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Global Financial Stability Report
Global Financial Stability Report: Bridge to Recovery
October 2020
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October 2020
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Near-term global financial stability risks have been contained as an unprecedented policy response to the coronavirus (COVID-19) pandemic has helped avert a financial meltdown and maintain the flow of credit to the economy. For the first time, many emerging market central banks have launched asset purchase programs to support the smooth functioning of financial markets and the overall economy. But the outlook remains highly uncertain, and vulnerabilities are rising, representing potential headwinds to recovery. The report presents an assessment of the real-financial disconnect, as well as forward-looking analysis of nonfinancial firms, banks, and emerging market capital flows. After the outbreak, firms’ cash flows were adversely affected as economic activity declined sharply. More vulnerable firms—those with weaker solvency and liquidity positions and smaller size—experienced greater financial stress than their peers in the early stages of the crisis. As the crisis unfolds, corporate liquidity pressures may morph into insolvencies, especially if the recovery is delayed. Small and medium-sized enterprises (SMEs) are more vulnerable than large firms with access to capital markets. Although the global banking system is well capitalized, some banking systems may experience capital shortfalls in an adverse scenario, even with the currently deployed policy measures. The report also assesses the pandemic’s impact on firms’ environmental performance to gauge the extent to which the crisis may result in a reversal of the gains posted in recent years.
Near-term global financial stability risks have been contained as unprecedented and timely policy response to the coronavirus (COVID-19) pandemic has helped avert a financial meltdown and maintain the flow of credit to the economy. But the outlook remains highly uncertain, and vulnerabilities are rising, representing potential headwinds to recovery. Vulnerabilities have increased in the nonfinancial corporate sector as firms have taken on more debt to cope with cash shortages and in the sovereign sector as fiscal deficits have widened to support the economy. As the crisis unfolds, corporate liquidity pressures may morph into insolvencies, especially if the recovery is delayed. Small and medium-sized enterprises (SMEs) are more vulnerable than large firms with access to capital markets. Although the global banking system is well capitalized, some banking systems may experience capital shortfalls in an adverse scenario, even with the currently deployed policy measures. Nonbank financial institutions have managed to withstand the market turmoil thanks to swift policy interventions, but fragilities remain, and the damage could be more extensive in a more prolonged period of market stress. Some emerging and frontier market economies already face financing challenges, which may lead to rising debt distress or financial instability. Looking ahead, it is imperative that policy support is maintained for the recovery to take hold. As economies reopen, accommodative monetary and financial conditions, credit availability, and targeted solvency support will be essential to sustaining the recovery.
The COVID-19 pandemic has hit emerging and frontier market economies hard, but the policy response has been equally strong. Policymakers have taken steps to soften the hit to economic activity, ease financial conditions, and reduce stress in domestic markets. For the first time, many emerging market central banks have launched asset purchase programs to support the smooth functioning of financial markets and the overall economy. Asset purchases have been effective in reducing bond yields and have not contributed to currency depreciation, but they appear to have taken longer to reduce broader domestic bond market stress. This chapter examines the effectiveness of these unconventional policy measures and concludes that asset purchases with credible monetary policy frameworks and good governance may be a useful addition to the policy toolkit of central banks in emerging and frontier market economies, although a careful ongoing evaluation of associated risks is needed, especially for open-ended programs. In frontier market economies, the policy focus has been on addressing the effect of the pandemic while dealing with high debt. This chapter examines the potential impact on investor perception of sovereign risk as a result of the expected treatment of different classes of creditors in future debt restructurings.
The COVID-19 pandemic has adversely affected nonfinancial corporate sector cash flows, generating liquidity and solvency pressures. In the G7 economies borrowing surged in March and into the second quarter of 2020, thanks to credit line drawdowns and unprecedented policy support. This allowed firms to build cash buffers to cope with a period of reduced cash flow and high uncertainty. In the United States, the bond market has been buoyant since the end of March, but credit supply conditions for bank loans and the syndicated loan market have tightened. In other G7 economies, credit supply conditions eased somewhat across markets during the second quarter. Among listed firms, entities with weaker solvency or liquidity positions before the onset of COVID-19, as well as smaller firms, suffered relatively more financial stress in some economies in the early stages of the crisis. However, residual signs of strain remained as of the end of June, when the stock market underperformance of French, UK, and US firms with pre–COVID-19 liquidity vulnerabilities ranged between 4 and 10 percentage points. Policy interventions, especially those directly targeting the corporate sector, had a beneficial effect overall. Looking ahead, premature withdrawal of policy support could jeopardize the success achieved so far in broadly meeting the nonfinancial corporate sector’s funding needs.
Banks entered the COVID-19 crisis with higher levels of capital than before the global financial crisis, and policymakers have quickly deployed policies to support economic activity and the ability of banks to lend. However, the sheer size of the shock and the likely increase in defaults from firms and households may challenge banks’ profitability and capital positions. A forward-looking simulation of capital ratios in a sample of 350 banks from 29 jurisdictions, accounting for 73 percent of global banking assets, shows that capital ratios would decline as a result of the COVID-19 crisis, but remain, on average, comfortably above regulatory minimums. However, there are differences across and within regions. A weak tail of banks, accounting for 8.3 percent of assets in the sample, might fail to meet minimum regulatory capital requirements in an adverse scenario. Government loan guarantees and other bank-specific policies help relieve the decline of reported capital ratios and reduce bank capital shortfalls. Policymakers should pay attention to intertemporal trade-offs, as policies that reduce the financial stability risks of a transitory shock may increase longer-term vulnerabilities to banks’ loss-absorbing capacity. Policies to limit capital distributions and ensure adequate funding for deposit guarantee programs, as well as contingency plans for response to possible pressures, would help address the consequences of a potentially adverse scenario.
The shutdown in economic activity as a result of the COVID-19 crisis has resulted in a temporary decline in global carbon emissions, but the long-term impact of the pandemic on the transition to a low-carbon economy remains uncertain. On the one hand, the economic fallout from the crisis may constrain firms’ ability to invest in green projects, thus slowing down the transition. On the other hand, the pandemic could increase awareness of catastrophic risks and induce a structural shift in consumer and investor preferences toward environmentally friendly products, providing an opportunity to accelerate the transition. Looking back at previous episodes of financial and economic stress, this chapter finds that tighter financial constraints and adverse economic conditions are generally detrimental to firms’ environmental performance, setting it back by several years. This suggests that the COVID-19 crisis could potentially slow down the transition to a low-carbon economy. In light of the urgent need to reduce global greenhouse gas emissions, climate policies and green investment packages are needed to support a green recovery and the energy transition. Policies aimed at fostering sustainable finance, such as improved transparency and standardization, could further help alleviate firms’ financial constraints and mobilize green investments.
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