By Tobias Adrian Russia’s invasion of Ukraine raises financial stability risks for the world and poses questions about the longer-term impact on economies and markets. The war, amid an already slowing recovery from the pandemic, is set to test the resilience of financial markets and poses a threat to financial stability as discussed in our latest Global Financial Stability Report.
Ukraine and Russia face the most pressing risks. Yet it is already clear that the severity of disruptions in commodity markets and to supply chains are creating downside risks by weighing adversely on macrofinancial stability, inflation, and the global economy.
Since the beginning of the year, financial conditions have tightened significantly across most of the world, particularly in Eastern Europe. Amid rising inflation, expected interest-rate hikes have led to a notable tightening in advanced economies in the weeks following the Russian invasion of Ukraine. Even with that tightening, financial conditions are close to historical averages, and real rates remain accommodative in most countries.
Tighter financial conditions help to slow demand, as well as to prevent an unmooring of inflation expectations (that is, where anticipation of continued price increases in the future becomes the norm) and to bring inflation back to target.
Many central banks may have to move further and faster than what is currently priced in markets to contain inflation. This could bring policy rates above neutral levels (a “neutral” level is one at which monetary policy is neither accommodative nor restrictive and is consistent with the economy maintaining full employment and stable inflation). This is likely to lead to even tighter global financial conditions. The new geopolitical reality complicates the work of central banks, which already faced a delicate balancing act with stubbornly high inflation. They must bring inflation back to target, mindful that excessive tightening of global financial conditions hurts economic growth. Against this backdrop, and in light of heightened financial stability risks, any sudden reassessment and repricing of risk resulting from an intensification of the war in Ukraine, or from an escalation of sanctions on Russia, may expose some of the vulnerabilities built up during the pandemic (surge in house prices and stretched valuations), leading to a sharp decline in asset prices.
Shock transmission
Repercussions of the war and ensuing sanctions continue to reverberate. The resilience of the global financial system will be tested through various potential amplification channels. These include the exposures of financial institutions to Russian and Ukrainian assets; market liquidity and funding strains; and the acceleration of cryptoization—residents opting to use crypto assets instead of the local currency—in emerging markets.
Europe bears a higher risk than other regions due to its geographic proximity to the war, reliance on Russian energy, and the non-negligible exposure of some banks and other financial institutions to Russian financial assets and markets. Moreover, ongoing volatility in commodity prices may severely pressure commodity financing and derivatives markets and could even cause more disruptions like the wild swings that halted some nickel trading last month. Such episodes, amid heightened geopolitical uncertainty, may weigh on liquidity and funding conditions.  Emerging and frontier markets now face higher risks of capital outflows, with differentiation across countries between commodities importers and exporters. Amid geopolitical uncertainty, the interplay of tighter external financial conditions and the US Federal Reserve normalization (first rate increase delivered in March and unwinding of the balance sheet expected to be faster), is likely to increase the risk of capital flight.  Following the Russian invasion of Ukraine, the number of frontier market sovereign issuers trading at distressed levels (that is, spreads above 1,000 basis points) has surged higher to more than 20 percent of issuers, surpassing pandemic-peak levels. While worrisome, this has a limited impact on systemic concerns given these issuers account for a relatively lower proportion of total outstanding debt, to date.
In China, the recent equity sell-off, particularly in the technology segment, combined with ongoing stress in the real estate sector and renewed lockdowns, have raised concerns about a growth slowdown, with possible spillovers to emerging markets. Financial stability risks have risen amid ongoing stress in the battered real estate sector. Extraordinary financial support measures may be needed to ease balance sheet pressures, but these would add to debt vulnerabilities down the road.
Policy actions
In the near term, central banks should take decisive action to prevent inflation from becoming entrenched and keep expectations of future price increases in check. Interest rates might have to rise beyond what is currently priced in markets to get inflation back to target in a timely manner. This may entail pushing interest rates well above their neutral level. For advanced-economy central banks, clear communication is crucial to avoid unnecessary volatility in financial markets, by providing clear guidance about the tightening process while remaining data dependent.
