Higher-for-Longer Interest Rate Environment is Squeezing More Borrowers
IMF Blog, October 10, 2023
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- Authors: Tobias Adrian
- Published: October 10, 2023
Overview
- The world’s central banks have raised policy rates aggressively to tame inflation: about 400 basis points on average in advanced economies since late 2021, and around 650 basis points in emerging market economies.
- Core inflation remains elevated in several economies, especially the United States and parts of Europe, so major central banks may need to keep interest rates higher for longer.
- The Global Financial Stability Report (GFSR) signals downside risks to the world economy and highlights a growing deterioration in borrowers’ ability to service debt (credit risk).
Key findings on borrower stress
- Corporate sector:
- Many firms are drawing down cash buffers as earnings moderate and debt servicing costs rise.
- The GFSR shows increasing shares of small and mid-sized firms in both advanced and emerging market economies with barely enough cash to pay their interest expenses.
- Defaults are on the rise in the leveraged loan market (financially weaker firms’ borrowing).
- More than $5.5 trillion of corporate debt comes due in the coming year.
- Households:
- Excess savings in advanced economies have steadily declined from peak levels early last year that were equal to 4 percent to 8 percent of gross domestic product.
- Signs of rising delinquencies in credit cards and auto loans.
- Real estate:
- Home mortgages now carry much higher interest rates than a year ago, eroding savings and weighing on housing markets.
- Countries with predominantly floating rate mortgages have generally experienced larger home price declines.
- Commercial real estate faces funding drying up, transactions slowing, and defaults rising.
- Governments:
- Frontier and low-income countries are having a harder time borrowing in hard currencies as foreign investors demand greater returns; hard currency bond issuances this year have occurred at much higher coupon—or interest—rates.
- Major emerging economies largely do not face the same predicament given better economic fundamentals and financial health, though foreign portfolio investment flows have slowed.
- Material amounts of foreign investment have left China in recent months as mounting troubles in its property sector have dented investor confidence.
Spillovers, market reactions, and systemic risks
- Most investors currently appear optimistic, pricing in a global soft landing where higher rates contain inflation without causing a recession; this has eased financial conditions despite mounting borrower stress.
- Two key risks from this optimism:
- Relatively easy financial conditions could continue to fuel inflation.
- Rates can tighten sharply if adverse shocks occur (examples noted: an escalation of the war in Ukraine or an intensification of stress in the Chinese property market).
- A sharp tightening of financial conditions would:
- Strain weaker banks already facing higher credit risks.
- Reduce bank lending (surveys cite rising borrower risk as a key reason for slowdown).
- Cause many banks to lose significant amounts of equity capital in a scenario with high inflation, high interest rates, and a global recession.
- Threaten funding for weak banks if stock-market capitalization falls below the value of their balance sheet.
- Fragilities also exist in nonbank financial intermediaries (hedge funds, pension funds) that lend in private markets.
Policy recommendations and tools
- Central banks must remain determined to bring inflation back to target; sustained economic growth and financial stability is not possible without price stability.
- If financial stability is threatened, policymakers should:
- Promptly use liquidity support facilities and other tools to mitigate acute stress and restore market confidence.
- Given the importance of healthy banks to the global economy, there is a need to further enhance financial sector regulation and supervision.
Tobias Adrian — October 10, 2023