in 2024 may lead to fiscal “slippages,” increasing sensitivity of interest rates to sovereign issuance and central bank quantitative tightening. - Investor sentiment in China remains weak and may continue to weigh on the property and local government sectors. ### Monetary policy and financial market developments - Market pricing suggests multiple policy rate cuts in major advanced economies during the year: - Market pricing currently indicates up to two rate cuts by the Federal Reserve, expected over the second half of the year. - Around three European Central Bank cuts by October. - One Bank of England cut by August. - Japan remains an outlier, with markets pricing a gradual increase in the policy rate following the Bank of Japan’s exit from long-standing negative interest rate policy and other unconventional measures. - At its March meeting, the Bank of Japan hiked the short-term policy rate band to above zero (between 0 to 0.1 percent) for the first time since 2016, abolished yield curve control, halted purchases of exchange-traded funds and Japanese real estate investment trust shares, and announced that gross Japanese government bond purchases will be conducted at broadly the same amounts as in the recent past while commercial paper and corporate bond purchases will be gradually reduced before being discontinued in about one year’s time. - As inflation has slowed, expectations of future inflation have fallen in the euro area but have risen some for the United States. - Core inflation remains above central bank targets in most countries, leaving the global economy susceptible to inflationary shocks. - Option prices and survey forecasts signal elevated uncertainty and increased disagreement about future US inflation levels and US growth relative to the euro area. ### Longer-term interest rates and term premiums - Global long-term interest rates have declined, on net, since the October 2023 Global Financial Stability Report, driven by a lower expected path of policy rates and a compression of the term premium. - The 10-year US Treasury yield approached 5 percent at one point in September–October 2023, driven by a term premium increase of around 70 basis points. - The real risk premium component of the term premium rose during that episode, reflecting fiscal and economic uncertainty. - Current levels of real risk premiums across future horizons remain elevated compared with the end of the previous tightening cycle in January 2019 and to the average after the global financial crisis. - Spillovers from US term premiums to other advanced economies and emerging markets have steadily risen in recent years; co-movements among global long-term interest rates could remain pronounced. ### Asset prices, leverage, and credit conditions - Global equity markets have experienced broad-based rallies since the October 2023 Global Financial Stability Report, with the largest gains in Japan and the United States; Chinese stocks have significantly underperformed. - European and US corporate bond markets have rallied with narrower borrowing spreads for both investment-grade and high-yield issuers. - Reaching for yield is reemerging: corporations, including lower-rated ones, find financing easier through corporate bond markets and private credit markets that are opaque to policymakers. - Leveraged trading strategies (for example, bond basis trades or exotic stock options linked to Chinese stocks) and open-end bond fund inflows have increased liquidity transformation risks; illiquid assets such as private credit are being marketed to retail investors. - Faster private credit growth could stimulate aggregate demand and make disinflation more challenging. - Many frontier and low-income countries remain under financing stress with limited rollover options; more businesses and households globally are set to default as they grapple with high interest rates and tighter bank lending standards. ### Medium-term vulnerabilities and data/regulatory priorities - Continued accumulation of debt in public and private sectors is a salient medium-term risk; some governments may find it difficult to service debt in the future. - Private-sector leveraged exposures to financial assets may foretell elevated financial stability risks in coming years. - Policy and supervisory priorities include: - Central banks should avoid easing monetary policy prematurely and push back as appropriate against overly optimistic market expectations for policy rate cuts; where disinflation progress is sufficient, central banks should gradually move to a more neutral stance. - Emerging and frontier economies should strengthen efforts to contain debt vulnerabilities; in China, implement robust policies to restore confidence in the real estate sector and avoid further contagion to other sectors of the financial system. - Supervisory and regulatory authorities should use stress tests and early corrective action to ensure banks and nonbank financial institutions are resilient to strains in commercial and residential real estate and to credit-cycle deterioration. - Authorities need to improve the breadth and reliability of data used to monitor risks associated with rapid growth of lending by nonbank financial institutions to firms. - Regulatory and crisis management tools for nonbank financial institutions need to be further developed. *Source: Chapter 1 at a Glance, Global Financial Stability Report (April 2024).* ### 1. Option-Implied Probability Distributions of Federal Funds Outcomes ### 1. Option-Implied Probability Distributions of Federal Funds Outcomes ### Option-implied short-term rate distributions and volatility - Option-implied probability densities are based on short-dated interest rate swap options, denominated in US dollars and euros. - Interest rates’ volatility, corresponding to the near term, remains elevated for both the United States and the euro area. - Short-term interest rate uncertainty is captured by 1y1y at-the-money swaption-implied volatility; the ICE Bank of America MOVE index tracks the weighted average basket of at-the-money one-month options of 2-, 5-, 10-, and 30-year interest rate swaps. - Horizontal dashed lines in the volatility series represent the averages of the USD 1y1y volatility over the periods before and after January 2022. ### Decomposition and drivers of long-term yields - Long-term bond yields across major advanced and emerging market economies have declined, on net, since the October 2023 GFSR, in most cases driven by a fall in expected path of short-term rates as well as term premiums. - However, between mid-September and end-October 2023, term premiums exerted significant upward pressure on yields, reflecting fiscal concerns in the United States, mainly due to higher real risk premiums. - Real risk premiums across future horizons are currently elevated compared to the post-GFC average and following the end of the previous tightening cycle. ### Spillovers and historical context - Spillovers from changes in US term premium to advanced economies (AEs) and emerging markets (EMs) are measured as the proportion of variation in AE and EM term premium explained by shocks emanating from US term premium (Diebold and Yilmaz 2009 methodology). - On average, over a longer time period, spillovers to AEs have stood around 45 percent compared to 11 percent for EMs, albeit with significant variation over time. - For instance, at the time of the taper tantrum, EM spillover was around 15 percent. - Spillovers shown correspond to a 50-week rolling window. *Italic: Source — ch1 - 1. Option-Implied Probability Distributions of Federal Funds Outcomes (PDF chapter content).