Interest Rate Increases, Volatile Markets Signal Rising Financial Stability Risks
IMF Blog, October 11, 2022
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Bibliographic details
- Authors: Tobias Adrian
- Published: October 11, 2022
Overview
- Global financial conditions have tightened as central banks accelerate monetary policy normalization to keep rapid inflation from becoming entrenched.
- Amid a highly uncertain global environment, risks to financial stability have increased substantially.
- Major issues include inflation at multi-decade highs, continuing deterioration of the economic outlooks in many regions, and persistent geopolitical risks.
- This blog is based on Chapter 1 of the October 2022 Global Financial Stability Report, “Financial Stability in the New High-Inflation Environment.”
Market dynamics and liquidity
- Central banks confronting stubbornly high inflation have had to accelerate monetary policy tightening.
- Financial asset prices have fallen as monetary policy has tightened, the economic outlook has deteriorated, recession fears have grown, borrowing in hard currency has become more expensive, and stress in some nonbank financial institutions has accelerated.
- Bond yields are rising broadly across credit ratings, with borrowing costs for many countries and companies already rising to the highest levels in a decade or more.
- Market liquidity has deteriorated across some key asset classes due to volatile interest rates and asset prices; this poor market liquidity could amplify any rapid, disorderly repricing of risk.
Vulnerabilities across sectors
- Financial vulnerabilities are elevated for:
- governments, many with mounting debt;
- nonbank financial institutions such as insurers, pension funds, hedge funds and mutual funds.
- Rising rates have added to stresses for entities with stretched balance sheets.
- Property sector concerns:
- The faltering property sector in many countries raises concerns about risks that could broaden and spill over into banks and the macroeconomy.
- Risks to housing markets are growing because of rising mortgage rates and tightening lending standards, with many more potential borrowers now being squeezed out of markets.
- Stretched housing valuations could adjust sharply in some market segments.
Emerging and frontier markets
- Emerging markets face:
- high external borrowing costs,
- stubbornly high inflation,
- volatile commodity markets,
- heightened uncertainty about the global economy,
- policy tightening in advanced economies.
- Frontier markets face particularly severe strains driven by a combination of tightening financial conditions, deteriorating fundamentals, and high exposure to commodity price volatility.
- Investors have so far continued to differentiate across emerging economies. While many frontier markets are at risk of sovereign default, many of the largest emerging markets are more resilient to external vulnerabilities to date.
- After the stabilization of outflows in the first half of the year, foreign investors are again pulling back.
- Emerging and frontier market bond issuance in US dollars and other major currencies has slowed to the weakest pace since 2015.
- Without improved access to foreign funding, many frontier market issuers will have to seek alternative sources and/or debt reprofiling and restructurings.
- Recommended approaches for reducing debt risk:
- early engagement with creditors,
- multilateral cooperation,
- international support.
- For those in distress, bilateral and private sector creditors should coordinate on preemptive restructuring to avoid costly defaults and prolonged loss of market access.
- Where applicable, the Group of Twenty Common Framework should be used.
Banking sector and corporate pressures
- The global banking sector has been bolstered by high levels of capital and ample liquidity buffers.
- The IMF’s Global Bank Stress Test warns these buffers may not be enough for some banks:
- In the event a sharp tightening of financial conditions causes a global recession next year amid high inflation, 29 percent of emerging-market banks (by assets) would breach capital requirements.
- Most banks in advanced economies would fare much better, the stress test indicates.
- Corporate sector stress:
- The challenging macroeconomic environment is putting pressure on the global corporate sector.
- Credit spreads have widened substantially, and high costs are eroding corporate profits.
- For small firms, bankruptcies have already started to increase because of higher borrowing costs and diminished fiscal support.
Policy recommendations
- Central banks:
- Must act resolutely to bring inflation back to target and avoid a de-anchoring of inflation expectations, which would damage their credibility.
- Clear communication about policy decisions, commitment to price stability, and the need for further tightening will be crucial to preserve credibility and avoid market volatility.
- Exchange rate and foreign exchange intervention:
- Exchange rate flexibility helps countries adjust to the differential pace of monetary policy tightening across countries.
- In cases where exchange rate movements impede the central bank’s monetary transmission mechanism and/or generate broader financial stability risks, foreign exchange intervention can be deployed.
- Such interventions should be part of an integrated approach to addressing vulnerabilities as laid out in the IMF’s Integrated Policy Framework.
- Debt treatment for emerging/frontier markets:
- Reduce debt risk through early engagement with creditors, multilateral cooperation, and international support.
- Use preemptive restructuring coordinated among bilateral and private sector creditors to avoid costly defaults and prolonged loss of market access.
- Use the Group of Twenty Common Framework where applicable.
- Macroprudential policy:
- Policymakers should contain further buildup of vulnerabilities by adjusting selected macroprudential tools to tackle any pockets of risk.
- Striking a balance between containing potential threats and avoiding a disorderly tightening of financial conditions will be critical in this highly uncertain environment.
This blog is based on Chapter 1 of the October 2022 Global Financial Stability Report, “Financial Stability in the New High-Inflation Environment.”