## Chapter 1 at a Glance ## Source details **Canonical URL:** [Chapter 1 at a Glance](https://www.imf.org/-/media/files/publications/gfsr/2024/october/english/ch1revised.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2024/october/english/ch1revised.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2024/october/english/ch1revised.pdf.json) --- ### Near-term financial stability assessment - Since the April 2024 Global Financial Stability Report, near-term financial stability risks have remained contained. - Global economic activity has moderated, inflation has slowed, emerging markets have remained resilient, financial conditions have remained accommodative, and volatility in financial markets has remained low, on net. - The IMF’s Growth-at-Risk (GaR) model indicates near-term risks have remained contained at around the 40th historical percentile. - Market turmoil in early August was severe but short-lived; the Nikkei index declined by 12 percent on August 5. ### Key vulnerabilities and imbalances - Accommodative financial conditions facilitate further buildup of vulnerabilities: - Asset valuations appear lofty in equity and corporate credit markets. - Debt has climbed globally; government debt levels in many advanced and emerging market economies are substantially above prepandemic levels. - Use of leverage among nonbank financial intermediation (NBFI) such as hedge funds and private credit funds has increased. - Maturity mismatches at some open-ended funds and insurers have widened. - Fragilities persist in corporate and commercial real estate (CRE) sectors. - Elevated economic and geopolitical uncertainty has widened the disconnect with compressed financial volatility, increasing the probability that volatility could surge and amplify adverse shocks: - Half of the world’s population has elected or will elect new governments this year, contributing to policy uncertainty. - Ongoing military conflicts, notably in the Middle East and in Ukraine, add to unpredictability. - Potential nonlinear amplification channels: - Rising volatility can increase value-at-risk measures, bind risk limits, and trigger margin calls. - Broker–dealers constrained by risk limits may curtail intermediation. - NBFIs facing margin calls might deleverage by selling assets into falling markets. ### Recent monetary and market developments - Monetary policy and expectations: - Major central banks have begun to ease monetary policy since April 2024; the European Central Bank, Bank of England, the Federal Reserve, and Riksbank have cut policy rates. - The Bank of Japan raised its policy rate in July. - Markets price multiple policy rate cuts among major central banks over the remainder of this year and next. - The Federal Reserve is expected to cut its policy rate by almost 150 basis points by the end of 2025. - Financial volatility versus uncertainty: - Financial market volatility remains compressed despite elevated economic uncertainty and geopolitical risk. - Inflation uncertainty remains elevated; analysts foresee meaningful upside risks to core inflation over the coming year (including the possibility of 2 percent or higher core inflation). - Option-implied monetary policy scenarios show substantial likelihoods of both shallow cuts and deep adjustments, especially in the United States. - Yield curve and term premiums: - Long-term interest rates in most advanced economies have changed little, on net, since April 2024; some emerging markets have seen upward pressure from rising term premiums. - The US yield curve has disinverted (10-year minus 2-year Treasury yields steepened) after a historically long period of inversion. - The recent steepening features both a decline in the expected policy rate path and a rise in term premiums, including persistent inflation risk. ### Quantitative tightening and funding risks - Group of Ten central banks reduced their balance sheets from a peak of $28 trillion in March 2022 to $21.5 trillion. - Quantitative tightening has proceeded in an orderly manner so far, but a key tail risk is that it may drain bank reserves too much, risking funding squeezes comparable to the US repo market turmoil in September 2019. - Simultaneous quantitative tightening across jurisdictions raises the odds of spillovers if inadequate bank reserves emerge in any single jurisdiction. ### Emerging markets and specific downside risks - Emerging markets have broadly demonstrated resilience, notably against currency pressures, with several central banks focused on domestic inflation and using exchange rate adjustments as a buffer. - Key downside risks: - Slowing growth outlook in China and fragilities in its financial system—policy support has so far not stabilized the housing market downturn or restored confidence. - Access to funding for frontier markets and economies with weaker fiscal buffers may become more constrained. - Underinvestment in climate finance would delay mitigation and adaptation in emerging markets and developing economies, creating future financial stability implications. - Sovereign credit spreads in emerging markets have become sensitive to countries’ fiscal buffers; certain weaker jurisdictions may struggle to refinance maturing debt at sustainable interest rates. ### Channels for future market stress - When shocks occur and volatility spikes: - Hedge funds may unwind leveraged positions. - Algorithmic traders and AI-driven strategies may sell into falling markets, potentially exacerbating price declines. - Broker–dealer intermediation capacity may be constrained by risk limits. - The early August episode illustrated how quickly volatility can catch up to uncertainty, force unwinding of leveraged trades, and trigger feedback loops between asset prices and deleveraging. ### Policy recommendations to address vulnerabilities - For central banks: - Communicate clearly that the path of monetary policy should not react excessively to any individual data point to reduce uncertainty. - Where growth and inflation momentum are set to continue, gradually ease monetary policy toward a more neutral stance. - Where inflation remains stubbornly above targets, push back against overly optimistic investor expectations for policy easing that would further stretch asset prices. - For fiscal authorities: - With sovereign debt levels substantially above prepandemic levels in many economies, fiscal adjustments should primarily focus on credibly rebuilding buffers to keep external financing costs reasonable and help anchor medium-term inflation expectations. - Sovereign borrowers in frontier economies and low-income countries should strengthen efforts to contain risks associated with high levels of debt vulnerability. - For financial regulation and supervision: - Strengthen policies that address nonbank leverage and liquidity mismatches. - Renew efforts to implement internationally agreed-upon bank prudential standards in a timely and consistent manner to reduce regulatory arbitrage across borders and sectors. - Expand recovery and resolution plans, ensure financial institutions are prepared to access central bank liquidity, and intervene early to prevent strains from becoming systemic. - Engage more actively with certain types of NBFIs that amplified early August turmoil. *International Monetary Fund | Chapter 1 at a Glance (from ch1revised - Chapter 1 at a Glance)* --- ### Inflation Risk Premium and Real Risk — decomposition and market implications - Decomposition methods and data sources: - Expected short-rate and term premiums decomposition follows Adrian, Crump, and Moench (2013). - Joint decomposition of nominal and real yields follows Abrahams and others (2016). - Data sources: Bank of England; Bloomberg Finance L.P.; European Central Bank; Federal Reserve; and IMF staff calculations. - Observed developments: - Decomposition of changes in 10-year bond yields since April 2024 GFSR is shown in basis points. - Average reaction of the US 10-year government bond yield is calculated three months into a steepening episode since 2000. - Steepening episodes and asset returns: - Bear steepening has favored risk assets more than bull steepening. - Asset return patterns illustrated include WTI, Cyclicals, MSCI EM, Nikkei 225, S&P Value, Russell 2000, S&P Growth, S&P 500, Euro STOXX 600, Defensives, FTSE 100, Gold, DXY, Japan 10-Year, German 10-Year, US 10-Year. - Net issuance, term premiums, and Treasury market structure: - Net issuance of Treasuries is projected to remain elevated, possibly pushing up term premiums. - Quantitative tightening shifts the buyer base toward more price-sensitive investors, introducing scarcity premium for core sovereign bonds. - Treasury specifics: increased share of free float Treasury securities could exert an upward push on Treasury yields and volatility over time. - Department of the Treasury has increasingly issued more shorter-term debt; “Steady and predictable 15–20% recommended bills” shown in source. - Bloated dealer inventory presents a medium-term risk given potential balance-sheet constraints in adverse conditions. - Market functioning and recommended vigilance: - Continued vigilance by central banks to monitor funding markets is needed to mitigate tail risk from funding strains. - Quantitative tightening could increase bouts of volatility in government bond markets as buyer base moves toward more price-sensitive investors. --- ### Equity market valuations, concentration, and vulnerabilities - Equity rally and volatility: - Global equity rally continued since April 2024 GFSR but was interrupted by a severe transitory sell-off in early August (peak noted August 5). - Implied volatility for equities spiked during the early August sell-off. - Investment-grade and high-yield corporate bond spreads widened after a long period of decompression. - Valuation concentration and required earnings growth: - Since January, the share of the Magnificent 7 (M7) increased from 20 to 30 percent of the overall S&P 500 index. - Correlation estimates: correlation between M7 and the S&P has increased from around 40 percent to just above 65 percent since May; correlation of average pairwise M7 has increased from 10 to 50 percent over the same period. - Since 2023, there have been 69 days on which fewer than 150 stocks have moved in the same direction as the index. - The S&P 500 is trading above its historical upper quartile in terms of forward price-to-earnings ratio since 1990. For this ratio to return to its historical 10-year average by 2026, earnings per share on the S&P and Nasdaq would need to post compounded annual growth rates of close to 25 and 30 percent, respectively. - The Russell 2000 outperformed the Nasdaq by about 10 percentage points between the beginning of July and early August. --- ### S&P 500 Decomposition and Growth-at-Risk (GaR) statistics - S&P 500 dynamics: - Price index benchmark: January 1, 2023 = 100. - Observation: "The fewest number of stocks are moving in the same direction as the index since 1997, with M7 stocks dictating index movements recently." - Financial conditions and GaR key figures: - Over the next year, there is a 5 percent probability that global real growth will fall below 1.2 percent. - Baseline World Economic Outlook growth forecast cited: 3.2 percent. - GaR is "around the 40th historical percentile" for near-term risk. - Scenario: if financial conditions were to tighten by 2.5 standard deviations and remain at that restrictive level for one quarter, the year-ahead GaR could worsen to its lowest historical quintile. - Methodological note: full sample regression starts in 1991:Q1; post–COVID-19 sample estimation begins in 2021:Q1; a 75 percent weight is applied to the post–COVID-19 regression estimates. - Interpretation: near-term downside risk is contained by accommodative financial conditions and moderate credit growth; medium-term GaR (four years ahead) has been at around historically elevated levels since 2023 and "remains at its worst quintile currently." --- ### Decomposition of Currency Returns and spillovers to EM term premiums - Methodology and key parameters: - Carry factor construction follows Verdelhan (2018) using a portfolio of 16 EM and 9 advanced economy currencies. - Rolling regression window: 18 months. - Spillover measure uses a 100-week rolling window and follows Diebold and Yilmaz (2009). - EM sample for spillovers: 15 countries accounting for about 76 percent of total EM GDP. - Findings: - Spillover of changes in US term premium remains high, notably for CEEMEA. - Increases in term premiums in most emerging markets have primarily driven recent changes in yields. - Data sources: Bloomberg Finance L.P.; EUROPACE AG/Haver Analytics; IMF, World Economic Outlook database; national sources; and IMF staff calculations. --- ### Portfolio