* ### 5. Mexico Lending Standards (One-Year Lead) ### 5. Mexico Lending Standards (One-Year Lead) ### Commercial Real Estate Stress Has Intensified - Global private and institutional CRE prices declined by 12 percent globally over the past year in real terms. - US office sector prices declined by 23 percent; Europe declined by 17 percent. - Asia-Pacific (excluding China) CRE prices remained relatively stable on aggregate due to positive net operating income partially offsetting high debt-servicing costs. - Vacancy rates continued to rise in 2023; absorption rates have been negative, indicating persisting sector upheaval. - In a severely adverse scenario (5 percent probability), three-year real CRE price declines could reach: - 20 percent in the Europe, Middle East, and Africa region, - 23 percent in North America, - more than 25 percent in the office sector. ### Drivers of CRE Price Declines - Declines are driven by both higher global interest rates and postpandemic structural changes to CRE demand (including remote work effects on lease revenues, occupancy, lease durations, and market rents). - Structural shifts (work-from-home) have weighed on CRE transactions, particularly in major global cities. - Elevated interest rates have pushed up debt costs, causing yields from owning CRE to fall below the cost of financing purchases with debt in some cases. ### Market Functioning and Financing Stress - US CRE debt is estimated at almost $6 trillion. - Of the $1 trillion of US CRE debt maturing in 2024 and 2025, the refinancing gap exceeds $300 billion (analyst estimates). - Market-based CRE financing slowed: CMBS issuance down 45 percent from the previous year. - CMBS delinquencies for office-specializing securities reached 6.1 percent, up from 1.5 percentage points a year ago. - Bank net charge-off rates for CRE loans rose briskly. - The share of REITs with an interest coverage ratio (ICR) below 1 increased in 2023 relative to previous years. - 15 percent of REITs specializing in the office sector are potentially in debt distress, a 10 percentage point increase from the previous year. ### Potential Mitigants and Enduring Challenges - An easing in financial conditions could aid CRE market recovery by lowering the financial burden on investors and facilitating refinancing or restructuring of loans. - Enduring challenges include the scale of past rate hikes, higher labor and material costs, and structurally lower occupancy rates in some sectors. ### Concerns About Banks’ Exposures to CRE - CRE loans constitute a sizable portion of total bank loans in several banking systems. - In the United States: - CRE loans make up about 18 percent of total bank loans. - An estimated $277 billion in CRE loans will mature in 2024, $82 billion of which are backed by office properties. - The nonperforming CRE loan rate by end-2023 doubled from a year earlier to 0.81 percent from 0.40 percent at end-2022. - The CRE coverage ratio (loan-loss reserves to nonperforming loans) fell to 154 percent from 200 percent for the banking sector; the decline was more pronounced for US global systemically important banks than for other banks. - Most banks appear to have adequate loan-loss reserves and capital buffers on aggregate, but investor pressure has risen after banks announced losses or provisions on their US CRE portfolios. - CRE lending standards tightened in both the euro area and the United States (net percent of respondents showing tightening). ### Distributional and Segment Risks - Credit losses are expected to vary across CRE categories, geographic regions, and bank sizes. - Nonfarm nonresidential loans (which include office) represent the largest CRE subcomponent across US banks. - Regional differences are substantial: the proportion of office loans with a high probability of default indicates areas of concentrated risk in major metropolitan areas. *Italic: Source — Chapter excerpt: Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks (April 2024), Chapter 1, figures and text on commercial real estate and banking exposures.* ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### Commercial Real Estate (CRE) Exposures and Nonperforming Loans - GSIBs from the United States are more exposed to problematic office CRE areas in central business districts than small banks, but GSIBs have significantly smaller CRE exposures to Tier 1 capital. - Nonperforming loans are expected to climb further in coming quarters; in the United States, quarterly CRE nonperforming loans and losses did not peak until nine quarters after the start of the global financial crisis in mid-2007. - One-third of US banks, mainly small and medium banks, with $3.7 trillion in total assets, reported CRE exposures exceeding 300 percent of their Tier 1 capital plus the allowance for credit losses. - Example of realized stress: a large non-GSIB bank reported sizable provisions for CRE-related loan losses in its fourth quarter 2023 earnings release (Box 1.3). ### Residential Real Estate Developments and Risks - Since October 2023, residential home prices have continued to move modestly downward in most countries but generally remain above the prepandemic average. - Quarterly real house prices declines (latest available): advanced economies −2.7 percent year over year; emerging markets −1.6 percent year over year. - Chinese property market has fared worse than other countries for reasons other than interest rate pressures. - Household debt sustainability: - Debt sustainability ratios across advanced economy households are still at modest levels (latest data: third quarter of 2023). - Assuming the average interest on households’ outstanding debt increases further in the fourth quarter of 2023, in line with the average quarterly pace observed in 2023, debt service ratios could increase by up to almost 2 percentage points. - The effect would be larger in more leveraged consumer markets such as Denmark, The Netherlands, and Sweden. - United States specifics: - Monthly home prices have risen by 6.1 percent since the beginning of last year. - 30-year mortgage rates declined from a peak of 7.8 percent to 6.8 percent, but remain around 3 percentage points above pandemic lows. - Mortgage originations are 21 percent lower than one year ago. - Underwriting standards have been more stringent since the global financial crisis; household sector leverage never rebounded, which has helped safeguard stability in the household sector. ### Compressed Volatility, High Cross-Asset Correlations, and Repricing Risks - Volatility has declined to multiyear lows for most asset classes. - Volatility risk premium (spread between market-implied volatility and model-based fair value) has fallen across maturities since the October 2023 Global Financial Stability Report. - Shorter-dated volatility risk premiums are now deeply in negative territory, similar to levels just before the start of the tightening cycle in 2022. - Financial conditions are more responsive to economic data releases in this hiking cycle: - Intraday financial conditions move appreciably in response to core consumer price index surprises (actual core inflation minus Bloomberg survey median), reflecting investor attention to the Federal Reserve’s data dependence. - Sizable inflation surprises may abruptly change financial conditions and rapidly decompress low asset price volatility. - Average correlation across advanced economy and emerging market equities, bonds, credit, and commodity indices is high, exceeding the 90th historical percentile. - Elevated correlations increase risk that shocks hitting correlated markets could cause simultaneous price reversals and contagion. ### Structural Drivers of Elevated Correlations - Passive investing and hedge fund behavior: - Use of passive investing vehicles, such as ETFs, has increased significantly. - ETFs focused on high-yield and emerging market bonds are more sensitive to market-wide proxies, such as S&P 500 returns, than their respective underlying indices. - Hedge funds have shifted from picking individual securities toward increased trading of index-level securities (futures, options, ETFs). - Assets of multi-strategy hedge funds that are more likely to trade index-level securities increased to almost $700 billion from $356 billion in 2020. - The ratio of gross notional exposure of derivatives to net asset value for multi-strategy hedge funds rose to 14.8 in the second quarter of 2023 from 5.5 in the fourth quarter of 2014. - These structural shifts increase exposure to common shocks across financial markets rather than to asset-specific fundamentals, and multi-strategy hedge funds have increased financial leverage over the past decade. ### Medium-Term Vulnerabilities — Resilience of Major Emerging Markets - Most major emerging markets have shown resilience to the external environment; inflation has eased markedly in many emerging markets following early and proactive monetary tightening. - Regional and policy specifics: - Latin America notably saw measures of core inflation peak in early 2023 and continue to decline for most economies. - On average, emerging market central banks have raised policy rates by 780 basis points from trough to peak after the pandemic, compared with an average increase of 400 basis points by advanced economy central banks. - Early tightening widened the average nominal interest rate differential between emerging markets and the United States to over 6 percentage points. - Real rates also rose on an ex ante basis. - Currency volatility: - Emerging market currencies experienced modest volatility against the dollar even as advanced economies hiked rates. - Volatility rose substantially for currencies in Latin America and in CEEMEA when advanced economies began rate hikes, but declined soon after. - For Asian currencies, volatility has been low throughout the cycle. - Portfolio flows: - Portfolio flows to emerging markets recovered since the October 2023 Global Financial Stability Report. - The IMF’s measure of capital flows-at-risk improved on the back of constructive investor sentiment. - Flows to local currency bond and equity markets in emerging markets (excluding China) were robust in the final quarter of 2023, before softening in early 2024. *Source: CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION (PDF).