In emerging markets, many central banks have already significantly tightened policy. They should continue to do so—depending on individual circumstances—to preserve their inflation-fighting credibility and anchor inflation expectations.
Policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities (for example, to lean against the surge in house prices), while avoiding a broad tightening of financial conditions. Striking the right balance here is important given uncertainties about the economic outlook, the ongoing monetary policy normalization process, and limits on post-pandemic fiscal space.
Policymakers will also face structural issues such as fragmentation in capital markets, which would have implications for the role of the US dollar. Payment systems face similar risks as central banks seek to establish their own digital currencies that are independent of existing international networks. Regulators will also be under pressure to narrow regulatory gaps to ensure integrity and protect consumers in the fast-evolving world of crypto assets.
At the same time, tradeoffs between energy security (adequate, affordable supplies) and climate (regulatory mechanisms intended to increase oil and gas prices) are being laid bare as supply and price effects of international sanctions on Russia ripple across Europe and beyond. There may be some setbacks in the climate transition in the immediate future, but the impetus to reduce energy dependency on Russia could be a catalyst for change. Policymakers should, therefore, strive to honor commitments on climate and intensify their efforts to achieve net-zero targets, while taking additional appropriate steps to address energy security concerns. | (PHOTO: JOEL CARILLET/ISTOCK BY GETTY IMAGES) | By Pierre-Olivier Gourinchas Global economic prospects have been severely set back, largely because of Russia’s invasion of Ukraine. This crisis unfolds even as the global economy has not yet fully recovered from the pandemic. Even before the war, inflation in many countries had been rising due to supply-demand imbalances and policy support during the pandemic, prompting a tightening of monetary policy. The latest lockdowns in China could cause new bottlenecks in global supply chains. In this context, beyond its immediate and tragic humanitarian impact, the war will slow economic growth and increase inflation. Overall economic risks have risen sharply, and policy tradeoffs have become even more challenging. Compared to our January forecast, we have revised our projection for global growth downwards to 3.6 percent in both 2022 and 2023. This reflects the direct impact of the war on Ukraine and sanctions on Russia, with both countries projected to experience steep contractions. This year’s growth outlook for the European Union has been revised downward by 1.1 percentage points due to the indirect effects of the war, making it the second largest contributor to the overall downward revision.  The war adds to the series of supply shocks that have struck the global economy in recent years. Like seismic waves, its effects will propagate far and wide—through commodity markets, trade, and financial linkages. Russia is a major supplier of oil, gas, and metals, and, together with Ukraine, of wheat and corn. Reduced supplies of these commodities have driven their prices up sharply. Commodity importers in Europe, the Caucasus and Central Asia, the Middle East and North Africa, and sub-Saharan Africa are most affected. But the surge in food and fuel prices will hurt lower-income households globally, including in the Americas and the rest of Asia. Eastern Europe and Central Asia have large direct trade and remittance links with Russia and are expected to suffer. The displacement of about 5 million Ukrainian people to neighboring countries, especially Poland, Romania, Moldova and Hungary, adds to economic pressures in the region. Pressures amplified The medium-term outlook is revised downwards for all groups, except commodity exporters who benefit from the surge in energy and food prices. Aggregate output for advanced economies will take longer to recover to its pre-pandemic trend. And the divergence that opened up in 2021 between advanced and emerging market and developing economies is expected to persist, suggesting some permanent scarring from the pandemic.  Inflation has become a clear and present danger for many countries. Even prior to the war, it surged on the back of soaring commodity prices and supply-demand imbalances. Many central banks, such as the Federal Reserve, had already moved toward tightening monetary policy. War-related disruptions amplify those pressures. We now project inflation will remain elevated for much longer. In the United States and some European countries, it has reached its highest level in more than 40 years, in the context of tight labor markets.  