(Credit: IMF Photos) By Tobias Adrian Banking oversight was significantly strengthened after the global financial crisis, in part by requirements for banks to hold more capital and liquid assets and be stress tested to help ensure resilience to adverse shocks. Yet the global financial system is showing considerable strains as rising interest rates shake trust in some institutions. The failures of Silicon Valley Bank and Signature Bank in the United States—caused by the fleeing of uninsured depositors out of the realization that high interest rates have led to large losses in these banks’ securities portfolios—and the government supported acquisition of Switzerland’s Credit Suisse by rival UBS have rocked market confidence and triggered significant emergency responses by authorities. Our latest Global Financial Stability Report shows that risks to bank and nonbank financial intermediaries have increased as interest rates have been rapidly raised to contain inflation. Historically, such forceful rate increases by central banks are often followed by stresses that expose fault lines in the financial system.  |
In its role of assessing global financial stability, the IMF has flagged gaps in the supervision, regulation, and resolution of financial institutions. Previous Global Financial Stability Reports warned of strains in bank and nonbank financial intermediaries in the face of higher interest rates. It’s not 2008 While the banking turmoil has raised financial stability risks, its roots are fundamentally different from those of the global financial crisis. Before 2008, most banks were woefully undercapitalized by today’s standards, held far fewer liquid assets, and had much more exposure to credit risk. In addition, there was excessive maturity and credit risk transformation of the broader financial system, high degrees of complexity of financial instruments, and risky assets predominantly funded by short-term loans. Troubles that began at some banks quickly spread to nonbank financial firms and other entities through their interconnections. The recent turmoil is different. The banking system has much more capital and funding to weather adverse shocks, off balance sheet entities have been unwound, and credit risks have been curbed by more stringent post-crisis regulations. Instead, it was a meeting between the steep and rapid rise in interest rates and fast-growing financial institutions that were unprepared for the rise. At the same time, we also learned that troubles at smaller institutions can shake broader financial market confidence, particularly as persistently high inflation continues to cause losses on banks’ assets. In this sense, the current turmoil is more akin to the 1980s savings and loan crisis and the events leading up to the 1984 failure of Continental Illinois National Bank and Trust Co., which was then the largest in US history. These institutions were less capitalized and had unstable deposits. Growing threats Recently, bank stocks have declined on the industry’s travails, which have raised the cost of funding of banks and may well lead to curtailed lending. At the same time, perhaps surprisingly, overall financial conditions have not tightened meaningfully and remain looser than in October. Equity valuations remain stretched, notably in the United States. Modestly wider corporate credit spreads are largely offset by lower interest rates. Investors are therefore pricing a fairly optimistic scenario and expect inflation to decline without much more increases in interest rates. While market participants see recession probabilities as high, they also expect the depth of the recession to be modest. This sanguine view could be challenged by further acceleration of inflation, resulting in a reassessment by investors of the path of interest rates and possibly leading to an abrupt tightening in financial conditions. Stresses could then re-emerge in the financial system. Trust—the foundation of finance—could continue to erode. Funding could disappear rapidly for banks and nonbanks, and fears could spread, amplified by social media and private chat groups. Nonbank financial firms—a fast growing part of the financial system—could also be exposed to credit risk deterioration associated with a slowing economy. For example, some real estate funds have seen large declines in their asset valuations. Shares of banks in major emerging market economies have so far experienced little contagion from the banking turmoil in the United States and Europe. Many of these lenders are less exposed to the risk of rising interest rates, but they generally hold assets with lower credit quality, and some have less deposit insurance coverage. Furthermore, high sovereign debt vulnerabilities are pressuring many lower-rated emerging market and frontier economies, with potential spillovers effects to their banking sectors. Quantifying risks Our growth-at-risk metric, a measure of risks to global economic growth from financial instability, indicates about a 1-in-20 chance that world output could contract by 1.3 percent over the next year. There’s an equal probability that gross domestic product could shrink by 2.8 percent in a severe tightening of financial conditions in which corporate and sovereign spreads widen, stock prices fall, and currencies weaken in most emerging