flows, capital-flow risks, and investor base - Recent portfolio flow dynamics: - Portfolio flows to emerging markets have been positive on net in recent months, with notable large inflows into local currency bonds in several countries (for example, Egypt and Türkiye) and inflows into Indian markets benefiting from India’s inclusion in global bond indices. - Capital-flows-at-risk: - The IMF’s capital-flows-at-risk measure indicates there is a 5 percent probability that emerging market outflows could reach 2.4 percent of GDP over the next three quarters — a marginal increase in outflow risk since the April 2024 Global Financial Stability Report. - Investor base and fund flows: - Long-term domestic investors (insurers and pension funds) have absorbed increasing shares of EM bonds. - Dedicated emerging market bond and equity funds domiciled in the United States have experienced cumulative outflows since March 2022. - Year-to-date international issuance of sovereign bonds has risen to its highest level since 2021, although weak inflows into hard-currency bond funds persist. - Definitions and notes: - “Portfolio flows at risk” is defined as the 5th percentile of the three-quarters-ahead nonresident portfolio flows’ probability density. - Panel 3 includes monthly data on 16 countries for equity flows and 20 countries for bond flows. - Daily data on Chinese equity flows ceased being available as of August 11. --- ### Fiscal buffers, sovereign risk pricing, and market access - Fiscal consolidation and analyst expectations: - Momentum on fiscal consolidation has waned after pandemic progress. - Market analysts’ consensus expectations regarding the budget balance for the aggregate government in 15 major emerging markets over the next three years have become more pessimistic and are firmly in deficit territory. - 11 of these countries are set to underperform analysts’ forecasts for fiscal year 2024. - Fiscal buffer diagnostics: - “Small or worsening” sovereigns: fiscal buffers beyond a deficit of 2 percent. - “Borderline” sovereigns: fiscal buffers ranging from –2 to 2 percent and expect widening fiscal year 2024 primary deficits. - “Large or improving” sovereigns: fiscal buffers exceeding 2 percent, as well as borderline sovereigns expected to experience narrowing fiscal year 2024 primary deficits. - The 2024 fiscal buffer is estimated by subtracting the long-term debt-stabilizing primary balance from the expected 2024 primary balance. - Sovereign risk pricing: - Of the 80 sovereigns sampled, 17 (21 percent) have average ratings at CCC+ or worse, compared with 4 (5 percent) in December 2019. - B-rated sovereigns have a cumulative default rate of up to 17 percent over a period of five years. - Examination since 2020 suggests hard-currency spreads for 12 out of a sampled 19 defaulting sovereigns exceeded 10 percent before a downgrade to CCC or worse. - Policy implications: - Sovereigns with weaker fiscal buffers need to improve primary balances to avoid a “debt begets more debt” outcome amid still-high global interest rates. --- ### Frontier markets: maturities, issuance, and spreads - Upcoming maturities and refinancing pressures: - Roughly $4 billion of frontier debt coming due in the remainder of 2024. - Roughly $13 billion due in 2025. - Roughly $14 billion due in 2026. - Roughly 60 percent of maturing bonds are issued by countries with prevailing yields close to or above 10 percent. - Issuance and spreads: - Frontier sovereign spreads tightened further in the second quarter, approaching long-term average levels. - Just 14 percent of frontier economies have sovereign spreads above 1,000 basis points. - The “frontier market” classification comprises 43 countries. --- ### China: slowing growth, housing adjustment, and financial system risks - Inflation and macro dynamics: - One-year-ahead expected CPI inflation has nearly halved from a year ago to 1.3 percent. - Current headline inflation level noted at 0.3 percent with increased probability of falling below that level. - Housing market metrics: - Primary home prices down 7 percent from their peaks; secondary home prices down 13 percent from their peaks. - Primary market sales are 40 percent lower than their prepandemic peak. - Bond market and policy actions: - Both the 2- and 10-year central government bond yields have fallen to near record lows. - On August 31, the central bank announced secondary market transactions in August buying short-term central government bonds and selling long-term central government bonds, resulting in a net liquidity injection of 100 billion yuan. - Banking system and AMCs: - Reported NPL ratios remained low so far: mortgage NPL ratios less than 1 percent; manageable direct exposures to developers less than 6 percent of total bank loans. - Banks have been proactive in addressing NPAs with write-offs and disposals topping 3 trillion yuan each year since 2020. - Four national AMCs established in 1999 hold about 80 percent market share; a fifth national AMC, established in 2020, holds less than 0.2 percent of total AMC assets. - Capital levels proxied by equity-to-asset ratios have dropped to distressed levels below 5 percent at two of the national AMCs. - Risks: - A sudden rise in benchmark bond yields could trigger sharp repricing across fixed income markets, redemptions from investment funds, and significant market volatility. --- ### Commercial real estate (CRE), maturing debt, and bank exposures - CRE price and volume developments: - Global CRE prices have fallen by 12 percent year over year. - The US office sector is experiencing a 23 percent decline. - The European office sector is experiencing a 16 percent decline. - Transaction volumes were just over $130 billion in 2023, a 37 percent decrease from 2022. - Maturing debt and funding gaps: - Nearly $1 trillion in CRE debt will mature between 2024 and 2025 in the United States alone, with a funding gap of almost $300 billion. - Globally, about 40 percent of loans held by banks, 25 percent by commercial mortgage-backed securities (CMBSs), and 20 percent by investor-driven lenders such as debt funds are maturing over this period. - CMBS lenders have the largest exposure to loans maturing in 2024, accounting for nearly 30 percent of the balance. - Distress indicators and downside risk: - Delinquencies of CMBSs specializing in office properties are above 8 percent, up 3 percentage points from the previous year. - CRE price-at-risk model estimates (5 percent probability adverse scenario) project real price declines over the next three years of about 20 percent in North America and 19 percent in Europe. - Banks’ concentrated exposure and stress-test findings: - Sample covers 398 banks in Asia, Europe, and the United States. - High CRE exposure ratio defined as CRE exposure in Tier 1 capital greater than 300 percent in the United States and greater than 100 percent in Europe. - Simplified severe CRE office stress test: exposures to CRE offices lose 50 percent of their value. - Result: 4 percent of the banks in the sample (US and European banks)—representing 1 percent of assets—would find their Tier 1 capital ratios dipping below 7 percent. - Stress test ratios noted: ratio would drop from 17 to 13.3 percent; 12.3 to 11.3 percent among European banks (figures preserved as in source). --- ### Corporate credit, private credit expansion, and refinancing risks - Corporate fundamentals and insolvency risk: - Global distance to insolvency indicates that around one-quarter of firms are vulnerable to insolvency. - Fallen angels vs. rising stars: among investment-grade firms, debt issued by “fallen angels” is now roughly equal to the amount of “rising stars.” - Stock-to-flow measure: leverage of global nonfinancial corporations decreased from 108 percent in 2021 to below 100 percent currently, while remaining years to maturity of debt are shortening. - Refinancing and interest coverage: - Among global corporate debt coming due in 2025, fixed-rate debt accounts for close to 50 percent, with existing coupons between 3.5 and 4 percent, significantly lower than the current refinancing yield of 5.5 percent. - Refinancing stress scenario: if monetary policy does not ease, refinancing 2024 and 2025 bonds at higher interest rates would bring ICRs down by an average of 12 percent. - Private credit vulnerabilities: - Collateralized loan obligation issuance volumes in the United States and euro area for Q2 2024 were 60–90 percent higher than the average volumes between Q1 2022 and Q1 2024. - Private credit growth and opaqueness raise concerns about underwriting deterioration, increased PIK usage, and deferred-loss recognition that could trigger frozen fundraising, runs on semiliquid funds, and wider spillovers. --- ### Pensions, insurers, synthetic risk transfers (SRTs), and tokenization - Defined-contribution pensions and unit-linked insurance products: - Sample of 26 funds in several advanced economies accounts for $1.4 trillion in assets under management. - Australian superannuation funds hold, on average, illiquid exposures exceeding 20 percent of total assets; illiquid level 3 assets in five of the largest Australian funds estimated to account for almost one-quarter of total assets. - Supervisory recommendation: monitor compatibility between asset liquidity and client switching notice periods; conduct liquidity stress tests. - Synthetic risk transfers (SRTs): - More than $1.1 trillion in assets have been synthetically securitized since 2016, of which almost two-thirds were in Europe. - Industry estimates expect issuance of SRTs to remain above $200 billion in Europe and to more than triple in the United States to surpass $50 billion in 2024. - Buyers: private credit funds >60 percent market share; pension funds close to 20 percent. - Financial-stability concerns: SRTs may mask true bank risk, increase interconnectedness, and reduce transparency. - Supervisory implication: improve data collection and centralized reporting on SRT transactions. - Tokenization of real-world assets: - Use cases gaining traction: money market funds’ shares, repos, and Treasuries. - Reported benefits: potential immediate trade settlement, lower costs, fractional use of safe and liquid collateral, and improved intraday repo liquidity management. - Performance example: Franklin OnChain US Government Money Fund’s average annual return through the end of July 2024 was 5.3 percent, compared with 5.0 for Federated Hermes’ Treasury Obligations Fund. - Risks: increased interconnectedness between crypto and traditional markets, shocks during weekends when underlying assets cannot be traded, technology failures, and leverage amplification. - Supervisory recommendation: continue to monitor interconnectedness risks between crypto and traditional capital markets. --- ### Domestic investors in local bond markets (Box findings) - Role of pension and insurance funds: - Pension and insurance funds tend to prefer longer-dated securities and inflation-linked assets to match liabilities. - Finding: Countries with a rising share of holdings among pension and insurance funds broadly experienced less pressure on term premiums. - Availability heterogeneity: - Local government bonds with remaining maturities of at least 10 years or inflation linkage vary across jurisdictions (percent axis 0 to 80 percent in source figure). - Risks: - Concentration risk in LCGBs and vulnerability to large losses if interest rates rise precipitously or inflation surges. - Funding risk for governments if unexpected redemptions occur. - Data and sources: Arslanalp and Tsuda 2014; Bank for International Settlements; Bloomberg Finance L.P.; Financial Stability Board; and IMF staff calculations. *Source: Chapter 1, "Steadying the Course: Financial Markets Navigate Uncertainty," GLOBAL FINANCIAL STABILITY REPORT, October 2024 (figures, notes, and text as provided).* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Near-term financial stability assessment - Since the April 2024 Global Financial Stability Report, near-term financial stability risks have remained contained. - Global economic activity has moderated, inflation has slowed, emerging markets have remained resilient, financial conditions have remained accommodative, and volatility in financial markets has remained low, on net. - The IMF’s Growth-at-Risk (GaR) model indicates near-term risks have remained contained at around the 40th historical percentile. - Market turmoil in early August was severe but short-lived; the Nikkei index declined by 12 percent on August 5. ### Key vulnerabilities and imbalances - Accommodative financial conditions facilitate further buildup of vulnerabilities: - Asset valuations appear lofty in equity and corporate credit markets. - Debt has climbed globally; government debt levels in many advanced and emerging market economies are substantially above prepandemic levels. - Use of leverage among nonbank financial intermediation (NBFI) such as hedge funds and private credit funds has increased. - Maturity mismatches at some open-ended funds and insurers have widened. - Fragilities persist in corporate and commercial real estate (CRE) sectors. - Elevated economic and geopolitical uncertainty has widened the disconnect with compressed financial volatility, increasing the probability that volatility could surge and amplify adverse shocks. - Half of the world’s population has elected or will elect new governments this year, contributing to policy uncertainty. - Ongoing military conflicts, notably in the Middle East and in Ukraine, add to unpredictability. - Potential nonlinear amplification channels: - Rising volatility can increase value-at-risk measures, bind risk limits, and trigger margin calls. - Broker–dealers constrained by risk limits may curtail intermediation. - NBFIs facing margin calls might deleverage by selling assets into falling markets. ### Recent monetary and market developments - Monetary policy and expectations: - Major central banks have begun to ease monetary policy since April 2024; the European Central Bank, Bank of England, the Federal Reserve, and Riksbank have cut policy rates. - The Bank of Japan raised its policy rate in July. - Markets price multiple policy rate cuts among major central banks over the remainder of this year and next. - The Federal Reserve is expected to cut its policy rate by almost 150 basis points by the end of 2025. - Financial volatility versus uncertainty: - Financial market volatility remains compressed despite elevated economic uncertainty and geopolitical risk. - Inflation uncertainty remains elevated; analysts foresee meaningful upside risks to core inflation over the coming year (including the possibility of 2 percent or higher core inflation). - Option-implied monetary policy scenarios show substantial likelihoods of both shallow cuts and deep adjustments, especially in the United States. - Yield curve and term premiums: - Long-term interest rates in most advanced economies have changed little, on net, since April 2024; some emerging markets have seen upward pressure from rising term premiums. - The US yield curve has disinverted (10-year minus 2-year Treasury yields steepened) after a historically long period of inversion. - The recent steepening features both a decline in the expected policy rate path and a rise in term premiums, including persistent inflation risk premium. - The coexistence of bull-steepening (falling expected short-term rates) and bear-steepening (rising term premiums) dynamics may add to investor uncertainty about asset allocation. ### Quantitative tightening and funding risks - Group of Ten central banks reduced their balance sheets from a peak of $28 trillion in March 2022 to $21.5 trillion. - Quantitative tightening has proceeded in an orderly manner so far, but a key tail risk is that it may drain bank reserves too much, risking funding squeezes comparable to the US repo market turmoil in September 2019. - Simultaneous quantitative tightening across jurisdictions raises the odds of spillovers if inadequate bank reserves emerge in any single jurisdiction. ### Emerging markets and specific downside risks - Emerging markets have broadly demonstrated resilience, notably against currency pressures, with several central banks focused on domestic inflation and using exchange rate adjustments as a buffer. - Key downside risks: - Slowing growth outlook in China and fragilities in its financial system—policy support has so far not stabilized the housing market downturn or restored confidence. - Access to funding for frontier markets and economies with weaker fiscal buffers may become more constrained. - Underinvestment in climate finance would delay mitigation and adaptation in emerging markets and developing economies, creating future financial stability implications. - Sovereign credit spreads in emerging markets have become sensitive to countries’ fiscal buffers; certain weaker jurisdictions may struggle to refinance maturing debt at sustainable interest rates. ### Channels for future market stress - When shocks occur and volatility spikes: - Hedge funds may unwind leveraged positions. - Algorithmic traders and AI-driven strategies, which have gained significant market share across asset classes, may sell into falling markets, potentially exacerbating price declines. - Broker–dealer intermediation capacity may be constrained by risk limits. - The early August episode illustrated how quickly volatility can catch up to uncertainty, force unwinding of leveraged trades, and trigger feedback loops between asset prices and deleveraging. ### Policy recommendations to address vulnerabilities - For central banks: - Communicate clearly that the path of monetary policy should not react excessively to any individual data point to reduce uncertainty. - Where growth and inflation momentum are set to continue, gradually ease monetary policy toward a more neutral stance. - Where inflation remains stubbornly above targets, push back against overly optimistic investor expectations for policy easing that would further stretch asset prices. - For fiscal authorities: - With sovereign debt levels substantially above prepandemic levels in many economies, fiscal adjustments should primarily focus on credibly rebuilding buffers to keep external financing costs reasonable and help anchor medium-term inflation expectations. - Sovereign borrowers in frontier economies and low-income countries should strengthen efforts to contain risks associated with high levels of debt vulnerability. - For financial regulation and supervision: - Strengthen policies that address nonbank leverage and liquidity mismatches. - Renew efforts to implement internationally agreed-upon bank prudential standards in a timely and consistent manner to reduce regulatory arbitrage across borders and sectors. - Expand recovery and resolution plans, ensure financial institutions are prepared to access central bank liquidity, and intervene early to prevent strains from becoming systemic. - Engage more actively with certain types of NBFIs that amplified early August turmoil. *International Monetary Fund | Chapter 1 at a Glance (from ch1revised - Chapter 1 at a Glance)* ### 6. Ination Risk Premium and Real Risk ### 6. Ination Risk Premium and Real Risk ### Decomposition of longer-term yields and recent movements - Decomposition methods and data sources: - Expected short-rate and term premiums decomposition follows Adrian, Crump, and Moench (2013). - Joint decomposition of nominal and real yields into expected inflation, real expected short-term rate, inflation risk premium, and real term premium follows Abrahams and others (2016). - Data sources: Bank of England; Bloomberg Finance L.P.; European Central Bank; Federal Reserve; and IMF staff calculations. - Observed developments: - Ten-Year Government Bond Yields shown for selected advanced and emerging market economies indicate variation across country yields (panels 1 and 2). - Decomposition of changes in 10-year bond yields since April 2024 GFSR shown in basis points (panel 3). - Average reaction of the US 10-year government bond yield is calculated three months into a steepening episode since 2000; steepening episodes defined as in Goldman Sachs (2023) (panel 4). ### Steepening episodes, drivers, and asset returns - Definitions and findings: - Steepening episodes classified as bear steepening and bull steepening (Goldman Sachs, 2023). - Panel 4 shows evolution of US yield curve slope since 1999 (basis points). - Panel 5 decomposes changes in US 10-year yields during historical steepening episodes versus recent period (basis points). - Asset return patterns: - Bear steepening has favored risk assets more than bull steepening (Figure 1.4). - Panel 1 (Figure 1.4) displays average annualized returns for selected assets over different steepening periods. - WTI, Cyclicals, MSCI EM, Nikkei 225, S&P Value, Russell 2000, S&P Growth, S&P 500, Euro STOXX 600, Defensives, FTSE 100, Gold, DXY, Japan 10-Year, German 10-Year, US 10-Year shown to illustrate differential performance across steepening types. ### Net issuance, term premiums, and Treasury market structure - Net supply and projections: - Net issuance of Treasuries is projected to remain elevated, possibly pushing up term premiums. - Net supply of Treasury bonds relative to GDP is shown as percent, annualized average (panel 2, Figure 1.4), with higher values indicating deteriorating liquidity. - Buyer base shifts and quantitative tightening (QT) effects: - Since the April GFSR, advanced economy central banks continued reducing their footprint in domestic sovereign bond markets (Figure 1.5). - QT shifts buyer base toward more price-sensitive investors, introducing scarcity premium for core sovereign bonds as banks favor them for liquidity management and regulatory capital purposes (Figure 1.5, panel 2). - For noncore issuers, reduced ECB holdings are offset by “other domestic investors,” which include households and the more price-sensitive hedge fund sector, potentially increasing volatility in noncore bond markets. - US Treasury specifics: - Quantitative tightening has increased the share of free float Treasury securities (Treasury free float referenced in Figure 1.6, right scale), which could exert an upward push on Treasury yields and volatility over time. - The Department of the Treasury has increasingly issued more shorter-term debt to meet funding needs, which might lower borrowing costs in the near term but could expose the Treasury to higher future financing cost (Figure 1.6, panel 1). - The share of bills in the market has risen amid more free-floating Treasury securities; “Steady and predictable 15–20% recommended bills” is shown in panel 1 (Figure 1.6). - Primary dealers are increasingly warehousing longer-dated securities; dealer inventory and hedge fund holdings as a share of Treasury debt outstanding shown in percent (Figure 1.6, panel 2). - Bloated dealer inventory presents a medium-term risk because in adverse market conditions primary dealers with larger Treasury inventories are more likely to face internal balance sheet constraints that could prevent them from absorbing sales, worsening sell-offs. ### Market functioning, risks, and recommended vigilance - Volatility and market risk drivers: - Continued vigilance by central banks to monitor funding markets is needed to preemptively mitigate tail risk from funding strains and interconnected markets. - Quantitative tightening could increase bouts of volatility in government bond markets as buyer base moves toward more price-sensitive investors. - If government bond issuance increases to finance persistent fiscal deficits, higher volatility could be further amplified—especially in noncore bond markets. - Intermediary and investor behavior: - Domestic banks and foreign investors have offset reduced ECB holdings for core issuers like Germany; for noncore issuers, the offset has been by “other domestic investors” including households and hedge funds. - End users (pension funds, insurance companies, mutual funds, corporations, and individual investors) are ultimate holders of Treasury securities; primary dealers and brokers facilitate trading and liquidity. - Rise in household Treasury holdings (primarily driven by hedge funds) slowed since April 2024 GFSR, consistent with increased warehousing by primary dealers. ### Equity market valuations, concentration, and vulnerabilities - Equity rally and volatility: - Global equity rally continued since April 2024 GFSR but was interrupted by a severe transitory sell-off in early August (peak noted August 5). - Implied volatility for equities spiked during the early August sell-off (Figure 1.7, panel 2). - Investment-grade and high-yield corporate bond spreads widened after a long period of decompression (Figure 1.7, panels 3 and 4). - Valuation concentration and required earnings growth: - Since January, the share of the Magnificent 7 (M7) increased from 20 to 30 percent of the overall S&P 500 index (market capitalization). - Correlation estimates: correlation between M7 and the S&P has increased from around 40 percent to just above 65 percent since May; correlation of average pairwise M7 has increased from 10 to 50 percent over the same period. - Since 2023, there have been 69 days on which fewer than 150 stocks have moved in the same direction as the index, signaling concentration risk. - The S&P 500 is trading above its historical upper quartile in terms of forward price-to-earnings ratio since 1990. For this ratio