The risk is rising that inflation expectations drift away from central bank inflation targets, prompting a more aggressive tightening response from policymakers. Furthermore, increases in food and fuel prices may also significantly increase the prospect of social unrest in poorer countries. Immediately after the invasion, financial conditions tightened for emerging markets and developing countries. So far, this repricing has been mostly orderly. Yet, several financial fragility risks remain, raising the prospect of a sharp tightening of global financial conditions as well as capital outflows. On the fiscal side, policy space was already eroded in many countries by the pandemic. Withdrawal of extraordinary fiscal support was projected to continue. The surge in commodity prices and the increase in global interest rates will further reduce fiscal space, especially for oil- and food-importing emerging markets and developing economies. The war also increases the risk of a more permanent fragmentation of the world economy into geopolitical blocks with distinct technology standards, cross-border payment systems, and reserve currencies. Such a tectonic shift would cause long-run efficiency losses, increase volatility and represent a major challenge to the rules-based framework that has governed international and economic relations for the last 75 years. Policy priorities Uncertainty around these projections is considerable, well-beyond the usual range. Growth could slow down further while inflation could exceed our projections if, for instance, sanctions extend to Russian energy exports. Continued spread of the virus could give rise to more lethal variants that escape vaccines, prompting new lockdowns and production disruptions. In this difficult environment, national-level policies and multilateral efforts will play an important role. Central banks will need to adjust their policies decisively to ensure that medium- and long-term inflation expectations remain anchored. Clear communication and forward guidance on the outlook for monetary policy will be essential to minimize the risk of disruptive adjustments. Several economies will need to consolidate their fiscal balances. This should not impede governments from providing well-targeted support for vulnerable populations, especially in light of high energy and food prices. Embedding such efforts in a medium-term framework with a clear, credible path for stabilizing public debt can help create room to deliver the needed support. Even as policymakers focus on cushioning the impact of the war and the pandemic, other goals will require their attention. The most immediate priority is to end the war. On climate, we must close the gap between stated ambitions and policy actions. An international carbon price floor differentiated by country income levels would provide a way to coordinate national efforts aimed at reducing the risks of catastrophic climate events. Equally important is the need to secure equitable worldwide access to the full complement of COVID-19 tools to contain the virus, and to address other global health priorities. Multilateral cooperation remains essential to advance these goals. Policymakers should also ensure that the global financial safety net operates effectively. For some countries, this means securing adequate liquidity support to tide over short-term refinancing difficulties. But for others, comprehensive sovereign debt restructuring will be required. The Group of Twenty’s Common Framework for Debt Treatments offers guidance for such restructuring but has yet to deliver. The absence of an effective and expeditious framework is a fault line in the global financial system. Particular attention should also be paid to the overall stability of the global economic order to make sure that the multilateral framework that has lifted hundreds of millions out of poverty is not dismantled. These risks and policies interact in complex ways over varying timeframes. Rising interest rates and the need to protect vulnerable populations against high food and energy prices make it more difficult to maintain fiscal sustainability. In turn, the erosion of fiscal space makes it harder to invest in the climate transition, while delays in dealing with the climate crisis make economies more vulnerable to commodity price shocks, which feeds into inflation and economic instability. Geopolitical fragmentation worsens all these trade-offs, increasing the risk of conflict and economic volatility and decreasing overall efficiency. In the matter of a few weeks, the world has yet again experienced a major shock. Just as a durable recovery from the pandemic was in sight, war broke out, potentially erasing recent gains. The many challenges we face call for commensurate and concerted policy actions at the national and multilateral levels to prevent even worse outcomes and improve economic prospects for all.  PHOTO: FRANCKREPORTER/ISTOCK BY GETTY IMAGES | By Silvia Albrizio, Sonali Das, Christoffer Koch, Jean-Marc Natal, and Philippe Wingender Governments succeeded in lessening the economic pain of the pandemic by providing plenty of liquidity to stricken consumers and businesses through credit guarantees, concessional lending and moratoriums on interest payments. But although these policies proved effective in supporting balance sheets, they also led to a spike in private debt, extending a steady increase in leverage spurred by supportive financial conditions since the global financial crisis of 2008. Global private debt surged by 13 percent of the world’s gross domestic product in 2020—faster than the rise seen during the global financial crisis and almost as fast as public debt. We estimate that recent levels of leverage could slow economic recovery by a cumulative 0.9 percent of GDP in advanced economies and 1.3 percent in emerging markets on average over the next three years. Greater debt drag Aggregate figures do not tell