economies. Resolute policies Faced with heightened risks to financial stability, policymakers must act resolutely to maintain trust. Gaps in surveillance, supervision, and regulation should be addressed at once. Resolution regimes and deposit insurance programs should be strengthened in many countries. In acute crisis management situations, central banks may need to expand funding support to both bank and nonbank institutions. These tools would help central banks maintain financial stability, allowing monetary policy to focus on achieving price stability. If financial sector distress was to have severe repercussions affecting the broader economy, policymakers may need to adjust the stance of monetary policy to support financial stability. If so, they should clearly communicate their continued resolve to bring inflation back to target as soon as possible once financial stress lessens. —This blog is based on Chapter 1 of the April 2023 Global Financial Stability Report, “A Financial System Tested by Higher Inflation and Interest Rates.” | (Credit: deberrar/Adobe Stock) By Pierre-Olivier Gourinchas Read this blog here to view our country-by-country table of World Economic Outlook projections and interactive charts.The global economy’s gradual recovery from both the pandemic and Russia’s invasion of Ukraine remains on track. China’s reopened economy is rebounding strongly. Supply chain disruptions are unwinding, while dislocations to energy and food markets caused by the war are receding. Simultaneously, the massive and synchronized tightening of monetary policy by most central banks should start to bear fruit, with inflation moving back towards targets. We forecast in our latest World Economic Outlook that growth will bottom out at 2.8 percent this year before rising modestly to 3 percent next year—0.1 percentage points below our January projections. Global inflation will fall, though more slowly than initially anticipated, from 8.7 percent last year to 7 percent this year and 4.9 percent in 2024.  This year’s economic slowdown is concentrated in advanced economies, especially the euro area and the United Kingdom, where growth is expected to fall to 0.8 percent and -0.3 percent this year before rebounding to 1.4 and 1 percent respectively. By contrast, despite a 0.5 percentage point downward revision, many emerging market and developing economies are picking up, with year-end to year-end growth accelerating to 4.5 percent in 2023 from 2.8 percent in 2022. Risks Recent banking instability reminds us, however, that the situation remains fragile. Once again, downside risks dominate and the fog around the world economic outlook has thickened. First, inflation is much stickier than anticipated, even a few months ago. While global inflation has declined, that reflects mostly the sharp reversal in energy and food prices. But core inflation, which excludes energy and food, has not yet peaked in many countries. We expect year-end to year-end core inflation will slow to 5.1 percent this year, a sizeable upward revision of 0.6 percentage points from our January update, and well above target. Moreover, activity shows signs of resilience as labor markets remain very strong in most advanced economies. At this point in the tightening cycle, we would expect to see more signs of output and employment softening. Instead, our output and inflation estimates have been revised upwards for the last two quarters, suggesting stronger-than-expected aggregate demand. This may call for monetary policy to tighten further or to stay tighter for longer than currently anticipated. Should we worry about the risk of an uncontrolled wage-price spiral? At this point, I remain unconvinced. Nominal wage gains continue to lag price increases, implying a decline in real wages. Somewhat paradoxically, this is happening while labor demand is very strong, with firms posting many vacancies, and while labor supply remains weak— many workers have not fully rejoined the labor force after the pandemic. This suggests real wages should increase, and I expect they will. But corporate margins have surged in recent years—this is the flip side of steeply higher prices but only modestly higher wages—and should be able to absorb much of the rising labor costs, on average. Provided inflation expectations remain well-anchored, that process should not spin out of control. It may well, however, take longer than anticipated. It was never going to be an easy ride More worrisome are the side effects that the sharp monetary policy tightening of the last year is starting to have on the financial sector, as we have repeatedly warned might happen. Perhaps the surprise is that it took so long. Following a prolonged period of muted inflation and low interest rates, the financial sector had become too complacent about maturity and liquidity mismatches. Last year’s rapid tightening of monetary policy triggered sizable losses on long-term fixed-income assets and raised funding costs. The stability of any financial system hinges on its ability to absorb losses without recourse to taxpayers’ money. The brief instability in the United Kingdom’s gilt market last fall and the recent banking turbulence in the United States underscore that significant vulnerabilities exist both among banks and nonbank financial intermediaries. In both cases, financial and monetary authorities took quick and strong action and, so far, have prevented further instability. Our World Economic Outlook explores a scenario where banks, faced with rising funding costs and the need to act more prudently, cut down lending further. This leads to an additional 0.3 percent reduction in output this year. Yet, the financial system may well be tested even more. Nervous investors often look for the next weakest link, as they did with Crédit Suisse, a globally systemic but ailing European bank. Financial institutions with excess leverage, credit risk or interest rate exposure, too much dependence on short-term funding, or located in jurisdictions with limited fiscal space could become the next target. So could countries with weaker perceived fundamentals.  