The recent Financial Stability Report (April 2024) released by the International Monetary Fund has observed that the market sentiment has been buoyant since its last report (October, 2023) apparently due to the expectations that global disinflation is in its last mile and so it is imperative that the monetary policy will be easing world-wide. There are reasons to think positive in that direction, such as, the Interest rates were down worldwide, the stocks were rising and the corporate and sovereign borrowing spreads have narrowed notably.
Buoyancy seen across markets
As the global financial conditions have reportedly eased, many emerging markets are not only getting increased capital inflows but the likelihood that they are going to reverse anytime soon have also reportedly declined. This buoyancy across markets does not seem to be an issue of sentiment only, rather, the confidence is building up on account of better-than-expected economic data in many economies of the world.
Both the investors and central banks are hopeful that monetary policy may be eased in the coming periods as the restrictive monetary conditions largely reflected through cumulative interest rate increases over the past two years seem to have paid off and succeeded in bringing inflation back to most central banks’ targeted ranges.
However, it is observed that the global inflation continues to be above those targets and so there are chances that it may trigger instability. Disinflation is reported to be perhaps in the last mile but it is also true that inflationary forces have not disappeared for sure and so they may come back as well.
But at the same time, the good thing is that the financial system and even the external sectors have shown good amount of resilience particularly in the emerging markets despite the persistent increase in the interest rates under the monetary tightening. Even the bank failures in Switzerland and the United States that occurred in March 2023 did not have any trickle down impact in the other parts of the financial system and they continued to show signs of stability.
Ifs and buts remain
The IMF’s growth-at-risk framework analysis reflects that the near-term financial stability risks have receded and there is less of a downside risk to global growth in the coming year, but, there is also no denying the possibility that there exist several obvious near-term financial fragilities still and so you cannot just be sure that inflation would not turn its back again.
Talking about the banking sector, for example, even as the Salient Near-Term Risks Commercial real estate (CRE) prices have declined by 12 percent globally over the last one year in real terms amid rising interest rates and structural changes after the COVID-19 pandemic, the banks appear to be well positioned to absorb CRE losses in aggregate, yet the economies where the banks hold large amounts of CRE loans and the CRE segments are currently experiencing weak demand, there may be signs of strain popping up in the near term.
However, there are some balancing forces in the residential home exposures. The residential home prices have generally remained above pre-pandemic levels, yet they have continued to adjust downward in most countries due to higher mortgage rates. Yet, since the household debt sustainability ratios are at modest levels globally it is estimated that a surge in residential mortgage defaults remains a tail risk.
Decline in volatility is a sign of relief but be wary of surprises
Another positive note is in respect of most asset classes where volatility has reportedly declined considerably giving boost to optimism that the global rate hike cycle is near its end. And no wonder the average correlation across equities, bonds, credit, and commodity indices in both advanced economies and emerging markets reached to historic highs in some of the recent trading sessions.
It appears that the financial conditions have become more responsive to the restrictive policy measures and thus inflation was brought within the tolerable limits in several economies. But IMF warns that if there are sizable inflation surprises, they may as well abruptly change investor sentiment, rapidly decompressing asset price volatility and causing simultaneous price reversals among correlated markets, thus prompting a sharp tightening in financial conditions.
Vulnerabilities may build up in the medium term
As there is a possibility of surprise price rises in certain sectors, the IMF foresees some vulnerabilities building up in the medium-term along the last mile of the disinflation move. IMF seems to be concerned about the rising advent of both the public and private debt in advanced economies as well as certain emerging markets which may stress out the concerned economies. However, here also the IMF does the balancing act by reporting that major emerging markets continue to show resilience.
As a result of the aggressive tightening measures adopted by the central banks of major emerging market economies, inflation has eased considerably in these economies giving the space to their central banks to go for reduction in the policy rates.
However, there are a few challenges that the global economy is still faced with for instance, the interest rates and deficits are still high and growth is moderating and many emerging markets are currently experiencing high real refinancing costs relative to economic growth. Besides, some countries may find it increasingly difficult to service outstanding sovereign debt, which results in a “debt begets more debt” syndrome.
Other challenges that pose rising concern for macro-financial stability include growing advent of digitalization, evolving technologies, and increasing geopolitical tensions and possibility of cyber incidents having malicious intent.
Policies to tackle emerging vulnerabilities
As per the FSR, the majority of banks showed resilience during the March 2023 turmoil. Strong capital and liquidity buffers and improved profitability have lifted bank stock prices across countries since then. However, IMF staff’s key risk indicators suggest that banks having around one fifth of global banking assets remain vulnerable on account of breach of at least three of the five key risk indicators on account of multiple pressures and Chinese and US banks constitute most of this subset. Besides, many nonbanks, open-end bond funds, which reportedly received large inflows in recent years, may grapple with excessive liquidity syndromes. Also, there is need to adopt better cyber legislation and cyber-related governance arrangements at firms to mitigate risks of cyber attacks.
IMF has advised the Central banks to avoid premature monetary easing in spite of overly optimistic market expectations for policy rate cuts as it could complicate the last mile of disinflation. Thus even when it is observed that inflation is moving back sustainably towards the target, the central banks may rather gradually prefer a more neutral stance of policy rather than directly shifting to easing cycle until probably they reasonably believe that yes the “elephant” (Inflation) has actually gone into the forest (“tolerable limits”) and it is going to be there not to return anytime soon!
Besides, central banks are advised to strengthen measures to deal with debt vulnerabilities and any possibilities of strains developing in commercial and residential real estate. In a nutshell, the central banks are advised to adopt proactive supervisory and regulatory approach to deal with the potential risks of the fast-growing private credit market. They are also advised to go for cross-sectoral and cross-border regulatory cooperation and make risk assessments consistent across financial sectors.
Disclaimer: This article is based on the Author’s own understanding of the FSR, April 2024 published by the International Monetary Fund (IMF). For policy making and other financial decisions parameters, the stakeholders are advised to refer to the detailed contents of the Report as referenced above.