* ### 2024. Chinese portfolio inflows have rebounded ### 2024. Chinese portfolio inflows have rebounded ### Portfolio flows, probabilities, and recent dynamics - Chinese portfolio inflows "have rebounded somewhat in recent months." - Across all emerging markets: - Estimated likelihood of outflows over the next year declined from 32 percent to 27 percent. - The 5th percentile of one-year-ahead capital outflows fell to 2.3 percent of GDP. - EM portfolio inflows accelerated in the fourth quarter of 2023 before moderating in the first quarter of 2024. - EM FX volatility has declined and remained relatively contained even as advanced economy interest rates rose sharply. ### Interest rate differentials and market expectations - Since the start of 2023: - Latin American interest rate differentials compared with the United States have declined by nearly 200 basis points on average, led by Brazil and Chile. - In CEEMEA, the average differential has declined by about 120 basis points. - Markets have been pricing a declining interest rate differential in relation to the United States since early in 2022. - For Asia excluding China and CEEMEA, expectations for one-year-ahead interest differentials peaked in the first and third quarters of 2022, respectively, and have declined since. - Latin American markets correctly predicted a year before that policy differentials would peak in late 2022. - This pricing reflects investor recognition of countries' progress fighting inflation, which has helped keep currency volatility, capital outflows, and other external pressures at bay and allowed major emerging markets to focus monetary policy on inflation. ### Risks if policy differentials close faster or US rates remain high - External pressures could re-emerge if policy rate differentials turn out narrower than currently priced in, especially if advanced economies keep rates higher than anticipated to fight stubbornly high inflation. - Historically, emerging markets have faced spillovers of term premium shocks from the United States. - Relative resilience factors: - Countries with strong current accounts, fiscal credibility, and relatively lower short-term debt will tend to face more moderate capital flow stress (Fratzscher 2012). - The strength of institutional frameworks and the depth of domestic capital markets can plausibly impact emerging market resilience to external financial stress. ### Geopolitical risks in MENA and funding conditions - An escalation of current conflicts in the Middle East and North Africa (MENA) could trigger a repricing of emerging market sovereign risk and tighter financing conditions as markets reassess potential default risk. - For now, market indicators suggest contagion from the conflict remains contained: - Despite initial heightening of risk aversion in October, energy prices and implied volatility have moderated. - Hard currency bond spreads tightened for most MENA sovereigns, some to levels even tighter than before the current conflict. - Major MENA sovereigns and firms continue to tap international markets to raise funding. ### Investor focus on fiscal sustainability and sovereign financing risks - Investors are increasingly focused on medium-term fiscal sustainability in major emerging markets. - Emerging market local currency bond yields: - Are broadly trading near the upper end of their historical range on a nominal basis and, to a lesser degree, on an inflation-adjusted basis. - Could remain elevated as investors demand additional compensation (term premiums) for holding emerging market bonds instead of receiving US long-term real interest rates. - Term premiums and expected short-term rates: - In several emerging markets, term premiums are now substantially higher than their prepandemic levels, together with higher expected short-term rates. - Real financing rates are proxied by the real 5y10y-forward Treasury yield. - Emerging bond yields are decomposed into term-premium and risk-neutral expected short-term rates using the Adrian, Crump, and Moench (2013) methodology. - Hard-currency sovereign bond market: - Emerging markets across the ratings spectrum will need to refinance or issue new debt close to current secondary market yields, which are significantly above the coupons paid on existing debt stock. - Secondary market yields on international dollar bonds are well above coupons on existing debt stock, implying higher debt servicing costs going forward. ### Issuance, investor base, and absorption of domestic bond supply - Averaged across emerging markets, net domestic local currency bond issuance is nearly 1 percentage point of GDP higher than in prepandemic years. - During 2020–21, banks and, in some cases, central banks stepped in to absorb significant amounts but have since slowed their purchases. - Foreign inflows have not been consistent in recent years. - Nonbank financial institutions (NBFIs) have become influential buyers in several countries, but: - The depth of that investor base, allocation strategies, and regulatory frameworks vary considerably across countries. - There is no guarantee these institutions will remain the marginal buyers of emerging market government bonds if policy or investor preferences change. - Emerging markets facing sizeable expected debt issuance and uncertainty about who will absorb additional debt are more likely to experience market instability even absent external shocks. ### Market-implied default rates, refinancing costs, and fiscal concerns - Even though emerging market hard-currency sovereign spreads narrowed recently—likely due to easing global financial conditions—market-implied default rates over the next five years remain higher than in 2019 for some sovereigns, even after adjusting for recent credit rating changes. - This suggests investors are more attuned to debt sustainability risks in the medium term, reflecting: - Pandemic-era fiscal expansions. - Higher debt burdens. - A disproportionate increase in the share of external borrowings by some emerging markets. - Increasing fiscal burdens financed by more external borrowing for some sovereigns heighten concerns about adequacy of fiscal buffers. - With interest rates settling at higher levels than before the pandemic, inflation coming down, and growth moderating: - An increasing number of emerging market sovereigns have high real refinancing costs relative to economic growth. - Many face large interest payments as a share of government revenues. - Looking ahead: - The gap between five-year-ahead real local currency interest rates—implied by long-term government bond yields—and consensus forecasts of real growth is expected to increase. *Source: IMF staff analysis in "2024. Chinese portfolio inflows have rebounded" (chapter 1).* ### 1.5 to 3.0>3.0 ### 1.5 to 3.0>3.0 ### Sovereign Debt Vulnerabilities and Implied R–G - Without fiscal consolidation, more sovereigns will find it difficult to service debt, see their fiscal buffers dwindle, and face even higher sovereign interest rates. - A “debt begets more debt” vulnerability may be building, particularly in a high-for-longer interest rate environment. - Implied market default rates in referenced analysis are derived from pricing of five-year CDS spreads with assumption of 50 percent recovery rate. - Five-year historical default range referenced is from Moody’s, Fitch, and S&P sovereign default studies. - Average maturity of local currency government debt in referenced panel is a simple average of 14 major sovereigns with all data as of March 28, 2024. - Ex post real yields are local currency government financing rates less trailing 12-month inflation rate. - Implied government financing rates in referenced panel are proxied by five year local currency government yields. - Ex ante estimates consider consensus 5-year estimates of real economic growth and inflation; projected refinancing rates are reflected by the local 5y5y forward, adjusted for differences in term premiums as of December 31, 2023. ### Frontier Economies and Low-Income Countries (LICs): Financing Conditions and Risks - Financing conditions improved as lower secondary market yields—a combination of reduced spreads and the decline in Treasury yields—made issuance more affordable. - In contrast with significant issuance in years immediately preceding major central bank rate-hike cycles, issuance was minimal throughout 2022 and 2023. - Net issuance—gross issuance minus maturing bonds—has