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| | (Credit: Adobe Stock) By Mario Catalán, Fabio Natalucci, Mahvash S. Qureshi, and Tomohiro Tsuruga Concerns about global economic and financial fragmentation have intensified in recent years amid rising geopolitical tensions, strained ties between the United States and China, and Russia’s invasion of Ukraine. Financial fragmentation has important implications for global financial stability by affecting cross-border investment, international payment systems, and asset prices. This in turn fuels instability by increasing banks’ funding costs, lowering their profitability, and reducing their lending to the private sector. Effects on cross-border investment Geopolitical tensions, measured by the divergence in countries’ voting behavior in the United Nations General Assembly, can play a big role in cross-border portfolio and bank allocation, as we write in an analytical chapter of the latest Global Financial Stability Report . An increase in tensions between an investing and a recipient country, such as between the United States and China since 2016, reduces overall bilateral cross-border allocation of portfolio investment and bank claims by about 15 percent. Investment funds are particularly sensitive to geopolitical tensions and tend to reduce cross-border allocations notably to countries with a diverging foreign policy outlook.  Financial stability risks Geopolitical tensions threaten financial stability through a financial channel. Imposition of financial restrictions, increased uncertainty, and cross-border credit and investment outflows triggered by an escalation of tensions could increase banks’ debt rollover risks and funding costs. It could also drive-up interest rates on government bonds, reducing the values of banks’ assets and adding to their funding costs. At the same time, geopolitical tensions are transmitted to banks through the real economy. The effect of disruptions to supply chains and commodity markets on domestic growth and inflation could exacerbate banks’ market and credit losses, further reducing their profitability and capitalization. The stress is likely to diminish the risk-taking capacity of banks, prompting them to cut lending, further weighing on economic growth. The financial and real-economy channels are likely to feed off one another, with the overall effect being disproportionately larger for banks in emerging markets and developing economies, and for those with lower capitalization ratios.  In the longer run, greater financial fragmentation stemming from geopolitical tensions could also roil capital flows and key economic and financial market indicators by limiting the possibilities for international risk diversification, such as by reducing the number of countries in which domestic residents can invest. How to curb risks Supervisors, regulators, and financial institutions should be aware of the risks to financial stability stemming from a potential rise in geopolitical tensions and commit to identify, quantify, manage, and mitigate these threats. A better understanding and monitoring of the interactions between geopolitical risks and more traditional ones related to credit, interest rate, market, liquidity, and operations could help prevent a potentially destabilizing fallout from geopolitical events. To develop actionable guidelines for supervisors, policymakers should adopt a systematic approach that employs stress testing and scenario analysis to assess and quantify transmission channels of geopolitical shocks to financial institutions. Other steps include: In response to rising geopolitical risks, economies reliant on external financing should ensure an adequate level of international reserves, as well as capital and liquidity buffers at financial institutions. - Policymakers should strengthen crisis preparedness and management frameworks to deal with potential financial instability arising from heightened geopolitical tensions. Cooperative arrangements between different national authorities should continue to help ensure effective management and containment of international financial crises, including through development of effective resolution mechanisms for financial institutions that operate in multiple jurisdictions.
- The global financial safety net—a set of institutions and mechanisms that insure against crises and financing to mitigate their impact—must be reinforced through mutual assistance agreements between countries. These would include regional safety nets, currency swaps, or fiscal mechanisms—and precautionary credit lines from international financial institutions.
- In the face of geopolitical risks, efforts by international regulatory and standard-setting bodies, such as the Financial Stability Board and the Basel Committee on Banking Supervision, should continue to promote common financial regulations and standards to prevent an increase in financial fragmentation.