to return to its historical 10-year average by 2026, earnings per share on the S&P and Nasdaq would need to post compounded annual growth rates of close to 25 and 30 percent, respectively—levels far higher than current market expectations. - The Russell 2000 outperformed the Nasdaq by about 10 percentage points between the beginning of July and early August, reflecting rotation from growth toward smaller stocks with less-demanding valuation. - Equity composition and fragility: - Evidence of increased correlation within M7 and between M7 and broader indices increases concentration risk, making headline index returns more sensitive to adverse developments among a few large-cap technology stocks. ### Emerging markets and crypto developments - Emerging market assets: - Market turbulence in early August so far has not significantly affected emerging market assets. Sovereign spreads for EM bonds denominated in US dollars have remained tight relative to spreads on investment-grade corporate bonds since the April 2024 GFSR. - Spreads between local currency bonds and some Latin American sovereigns have widened, with upward revisions to policy rate paths partly driving the movement. - Emerging market equity valuations for most countries remain below historical averages. - Risks ahead for EM assets include uncertainty induced by monetary policy in advanced economies—especially the United States—and policies of newly elected governments that affect geopolitical landscape and fragmentation risks. - Crypto market: - Crypto market capitalization is reported at $2.2 trillion, below its historical peak in November 2021. - The crypto rally earlier this year has started to fade after earlier optimism from approvals of spot Bitcoin and Ethereum exchange-traded products. - Crypto valuations have been driven recently by high rolling correlation between Bitcoin and other asset classes such as equities (S&P 500) and gold, rather than idiosyncratic developments within crypto. - Widespread adoption of crypto assets could undermine monetary policy effectiveness, circumvent capital flow measures, exacerbate fiscal risks, divert resources from financing the real economy, and threaten global financial stability. *Source: Chapter 1, "Steadying the Course: Financial Markets Navigate Uncertainty," GLOBAL FINANCIAL STABILITY REPORT, October 2024 (figures, notes, and text as provided).* ### 1. S&P 500 Decomposition ### 1. S&P 500 Decomposition ### S&P 500 dynamics and market breadth - Price index benchmark: January 1, 2023 = 100. - Observation: "The fewest number of stocks are moving in the same direction as the index since 1997, with M7 stocks dictating index movements recently." - Panel highlights: - Daily returns and constituent movements: shows daily returns (percent) and number of constituents; comment: "Current valuations of technology stocks demand high earnings growth, while smaller stocks appear undervalued." - Required earnings growth to justify existing valuation: metric expressed in percent; note: panel calculates "required growth to return to historical multiple" as the CAGR required to make the three-year-forward (end of 2026) price-to-earnings ratio return to its 10-year historical average. Dashed vertical line indicates indices within the United States. - Return ratios and volatility of large stocks relative to small stocks: ratios based on weekly returns; "Large to small cap volatility" defined as the implied volatility for the S&P 500 divided by the implied volatility for the Russell 2000. - Acronyms and indices referenced exactly: M7 = Magni§cent 7; SPW = S&P 500 Equal Weighted Index; SPX = S&P 500 Index; AEs = advanced economies; CAGR = compound annual growth rate; CPI = consumer price index; EMs = emerging markets; ERP = equity risk premium; ex = excluding. ### Emerging markets: asset performance and spreads - US dollar emerging market sovereign spreads remain tight relative to US investment-grade firms. - Panel metrics and observations: - Spread of Emerging Market Sovereign External Debt Against US Investment-Grade Firms, and Spreads of US Investment-Grade Firms Against Treasuries: shown in basis points. - Emerging market government local yields: "remained broadly stable." - Spreads of Local 10-Year Government Bonds as a Share of 10-Year Treasury Yields, and 10-Year Treasury Yields: shown in percent. - Equities: "Emerging market equities have performed positively this year, though valuations remain lower than historical averages." - Year-to-date total returns to equity in emerging markets and normalized forward price-to-earnings ratio against historical 10 years: returns in local currency (percent) and forward P/E (normalized z-score). Note: fourteen major emerging markets included; Asia = India, Indonesia, Malaysia, the Philippines, Thailand; CEEMEA = Hungary, Poland, Romania, South Africa; LATAM = Brazil, Chile, Colombia, Mexico, Peru. Thailand excluded from panel 1 for lack of hard-currency debt. - Sources and definitions preserved: P/E = price to earnings; UST 10 yr = Treasury 10-year yield; YTD = year to date; CEEMEA = Central and Eastern Europe, the Middle East, and Africa; IG = investment grade; corp. = corporations. ### Crypto assets: fading rally and correlations - Indexed prices benchmark: January 1, 2024 = 100. - Observation: "Optimism with regard to crypto assets has dissipated over the course of 2024 so far." - Panel highlights: - Prices of selected crypto assets and approvals of products traded on spot exchanges: indexed series for Bitcoin, Ethereum, Solana, Binance coin, and notable comparisons (Ethereum listed twice in source). - Correlations: one-year rolling correlation between Bitcoin and other assets shows "High correlations between Bitcoin and other asset classes suggest that broader risk sentiment drives crypto markets." - Regulatory approvals annotations: BTC ETP approval, ETH ETP approval noted in panel. - Sources and note preserved: BTC = Bitcoin; ETH = Ethereum; ETP = exchange-trade product; UST = US Treasuries. ### Financial conditions and Growth-at-Risk (GaR) - Summary: "Financial conditions have marginally tightened in many regions" though "still-elevated equity and corporate bond valuations have kept financial conditions in advanced economies relatively easy by historical standards." - China: financial conditions measured by price indicators have loosened due to monetary policy easing, narrowing corporate credit spreads, and some diminution of external headwinds; quantity indicators such as credit growth continue weakening. - GaR assessment key figures and scenarios: - Over the next year, there is a 5 percent probability that global real growth will fall below 1.2 percent. - Baseline World Economic Outlook growth forecast cited: 3.2 percent. - GaR is "around the 40th historical percentile" for near-term risk. - Scenario: if financial conditions were to tighten by 2.5 standard deviations and remain at that restrictive level for one quarter, the year-ahead GaR could worsen to its lowest historical quintile. - Methodological note: the scenario used in panel 1 calibrates the response of global financial conditions to a spike in Chicago Board Options Exchange Volatility Index, as seen on August 5, 2024 (EDT); the level of Chicago Board Options Exchange Volatility Index used is computed as the average of intraday VIX recorded at five-minute intervals from the start to end of business on that day. - Estimation details preserved: full sample regression starts in 1991:Q1; post–COVID-19 sample estimation begins in 2021:Q1; a 75 percent weight is applied to the post–COVID-19 regression estimates. - Interpretation: near-term downside risk is contained by accommodative financial conditions and moderate credit growth; medium-term GaR (four years ahead) has been at around historically elevated levels since 2023 and "remains at its worst quintile currently." Easy financial conditions and strong credit growth reduce near-term risks but prompt a buildup of vulnerabilities that raises downside risks in coming years; the intertemporal trade-off is nonlinear in uncertainty. ### Emerging markets resilience and monetary policy spillovers - Aggregate assessment: "Emerging markets have confronted a multitude of global shocks and elevated economic uncertainty since the pandemic," deploying proactive monetary policy and foreign exchange measures to strengthen resilience. - Heat map result: market stress has remained largely moderate in interest rates, foreign exchange, and other assets across 14 major emerging markets. - Risks and outlook: - Global uncertainty may remain elevated owing to geopolitical developments and uncertain policies of newly elected governments; divergence among emerging markets may become more pronounced. - Frontier markets: "Financial conditions for frontier markets remain challenging, with many countries grappling with higher borrowing costs and financial instability still not having access to funding through international markets despite sovereign spreads that are moderating lower." - Monetary policy synchronization and currency drivers: - Positive interest rate differentials in emerging markets vis-à-vis advanced economies have generally narrowed since the April 2024 GFSR, putting pressure on emerging market currencies. - Increased volatility, including the rapid appreciation in early August in the Japanese yen, has made carry trades less attractive on a risk-adjusted basis. - IMF staff model findings: carry factor was the dominant driver of currency moves in 2023; in 2024 an idiosyncratic factor (a proxy for domestic policy risks and uncertainty) has played an important role alongside the strength of the US dollar, notably for Latin American currencies and the South African rand. - Policy responses: some central banks in emerging markets slowed or paused rate cut cycles and conducted foreign exchange interventions to smooth currency volatility. - Recent development: "The Fed rate cut in September and the subsequent weakening of the US dollar have eased some of the pressures faced by EM central banks, and markets continue to expect easing across emerging markets broadly." - Figure and indicator notes preserved: heat map z-scores based on 10 years of monthly observations; high market stress defined as z-score > +2, low market stress as z-score < −2; indicators include short-term policy rates (ex ante real policy rate, ex post real policy rate), FX market (ATM-option-implied vol., FX-implied yield diff.), external funding market (sovereign five-year CDS, EM sovereign spread vs. UST), domestic bonds (Govt. 2s10s, local corporate spread), domestic equities (equity realized vol., overall forward P/E ratio). *Source: ch1revised - 1. S&P 500 Decomposition (PDF chapter), GLOBAL FINANCIAL STABILITY REPORT: STEAdYING ThE COuRSE: uNCERTAINTY, ARTIFICIAL INTELLIGENCE, ANd FINANCIAL STABILITY, International Monetary Fund | October 2024.