## Financial Fragilities along the Last Mile of Disinflation (Executive Summary) ## Source details **Canonical URL:** [Financial Fragilities along the Last Mile of Disinflation (Executive Summary)](https://www.imf.org/-/media/files/publications/gfsr/2024/april/english/execsum.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2024/april/english/execsum.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2024/april/english/execsum.pdf.json) --- ### Market backdrop and near-term outlook - Financial market sentiment has been buoyant since the October 2023 Global Financial Stability Report on expectations that global disinflation is entering its “last mile” and monetary policy will be easing. - Interest rates are down worldwide, on balance; stocks are up about 20 percent globally; corporate and sovereign borrowing spreads have narrowed notably. - Global financial conditions have eased. - The estimated likelihood of capital outflows over the next year for emerging markets has declined. - Confidence in a soft landing is growing on better-than-expected economic data, and investors and central banks expect monetary policy to ease in the coming quarters. - Caveat: global inflation remaining persistently above central bank targets could trigger instability; oscillation of core inflation prints in some countries indicates the disinflation effort is not yet complete. - So far, cracks unmasked by high interest rates have not ruptured further; bank failures in Switzerland and the United States in March 2023 did not spread, and soundness indicators mostly indicate continued resilience. - Near-term financial stability risks have receded and downside risk to global growth in the coming year is lower based on the IMF’s growth-at-risk framework analysis. ### Salient near-term vulnerabilities - Commercial real estate (CRE) - CRE prices have declined by 12 percent globally over the past year in real terms amid rising interest rates and structural changes after the COVID-19 pandemic. - US and European office sectors have seen the largest declines. - Banks appear well positioned to absorb CRE losses in aggregate, but certain countries may experience more strains where banks hold large amounts of CRE loans, especially if concentrated in weak-demand CRE segments. - Within banking systems, some banks could suffer larger losses, potentially exacerbated by less stable funding. - Residential real estate - Real house prices have continued to adjust downward in most countries but generally remain above prepandemic levels. - Declines in real house prices: advanced economies: –2.7 percent year over year; emerging markets: –1.6 percent year over year. - Household debt sustainability ratios are at modest levels globally; a surge in residential mortgage defaults remains a tail risk. - Volatility and market sensitivity - Volatility has declined to multiyear lows for most asset classes; average correlation across equities, bonds, credit, and commodity indices in both advanced economies and emerging markets exceeds the 90th historical percentile. - Low volatility masks that financial conditions have become more responsive in this hiking cycle than in past cycles to economic data releases, especially inflation prints. - Sizable inflation surprises could abruptly change investor sentiment, rapidly decompress asset price volatility, cause simultaneous price reversals among correlated markets, and sharply tighten financial conditions. - Emerging markets and frontier/frontier-low income countries - The risk-on environment has rekindled capital inflows for many emerging markets on balance; some frontier economies and low-income countries have issued sovereign bonds after a lengthy hiatus. - The easing of global financial conditions has benefited frontier economies and low-income countries; high-yield sovereign spreads have outperformed investment-grade spreads in recent months after reaching historically high levels in 2023. - Many countries face a substantial number of hard currency bonds maturing over the next two years. - Local banking institutions in some low-income developing countries have significantly increased holdings of sovereign debt, raising sovereign–bank nexus risks. - China - China’s housing market downturn shows few signs of bottoming out: declines in new home prices moderate relative to other corrections, but existing home prices and activity measures (starts, sales, real estate investments) have sharply declined. - China’s stock market has come under pressure in recent months. - Losses in parts of China’s asset management industry could spill over to bond and funding markets. - Policy steps since the third quarter of 2023 have yet to turn sentiment around. - Corporate sector and private credit - Corporate credit spreads have narrowed since the October 2023 GFSR, but recent corporate earnings gains appear to be losing momentum in most regions. - Cash liquidity buffers for firms eroded further over 2023 because of still-high global interest rates. - As of the third quarter of 2023, the share of small firms with a cash-to-interest-expense ratio below 1 was around one-third in advanced economies and more than half in emerging markets. - Sizable amounts of corporate debt will mature in the coming year across countries at interest rates significantly higher than existing coupons, which could make refinancing challenging. - Private credit is a rapidly growing market providing loans to midsize firms outside commercial banks and public debt markets and has helped fuel faster recovery in corporate borrowing; Chapter 2 identifies vulnerabilities of