A sharp tightening of global financial conditions—a so-called ‘risk-off’ event—could have a dramatic impact on credit conditions and public finances, especially in emerging market and developing economies. It would precipitate large capital outflows, a sudden increase in risk premia, a dollar appreciation in a rush to safety, and major declines in global activity amid lower confidence, household spending and investment. In such a severe downside scenario, global growth could slow to 1 percent this year, implying near stagnant income per capita. We estimate the probability of such an outcome at about 15 percent.  We are therefore entering a tricky phase during which economic growth remains lackluster by historical standards, financial risks have risen, yet inflation has not yet decisively turned the corner. Policies More than ever, policymakers need a steady hand and clear communication. With financial instability contained, monetary policy should remain focused on bringing inflation down, but stand ready to quickly adjust to financial developments. A silver lining is that the banking turmoil will help slow aggregate activity as banks curtail lending. In and of itself, this should partially mitigate the need for further monetary tightening to achieve the same policy stance. But any expectation that central banks will prematurely surrender the inflation fight would have the opposite effect: lowering yields, supporting activity beyond what is warranted, and ultimately complicating the task of monetary authorities. Fiscal policy can also play an active role. By cooling off economic activity, tighter fiscal policy would support monetary policy, allowing real interest rates to return faster to a low natural level. Appropriately designed fiscal consolidation will also help rebuild much needed buffers and help strengthen financial stability. While fiscal policy is turning less expansionary in many countries this year, more could be done to regain fiscal space. Regulators and supervisors should also act now to ensure remaining financial fragilities don’t morph into a full-blown crisis by strengthening oversight and actively managing market strains. For emerging market and developing economies, this also means ensuring proper access to the Global Financial Safety Net, including the IMF’s precautionary arrangements, access to the US Federal Reserve Foreign and International Monetary Authorities repo facility, or to central bank swap lines, where relevant. Exchange rates should be allowed to adjust as much as possible unless doing so raises financial stability risks or threatens price stability, in line with our Integrated Policy Framework.  Our latest projections also indicate an overall slowdown in medium-term growth forecasts. Five-year ahead growth projections declined steadily from 4.6 percent in 2011 to 3 percent in 2023. Some of this decline reflects the growth slowdown of previously rapidly growing economies such as China or Korea. This is predictable: growth slows down as countries converge. But some of the more recent slowdown may also reflect more ominous forces: the scarring impact of the pandemic, a slower pace of structural reforms, as well as the rising and increasingly real threat of geoeconomic fragmentation leading to more trade tensions, less direct investment and a slower pace of innovation and technology adoption across fragmented ‘blocks.’ A fragmented world is unlikely to achieve progress for all, or to successfully tackle global challenges such as climate change or pandemic preparedness. We must avoid that path at all costs. —This blog is based on Chapter 1 of the April 2023 World Economic Outlook : “A Rocky Recovery.” | (Credit: Kim Haughton/IMF Photo) By Adrian Peralta-Alva and Prachi Mishra Public debt soared to a record during the pandemic, topping global gross domestic product. Now, with government debt still elevated, the rise in interest rates and the strong US dollar are adding to interest costs, in turn weighing on growth and fueling financial stability risks. With several economies already in debt distress, we explore in an analytical chapter of our latest World Economic Outlook what policies work best to durably reduce public debt ratios (or debt to GDP).  Using two decades of data, we find that an adequately tailored fiscal contraction of about 0.4 percentage point of GDP—the average size in our sample—lowers the debt ratio by 0.7 percentage point in the first year and up to 2.1 percentage points after five years. But the timing of the adjustment can impact what effect it has. The probability of reducing debt ratios through consolidation improves from the baseline (average) of about half to three-quarters when undertaken during a domestic and global boom or periods during which financial conditions are loose and uncertainty is low.  