Ultimately, policymakers should be aware that imposing financial restrictions for national security reasons could have unintended consequences for global macro-financial stability. Given the significant risks to global macro-financial stability, multilateral efforts should be strengthened to reduce geopolitical tensions and economic and financial fragmentation. —This blog is based on Chapter 3 of the April 2023 Global Financial Stability Report,“Geopolitics and Financial Fragmentation: Implications for Macro-Financial Stability." Dear maria, We just published a new blog—please find the full text below. |
| | (Credit: Shivendu Shukla/Unsplash) By JaeBin Ahn, Ashique Habib, Davide Malacrino , and Andrea F. Presbitero As geopolitical tensions rise, companies and policymakers are increasingly looking at strategies to make supply chains more resilient by moving production home or to trusted countries. The US Treasury Secretary argued in April 2022 that firms should move towards the friend-shoring of supply chains. More recently, the European Commission proposed the Net Zero Industry Act to counter the subsidies in the US Inflation Reduction Act. And China aims to replace imported technology with local alternatives to depend less on geopolitical rivals. These examples highlight the rising trend of geoeconomic fragmentation, as we show in an analytical chapter of the latest World Economic Outlook. Our analysis of the impact on foreign direct investment shows that such flows have been characterized by divergent patterns across host countries, particularly in strategic sectors, like semiconductors. The flow of strategic FDI to Asian countries started to decline in 2019 and has recovered only mildly in recent quarters, except for flows to China that have not yet recovered.  Over the last decade, the share of FDI flows among geopolitically aligned economies has kept rising, more than the share for countries that are closer geographically, suggesting that geopolitical preferences increasingly drive the geographic footprint of FDI.  These trends also indicate that if geopolitical tensions continue to intensify and countries further diverge along geopolitical fault lines, FDI may become even more concentrated within blocs of aligned countries. Along with shifts in new flows, we also explore whether increasing fragmentation could lead to existing direct investments being relocated by building an index of countries’ exposure to such developments. Emerging market and developing economies are more vulnerable to FDI relocation than advanced economies, in part because they rely more on flows from more geopolitically distant countries. Several large emerging economies are vulnerable to the relocation of FDI, indicating that fragmentation risk isn’t just concentrated in a few countries. Nor are advanced economies immune, particularly those with significant FDI stocks in strategic sectors. As vulnerabilities can also extend to non-FDI flows, which is detailed in an accompanying analytical chapter of the April 2023 Global Financial Stability Report, a rise in political tensions could trigger a large reallocation of capital flows at the global level.  While reconfigured supply chains could potentially strengthen national security and help maintain a technological advantage over geopolitical rivals, reshoring or friend-shoring to existing partners will often reduce diversification and make countries more vulnerable to macroeconomic shocks. In addition, our new analysis suggests that relocating FDI closer to source countries could hurt host economies through reduced access to capital and technological advances. Our analysis finds that the entry of multinational corporations in foreign countries often directly benefits domestic firms. In advanced economies, increased competition from foreign firms spurs domestic enterprises to be more productive. In emerging market and developing economies, domestic suppliers benefit from technology transfers and increased local demand for components that end up being used in downstream industries. These benefits are more likely when foreign companies enter a country to produce inputs that will be supplied to affiliated firms—think of the Samsung Electronics semiconductor factory in Vietnam that, makes products sold mainly to other units of the Korean conglomerate around the world. This is because this type of vertical FDI is concentrated among intermediate-goods producers that deploy more sophisticated and skill-intensive technology. Poorer world Finally, we use hypothetical scenarios to illustrate the possible impact of long-term fragmentation of investment flows. In general, a fragmented world is likely to be a poorer one. We estimate that long-term global output losses are close to 2 percent of world gross domestic product. These losses are likely to be unevenly distributed. Emerging market and developing economies are particularly affected by reduced access to investment from advanced economies, due to reduced capital formation and productivity gains from the transfer of better technologies and know-how. While there may be winners from investment flow diversion, such gains are subject to substantial uncertainty. Some economies, such as those that remain open to different geopolitical blocs, could enjoy gains from redirected investment. Such benefits, however, are likely to be at least partly offset by spillovers from weaker external demand. In addition, in a fragmented world with heightened geopolitical tensions, investors may worry that nonaligned economies will be forced to choose one bloc or the other in the future, and such uncertainty could intensify losses. The widespread economic costs from FDI fragmentation suggest that policymakers should carefully balance the strategic motivations behind reshoring and friend-shoring against economic costs to their own economies and the spillovers to others. The estimated large and widespread long-term output losses show why it’s crucial to foster global integration—especially as major economies endorse inward-looking policies. At the same time, the current rules-based multilateral system must adapt to the changing world economy and should be complemented by credible mechanisms to mitigate spillovers from unilateral policy actions. As policy uncertainty amplifies losses from fragmentation, multilateral actions should be taken to minimize such uncertainty, including by improving information sharing through multilateral dialogue. The development of a framework for international consultations on, for instance, the use of subsidies to provide incentives for reshoring or friend-shoring of FDI could help governments identify unintended consequences. It could also mitigate cross-border spillovers by reducing uncertainty and promoting transparency on policy options. —This blog is based on Chapter 4 of the April 2023 World Economic Outlook:“Geoeconomic Fragmentation and Foreign Direct Investment.” |