the whole story, however. The impact of the pandemic on the finances of households and firms has varied across countries and within them, reflecting differences in their policy responses and the sectoral composition of their economies. For example, contact-intensive services such as entertainment contracted as people stayed at home, but production and exports of computers, software and other goods expanded as consumers spent more on appliances. The impact on consumer and business balance sheets, especially those most exposed to the pandemic, differed greatly depending on the support provided by governments. Our analysis shows that the post-pandemic drag on growth could be much larger in countries where (1) indebtedness is more concentrated among financially stretched households and vulnerable firms, (2) fiscal space is limited, (3) the insolvency regime is inefficient, and (4) monetary policy needs to be tightened rapidly. Low-income households and vulnerable firms (highly indebted and unprofitable businesses that are struggling to make interest payments) are typically less able to withstand a high level of debt. As a result, they are likely to make sharper cuts to consumption and investment spending in the future. The drag on future growth is therefore expected to be greatest in countries that experienced the largest increases in indebtedness among low-income households and vulnerable firms during the pandemic. Consumers in China and South Africa saw the largest increases in household debt ratios among the countries for which detailed data are available. But the experience of households in these two countries was very different: in China leverage increased the most among lower-income households whereas households with higher incomes accounted for most of the increase in South Africa. Among advanced economies, low-income households in the United States, Germany, and the United Kingdom saw comparatively larger increases in debt than those in France and Italy, where leverage actually declined for poorer households.  The impact of the pandemic on businesses varied, too. Vulnerable firms—highly concentrated in contact-intensive services—often borrowed to survive the drop in revenues caused by the pandemic. Future investment is therefore likely to be lower in countries with a higher share of contact-intensive sectors. Rising inflation and interest rates As economies recover and inflation accelerates, governments should take account of the impact of fiscal and monetary policy tightening on the most financially stretched consumers and businesses when pacing the exit from extraordinary support policies. For example, we estimate that a surprise tightening of 100 basis points would slow investment by the most leveraged firms by a cumulative 6.5 percentage points over two years—four percentage points more than for the least leveraged.  Where the recovery is well underway and balance sheets are in good shape, fiscal support could be reduced faster, facilitating the work of central banks. Elsewhere, governments should target fiscal support to the most vulnerable in the transition to recovery while keeping within credible medium-term fiscal frameworks. To prevent rapid tightening of monetary policy from causing large and potentially long-lasting disruptions, policymakers should pay close attention to adverse developments in the financial sector. This is especially important in countries where a wave of bankruptcies in sectors heavily hit by the pandemic could spill over to the rest of the economy. Governments in these countries could incentivize restructuring over liquidation and, where necessary, extend solvency support. Insolvency, restructuring regimes Authorities should also enhance restructuring and insolvency mechanisms (through dedicated out-of-court restructuring, for instance) to promote a rapid reallocation of capital and labor toward the most productive firms. Similarly, if large household debts threaten recovery, governments should consider cost-effective debt restructuring programs aimed at transferring resources to relatively vulnerable individuals who are more likely to spend their income. These programs should, by their design, seek to minimize moral hazard. In short, the recent surge in indebtedness of households and firms poses risks to the pace of recovery. Yet this risk is not equally distributed. Careful, real-time monitoring of the balance sheets of low-income households and vulnerable firms is key to calibrating the unwinding of support measures. This could prevent sudden distress when financial conditions tighten. —This blog, based on Analytical Chapter 2 of the April 2022 World Economic Outlook, “Private Sector Debt and the Global Recovery,” also reflects support from Evgenia Pugacheva and Yarou Xu. (IMAGE: ILGOR KUTYAEV/ISTOCK BY GETTY IMAGES) | By Andrea Deghi, Fabio Natalucci and Mahvash S. Qureshi The pandemic has left emerging-market banks holding record levels of government debt, increasing the odds that pressures on public-sector finances could threaten financial stability. Authorities should act quickly to minimize that risk. Governments around the world have spent aggressively to help households and employers weather the economic impact of the pandemic. Public debt has mounted as governments have issued bonds to cover their budget deficits. The average ratio of public debt to gross domestic product—a key measure of a country’s fiscal health—rose to a record 67 percent last year in emerging market countries, according to Chapter 2 of the IMF’s April 2022 Global Financial Stability Report. Emerging-market banks have provided most of that credit, driving holdings of government debt as a percentage of their assets to a record 17 percent in 2021. In some economies, government debt amounts to a quarter of bank assets. The result: emerging-market governments rely heavily on their banks for credit, and these banks rely heavily on government bonds as an investment that they can use as collateral for securing funding from the central bank.  