* ### 3. Decomposition of Currency Returns ### 3. Decomposition of Currency Returns ### Currency return decomposition and methodology - Carry factor includes both interest rate differential and a global carry factor; the construction of the global carry factor and the dollar factor follows Verdelhan (2018), using a portfolio of 16 EM and 9 advanced economy currencies. - The decomposition is based on a rolling regression over 18 months. - Panel 6 reports spillovers from changes in US term premiums to EM term premiums using the Diebold and Yilmaz (2009) methodology; the spillover measure is the proportion of variation in EM term premiums explained by shocks emanating from US term premiums. - The spillovers shown correspond to a 100-week rolling window. - EMs in the spillover measure include 15 countries accounting for about 76 percent of total EM GDP. - The spillover of changes in US term premium remains high, notably for CEEMEA. ### Effects on emerging market yields - Greater policy alignment between advanced economies and emerging markets should stabilize interest rate differentials but may increase sensitivity of EM bond yields to advanced-economy yields through both synchronized expected policy paths and spillovers from the term premium component. - Increases in term premiums in most emerging markets have primarily driven recent changes in yields. ### Key statistics and technical notes (preserved exactly as in source) - Rolling regression window: 18 months. - Spillover rolling window: 100-week rolling window. - Portfolio for constructing global carry and dollar factors: 16 EM and 9 advanced economy currencies. - EM sample for spillovers: 15 countries accounting for about 76 percent of total EM GDP. ### Data sources referenced - Bloomberg Finance L.P.; EUROPACE AG/Haver Analytics; IMF, World Economic Outlook database; national sources; and IMF staff calculations. ### Notation and country codes appearing in figures (as in source) - BRL = Brazilian real; CEEMEA = Central and Eastern Europe, the Middle East, and Africa; CLP = Chilean peso; CNH = Chinese renminbi; COP = Colombian peso; EM = emerging market; EMEA = Europe, the Middle East, and Africa; FX = foreign exchange; GFSR = Global Financial Stability Report; HUF = Hungarian forint; IDR = Indonesian rupiah; INR = Indian rupee; LATAM = Latin America; MXN = Mexican peso; MYR = Malaysian ringgit; PEN = Peruvian sol; PHP = Philippine peso; PLN = Polish zloty; Q1 = first quarter; Q2 = second quarter; RON = Romanian new leu; THB = Thai baht; YTD = year to date; ZAR = South African rand. --- ### Portfolio flows and capital-flow risks ### Recent portfolio flow dynamics - Portfolio flows to emerging markets have been positive on net in recent months, with notable large inflows into local currency bonds in several countries (for example, Egypt and Türkiye) and inflows into Indian markets benefiting from India’s inclusion in global bond indices. - Equity flows have been under pressure in some countries. ### Capital-flows-at-risk - The IMF’s capital-flows-at-risk measure indicates there is a 5 percent probability that emerging market outflows could reach 2.4 percent of GDP over the next three quarters — a marginal increase in outflow risk since the April 2024 Global Financial Stability Report. - Rising market volatility, as seen during the early August shock, would materially increase outflow risks if sustained. ### Investor base and fund flows - Long-term domestic investors (insurers and pension funds) have absorbed increasing shares of EM bonds, mitigating portfolio outflow risks to some extent. - Foreign investors have become more cautious; portfolio inflow cycles have become shorter and smaller on average. - Dedicated emerging market bond and equity funds domiciled in the United States have experienced cumulative outflows since March 2022. - Year-to-date international issuance of sovereign bonds has risen to its highest level since 2021, although weak inflows into hard-currency bond funds suggest market conditions could become more challenging absent a turnaround. ### Data and methodology notes (preserved exactly) - “Portfolio flows at risk” is defined as the 5th percentile of the three-quarters-ahead nonresident portfolio flows’ probability density. - Panel 3 includes monthly data on 16 countries for equity flows and 20 countries for bond flows. - Inflow episodes are reset at the first monthly occurrence of outflows. - AUM = assets under management; EM ex China = emerging markets excluding China. - Daily data on Chinese equity flows ceased being available as of August 11. --- ### Fiscal buffers, sovereign risk pricing, and market access ### Fiscal consolidation and analyst expectations - Momentum on fiscal consolidation has waned after pandemic progress. - Market analysts’ consensus expectations regarding the budget balance for the aggregate government in 15 major emerging markets over the next three years have become more pessimistic and are firmly in deficit territory. - 11 of these countries are set to underperform analysts’ forecasts for fiscal year 2024. ### Fiscal buffer definitions and diagnostics - The long-term debt-stabilizing primary balance concept and construction are described in the source (see Fiscal Monitor methodology exposition in text). - “Small or worsening” sovereigns are identified as those with fiscal buffers beyond a deficit of 2 percent; “borderline” sovereigns have fiscal buffers ranging from –2 to 2 percent and expect widening fiscal year 2024 primary deficits; “large or improving” sovereigns have fiscal buffers exceeding 2 percent, as well as borderline sovereigns expected to experience narrowing fiscal year 2024 primary deficits. - A “reasonable rate” is within the –2 to 2 percent range, as the average five-year standard deviation of sample sovereigns’ primary balances is about 2 percent of GDP (based on expectations from fiscal year 2020 to fiscal year 2024). - The 2024 fiscal buffer is estimated by subtracting the long-term debt-stabilizing primary balance from the expected 2024 primary balance. ### Sovereign risk pricing and ratings - Emerging markets with worse fiscal buffers generally have higher credit default spreads. - Spreads are diverging between countries with “large or improving” and “small and worsening” buffers. - Rating downgrades are susceptible to “cliff effects” that can further constrain funding conditions owing to incorporation of ratings into regulations and risk limits. - Historical patterns indicate sequential downgrades can push sovereigns toward losing market access even when a notch or two above the “near default: CCC ratings” threshold. - Of the 80 sovereigns sampled, 17 (21 percent) have average ratings at CCC+ or worse, compared with 4 (5 percent) in December 2019. - B-rated sovereigns have a cumulative default rate of up to 17 percent over a period of five years, based on historical five-year issuer-weighted rating transition studies (Fitch, Moody’s, S&P studies referenced in source). - An examination of default events since 2020 suggests hard-currency spreads for 12 out of a sampled 19 defaulting sovereigns exceeded 10 percent before a downgrade to CCC or worse. ### Policy implications (implied by source analysis) - Sovereigns with weaker fiscal buffers need to improve primary balances to avoid a “debt begets more debt” outcome amid still-high global interest rates and larger spillovers from advanced economies. - Maintaining sufficient fiscal buffers and flexibility during periods of strong growth is important to mitigate effects of unexpected shocks and preserve market access. --- ### Frontier markets: spreads, restructurings, and market access ### Recent developments - Frontier sovereign spreads tightened further in the second quarter, approaching long-term average levels. - Significant progress on debt restructuring has lifted investor sentiment: Eurobond restructurings in Suriname, Zambia and Ghana were completed in December, June, and October, respectively, while an agreement in principle was reached with creditors in Sri Lanka in September. - Policy actions (for example in Nigeria) — rate hikes and clearing of overdue domestic central bank foreign exchange obligations — have contributed to greater currency stability. ### Issuance and spreads - Frontier economies continued to issue international debt in the second quarter, although yields remained high. - Just 14 percent of frontier economies have sovereign spreads above 1,000 basis points. - The “frontier market” classification comprises 43 countries (either included in the JPMorgan Next Generation Market index or, if not included, low-income countries with international bond issuance). --- *Source: ch1revised - 3. Decomposition of Currency Returns, ch1revised - 3. Decomposition of Currency Returns (PDF chapter/section).* ### CHAPTER 1 STEAdYING ThE COuRSE: FINANCIAL MARkETS NAvIGATE uNCERTAINTY ### CHAPTER 1 STEAdYING THE COURSE: FINANCIAL MARKETS NAVIGATE UNCERTAINTY ### Frontier Market Developments - Sovereign spreads have tightened for frontiers, but yields remain high. - A large proportion of debt maturing in coming months is trading close to or above 10 percent. - Upcoming maturities and refinancing pressures: - Roughly $4 billion of frontier debt coming due in the remainder of 2024. - Roughly $13 billion due in 2025. - Roughly $14 billion due in 2026. - Roughly 60 percent of maturing bonds are issued by countries with prevailing yields close to or above 10 percent, notably frontier economies in South Asia and sub-Saharan Africa. - Maturity profile and exposures: - Decline in the weighted average maturity (WAM) of frontier debt issuance increases exposure to expectations regarding monetary policy and more frequent refinancing needs. - Distribution of maturities includes categories: Under 7y, 7 to 15y, 15 to 30y, Over 30y; WAM is highlighted as an average metric. - Fiscal and debt metrics: - Debt-to-GDP ratios for both emerging market and frontier economies remain well above historical average levels. - Under IMF staff projections, these debt levels are not expected to come down meaningfully in the medium term. - Interest repayment burdens for frontier economies are projected to ease somewhat but remain relatively high in the medium term. - Data/indices referenced: - JPMorgan Next Generation Market Index percentiles (25th to 75th) used in presenting frontier spreads and yields. - EMBIG referenced for emerging market bond comparisons. ### Sustainable Debt Issuance by Emerging Markets - Global issuance of sustainable debt rebounded in the first half of 2024. - Green bonds remained the largest component, accounting for roughly half of sustainable debt issuance and exceeding the amount issued in the first six months of past years. - Emerging market share and composition: - The share of issuance by emerging markets has somewhat declined recently. - Sustainable debt accounts for a relatively small portion of total debt issuance in emerging markets. - The share of offshore issuance of sustainable debt in total issuance of sustainable debt is somewhat higher, reflecting investor preference for hard-currency over local-currency debt. - Adaptation versus mitigation finance: - Different estimates suggest that about 75 to 90 percent of climate finance flows are directed toward mitigation efforts. - International adaptation finance flows to developing countries are 10 to 18 times below estimated needs, and the gap is widening. - Tracked adaptation finance is dominated by public actors (98 percent). - Among private financial institutions surveyed, three out of five intend to increase allocation to adaptation investments, but they cite barriers including high perceived risk, need for product innovation, public–private partnerships, practical investment guidance, and investor-relevant metrics. - Country-level notes: - Panel 2 country labels use ISO country codes; examples shown include UAE, BRA, CHL, CHN, IND, IDN, MEX, ZAF, THA, TUR. - Measurement details: - Panel 1 uses a four-quarter moving average of total issuance in EMs as a percentage of global issuance; the third quarter of 2024 value is based on information as of August 2024. - “24:Q3 (norm)” refers to normalized value for the third quarter of 2024, based on issuances during July–August 2024. ### China: Slowing Growth, Deflationary Pressures, and Financial System Risks - Macro and inflation dynamics: - One-year-ahead expected CPI inflation has nearly halved from a year ago to 1.3 percent. - Current headline inflation level noted at 0.3 percent with increased probability of falling below that level. - Housing market and demand: - Home price declines: primary home prices down 7 percent from their peaks; secondary home prices down 13 percent from their peaks. - Primary market sales are 40 percent lower than their prepandemic peak. - Housing market adjustment is entering its fourth year and weighing on business and consumer confidence. - Bond yields and market signals: - Both the 2- and 10-year central government bond yields have fallen to near record lows. - Compression of term premiums, especially for longer-term rates, signals weaker economic outlook and flight to safety. - Outperformance of defensive and high-dividend sectors (utilities and energies) indicates low appetite for risk. - Policy actions and market reactions: - At end-September, authorities unveiled monetary and regulatory stimulus measures aimed at bolstering domestic economy and stabilizing property sector and consumer sentiment; initial stock appreciation was later partially retraced. - Over the past few months, authorities issued warnings against interest rate risks and took preemptive measures; on August 31, the central bank announced secondary market transactions in August buying short-term central government bonds and selling long-term central government bonds, resulting in a net liquidity injection of 100 billion yuan. - Bond market flows: - Decline in benchmark bond yields drove other bond yields lower, led by local government financing vehicle (LGFV) debt following fiscal support for financially weak regions. - Institutions like retail-focused wealth management products and mutual funds have displayed strong appetite for fixed income assets. - Foreign investors increased holdings of renminbi-denominated bonds, particularly negotiable certificates of deposit in the interbank market. - Risks: - A sudden rise in benchmark bond yields could trigger sharp repricing across fixed income markets, redemptions from investment funds, and significant market volatility. - Banking system performance and asset quality: - Reported NPL ratios remained low so