private credit markets including relatively fragile borrowers, semiliquid investment vehicles, multiple layers of leverage, stale valuations, and interconnectedness. - Sovereign debt markets and quantitative tightening - Some advanced economies will likely require heavy government bond issuances to fund fiscal deficits. - Annual quantitative tightening paces cited: Bank of England: £100 billion; European Central Bank: €212 billion; US Federal Reserve: $780 billion. - The buyer base for government bonds has shifted toward more price-sensitive marginal buyers, suggesting more volatility in bond markets in the medium term. - Some countries may find it increasingly difficult to service outstanding sovereign debt, risking a “debt begets more debt” dynamic. - Banking sector vulnerabilities - Majority of banks showed resilience during the March 2023 turmoil; strong capital and liquidity buffers and improved profitability have lifted bank stock prices across countries. - IMF staff key risk indicators suggest a subset of banks remains vulnerable: banks with aggregate assets of $33 trillion, or 19 percent of global banking assets, have breached at least three of the five key risk indicators. - Chinese and US banks constitute most of this subset; for some Chinese banks breaches are driven by thinning capital ratios and asset quality concerns; some large regional US banks face multiple pressures. - Nonbank financial sector risks - Open-end bond funds, including ones focused on less liquid assets, have received large inflows; excessive liquidity transformations could reappear as seen in prior stress episodes. - Cyber risk - With growing digitalization, cyber incidents—especially malicious ones—are a rising macrofinancial stability concern. - Although most losses from cyberattacks are modest, the risk of extreme losses has been increasing. - The financial sector is particularly exposed due to sensitive data, high concentration, and technological and financial interconnectedness. - Cyber policy frameworks often remain inadequate, especially in emerging market and developing economies. ### Medium-term vulnerabilities and implications - Public and private debt continues to accumulate in advanced economies and emerging markets, potentially exacerbating adverse shocks and worsening downside risks to growth over time. - Emerging market resilience has been notable given early and aggressive central bank tightening, but questions remain whether resilience marks a turning point; investors are increasingly focused on medium-term fiscal sustainability. - The combination of high interest rates, high deficits, declining inflation, and moderating growth has led some emerging markets to face high real refinancing costs relative to growth. - Fast-growing private credit markets and changes in the government bond buyer base imply potentially greater market volatility and interconnected vulnerabilities across financial sectors. ### Policy recommendations - Monetary policy - Central banks should avoid premature monetary easing. - Central banks should appropriately push back against overly optimistic market expectations for policy rate cuts that could add to the easing of financial conditions and complicate the last mile of disinflation. - Where disinflation progress suggests inflation is moving sustainably toward the target, central banks should gradually move to a more neutral stance of policy. - Fiscal and sovereign debt - Authorities should strengthen efforts to contain debt vulnerabilities, including in emerging market and frontier economies. - In China, robust policies to restore confidence in the real estate sector are critical. - Supervision, regulation, and resolution - Supervisory and regulatory authorities should use appropriate tools, including 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 the credit cycle downturn. - Further progress on resolution frameworks and readiness to apply them is critical to address weak or failing banks without undermining financial stability or risking public funds. - Central bank balance sheet normalization - Quantitative tightening and balance sheet reduction need to proceed with care. - Central banks should carefully monitor market functioning issues and mobilize to address potential market stresses. - Ensure banks are prepared to access central bank liquidity and intervene early to address liquidity stress in the financial sector to mitigate financial instability. - Private credit oversight - Given potential risks from the fast-growing private credit market, authorities should consider a more proactive supervisory and regulatory approach. - Close data gaps and enhance reporting requirements to comprehensively assess risks. - Strengthen cross-sectoral and cross-border regulatory cooperation and make risk assessments consistent across financial sectors. - Cybersecurity and operational resilience - Develop a cybersecurity strategy to strengthen the cyber resilience of the financial sector, accompanied by effective regulation and supervisory capacity and improved reporting of cyber incidents. - Deliver critical services to address disruptions and limit potential damage to the financial system. - Financial firms should develop and test response-and-recovery procedures to remain operational in the face of cyber incidents. - Cross-border coordination is crucial given the global nature and systemic implications of cyberattacks. *Source: Executive Summary, Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks (April 2024).* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2024/april/english/execsum.pdf_