essentially been zero over the past year (Figure 1.19, panel 1). - Yields on frontier and low-income country bonds remain much higher than those before the current advanced economy hiking cycle but have fallen markedly in recent months. - Several frontier economies issued new debt or rolled over maturities in Q1 2024 taking advantage of improved market conditions. - High-yield sovereigns (frontier economies and LICs) have outperformed investment-grade sovereigns in recent months after historically high levels in 2023, driven by easier global financial conditions and progress in some restructuring cases (examples cited: Zambia late 2023 negotiations with international bondholders; Ghana reached a deal with official creditors in early 2024). - Frontier issuers have a combined US$30 billion in foreign currency bonds coming due in 2024 and 2025 (Figure 1.19, panel 2). - This US$30 billion is about the same amount as aggregate debt that matured in the entire five-year period from 2019 to 2023. - About half of the debt sold in 2017–21 had initial maturities of 10 or fewer years. - Fiscal responses to the pandemic ballooned total debt for frontier economies and LICs (Figure 1.19, panel 3). - Even if markets roll over upcoming maturities, likely higher coupons on replacement debt will place further fiscal burden in coming years. - Many low-income countries have increasingly borrowed on commercial rather than concessional terms (see April 2024 Fiscal Monitor referenced). - With external markets effectively closed during prior years, fiscal authorities have turned to domestic markets; local banking institutions have significantly increased their holdings of sovereign debt, increasing potential sovereign–bank nexus risks—particularly for low-income countries in Africa (Figure 1.19, panel 4). - Should financing conditions tighten again, local markets in these countries could be pressured further. - Note: Panels 1 and 2 refer to frontier markets defined as countries with hard currency debt included in the J.P. Morgan NEXGEM index. Panels 3 and 4 sample countries are those classified as LICs by the IMF. ### China: Housing Market, LGFVs, and Policy Support Limits - China’s housing market downturn shows few signs of bottoming out. - Declines in new home prices have been moderate to date compared with major correction episodes of the past (for example, Japan in the early 1990s), while existing home prices and activity measures such as starts, sales, and investments have dropped off sharply (Figure 1.20, panel 1). - Limited new home price adjustment and extended use of forbearance for struggling developers have: - restrained negative spillovers to banks’ balance sheets, and - disincentivized debt restructuring crucial to a sustained housing recovery. - Recent support policies—mortgage rate cuts, easing of home purchase restrictions, promises for affordable housing and urban redevelopment—have had limited success restoring homebuyer confidence. - Financing conditions for the property sector remain tight for both banks and market-based financing despite official policy guidance for the financial sector to support housing (Figure 1.20, panel 2). - A large decline in presale revenues has added challenges and may have prevented completion of some construction projects, depressing land-sale proceeds to local governments at a time when LGFVs are due for large debt repayments over the next two years (Figure 1.20, panel 3). - Frontier of LGFV vulnerability: - High debt-to-earnings ratios put most LGFVs’ commercial viability in question. - LGFVs in financially weaker provinces face high financing costs (Figure 1.20, panel 4). - Policy note: Refinancing rates referenced are the local currency 5y5y forward, adjusted for differences in term premiums as of December 31, 2023; consensus analysts’ growth and inflation expectations over the next 5 to 10 years are used except South Africa (short-term 2025 estimates used). ### China: Equity Market Stress and Structured Products - China’s stock market experienced sharp declines: Chinese and Hong Kong SAR stock prices declined as much as 11 percent and 14 percent, respectively, since the October 2023 Global Financial Stability Report, despite a recent rebound (Figure 1.21, panel 1). - Equity market facts: - A 45 percent decline since the peak in 2021. - Multiyear low valuation as measured by forward-price-to-earnings ratio. - Investor disappointment about macro policy support, uncertainty in the property market outlook, and rising geopolitical risks have left sentiment fragile. - Structured products and derivative-linked exposures: - The “snowball product” is a structured deposit with embedded derivatives offering bond-like coupons if small-cap CSI indices stay within a predetermined range, with leverage options. - Estimated US$45 billion outstanding of such products sold by banks and security firms—these sellers effectively have short positions on stocks and hedge by buying stock futures. - As small-cap CSI indices fell, many leveraged investors failed margin calls, forcing sellers to liquidate products and unwind futures hedges, widening the stock–futures basis and intensifying selling pressure (Figure 1.21, panel 2). - Related products have been marketed offshore (examples: equity-linked investments in Korea; options on the Hang Seng China Enterprise Index) leading to spillovers to regional markets. - Footnote: There is an estimated US$20 billion of equity-linked investments in Korean markets. ### Chinese Asset Management Industry: Size and Vulnerabilities - As of 2023, total assets under management across various products were ¥110 trillion or nearly 90 percent of GDP (Figure 1.22, panel 1). - The 45 percent equity market decline since 2021 reduced net asset value of equity and hybrid mutual funds by over 20 percent, reflecting valuation losses and redemptions. - Many trust products have experienced large losses over the past three years, resulting in widespread defaults of real-estate-focused trust products; trust products are not allowed to use leverage, limiting their financial spillovers and their investor base is mostly institutions and high-net-worth individuals. - Wealth management products and investment funds focused on public sector debt: - Combined size is three times as large as trust funds. - Large fixed-income exposures consist almost entirely of credit bonds, making them more vulnerable to credit risks and rollover risks in a corporate bond market with average maturity only three years. - Wealth management products’ investor base is retail-focused and thus prone to run risks; these products are held almost exclusively by retail investors who are also bank depositors and lack experience handling investment volatility. - Example of past stress: Late 2022 spike in bond yields led to large-scale redemptions by retail investors fearing wealth management product losses, inducing further spikes in bond yields that spilled over to broader funding markets; the People’s Bank of China stabilized redemptions and funding rates with large liquidity injections into the interbank market. - Interconnectedness and leverage: - Interbank lending and lending between banks and nonbank financial institutions have increased notably in recent years. - Financial leverage in the interbank market, proxied by repo transaction volume, has risen sharply recently. - Shocks from wealth management products and mutual funds could quickly spread to banks through tightening credit and funding markets, with small and medium-sized banks having higher wholesale funding exposures being more vulnerable. - Note: Most Chinese corporate bonds are rated AA and above domestically; domestic ratings place considerable weight on perceived implicit guarantees and tend to be static with limited risk differentiation. ### Global Corporate Default Risk - Since the October 2023 Global Financial Stability Report, global corporate earnings projections improved due to prospects of a likely soft landing and expectations of monetary easing, reversing earlier downward trends (Figure 1.23, panel 1). - At sectoral level, interest-rate-sensitive sectors such as consumer discretionary showed notable developments (figure referenced). *International Monetary Fund | April 2024* ### 1. Asset Management Industry: Total Assets and Allocation ### 1. Asset Management Industry: Total Assets and Allocation ### Asset management industry size and allocation - Total assets and asset allocation are reported in "Trillions of renminbi; percent of total assets" across product types: WMP, Mutual funds, Private funds, Trust funds, Insurance, AMP. - Time series axis labels include: Jan. 2021; Apr. 21; Jul. 21; Oct. 21; Jan. 22; Apr. 22; Jul. 22; Oct. 22; Jan. 23; Apr. 23; Jul. 23; Oct. 23. - Charts include scales showing