Design also matters. In advanced economies, spending cuts are more likely to lower debt ratios than increasing revenues. Odds of success also improve when fiscal consolidation is reinforced by growth enhancing structural reforms and strong institutional frameworks. This explains why fiscal consolidation hasn't typically reduced debt ratios in the past—the right conditions and accompanying policies weren’t present. There are important factors for why fiscal consolidation alone didn’t reduce the debt ratio level in about half of the cases: first fiscal consolidation tends to slow GDP growth( see Chapter 3 of the 2010 WEO). Second, exchange rate fluctuations and transfers to state-owned enterprises or contingent liabilities can offset debt reduction efforts. These “below-the-line” operations can increase debt, despite improvements in the primary balance (which would ordinarily drive down debt). Examples include unexpected transfers that the government provided to state-owned enterprises in Mexico (2016), and clearance of payments past due by the government in Greece (2016), which were all recorded as below the line items in the fiscal account. Debt restructuring While well-designed fiscal consolidation and growth-friendly structural reforms can help reduce debt ratios, they may not be sufficient for countries in debt distress or facing increased rollover risks. In such cases, debt restructuring—a renegotiation of the terms of a loan—may be necessary. Restructuring is typically used as a last resort. It’s a complex process that requires the agreement of domestic and foreign creditors and involves burden sharing between different parties (for example, between residents and banks in most domestic restructurings). It can incur significant economic costs and there are reputational risks and coordination challenges. But when combined with fiscal consolidation, it can significantly reduce debt ratios—on average, up to 8 percentage points or more after 5 years in emerging markets and low-income countries. Seychelles, for example, had a debt ratio of over 180 percent in 2008, when the global financial crisis hit. After debt restructurings with both official Paris Club and private external creditors that involved a large reduction in face value of debt, this ratio sharply declined to 84 percent in 2010. Prudent fiscal policy combined with high GDP growth helped sustain the reduction in debt ratios. We also found that it matters how deep the restructuring is. Public debt in Belize remained elevated despite two sequential restructurings, suggesting that even when done early, debt will stay high if the treatment is not deep enough. By contrast, debt ratios in Jamaica were significantly reduced with early and deep restructurings that were executed through an extension of maturity and a reduction in coupon payments rather than a reduction in the face value of debt. Notably, the fiscal space created by the debt service relief from restructuring was saved, as reflected in its strong fiscal consolidation.  For countries that can afford a moderate and gradual reduction in debt ratios, it’s best to undertake fiscal consolidation when conditions are favorable, along with policies that include structural reforms aimed at promoting growth. Having strong institutional frameworks can prevent "below the line" operations that undermine debt reduction efforts and ensure that countries indeed build buffers and reduce debt during good times. Countries facing increased funding pressures or already in debt distress may have no viable alternative than a substantial or rapid debt reduction. Fiscal consolidation will likely be needed to regain market confidence and recover macroeconomic stability in these countries. In addition, policymakers should also consider timely debt restructuring. If pursued, the restructuring will need to be deep to reduce debt ratios. For restructurings to succeed, global policymakers must also promote mechanisms to enhance coordination and confidence among creditors and debtors. The Group of Twenty Common Framework should be improved to bring greater predictability, earlier engagement, a payment standstill, and further clarification on comparability of treatment. This blog is based on Chapter 3 of the April 2023 World Economic Outlook, “How to Tackle Soaring Public Debt.” The authors of the chapter are Sakai Ando, Tamon Asonuma, Alexandre Balduino Sollaci, Giovanni Ganelli, Prachi Mishra (co-lead), Nikhil Patel, Adrian Peralta-Alva (co-lead) and Andrea Presbitero, with support from Carlos Angulo, Zhuo Chen, Sergio Garcia and Youyou Huang. | (Credit: ultramansk/Adobe Stock) By Jean-Marc Natal and Philip Barrett Real interest rates have rapidly increased recently as monetary policy has tightened in response to higher inflation. Whether this uptick is temporary or partly reflects structural factors is an important question for policymakers. Since the mid-1980s, real interest rates at all maturities and across most advanced economies have been steadily declining. Such long-run changes in real rates likely reflect a decline in the natural rate, which is the real interest rate that would keep inflation at target and the economy operating at full employment–neither expansionary nor contractionary. The natural rate is a reference point for central banks that use it to gauge the stance of monetary policy. It is also important for fiscal policy. Because governments typically pay back debt over decades, the natural rate—the anchor for real rates in the long term—helps determine the cost of borrowing and the sustainability of public debts.  