Rising interest rates and market volatility signal growing risks to financial stability

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Financial conditions have tightened as central banks continue to raise interest rates. In a highly uncertain global environment, risks to financial stability have increased significantly.

The main issues facing financial systems include inflation at its highest level in decades, the continued deterioration of economic prospects in many regions and persistent geopolitical risks, as we explain in our latest stability report. global finance.

To prevent inflationary pressures from taking root, central banks faced with stubbornly high inflation had to accelerate the tightening of monetary policy. Moreover, people in advanced and emerging economies also face heightened risks and vulnerabilities across different sectors and regions.

Financial vulnerabilities are high for governments, many of which are indebted, as well as for non-bank financial institutions such as insurers, pension funds, hedge funds and mutual funds. Rising rates added to the strains for entities with stretched balance sheets.

At the same time, the ease and speed with which assets can be traded at a given price has deteriorated in some key asset classes due to volatility in interest rates and asset prices. This low market liquidity, coupled with pre-existing vulnerabilities, could amplify any rapid and disorderly repricing of risk, should it occur in the coming months.

Global markets are under stress as investors have recently become more risk averse amid heightened economic and political uncertainty. Financial asset prices have fallen as monetary policy has tightened, the economic outlook has deteriorated, recession fears have increased, hard currency borrowing has become more expensive and strains in some financial institutions not banking accelerated. Bond yields are rising globally across all credit ratings, with borrowing costs for many countries and companies already hitting the highest levels in a decade or more.

Real estate concerns

The failing real estate sector in many countries raises concerns about risks that could spread and ripple through banks and the macroeconomy. Risks to housing markets are increasing due to rising mortgage rates and tightening lending standards, with many potential borrowers now being squeezed out of the markets. Stretched home valuations could adjust sharply in some segments of the market.

Emerging markets face a host of risks, including high external borrowing costs, stubbornly high inflation and volatile commodity markets. They also face heightened uncertainty about the global economy and tighter policies in advanced economies.

Tensions are particularly high in frontier markets

— typically smaller developing economies — where challenges arise from a combination of tighter financial conditions, deteriorating fundamentals and high exposure to commodity price volatility.

So far, investors have continued to differentiate between emerging economies.

While many frontier markets are exposed to sovereign default risk, many of the largest emerging markets are more resilient to external vulnerabilities to date. Having said that,

after the stabilization of outflows in the first half of the year, foreign investors fell back again.

Emerging and frontier market bond issuance in US dollars and other major currencies has slowed to its weakest pace since 2015. Without better access to foreign funding, many frontier market issuers will have to seek alternative sources and/or debt reprofiling and restructurings.

The global banking sector has been supported by high levels of capital and ample liquidity reserves. However, the IMF’s Global Banking Stress Test warns that these reserves may not be sufficient for some banks. In the event that a sharp tightening of financial conditions causes a global recession next year amid high inflation, 29% of emerging market banks (in terms of assets) would fail to meet capital requirements. Most banks in advanced economies would fare much better, the stress test indicates.

The challenging macroeconomic environment is also putting pressure on the global corporate sector. Credit spreads have widened dramatically and high costs are eroding corporate profits. For small businesses, bankruptcies have already started to rise due to rising borrowing costs and declining fiscal support.

Policy recommendations

Central banks must act resolutely to bring inflation back to target and avoid an unanchoring of inflation expectations that would harm their credibility. Clear communication on policy decisions, commitment to price stability and the need for further tightening will be crucial to maintaining credibility and avoiding market volatility.

Exchange rate flexibility helps countries adjust to the differential pace of monetary policy tightening across countries. In cases where exchange rate movements impede the central bank’s monetary transmission mechanism and/or generate wider risks to financial stability, foreign exchange intervention may be deployed. Such interventions should be part of an integrated approach to addressing vulnerabilities, as outlined in the IMF strategy.

Integrated strategic framework .

Emerging and frontier markets should reduce debt risk through early engagement with creditors, multilateral cooperation and international support. For those in trouble, bilateral and private sector creditors should coordinate preventive restructuring to avoid costly defaults and prolonged loss of market access. Where appropriate, the common framework of the Group of Twenty should be used.

Policymakers face an exceptionally challenging financial stability environment. Although no global systemic events have materialized so far, they should contain a further build-up of vulnerabilities by adjusting some macroprudential tools to address all pockets of risk. In this highly uncertain environment, it will be essential to find a balance between containing these potential threats and avoiding a disorderly tightening of financial conditions.

—This blog is based on Chapter 1 of the October 2022 Global Financial Stability Report, “Financial Stability in the New High Inflation Environment.”

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