Economists have a name for this interdependence between banks and governments. They call it the “sovereign-bank nexus,” because government debt is also known as sovereign debt—a vestige of the Middle Ages, when kings and queens did the borrowing. There is reason to worry about this nexus. Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines. That could force banks—especially those with less capital—to curtail lending to companies and households, weighing on economic activity. As the economy slows and tax revenues shrivel, government finances could come under even more pressure, further squeezing banks. And so on. The sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop that ultimately could force the government into default. There is a name for that, too—the “doom loop.” It happened in Russia in 1998 and in Argentina in 2001-02.  Now, emerging-market economies are at greater risk than advanced economies for two reasons. For one, their growth prospects are weaker relative to the pre-pandemic trend compared with advanced economies, and governments have less fiscal firepower to support the economy. For another, external financing costs have generally risen, so governments will have to pay more to borrow. What could trigger the doom loop in a country? A sharp tightening of global financial conditions—resulting in higher interest rates and weaker currencies on the back of monetary policy normalization in advanced economies and intensifying geopolitical tensions caused by the war in Ukraine—could undermine investor confidence in the ability of emerging-market governments to repay debts. A domestic shock, such as an unexpected economic slowdown, could have the same effect. Risk channels So far, we have discussed one channel of risk—banks’ exposure to sovereign debt. Chapter 2 of the GFSR outlines two other potential channels through which risk is transmitted between the sovereign and banking sectors. One relates to government programs, such as deposit insurance, intended to support banks in times of stress. Strains on government finances could hurt the credibility of those guarantees, weaken investor confidence, and ultimately hurt banks’ profitability. Troubled lenders would then have to turn to government bailouts, further straining public-sector finances. Another channel works through the broader economy. A blow to public finances could push economy-wide interest rates higher, hurting corporate profitability and increasing credit risk for banks. That in turn would limit banks’ ability to lend to households and other corporate customers, curbing economic growth. Fiscal prudence, bank resilience All of this could put some emerging-market governments in a tough spot. On one hand, a sluggish recovery means they should continue to spend to support growth. But rising returns in advanced economies as central banks start to normalize monetary policy could make emerging-market debt less attractive and put upward pressure on borrowing costs. So fiscal prudence is needed to avoid a further intensification of the sovereign-bank nexus. Governments can also bolster investor confidence in their own finances by drawing up credible plans to narrow deficits over the medium term. Strengthening banking-sector resilience by conserving loss-absorbing capital buffers is also important. This can be done by limiting the amount of money that banks distribute to shareholders through dividends and stock buybacks, given heightened uncertainty about the economic outlook. In addition, asset quality reviews to guide adequate levels of capital may be necessary to quantify hidden losses and identify weak banks once forbearance has ceased. What else can policymakers do to protect themselves? Solutions will have to be tailored to the circumstances of each country, which vary widely. But broadly, they should: - Develop resolution frameworks for sovereign domestic debt to facilitate orderly deleveraging and restructuring in case they are needed;
- Improve transparency on all banks’ material sovereign exposures to assess the risks from possible sovereign distress;
- Conduct bank stress tests by taking into account the multiple channels of risk transmission in the nexus;
- Consider options to weaken the nexus—such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds—once the economic recovery is more firmly established and depending on market circumstances;
- Strengthen procedures to wind down banks in an orderly fashion if needed and to provide liquidity in a crisis;
- Promote a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets.
With the right policies, emerging-market economies can lessen the sovereign-bank nexus and reduce the risk of a financial or economic crisis. |
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