total assets (trillions of renminbi) from 0 to 3.5 and asset allocation (%) from 0 to 100. ### Bond market impact from WMP redemption - Chart metric reported in "Trillions of renminbi". - Note: NAV = net asset value; WMP = wealth management product. --- ### Corporate sector: earnings, spreads, and vulnerabilities ### Corporate earnings and market pricing - Global 12-month-forward EPS quarter-over-quarter changes are shown in percent; implied US policy rate change over coming one year is in basis points (right scale). - Panel observations: expected earnings fell with US rate hike speculation and recovered following rate cut expectations. - Sector-level performance highlights include Material, Consumer staple, Energy, Information technology, Consumer discretionary, Communication services, Financial institutions, Health care, Utilities, Real estate, Aerospace and defense. - Sources: Bloomberg Finance L.P.; Federal Reserve Board; Haver Analytics; Refinitiv DataStream; and IMF staff calculations. ### Corporate bond market composition and spreads - The proportion of CCC- or lower-rated firms in the speculative-grade corporate bond index was halved over the past decade. - Global speculative-grade corporate bond market chart uses "Billions of US dollars, percent". - Global equity and corporate bond performance since October 2023 shows corporate sector spread change in basis points and global equity sectors change in percent. - US Excess Bond Premium shown in percentage points with historical range including 1990–2023; note that excess bond premium historically widens significantly in recessions. - Corporate bond spread misalignments presented as "Deviation from fair value per unit of risk, quarterly averages, left scale; percentile, right scale" for US IG, US HY, Euro IG, Euro HY. - Conclusion: corporate spread valuations appear stretched relative to fundamentals; high-yield misalignments are severe for both US and euro area issuers by historical standards. --- ### More firms may become vulnerable in the medium term ### Cash liquidity buffers and interest expense sensitivity - As of Q3 2023, the share of small firms with a cash-to-interest expense ratio below 1 was around 33 percent in advanced economies and 55 percent in emerging markets. - If interest expense rises in line with current market yields, these shares would rise to 38 percent and 59 percent, respectively. - Figure caption: "Nearly 40 percent and 60 percent of small firms in AEs and EMs, respectively, do not have sufficient cash balances to cover their annual interest expenses if interest expenses increase to levels equivalent to current market yields." ### Corporate bankruptcies and refinancing risk - Corporate bankruptcies have steadily increased in the euro area, Japan, and the United States, led by smaller firms. - A considerable amount of corporate debt will mature in the coming year at interest rates significantly higher than existing coupon rates; charts show "Additional Cost of Refinancing versus Maturing Corporate Bonds for the Year (Percentage points; billions of US dollars)." - Blended yields are defined as "the average yield of both investment and speculative grade corporate bonds based on Bloomberg Bond Indices." ### Ratings, fallen angels, and default risk - Net rating upgrades among investment-grade firms have fallen sharply on a market-cap-weighted basis. - Borderline corporates just above speculative grade are at risk of becoming "fallen angels." - Scenario analysis of US BBB-rated firms (BBB+, BBB, and BBB– as rated by S&P) shows that even under a soft-landing scenario, by 2025 the probability of default will be higher for some firms, posing higher downgrade risks. - Projected probability of default of US BBB firms is based on the SEP median scenario; simulation sources include BuDA: A Bottom-Up Default Analysis Framework, version 3.5.1. ### Corporate credit growth dynamics - Global private nonfinancial corporate credit growth is recovering quickly in this hiking cycle compared with previous ones, including the cycle before the global financial crisis. - Panel displays four quarter changes of global private nonfinancial corporations’ credit-to-GDP ratio across cycles; comparisons include the 2005–07 cycle and the current cycle. --- ### Advanced-economy government bond supply and market implications ### Elevated issuance and term premium pressure - Some advanced economies will likely require heavy government bond issuances in the coming years to fund fiscal deficits and service debt carrying higher interest rates. - Net US and EU Treasury duration supply relative to GDP is shown in percent with historical time series starting in 2008 and covering projections to Dec. 2025. - Example: Treasury announcement comparisons—May 2023 announced $547 billion in bonds; August 2023 expectation was $593 billion while announced supply was $601 billion (all in 10-year equivalents) are cited in the notes. ### Sensitivity of yields to auction demand - Sensitivity of Treasury yields to auction demand is shown in basis points using intraday yield change within five minutes before to five minutes after Treasury bond auctions. - Observed increased sensitivity of intraday yields to the auction tail as US Treasury bond supply rose since August 2023. ### Real term premium projections - Projected US 10-year real term premiums are related to the share of Treasuries outstanding net of Federal Reserve holdings; projections include 68 and 95 percent confidence intervals. - Notes: Federal Reserve is shrinking its Treasury holdings by $60 billion per month, but may taper quantitative tightening in the second half of 2024. --- ### Demand base for longer-term bonds and quantitative tightening ### Shift in buyer composition - Since Sep. 2019, net issuances of Treasury securities in the United States are increasingly absorbed by the nonbank sector (households and hedge funds); banks have been net sellers. - In Europe, government bond issuance—especially from core euro area countries such as France and Germany—is increasingly purchased by nonbanks: households, asset managers, and the foreign sector. - New marginal buyers such as hedge funds are described as "more price sensitive and more attuned to debt sustainability" than past buyers like central banks. ### Quantitative tightening effects - Central banks shedding bonds at annual paces: Bank of England ~£100 billion; European Central Bank approximately €300 billion; US Federal Reserve $720 billion—effects extend to longer-term government bond markets and short-term funding markets. - BoE announced in September 2023 a reduction of the UK government bond portfolio by £100 billion over the following year. - ECB redemptions of the government bond portfolio are estimated to reach approximately €260 billion in 2024, with another €45 billion of redemptions announced from PEPP redemptions. - The Federal Reserve is shrinking its Treasury holdings by $60 billion per month. - Quantitative tightening withdraws liquidity and reduces commercial banks’ holdings of central bank reserves, which could lead to reserve scarcity and higher interbank borrowing costs. - A demand curve for reserves concept is referenced, with reserves over total bank assets representing the quantity dimension. --- *International Monetary Fund | April 2024* ### 1. Net Purchases of US Treasuries, by ### ch1 - 1. Net Purchases of US Treasuries, by ### Treasury and European sovereign bond purchases by investor sector - Panel: Net Purchases of US Treasuries, by Investor Sectors (Billions of US dollars, NSA) - Chart axis values shown: –1,500; –1,000; –500; 0; 500; 1,000; 1,500; 2,000. - Note: Hedge funds have become marginal buyers of Treasuries since the start of latest round of QT in the United States. - Panel: Net Purchases of EGBs, by Investor Sector (Billions of euros) - Chart axis values shown: –150; –100; –50; 0; 50; 100; 150; 200; 250; 300; 350. - Finding: In Europe, the foreign nonbank sector was the largest marginal buyer of European government bonds, albeit with considerable heterogeneity across issuer countries. - Data coverage: Panels 2 and 3 reflect data until 2023:Q2 (latest available). - Panel: Net Purchases of EGBs, by Issuer (Billions of euros) - Issuers listed: Austria; France; Belgium; Germany; Ireland; Greece; Italy; Portugal; The Netherlands; Spain; Total. - Chart axis values shown: –100; –50; 0; 50; 100; 150; 200; 250. - Data sources cited: Federal Reserve Board; Arslanalp and Tsuda 2012; and IMF staff calculations. - Note: Sovereign bond holdings of domestic hedge funds are included residually in the household category of the flow of funds and investor holdings. EGB = European government bond; GSE = government‑sponsored enterprise; MMF = money market fund; NSA = not seasonally adjusted. ### Reserves, quantitative