far: mortgage NPL ratios less than 1 percent; manageable direct exposures to developers less than 6 percent of total bank loans. - Banks have been proactive in addressing NPAs with write-offs and disposals topping 3 trillion yuan each year since 2020. - Since 2012, cumulative reported NPLs amounted to less than 3 trillion yuan in 2023, and write-off and disposal totaled 22 trillion, effectively lowering banks’ headline NPL ratios by 1.5 percentage points. - Note: NPA includes nonloan assets and is broader than NPLs; disclosure of NPA ratio is limited. - Systemic considerations: - Continued deterioration of asset quality would occur if policy support fails to restore growth momentum; weak credit demand is weighing on lending volumes and profit margins. - Reliance on frequent write-offs and disposals and on AMCs for NPA disposal is central to current bank headline NPL management. ### Asset Management Companies (AMCs) in China - Role and market structure: - Four national AMCs established in 1999 hold about 80 percent market share; they mainly serve state-owned and joint-stock banks. - More than 50 regional AMCs were established since 2015 and generally target smaller banks in their regions. - A fifth national AMC, established in 2020, remains small, holding less than 0.2 percent of total AMC assets. - Trends in NPA acquisition and disposal: - Disposals have focused on property and LGFV-related nonperforming loans. - AMCs’ acquisitions in 2023 originated largely from the property market, small and medium enterprises, and LGFV-related sectors. - Financial health and vulnerabilities: - Fundamentals of national AMCs have weakened since 2018 due to pandemic impacts, property market downturn, and overexpansion. - Capital levels, proxied by equity-to-asset ratios, have dropped to distressed levels below 5 percent at two of the national AMCs. - Regional AMCs appear more resilient on measures of equity-to-assets and profitability, possibly reflecting more confined business models; however, data availability and granularity are limited. - Regional AMCs are unlikely in the near term to fill any gap left by national peers. - Interconnectedness and systemic risk: - AMCs are intertwined with the financial system through investments, lending (or receivables), and reliance on bank and market financing. - A credit event at a large AMC would hamper a source of NPA disposal for banks and put some banks at risk. - Distress in one national AMC previously generated significant ripple effects, requiring a $6.6 billion state-led bailout in 2021. - Authorities have strengthened regulations on AMCs by centralizing supervision of local AMCs under the National Financial Regulatory Administration. - Composition and disclosures: - Panels show asset and liability composition differences between national and regional AMCs, and cumulative changes in banks’ NPLs, write-offs, and other disposals since 2012. - Disposals have been mainly through transferring NPAs to state-owned AMCs in the primary market; the secondary market—non-AMC buyers of NPAs—remains nascent. ### Corporate Credit and Market Valuation - Market valuation and spreads: - Investor optimism about a global soft landing has helped keep corporate bond spreads tight. - Misalignment in corporate bond valuation, based on a model that accounts for macro fundamentals, has remained at levels similar to those at the time of the April 2024 Global Financial Stability Report. - The degree of overvaluation among US issuers is elevated by historical standards. - Investor behavior: - Strong demand from overseas investors has driven valuation up; reported preference by some Japanese investors for US investment-grade corporate bonds over Treasuries due to compensating yields after foreign exchange costs. - Indicators and metrics: - Misalignment per risk unit and percentile metrics are used to show valuation divergence. - Comparative instruments include JGB 10-year, US IG corporate bonds, Treasury 10-year, and funding chains denoted as DL refinanced by BSL and BSL refinanced by DL. *Italic: Source — CHAPTER 1 STEAdYING THE COURSE: FINANCIAL MARKETS NAVIGATE UNCERTAINTY (ch1revised - CHAPTER 1 STEAdYING THE COURSE: FINANCIAL MARKETS NAVIGATE UNCERTAINTY).* ### 1. Misalignments in Corporate Bond Spreads ### 1. Misalignments in Corporate Bond Spreads ### Misalignments, foreign-exchange hedging, and syndicated loans - Misalignment measure: difference between market spread and model-based spread scaled by the standard deviation of monthly changes in spread; negative values indicate overvaluation (see October 2019 Global Financial Stability Report, Online Annex 1.1 for model details). - Foreign-exchange-hedged US corporate bonds are attractive to Japanese investors. - Foreign-exchange-hedged yield comparison highlighted (panel 2): yields hedged in Japanese yen are shown as percent. - Syndicated loan market activity: the syndicated loan market has become active recently, regaining share from private credit direct lenders. - Collateralized loan obligation issuance: experienced their largest issuance since the start of the Federal Reserve hiking cycle as investors sought alternative credit products. - Collateralized loan obligation issuance volumes in the United States and euro area for the second quarter of 2024 were 60–90 percent higher than the average volumes between the first quarter of 2022 and the first quarter of 2024. ### Corporate credit fundamentals and insolvency risks - Despite solid economic activity and large cash buffers for many firms, loan and bond defaults have steadily risen as weaker firms have struggled. - Forward-looking metric: global distance to insolvency indicates that around one-quarter of firms are vulnerable to insolvency. - Bankruptcy trends: bankruptcies among smaller firms have continuously risen in recent months, with cases exceeding prepandemic levels in Europe and Japan. - Fallen angels vs. rising stars: among investment-grade firms, debt issued by “fallen angels” is now roughly equal to the amount of “rising stars.” - Average maturity: borrowers have issued less long-term debt on average, increasing refinancing risks by concentrating repayment obligations. - Stock-to-stock approach finding: leverage of global nonfinancial corporations measured in terms of the debt-to-GDP ratio under the stock-to-flow approach decreased from 108 percent in 2021 to below 100 percent currently, while remaining years to maturity of debt are shortening faster — hence debt-to-GDP ratios adjusted for duration (debt-to-GDP times average remaining life) have been increasing steadily. - High-yield segment: average remaining life of high-yield debt declined to 4.6 years in the fourth quarter of 2023 from 6.7 years in the third quarter of 2009. ### Corporate debt sustainability: cash buffers, interest coverage, and refinancing pressures - Cash buffers: the share of firms with cash-to-interest-expense ratios below 1.5 has been increasing, especially among smaller firms. - Interest coverage ratio (ICR): ICR has deteriorated over the past year for some European and emerging Asian countries; ICR has slipped below two for some emerging Asia countries. - Refinancing exposure: among global corporate debt coming due in 2025, fixed-rate debt accounts for close to 50 percent, with existing coupons between 3.5 and 4 percent, significantly lower than the current refinancing yield of 5.5 percent. - Refinancing stress scenario: if monetary policy does not ease, refinancing 2024 and 2025 bonds at higher interest rates would bring ICRs down by an average of 12 percent. - Emerging market corporates: refinancing costs remain elevated for emerging market corporations, especially for foreign currency bonds; issuance has remained much slower than before the current monetary tightening cycle. - Policy-relevant mitigants: an easing in monetary policy would help firms in emerging markets with debt sustainability; a shift toward issuing in local, rather than foreign, currencies would also help. - Trade-tension scenario: in a scenario calibrated to reflect higher marginal financing costs (by 150 basis points) and higher input costs, if input costs increase by 10 percent, the weak tail of firms (ICRs less than one) would increase by an additional 3 to 6 percentage points, depending on the region, with the impact especially large in emerging markets. - Pretightening baseline for issuance: “pretightening trendline” is an average of values for 2019:Q1 and 2021:Q4 at $82.5 billion. ### Private credit expansion and vulnerabilities - Private credit definition: credit provided outside commercial banks or public debt markets. - Market impact: favorable outlook for private credit has pushed up stock prices of specialized asset managers, which have outperformed bank stocks and the broader equity market. - Market reach: private credit has entered credit segments beyond lending to midsized corporate borrowers, intensifying competition with banks in syndicated loan markets. - Underwriting deterioration: signs that rapid private credit growth, competition from banks on large deals, and pressure to deploy capital may be leading to deterioration of underwriting standards and weakened covenants. - Borrower stress indicators: high interest rates and leverage have jeopardized borrowers’ ability to service debt; interest coverage ratio and leverage (debt/EBITDA) for borrowers from US BDCs indicate significant pressure on cash flows. - Noncash interest practices: PIK (payment in kind) income as a share of interest and dividend income of US BDCs is highlighted as a risk factor when interest is paid in kind (no cash flow; coupon added to loan principal, usually at extra cost). *Source: IMF staff calculations and figures in chapter 1, “Misalignments in Corporate Bond Spreads,” Global Financial Stability Report: Steadying the Course: Financial Markets Navigate Uncertainty (October 2024).* ### CHAPTER 1 STEAdYING ThE COuRSE: FINANCIAL MARkETS NAvIGATE uNCERTAINTY ### CHAPTER 1 STEAdYING ThE COuRSE: FINANCIAL MARKETS NAvIGATE uNCERTAINTY ### Private credit: rising vulnerabilities and opacity - Business development companies, used as a proxy for the private credit industry, show interest coverage ratios (ICRs) have continued to decline because of borrowers’ high leverage, the floating rate nature of loans, and the slowdown of economic activity. - Defaults narrowly defined (missed payments) remain relatively rare because private credit vehicles can amend and extend loans and complement them with equity warrants; however, broader measures of default—including restructurings or breaches of covenants—are becoming frequent. - A significant share of borrowers face cash flow pressures, evidenced by an ever-growing share of payment-in-kind coupons. - The private credit industry’s opaqueness complicates risk assessment and quantification of loan deterioration. - Downside scenario risk: stale and uncertain valuations could lead to deferred realization of losses followed by a spike in defaults, potentially triggering: - frozen fundraising for private credit, - runs on semiliquid funds, - withdrawal of leverage and liquidity from banks and other investors, - simultaneous reductions in exposures across the private credit network and spillovers to other markets and the broader economy. ### Residential real estate: modest price declines, affordability stretched, stability risks contained - Yearly changes: - Real home prices in emerging markets have declined by 1.6 percent year over year. - Real home prices in advanced economies have declined by 0.3 percent year over year. - Global real house prices remain 5 percent above the prepandemic average. - US house prices have increased 2 percent year over year. - Supply-side constraints—rising construction costs and shortages of construction materials—have partly dampened the pass-through of elevated interest rates to price declines, producing varying price elasticity of new housing supply across countries. - Country heterogeneity: - Countries with a higher percentage of variable-rate mortgages (for example, Norway) and countries with very large postpandemic price buildups (for example, Canada) have recorded significant declines. - Home prices in Korea, South Africa, and Sweden, and to a lesser extent the euro area and the United Kingdom, have undergone annual declines. - China’s property sector remains weak despite recent government support measures. - Risk assessment: - There is still room for house prices to decline in jurisdictions with high household leverage and overvalued markets, and where substantial easing in monetary policy is less likely. - Risks to financial stability are contained because: - Further increases in mortgage rates are not projected to raise household debt-servicing expenses