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| | (Credit: gjp/iStock by Getty Images) By Antonio Garcia Pascual, Fabio Natalucci, and Thomas Piontek Recent strains at some banks in the United States and Europe are a powerful reminder of pockets of elevated financial vulnerabilities built over years of low rates, compressed volatility, and ample liquidity. Such risks could intensify in coming months amid the continued tightening of monetary policy globally, making it especially important to understand and safeguard this broad swath of the financial sector that comprises an array of institutions beyond banks. Nonbank financial intermediaries, including pension funds, insurers, and hedge funds, also play a key role in the global financial system by providing financial services and credit and thus supporting economic growth. The growth of the NBFI sector accelerated after the global financial crisis, accounting now for nearly 50 percent of global financial assets. As such, the smooth functioning of the nonbank sector is vital for financial stability. However, NBFI vulnerabilities appear to have increased in the past decade. As we show in an analytical chapter of the latest Global Financial Stability Report, NBFI stress tends to emerge alongside elevated leverage, for example borrowing money to finance their investments or boost returns, or using financial instruments, like derivatives. Stress is also brought on by liquidity mismatches, where an institution is unable to generate sufficient cash either through liquidation of assets, such as bonds or equities, or use of credit lines to satisfy investor redemption requests. Finally, high levels of interconnectedness among NBFIs and with traditional banks can also become a crucial amplification channel of financial stress. Last year’s UK pension fund and liability-driven investment strategies episode underscores the perilous interplay of leverage, liquidity risk, and interconnectedness. Concerns about the country’s fiscal outlook led to a sharp rise in UK sovereign bond yields that, in turn, led to large losses in defined-benefit pension fund investments that borrowed against such collateral, causing margin and collateral calls. To meet these calls, pension funds were forced to sell government bonds, pushing their yields even higher.  It is useful to take a step back and look at the current environment in which NBFIs find themselves. With the fastest inflation in decades, and with price stability at the core of most central bank mandates, injecting central bank liquidity for financial stability purposes could complicate the fight against inflation. In a low-inflation environment, central banks can respond to financial stress by easing policy such as cutting interest rates or purchasing assets to restore market functioning. Amid high inflation, however, challenging tradeoffs may emerge for central banks between fostering financial stability and achieving price stability during periods of stress that may threaten the health of the financial system. Policymakers need appropriate tools to tackle turmoil in the NBFI sector that may adversely affect financial stability. Robust surveillance, regulation, and supervision are essential pre-requisites. Policymakers must also narrow or eliminate gaps in regulatory reporting of key data, including how much risk firms are taking with their borrowing or use of derivatives. Policies are also needed to ensure NBFIs better manage risks, and this might be accomplished through timely and granular public data disclosures and governance requirements. These improvements in private sector risk management must be supported by appropriate prudential standards, including capital and liquidity requirements, alongside better resourced and stricter supervision. This would help steer the business decisions of the NBFIs themselves away from excessive risk taking by removing both the incentive and opportunity to take on too much risk. It would also likely reduce the need for and frequency of central bank intervention to provide liquidity support during systemic stress events. If central bank intervention is needed, they can consider three broad types of support: - Discretionary market-wide intervention should be temporary and targeted to those NBFI segments posing risk to financial stability. The timing is also critical—a framework should be in place where data-driven metrics trigger a potential intervention, while policymakers ultimately retain the discretion to intervene.
- Lender-of-last-resort intervention should be available when a systemically important nonbank institution comes under stress. Such lending should be at the discretion of the central bank, at a higher interest rate, fully collateralized, and accompanied by greater supervisory oversight. A clear timeline should be established for restoring the NBFI’s liquidity and return to market finance.
- Access to standing lending facilities could be granted to specific NBFI entities to reduce spillovers to the financial system, although the bar for such access should be very high to avoid moral hazard. Access should not be granted without the appropriate regulatory and supervisory regimes for the different types of NBFIs.