tightening (QT), and funding markets - Key observations and chart annotations: - Major central banks have committed to operate monetary policy under an ample reserve regime, that is, away from the steep part of this demand curve where funding rates are sensitive to reserve levels, and closer to the flatter part of the demand curve. - Maintaining reserves at ample levels can enhance functional market intermediation and provide more informative market prices, while the central bank balance sheet can be further wound down to allow for additional policy space in future expansions. - Because liquidity management practices and regulatory requirements have changed over time, pinning down the shape of the demand curve and the level at which reserves become scarce is challenging. - Heterogeneity in the distribution of reserves suggests these may become scarce sooner for some. - Empirical markers and numeric values shown in figure panels: - Panel 1 (Demand for Reserves across Major Advanced Economies) axes / annotations: Basis points, percent; numeric scale markers include 2.5; 15.0; 5.0; 7.5; 10.0; 12.5; –0.5; 3.0; 0; 0.5; 1.0; 1.5; 2.0; 2.5. - Panel 2 (Reserve Distributions) annotations: Percent; numeric markers include –15; –10; 0; 10; 15; 20. - Panel 3 (Bank Reserves versus Money Market Pricing) annotations: Percent, basis points; numeric markers include –100; 0; 100; 200; 300; 400 and 0; 20; 5; 10; 15. - Specific empirical points from text: - In the United States, various funding rates, including repurchase agreement or repo rates, have episodically jumped since the last Global Financial Stability Report, offering tentative signs that liquidity may not be ample for all. - So far, quantitative tightening has not drained reserves on a one-for-one basis in many countries because other components of central bank balance sheets can also adjust, like the Fed’s overnight reverse repo facility. - Money market funds substituted more than $1.5 trillion from the ON RRP facility with alternative investments (primarily Treasury bills); RRP balances have declined faster than the quantitative tightening pace since June 2023. - As QT progresses further, other sources of absorption will exhaust; reserve levels, and by extension interbank funding costs, will be more directly affected, increasing the likelihood and magnitude of episodic funding strains. - Policy implication: - The pace of quantitative tightening should account for its effect on funding markets to avoid excessive pricing strains; central banks need to provide funding backstops as QT progresses. ### Leveraged positions, basis trades, and repo funding - Key findings: - Despite some recent unwinding, the short positions of leveraged funds in Treasury futures remain large. - The Treasury market basis trade involves shorting futures and holding long Treasury bonds financed by borrowing in repo markets; under normal conditions it contributes to market liquidity and efficiency by aligning cash and futures markets. - The scale of the basis trade has increased leverage in the financial system as volumes of repos have increased substantially over the past year. - Quantitative values and observations: - Federal Reserve Board staff estimate hedge funds have increased basis trades activities by at least $317 billion since the first quarter of 2022. - Repo and futures shorts have increased; chart axis values shown for repo/futures panel: 0; 2,000; 4,000; 6,000; 8,000 (Billions of US dollars) and 0; 500; 1,000; 1,500 (overlay axis). - The share of Treasury bonds held by US Hedge Funds (excluding derivatives) is shown across dates from Dec. 2012 through Jun. 23 with axis percent markers 3; 4; 5; 6; 7; 8; 9 (Percent of Treasury outstanding). - Concentration: nearly half of the two-year futures positions are held by fewer than eight traders; panel axis markers for concentration chart: 0; 10; 20; 30; 40; 50; 60 (Percent). - Risks and historical precedent: - A spike in repo rates—triggered by surprises in QT—can render the basis trade unprofitable and could trigger forced selling of Treasury securities and a brisk unwinding of futures positions, as occurred in late 2019 when repo rates spiked and likely exacerbated Treasury illiquidity problems during the pandemic. - Aggressive use of repo financing makes the basis trade vulnerable to shocks such as upside inflationary surprises that lower the value of funds’ long bond positions, amplified by leverage. - A concentration of vulnerability has built up: a handful of highly leveraged funds account for most of the short positions in Treasury futures; some of these funds may have become systemically important to the Treasury and repo markets. ### Banking sector resilience and vulnerabilities - Aggregate resilience: - The vast majority of banks demonstrated resilience throughout the banking sector turmoil in 2023. - Strong capital and liquidity buffers and improved profitability and higher net interest margins have lifted bank stock prices across regions. - Vulnerable subset: - As of the fourth quarter of 2023, banks with an aggregate $33 trillion in total assets, or 19 percent of global banking assets, breached three of the five key risk indicators. - Chinese and US banks account for most of these banks. - In China: capital ratios are thinning and there are concerns about deteriorating asset quality as lower net interest margins and higher loan delinquencies are expected to take hold. - In the United States: some regional banks face heightened competition for deposits, increased funding costs, rising credit costs from nonperforming CRE exposures, elevated unrealized losses in securities portfolios, and decreased revenue from trading and investment banking activities. - Monitoring and forecasts: - Banks on the IMF’s monitoring list score significantly worse than banks not on the list across nearly all indicator categories, including Tier 1 capital ratio, market leverage, and returns on equity. - The monitoring list trims somewhat in the first half of 2024, likely reflecting expectations of a soft landing and stable return-on-equity for non-US regional banks. - Figure annotations and chart values: - Selected equity indices panel: Prices indexed January 1, 2023 = 100; chart axis values include 25; 45; 65; 85; 105; 125; 145. - Banks signaling KRIs by region panel: Total assets axis markers 0; 50; 100; 150; 200; 250 (trillions of US dollars); Number of banks axis markers 0; 50; 100 (right scale). - One-year-forward return on equity panel: Bloomberg consensus one-year forward EPS to equity; percent axis markers 8; 9; 10; 11; 12; 13; dates from Jan. 2023 through Mar. 24. ### Bank–sovereign nexus dynamics - Historical and recent patterns: - Sovereign debt outstanding has climbed markedly in both emerging markets and advanced economies since the pandemic due to increased government spending. - The bank-holdings-to-debt-outstanding ratio in 10 major advanced economies climbed precipitously before the global financial crisis until 2012, dropped in the middle of the past decade, then rose again at the onset of the pandemic. - Among 12 major emerging markets, the ratio declined until it spiked during the pandemic and has resumed declining over the past three years. - By the bank‑holdings‑to‑debt metric, the sovereign–bank nexus is now at its lowest point of the past two decades. - Spillover evidence from CDS spreads: - A panel vector autoregression for 10 major advanced economies shows that during the European crisis (2011–14), a 10‑basis‑point shock to sovereign spreads immediately raised average bank spreads by about 7 basis points, with persistent effects (10 months after the shock, bank spreads would still be about 8 basis points higher). - In the postpandemic period, the sovereign shock has affected banks more modestly (figure notes indicate hollow dots: not statistically significant for some periods). - Policy relevance: - High sovereign debt and concentrated bank holdings of sovereign bonds can amplify interest‑rate risk for banks and reduce governments’ capacity to support struggling banks without further raising their own borrowing costs, potentially creating a vicious cycle. *Italic: Sources: Federal Reserve Board; Arslanalp and Tsuda 2012; Bloomberg Finance L.P.; Commodity Futures and Trading Commission; Depository Trust and Clearing Company; European Central Bank; Haver Analytics; Visible Alpha; and IMF staff calculations.