significantly (“Scenario 1” in Figure 1.25, panel 4). - A limited number of risky and complex financial instruments are tied to the housing market. - Household and bank balance sheets are sound overall. ### Commercial real estate (CRE): acute pressures, maturing debt, and downside risks - Price and volume developments: - Global CRE prices have fallen by 12 percent year over year (latest available data). - The US office sector is experiencing a 23 percent decline. - The European office sector is experiencing a 16 percent decline. - Transaction volumes were just over $130 billion in 2023, a 37 percent decrease from 2022. - Sectoral and regional divergence: - US metro areas have higher vacancy rates and are projected to have negative net absorption rates. - Technological demand (AI, cloud computing) is expected to boost demand for data centers and similar CRE, especially in Asia-Pacific. - Postpandemic remote work and changing trade patterns are producing heterogenous performance across regions and property types. - Funding and financing shifts: - Tight bank lending standards and subdued investor sentiment are expected to further restrict CRE financing, leading to project delays or cancellations and reduced supply. - Equity investments by institutional investors have declined significantly as they favor debt instead. - Historically, offices accounted for 40 percent of cross-border CRE investments between 2010 and 2023; the office share has declined by close to 10 percentage points since 2022. - Maturing debt and funding gaps: - Nearly $1 trillion in CRE debt will mature between 2024 and 2025 in the United States alone, with a funding gap of almost $300 billion. - Globally, about 40 percent of loans held by banks, 25 percent by commercial mortgage-backed securities (CMBSs), and 20 percent by investor-driven lenders such as debt funds are maturing over this period. - CMBS lenders have the largest exposure to loans maturing in 2024, accounting for nearly 30 percent of the balance. - Distress and default indicators: - Delinquencies of CMBSs specializing in office properties are above 8 percent, up 3 percentage points from the previous year. - Real estate investment trusts (REITs) that depend on bank funding for liquidity have elevated expected frequencies of default in Canada and the United States. - Downside price risk: - CRE price-at-risk model estimates (5 percent probability adverse scenario) project real price declines over the next three years of about 20 percent in North America and 19 percent in Europe. - Distinguishing features of the current CRE cycle: - The unprecedented combination of maturing debt, high interest rates, a dearth of CRE sales, and varied effects across property types. - Rate cuts alone may not resolve challenges due to structural demand shifts from remote work, particularly for central business district offices. ### Banks’ concentrated exposure to office CRE and potential capital impacts - Bank exposure metrics and sample: - Financial reporting review covers 398 banks in Asia, Europe, and the United States, including all global systemically important banks. - A high CRE exposure ratio is defined as CRE exposure in Tier 1 capital greater than 300 percent in the United States and greater than 100 percent in Europe. - Disclosure and concentration: - Only about one-quarter of publicly traded US banks disclose exposures to the embattled office sector; only a few European banks disclose this information. - Among banks that report CRE office information: - About 25 percent of sample US banks report CRE office exposures in Tier 1 capital greater than 50 percent. - Almost 50 percent of sample European banks report CRE office exposures in Tier 1 capital greater than 50 percent. - Potential adverse scenario: - In an adverse scenario in which CRE office exposures lose 50 percent of their value, aggregate Tier 1 capital ratios of US banks would decrease (text cuts off before the exact aggregate effect is provided in the source). *Source: CHAPTER 1 STEAdYING ThE COuRSE: FINANCIAL MARkETS NAvIGATE uNCERTAINTY (PDF).* ### 12.3 to 11.3 percent. Among European banks, the ### ch1revised - 12.3 to 11.3 percent. Among European banks, the ### Commercial real estate (CRE) — office concentrations and stress-test findings - Ratio would drop from 17 to 13.3 percent. - 12.3 to 11.3 percent. - A simplified severe CRE office stress test was performed for a sample of 14 banks in Europe and 145 banks in the United States that disclosed CRE office exposures in their periodic reporting as of the end of 2023 or the first quarter of 2024. - Severe stress corresponds to a scenario in which exposures to CRE offices lose 50 percent of their value. - Although such a shock seems manageable at an aggregate level: - 4 percent of the banks in the sample (US and European banks)—representing 1 percent of assets—would find their Tier 1 capital ratios dipping below 7 percent. - High concentrations of CRE offices are defined as ratios of exposures of CRE offices to Tier 1 capital above 50 percent (panel 1 and panel 2 definitions). - In stock-market evidence: - As measured by changes in one-year stock prices as of July 31, 2024, US banks with high CRE concentrations that disclose their office exposures tend to outperform those not disclosing them. - “High CRE concentration” is defined as ratios of CRE exposures to Tier 1 capital plus loan loss reserves greater than 300 percent in the United States and ratios of CRE exposures to Tier 1 capital greater than 100 percent in Europe. - Note: Median shown as middle line in each box; dots depict outliers. CRE = commercial real estate. ### Global banking sector resilience and vulnerabilities - The global banking sector has remained resilient since the April 2024 Global Financial Stability Report, with capital and liquidity buffers ample and profitability having improved. - NPL ratios have risen in some forms of lending, such as consumer credit cards, auto loans, and CRE, but overall asset quality has not deteriorated significantly. - Banks’ profitability has benefited from higher noninterest income (fees and commissions) and measures to reduce operational costs, pushing up their stock valuations. - Near-term risks: - Net interest margin and bank profitability could be adversely affected by interest rate cuts, as banking assets tend to reprice more quickly than deposits. - Medium-term prospects: - Lower interest rates could stimulate a rebound in lending and reduced refinancing costs might help alleviate some pressures facing the CRE sector. - IMF staff key risk indicators: - Fewer banks expected to be flagged as deficient in three or more risk indicators by the end of the year. - The number of banks with four or more weak risk indicators is expected to rise, suggesting that weak banks are becoming increasingly vulnerable (trend more pronounced in Asia). - Smaller banks: - Smaller banks with assets less than $100 billion have featured more prominently on the monitoring list. - Common challenges include business-model issues leading to lower earnings and stock underperformance or undervaluation. - US-specific concerns: - Unrealized losses in securities portfolios and high CRE exposures remain a concern. - Some banks have increased use of synthetic risk transfers to manage risks and boost capital ratios, which requires attention from supervisors. - Market volatility and recession risk: - Early August market volatility led to a temporary sell-off of some banks’ stocks; investor fears about a forthcoming recession highlight vulnerabilities. - Supervisory attention is paramount to assess the effect of a downturn on banks’ safety and business-model soundness. - Financial crimes: - The significant risk that financial crimes pose to macrofinancial stability requires integration of anti–money laundering and counter–terrorism financing measures within the broader financial stability framework. ### Growth of bond funds, liquidity mismatches, and leverage - Two structural trends increasing vulnerability in bond funds: - Bond funds have grown strongly: assets under management increased sevenfold between 2009 and 2024 in the US market. - Holdings of US bonds among ETFs and open-ended mutual funds now account for about 25 percent of the total outstanding, up from about 10 percent in 2009. - Rotation toward institutional funds and ETFs: - Institutional mutual funds have overtaken retail mutual funds in size. - Fund flows and outflow risk: - Fund flows-at-risk are defined as the 5th percentile of the historical flow distribution; analysis uses monthly data covering 2014–24. - Bond ETFs and institutional mutual funds have higher medians and larger ranges of fund flows-at-risk; institutional mutual funds and some ETFs face large peak outflows. - Bond funds in emerging markets—both local currency and hard currency—stand out with relatively large fund flows-at-risk. - Leverage and repo usage: - Leveraged bond funds take on significant leverage through repurchase agreements. - Leveraged funds tend to experience larger peak outflows compared with nonleveraged peers. - Leveraged funds currently constitute a small share of the bond fund sector, with differences across jurisdictions. - Regulatory implication: - Regulators should be aware that deleveraging by even a small set of funds could have an outsized effect on the broader financial system. ### Hedge funds, carry trades, and the August sell-off - Hedge funds are a $7 trillion industry connected to global markets and can both propagate and amplify stress. - Recent positioning: - Hedge funds built substantial short positions in yen futures and long positions in US equity futures and in currencies of emerging markets. - Trigger and unwind: - After the Bank of Japan’s monetary policy decision and worse-than-expected US labor market data, the interest rate differential between Japan and the United States narrowed, equities declined, and the yen appreciated. - Many hedge funds reportedly reached risk limits and received increased margin calls, forcing rapid position closures and erasing the year’s returns for many hedge funds. - Evidence of market impact: - Panel markers include noncommercial net positions on yen futures; ratio of long to short futures and options in US equities; returns of commodity trading advisor hedge funds with dates noted July 2, 2024 and Aug. 6, 2024. - Transparency gap: - Limited transparency in the hedge fund industry makes it difficult for investors and supervisors to gauge leverage in real time and what might trigger another deleveraging episode. ### Illiquid investments by pensions and insurers — maturity-mismatch vulnerability - The share of defined-contribution pensions and unit-linked insurance products has risen globally in recent years (figures cited in panels 1 and 2 of Figure 1.31). - Clients of defined-contribution plans bear investment profits and losses; providers typically offer clients a menu of investment options (contextual description from the source). *Sources: Bloomberg Finance L.P.; S&P Capital IQ Pro; US firms’ annual reports and Securities and Exchange Commission Forms 10-Q and 10-K; and IMF staff estimates.