In an analytical chapter of our latest World Economic Outlook, we explore what forces have driven the natural rate in the past and what is the most likely future path for real interest rates in advanced and emerging market economies, based on the outlook for these factors. Historical drivers of natural rates An important question when analyzing past synchronized declines in real interest rates is how much they were driven by domestic as opposed to global forces. Does productivity growth in China and the rest of the world, for instance, matter for real interest rates in the United States? Our analysis concludes that global forces matter, but that their net effect on the natural rate has been relatively modest. Fast growing emerging market economies acted as a magnet for advanced economies’ savings, lifting their natural rate up as investors took advantage of higher rates of return abroad. However, because savings in emerging markets accumulated faster than these countries’ ability to provide safe and liquid assets, much of it was reinvested in advanced economies’ government securities—such as US Treasuries—pushing their natural rate back down, especially since the global financial crisis in 2008. To investigate this issue in more depth, we use a detailed structural model to identify the most important forces that can explain comovement in natural rates over the past 40 years. On top of global forces that impact net capital flows, we find that total factor productivity growth (the total amount of output produced with all factor inputs in the economy) and demographic forces, such as changes in fertility and mortality rates or time spent in retirement, are major drivers of the decline in natural rates. Higher fiscal financing needs have pushed up real rates in some countries, like in Japan and Brazil. Other factors, such as the increase in inequality or drop in labor shares have also played a role, but to a lesser extent. In emerging markets, the picture is more mixed with some countries, like India, seeing an increase in the natural rate over the period.  Outlook for real interest rates These factors are not likely to behave very differently in the future, so natural rates in advanced economies will likely remain low. As emerging market economies adopt more advanced technology, total factor productivity growth is expected to converge to the pace of advanced economies. When combined with an aging population, natural rates in emerging market economies are projected to decline towards advanced economies’ rates over the long term. Of course, this projection is as good as the projection of the underlying drivers. In the current post-pandemic context, alternative assumptions could be relevant: - Government support may be difficult to withdraw, increasing public debt. As a result, so-called convenience yields—the premium paid by investors in the form of foregone interest for holding scarce, safe, and liquid government debt—may erode, raising natural rates in the process.
- Transitioning to a cleaner economy in a budget neutral way would tend to push global natural rates lower in the medium term, as higher energy prices (reflecting a combination of taxes and regulations) would bring down the marginal productivity of capital. However, deficit-financing of public investment in green infrastructure and subsidies could potentially offset and even reverse this result.
- Deglobalization forces could intensify, leading to both trade and financial fragmentation, and bringing the natural rate up in advanced economies and down in emerging market economies.
Individually these scenarios would have only limited effects on the natural rate but a combination, especially of the first and third scenarios, could have a significant impact in the long run.  Overall, our analysis suggests that recent increases in real interest rates are likely to be temporary. When inflation is brought back under control, advanced economies’ central banks are likely to ease monetary policy and bring real interest rates back towards pre-pandemic levels. How close to those levels will depend on whether alternative scenarios involving persistently higher government debt and deficits, or financial fragmentation materialize. In large emerging markets, conservative projections of future demographic and productivity trends suggest a gradual convergence towards advanced economies’ real interest rates. This blog is based on Chapter 2 of the April 2023 World Economic Outlook,“The Natural Rate of Interest: Drivers and Implications for Policy." The authors of the chapter are Philip Barrett (co-lead), Christoffer Koch, Jean-Marc Natal (co-lead), Diaa Noureldin, and Josef Platzer, with support from Yaniv Cohen and Cynthia Nyakeri. |
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