Clear communication is critical, so that liquidity support is not perceived to be working at cross-purposes with monetary policy. For example, purchasing assets to restore financial stability while continuing with quantitative tightening to bring inflation back to target may cloud intent and complicate communication. Announcements of central bank liquidity support should clearly explain the financial stability objectives, program parameters and timing. At the same time, cooperation between domestic policy makers and international coordination between national authorities is essential. This helps better identify risks and manage crises. Specifically, internationally coordinated reforms can reduce the risks of cross-border spillovers, regulatory arbitrage, and market fragmentation. Given the growing size and intermediation capacity of the NBFI sector globally, the development of the right toolbox for access to central bank liquidity, along with the appropriate guardrails limiting the need for its use, is a priority. The need to do so is all that much greater given that financial sector vulnerabilities could be poised to grow amid the continued tightening of monetary policy. —This blog is based on Chapter 2 of the April 2023 Global Financial Stability Report, “Nonbank Financial Intermediaries: Vulnerabilities Amid Tighter Financial Conditions.” |
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| | (Credit: Kim Haughton/IMF Photos) By Vitor Gaspar, Carlos Eduardo Goncalves, Paolo Mauro, and Marcos Poplawski-Ribeiro High inflation can impose serious and lasting costs on the economy and people. But the distributive effects of inflation—the way it transfers money from some individuals to others—are complex. To respond effectively to the sharpest upsurge in inflation in three decades and to address the damage done to households, policymakers should have a better understanding of how inflation affects various segments of society in different places. In our April 2023 Fiscal Monitor, we study the effects of (unexpected) inflation on people’s well-being from mid-2021 to mid-2022—a period when food and energy prices rose earlier and faster than other prices. The chapter offers several lessons for policymakers on the impact of inflation on households’ budgets and how fiscal policy can help curb inflation while supporting the vulnerable. Impact on public finances Analyzing how inflation affects public finances, our main finding is that unexpected inflation—such as in the recent episode—erodes the real value of government debt at the expense of bondholders. For countries with debt exceeding 50 percent of GDP, each percentage point of unexpected (“surprise”) increase in inflation reduces public debt by 0.6 percentage points of GDP, with the effect lasting for several years.  As inflation becomes persistent and better anticipated, however, it stops contributing to declining debt ratios. Likewise, deficit-to-GDP ratios initially decline as spending fails to keep pace with the rise in the monetary value of the economy’s output. But such effects fade even quicker. Impact on households Based on public surveys of thousands of households in six economies (Colombia, Finland, France, Kenya, Mexico, and Senegal), we find that inflation from mid-2021 to mid-2022 impacted people through three main channels: their consumption patterns; their income from wages, pensions, or transfers; and their assets and liabilities. The below chart displays the estimated effects of these channels to a developing economy (Kenya) and to an advanced economy (France), prior to any new government intervention in support of households.  Although the impact varies across countries (and across income groups), the surveys reveal that: - The faster rise in food prices compared to other prices hurt poor families disproportionately because food represents a higher share of their total consumption. This effect was most pronounced in low-income countries.
- Inflation eroded real incomes in commodity-importing countries, as wages across all income groups did not keep pace with prices.
- As inflation eroded the monetary value of assets and liabilities, families with negative net worth benefitted at the expense of creditors, particularly in countries with developed financial and credit markets.
- Redistributive wealth effects of inflation were also influenced by the age of the head of household: young families, which tend to be net borrowers, experienced gains through the wealth channels, whereas old households saw their wealth eroded.
Curbing inflation while protecting the vulnerable Fiscal policy can support monetary policy in dealing with inflation because it also affects aggregate demand. Our statistical evidence suggests that fiscal policy’s impact on inflation has changed over the decades. For advanced economies we find that, since 1985, reducing public expenditure by 1 percentage point of GDP lowers inflation by half a percentage point. In addition, fiscal policy can also help protect the vulnerable.  The economic model used in the chapter incorporates inequality in incomes, consumption, and asset holdings. It shows that when central banks act alone—without the support of fiscal policy—they need to hike interest rates substantially to fight inflation. Fiscal tightening makes it possible to increase interest rates by less to contain inflation. But to safeguard the poor—who benefit more from public services—tax hikes or cuts in lower-priority spending must be combined with larger transfers. This strategy results, by design, in no drop in consumption for the poor, but also in a lower decline in overall consumption. — This blog is based on Chapter 2 of the April 2023 Fiscal Monitor: “Inflation and Disinflation: What Role for Fiscal Policy?” |
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