* ### 1. Share of Dened Contributions in Total Pension Assets by Country ### 1. Share of Defined Contributions in Total Pension Assets by Country ### Findings on defined-contribution (DC) pension and unit-linked insurance products - The share of defined-contribution pensions and the growth of unit-linked insurance products differ significantly across countries. - Selected defined-contribution private pension and superannuation funds (sample of 26 funds) domiciled in Australia, Canada, Germany, Mexico, Sweden, Switzerland, the United Kingdom, and the United States account for $1.4 trillion in assets under management. - Australian superannuation funds are required to allow clients to switch between different investment options generally within three business days, despite holding, on average, illiquid exposures exceeding 20 percent of their total assets. - Illiquid level 3 assets in five of the largest Australian superannuation funds, with assets under management exceeding $0.5 trillion, are estimated to account for almost one-quarter of total assets. ### Illiquid private investments and insurer exposures - Selected large private DC pension and superannuation funds have increased allocations to illiquid private equity and private credit in recent years. - US annuities (a type of unit-linked insurance product) have increased allocations to illiquid investments in a manner similar to general accounts, which already hold a substantially higher proportion of illiquid assets. - European unit-linked insurance products do not appear to have increased the shares of illiquid investments; exposures to assets such as real estate and private equity are materially smaller than those of European general account insurers. - Note on panel comparability: The calculations for illiquid investments in panel 4 do not include the same items in the European Union and the United States and therefore are not directly comparable. - US insurers’ illiquid investments are calculated as the sum of miscellaneous assets, mortgages, and real estate investments as of the end of 2022, according to the latest published factbook from the American Council of Life Insurers. - EU insurers’ illiquid investments are calculated as the sum of investments in real estate funds, alternative funds, private equity funds, infrastructure funds, real estate structured notes, real estate collateralized securities, mortgages, loans, and property as defined by the European Insurance and Occupational Pensions Authority. ### Liquidity-mismatch risks and potential market spillovers - Frequent opportunities for clients to enter or exit investment options can exacerbate liquidity mismatches between the underlying illiquid assets (private equity and private credit) and plan liabilities, because the effective duration of liabilities has been reduced. - Such liquidity mismatches could affect members’ outcomes in a liquidity stress event and could spill over to financial markets where pension funds and insurers have large footprints (government bonds, equities, corporate bonds). - Supervisory emphasis: In jurisdictions where DC pensions and unit-linked insurance products are material, supervisors should closely monitor the share of illiquid investments held by these products and ensure compatibility between asset liquidity and client switching notice periods. - Recommendation: Conduct liquidity stress tests that consider scenarios involving crises related to liquidity availability across the major asset classes. ### Policy recommendations and supervisory actions related to pensions and insurers - Supervisors should fill data gaps and cooperate across borders to ensure effective monitoring of interconnectedness risks posed by pension funds and insurers. - Liquidity stress tests should consider scenarios involving liquidity availability crises across major asset classes and include compatibility checks between asset liquidity and client switching notice periods. - Authorities should ensure that data gaps are addressed, including through international bodies such as the Financial Stability Board, to improve global monitoring. ### Synthetic risk transfers (SRTs) and synthetic securitization - SRTs move credit risks associated with a pool of assets from banks to investors through a financial guarantee or credit-linked notes while keeping the loans on banks’ balance sheets; through this protection, banks can effectively claim capital relief and reduce regulatory capital charges. - Global synthetic securitization volumes: more than $1.1 trillion in assets have been synthetically securitized since 2016, of which almost two-thirds were in Europe. - Market composition and trends: - In the United States, SRT activity picked up in 2023 and is expected to accelerate further as the regulatory landscape has become clearer. - In Europe, issuance is concentrated in corporate and small- and medium-enterprise lending; recent US transactions have centered on retail loans, particularly automobile loans. - Issuers in Europe include global systemically important banks and large banks; in the United States, regional banks issue SRTs as well. - Buyers: private credit funds have a market share exceeding 60 percent, followed by pension funds with close to 20 percent. - Example figures from an SRT structure illustration (assumption: Tier 1 Capital Requirement of 10.5 percent): - Without SRT: $87.50 (20% RWA), $11.00 (0% RWA), $1.50 (1,250% RWA) - With SRT (reference pool $100, 100% RWA): Tier 1 capital requirement $3.80; Tier capital requirement: $10.5; loan portfolio $100; reference pool $100; proceeds of note sale and credit protection; retained first loss and senior tranches. *Sources: American Council of Life Insurers; Bank of England; European Insurance and Occupational Pensions Authority; Preqin; Thinking Ahead Institute; and IMF staff calculations.* ### 1. Stylized Example of a Direct Bank-Issued ### 1. Stylized Example of a Direct Bank-Issued CLN Structure ### Synthetic risk transfers: Market size, mechanics, and motivations - Industry estimates expect issuance of SRTs to remain above $200 billion in Europe and to more than triple in the United States to surpass $50 billion in 2024. - Investors purchase SRTs to access loan categories not easily accessible through public markets or direct lending and to earn attractive returns of 8–12 percent compared with those from other asset classes. - Proceeds from capital relief can be used to originate more loans, fund stock repurchases, or pay dividends. - If interest rates fall, certain motivations behind SRTs become less relevant. - SRTs allow banks to: - limit loan book concentration, - reduce counterparty risk, and - for some US banks, avoid realizing potential mark-to-market losses linked to gyrations in interest rates compared with an outright sale of the loans. ### Stylized CLN treatment and risk-weighted assets (RWA) - Under securitization treatment, the senior tranche carries 20 percent in RWA. - The first-loss tranche carries 1,250 percent in RWA. - The RWA for the mezzanine tranche becomes zero because the bank is no longer exposed to the losses from this tranche. - CLN = credit-linked note; RWA = risk-weighted assets; sub. = subordinate. ### Financial-stability concerns and channels - SRTs may elevate interconnectedness and create negative feedback loops during stress (anecdotal evidence of banks providing leverage for credit funds to buy CLNs issued by other banks). - Such structures can retain substantial risk within the banking system but with lower capital coverage; the magnitude of interconnections is difficult to assess due to market opacity and lack of a centralized repository for SRT data. - SRTs may mask banks’ degree of resilience by increasing a bank’s regulatory capital ratio while its overall capital level remains unchanged. - Increased use of SRTs may reflect inability to build capital organically because of weaker fundamentals and profitability performance. - Overreliance on SRTs exposes banks to business challenges should liquidity from the SRT market dry up. - Although asset pools being securitized currently seem higher quality, there are signs of increased concerns regarding deterioration of asset quality (see SRTx™ Credit Risk Indices measuring market sentiment; index scale 0–100 with levels above 50 indicating a higher proportion of respondents estimating that credit risk is worsening). - Financial innovation may lead to securitization of riskier asset pools, complicating identification of ultimate risk holders. - Cross-sector regulatory arbitrage may reduce capital buffers in the broad financial system while overall risks remain largely unchanged. ### Supervisory implications and recommendations - Financial sector supervisors need to closely monitor these risks and ensure the necessary transparency regarding SRTs and their impact on banks’ regulatory capital. - Monitor market opacity and consider measures to improve data collection and centralized reporting on SRT transactions. - Assess incentives created by lower capital charges at bank level and potential cross-sector arbitrage effects. *This box was prepared by Gonzalo Fernandez Dionis, Yiran Li, and Silvia L. Ramirez.* ### Tokenization of real-world assets: adoption, benefits, and risks - Tokenization involves creating a digital representation of real-world assets on a blockchain. - Adoption in certain financial markets by large players could lead to increased interconnectedness between traditional financial markets and crypto markets. - Tokenization use cases gaining traction: money market funds’ shares, repos, and Treasuries. - Reported benefits: - potential immediate trade settlement, - lower costs related to ownership, - fractional use of safe and liquid collateral for liquidity management, - timely receipt of asset yields or coupons, - immediacy and cost-efficiency for intraday repo liquidity management. - Examples of institutional activity: BlackRock and Franklin Templeton launched tokenized Treasury funds; major banks use systems such as Onyx and Distributed Ledger Repo to tokenize shares of money market funds for collateral use and intraday repos. - Performance example: Franklin OnChain US Government Money Fund’s average annual return through the end of July 2024 was 5.3 percent, compared with 5.0 for Federated Hermes’ Treasury Obligations Fund. ### Tokenization financial-stability considerations - Current concerns are limited given still-small scale. - Over the medium term, tokenization deepens nexus between crypto and traditional financial systems; increased interconnectedness can transmit shocks or volatility between markets. - Potential volatility triggers: - investor uncertainty about token value or redeemability, - shocks occurring during weekends when underlying real-world assets cannot be traded or funded while token markets may remain open 24/7. - Other risks: technology failures and increased use of leverage through tokenization. - Interaction with stablecoins: growth of tokenized safe and liquid assets (e.g., tokenized Treasuries) can interact with the rise of stablecoins, noting many stablecoins do not offer returns. - Supervisory recommendation: continue to monitor risks related to interconnectedness within crypto markets and between crypto and traditional capital markets for potential increases in vulnerabilities. *This box was prepared by Gonzalo Fernandez Dionis and Kleopatra Nikolaou.* ### Box 1.4. Domestic Investors in Local Bond Markets: A Stabilizing Force? ### Box 1.4. Domestic Investors in Local Bond Markets: A Stabilizing Force? ### Role of domestic institutional investors (pension and insurance funds) - EMs with declining presence (n = 4) average; EMs with increasing presence (n = 7) average. - Pension and insurance funds tend to prefer longer-dated securities and inflation-linked assets to better match their liability structures. - These funds are a large fraction of local currency government bonds (LCGBs) outstanding in several countries and, in other jurisdictions, represent a growing asset class that could present an opportunity to extend the domestic yield curve. ### Evidence on term premiums and investor presence - Finding: Countries with a rising share of holdings among pension and insurance funds broadly experienced less pressure on term premiums. - Figure context: Change in Term Premiums for Local Currency 10-Year Government Bonds, March 2022 to June 2024 (Cumulative change to z-scores on domestic term premiums since the onset of the Federal Reserve’s hiking cycle). - Sample: 11 major emerging markets; local currency government bond holdings by pension and insurance funds assessed from December 2021 to December 2023. - Term premiums are on the 10-year yield and follow the methodology in Adrian, Crump, and Moench (2013). ### Availability and heterogeneity of long-dated and inflation-linked assets - The availability of long-dated and inflation-linked assets varies significantly across jurisdictions. - Figure context: Local Government Bonds That Have Remaining Maturities of at Least 10 Years or Are Linked to Inflation (Percent), axis showing 0 to 80 percent and country labels: ZAF, IND, COL, MYS, MEX, IDN, BRA, HUN, CHL, PER, PHL, TUR, POL. - Implication: In jurisdictions where such instruments are already a large fraction of LCGBs outstanding, pension and insurance funds may be well matched; in others, growth of this investor base could support domestic yield-curve extension. ### Risks and vulnerabilities - Concentration risk: With limited alternative options for domestic investment, funds may become overly concentrated in LCGB. - Market risk: Funds concentrated in LCGBs could be vulnerable to large losses should interest rates rise precipitously, the yield curve steepen sharply, or inflation surge. - Funding risk for governments: An unexpected increase in redemptions from these funds could drive a sudden rise in the cost of domestic funding. ### Data and methodological notes - Sources cited: Arslanalp and Tsuda 2014; Bank for International Settlements; Bloomberg Finance L.P.; Financial Stability Board; and IMF staff calculations. - Data labels in the figure use International Organization for Standardization (ISO) country codes. - EMs = emerging markets. *This box was prepared by Jeffrey Williams.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2024/october/english/ch1revised.pdf_