* ### 2. Response of Bank CDS Spreads to a One Standard Deviation Shock ### 2. Response of Bank CDS Spreads to a One Standard Deviation Shock to Sovereign CDS Spreads ### Key empirical responses - Panel estimation: impulse response functions from a panel VAR (1) show responses to a 10-basis point sovereign spread shock, with sovereign CDS spreads ordered before average bank CDS spreads; fixed effects included. - Immediate spillovers: - A sovereign shock raised bank CDS spreads by only 4 basis points at the outset in the most recent period reported. - Sovereign CDS-spread reactions to their own shock have been more or less the same over the past decade. - Country sets used in analysis: - Ten AE countries: Australia, Belgium, France, Germany, Italy, Japan, The Netherlands, Spain, Switzerland, the United Kingdom and the United States. - 12 major EMs: Brazil, Chile, Colombia, Hungary, India, Indonesia, Malaysia, Mexico, the Philippines, Poland, South Africa, and Türkiye. - Data and sources: Arslanalp and Tsuda (2012, 2014); Bloomberg Finance L.P.; Capital IQ; and IMF staff calculations. - Note on measurement: Within a country, CDS spreads for all Global Systemically Important Banks (GSIBs) are averaged. AE = advanced economy; CDS = credit default swap; EM = emerging market economy; GFC = global financial crisis; GSIBs = global systemically important banks; VAR = value at risk. ### Interpretation and systemic risk implications - The bank–sovereign nexus has weakened relative to past downturns but can rise quickly during economic stress, implying continued vigilance where this nexus poses systemic risks. - Spillback from banks to sovereigns is described as "more modest now," though the nexus remains subject to rapid deterioration in adverse scenarios. ### Methodological notes - Panels 2 and 3 in the analysis show impulse responses to a 10-basis point sovereign spread shock from a panel VAR (1). - Fixed effects are included in the panel VAR; within-country averaging for GSIB CDS spreads is applied. --- ### Liquidity Mismatch at Open-End Investment Funds ### Main findings - Open-end funds commonly invest in less-liquid assets while permitting daily redemptions, creating liquidity mismatches that can amplify shocks when: 1. Funds hold a substantial share of a market’s assets, 2. Funds face volatile redemption flows, 3. The underlying market is relatively illiquid. - Fund types of particular concern: high-yield corporate bond, leveraged-loan, and emerging market hard currency bond funds—these markets are relatively illiquid and funds have historically experienced large peak outflows. - Recent flow patterns: - Government and investment-grade corporate bond funds have seen strong inflows in recent years. - Investment-grade US corporate bond funds received close to 70 percent of their prepandemic net asset value in inflows since the pandemic onset. - Fund flow dynamics: - Fund flows are highly sensitive to changes in market sentiment and closely correlated with the performance of the relevant asset class. - A sell-off can amplify redemptions, and redemptions can amplify a sell-off; this feedback is particularly pronounced in high-yield corporate bond funds. - Fund flow at risk metric: - The 5 percent fund flow at risk was defined in Chapter 1 of the October 2023 Global Financial Stability Report. The value reflects that, historically, outflows surpassed this value, expressed in terms of net asset value, 5 percent of the time. ### Illustrative figure references (as presented) - Figure elements describe: - Panel 1: Fund Flow at Risk and Market Liquidity (liquidity score; arbitrary units, percentage). - Panel 2: Cumulative Fund Flows since January 2020 (Percentage of net asset value; black lines with whiskers indicate the minimum and maximum since January 2020). - Panel 3: Peak Fund Outflows and Peak Drawdowns since January 2020 (Percentage of net asset value). - Panel 4: US Corporate Bond Fund Flows and Asset Class Returns (Fund flows as percentage of assets under management, return in percent). - Time markers shown: March 2020 and March 2024 in figure context. ### Risks identified - With interest rates volatile and bond market liquidity low, funds could have trouble meeting redemptions, potentially triggering further outflow pressures. - Fund types with larger prolonged drawdowns typically have larger peak outflows. - The large inflows into investment-grade US corporate bond funds increase systemic risk given potential evaporation of corporate bond liquidity during stress. --- ### Policy Recommendations (selected, organized) ### Monetary and market-functioning measures - Central banks should: - Reflect country-specific circumstances in the stance of monetary policy. - Not prematurely ease in economies with persistent inflation. - Push against overly optimistic investor expectations for policy easing. - Gradually move to a more neutral policy stance where disinflation is sustainably evident. - Carefully monitor market functioning using broad indicators of liquidity conditions and funding rates in money markets, and be ready to address market stresses if needed. - Clearly communicate objectives and steps for removing liquidity, and emphasize willingness to use other liquidity support tools. - Set up emergency liquidity assistance frameworks in normal times and ensure all banks periodically test access to central bank instruments. ### Fiscal and sovereign debt management - Fiscal policy should: - Support the last mile of disinflation by rebuilding buffers, lowering term premiums, and containing the rise in debt. - Pace and composition of adjustment should depend on aggregate demand strength and available fiscal space. - Reprioritize spending to protect the most vulnerable within budget constraints. - Sovereign debt management and emerging markets: - Authorities should monitor the changing composition of the demand base for government bonds and assess associated risks. - Policymakers should promote depth of local-currency markets and a stable, diversified investor base by: 1. Establishing sound legal and regulatory frameworks for securities, 2. Developing efficient money markets, 3. Improving transparency of primary and secondary markets, 4. Improving predictability of issuance, 5. Bolstering market liquidity, 6. Developing robust market infrastructure. - Sovereign borrowers in EMs, frontier economies, and low-income countries should strengthen efforts to contain high debt vulnerabilities through creditor communications, multilateral cooperation, and international support. - Countries near debt distress should enhance early creditor contact and consider preemptive and orderly restructuring; the G20 Common Framework should be used where applicable. ### Financial-stability and macroprudential actions - Banking sector resilience: - Conduct stress tests that incorporate large CRE price declines, including smaller banks with material CRE exposure. - Review CRE valuation assumptions and ensure provisions are adequate. - Enhance corporate governance and risk management commensurate with banks’ risk profiles, including risk monitoring by bank boards and capital and liquidity stress tests. - Raise countercyclical capital buffers or sectoral systemic risk buffers where circumstances allow, with conditionality to avoid procyclical effects. - Nonbank sector and funds: - Reduce CRE-related systemic risks from nonbank financial institutions by ensuring effective liquidity management tools, considering leverage limits, and enhancing data collection. - CRE funds should redeem shares at lower frequency and require long notice or settlement periods; authorities should consider structuring such funds as closed-end funds depending on further analysis. - For private credit: enhance reporting requirements to improve monitoring of credit, liquidity, leverage, valuations, and interconnectedness risks; consider more intrusive supervisory and regulatory approaches given private credit’s growth and retail participation. - Prudential standard implementation: - Authorities should prioritize full, timely, and consistent implementation of internationally agreed-upon prudential standards; delays or deviations could undermine effectiveness and increase regulatory fragmentation. ### Country-specific recommendations (selected) - China: - To improve confidence and alleviate disinflationary pressures: deploy accommodative macroeconomic policies, structural and pro-market reforms, complete housing and restructure troubled property developers timely. - Consider additional monetary easing, reorientation of public expenditures toward households, and comprehensive fiscal reforms to ensure sustainability of local government finances. - Phase out forbearance, maintain adequate loss-absorbing buffers, and enforce prudential policies to restructure weak banks and safeguard financial stability. - Emerging markets: - Progress on inflation is notable, but central banks should avoid easing policy rates too aggressively. - Use IMF Integrated Policy Framework where applicable. - Foreign exchange interventions may be appropriate provided they do not impair policy credibility or substitute for needed adjustment. - In imminent crises, capital flow management measures may be an option as part of a broader package, but should not substitute for macroeconomic adjustments or domestic macroprudential policies. --- *Source: ch1 - 2. Response of Bank CDS Spreads to a One Standard Deviation Shock (IMF staff calculations and supporting sources).* ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### Policy frameworks, resolution, and cross-jurisdiction coordination - Central banks should be ready to provide liquidity against a broad universe of assets while abiding by the appropriate principles concerning collateralization, conditions, and state guarantees. - Further progress on adopting and implementing recovery and resolution frameworks is critical to address weak or failing banks without undermining financial stability or risking public funds. - International resolution standards apply to all banks that may prove to be systemic in times of wider stress; planning and preparation for resolution has focused mainly on the largest banks and in many countries the scope of this work should be expanded. - Resolution plans must be more flexible and public backstop funding mechanisms for resolution strengthened. - Resolution regimes for systemic and other large nonbank financial institutions, including central counterparties and insurers, should be introduced or further developed. - Regulatory coordination across sectors and jurisdictions is essential to identify risks, undertake effective actions, and manage crisis situations. - Jurisdictions should ensure data-sharing arrangements allow for timely coordination to identify cross-sectoral risks and determine further action as needed. - Where the sovereign–bank nexus is strong, policy responses should be tailored and include: - Strengthening medium-term fiscal frameworks in countries with limited fiscal space (see Chapter 1 of the April 2024 Fiscal Monitor). - Considering options to weaken the sovereign–bank nexus, such as implementing capital surcharges on banks’ holdings of sovereign bonds above specific thresholds and enhancing the banking crisis management framework. - Fostering a deep and diversified investor base, particularly in countries with underdeveloped local currency bond markets. ### Crypto assets and approval of spot Bitcoin ETPs - The approval of spot bitcoin exchange-traded products (ETPs) by the US Securities and Exchange Commission in early January 2024 led to record-breaking inflows and widened Bitcoin adoption. - Net inflows in the top 12 bitcoin funds reached more than $12 billion in the first quarter after the approval. - Bitcoin price reached a new all-time high of $73,805 on March 14, 2024. - ETPs remove certain frictions related to investing in bitcoin and widen the potential investor base, which could drive large shifts in asset allocation. - Portfolio optimization (maximizing the portfolio Sharpe ratio) across a hypothetical universe including gold, US Treasuries, investment-grade and high-yield bonds, S&P 500 equity returns, and bitcoin shows: - Pronounced fluctuations in the optimal portfolio allocation toward Bitcoin, with minimal or zero exposures in almost half of the years between 2011 and 2023—reflecting extreme volatility. - Financial stability considerations: - The spot market remains unregulated, exposing investors to significant risks despite some mitigations from ETPs (money laundering, financing of terrorism, operational and cyber risks). - Exchange-traded products can attract both retail and institutional investors, increasing their exposure to crypto markets. - Approval of Bitcoin ETPs may lead to a surge in portfolio allocation, potentially adding selling pressure on other asset classes as investors reallocate. - Reduction in frictions to invest can increase interconnectedness and potentially amplify systemic risk via contagion from crypto markets into other asset classes if large crypto price swings trigger portfolio losses and forced liquidations. - Recommendation: Authorities should enhance monitoring of the growing linkages between traditional financial institutions and the crypto ecosystem. ### Intertemporal risk trade-offs for US growth under credit growth scenarios (Growth-at-Risk) - Framework: IMF growth-at-risk (Adrian and others 2019, 2022) used to assess intertemporal trade-off for US growth given current financial conditions and credit growth. - Scenario calibration: - Scenario 1 is calibrated on the average quarterly credit growth over the two-year period following the 1972–74, 1977–80, and 1980–81 tightening cycles. - Scenario 2 is calibrated on the minimum quarterly credit growth over the same two-year periods. - Key numerical calibrations and outcomes: - Under Scenario 1, household credit grows by about 1.8 percent per quarter. - Result: near-term downside risk improves, whereas medium-term risks may remain elevated at around the baseline. - Under Scenario 1, corporate sector credit growth is equal to 2.3 percent. - Result: improvement in near-term risk is accompanied by more than proportionate deterioration in medium-term risk. - Stylized explanation: corporate debt has shorter average maturity (around eight years for corporate bonds and syndicated loans outstanding) than household debt, where 30-year mortgage loans make up a large share of debt. - Scenario 2 household credit growth calibration: –0.5 percent (minimum quarterly credit growth). - Result: households’ near-term risks would deteriorate considerably relative to baseline, with negligible improvement in medium-term risks. - Model notes: - The medium term is calculated as the average between years 4 and 8. - GaR = growth-at-risk. - Credit data sourced from the Bank for International Settlements; the conditional forecast density model augments current-quarter credit growth and financial conditions with quarterly credit growth rates for corporate and household sectors. ### United States regional banks — current vulnerabilities and metrics - Aggregate recovery since March 2023 stress: - Between March 2023 and January 31, 2024, deposit outflows stabilized (+3 percent) and the US regional bank equity index rebounded (+19 percent). - Ongoing investor concerns: - Failure of another regional institution could precipitate a broader loss of confidence in the sector. - January 2024 market shifts on timing and pace of US interest rate cuts, and announced substantial losses by a major US regional bank heavily exposed to commercial real estate (CRE), prompted a 10 percent decline in the regional bank stock index. - Concerns focus on banks with high unrealized bond losses from recent interest rate increases, concentrated CRE exposures, and large potential liquidity pressures from uninsured deposits and less-stable funding. - Key statistics on unrealized losses and concentrations: - Unrealized losses remained elevated at $477 billion in the fourth quarter of 2023 (even after a significant drop due to repricing of forward rates in December 2023). - One-third of US banks, mostly small and medium-sized ones, hold exposures to CRE exceeding 300 percent of their capital plus the allowance for credit losses, representing 16 percent of total banking system assets. - More than 100 banks (about 3 percent of banking system assets) have the combination of: - CRE exposure above 300 percent of capital plus allowance for credit losses, - unrealized losses greater than 25 percent of Tier 1 capital, - ratio of uninsured deposits to total deposits greater than 25 percent. - Weak tail metrics and system importance: - The weak tail of banks (mainly small and medium-sized banks) collectively represents an estimated $5.5 trillion in total assets, accounting for almost 23 percent of total banking system assets. - Data and definitions: - Analysis based on a data set including 4,528 deposit insured banks, accounting for 99.8 percent of total bank assets in the third quarter of 2023. - Bank size categories (Federal Reserve definitions used): - Small banks: less than $10 billion in total assets. - Medium banks: assets between $10 billion and $100 billion. - Large banks: assets above $100 billion. - CRE concentration measured by CRE exposure to Tier 1 capital plus the allowance for credit losses above 300 percent. - Unrealized losses and CRE concentration figures based on data set including 4,528 or 98 percent of deposit insured banks, accounting for 99.8 percent of total bank assets in third quarter of 2023. *International Monetary Fund | April 2024* ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### CHAPTER 1 FINANCIAL FRAGILITIES ALONG ThE LAST MILE OF dISINFLATION ### References - Adrian, Tobias, Nina Boyarchenko, and Domenico Giannone. 2019. “Vulnerable Growth.” American Economic Review 109 (4): 1263–89. - 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