Overview of the Global Financial Stability Report Update
• The prices of risky assets rebounded from their precipitous fall earlier this year, while benchmark interest rates fell, leading to an overall easing of financial conditions.
• The swift and bold steps central banks have taken to address severe market tensions have boosted confidence in markets, including in emerging countries, some of which have resorted to asset buying to the first time, which helped ease financial conditions.
• In this context of great uncertainty, a gap appears between the financial markets and the development of the real economy. This vulnerability could jeopardize the recovery if investors' risk appetite declines.
• Other vulnerabilities in the financial system may be crystallized by the COVID-19 pandemic. High debt levels may become unsustainable for some borrowers and losses caused by insolvency could test the resilience of banks in the country. certain countries.
• A few emerging and pre-emerging countries face refinancing risks and some of them have lost market access.
• While continuing to support the real economy, the authorities should closely monitor financial vulnerabilities and safeguard financial stability.
The prices of risky assets recovered as a result of the unprecedented measures taken by central banks.
In the two months since the April 2020 release of the Global Financial Stability Report, global financial conditions have eased considerably, following their sharp tightening earlier in the year. This easing was helped by both the notable drop in interest rates and the sharp rebound in the market values of risky assets.
In countries where the financial sector is systemically important, stock markets have recovered from their March lows, overall, to about 85 % from their mid-January level, on average, despite some dispersion.
Here, the countries with systemically important financial sectors are those that have the obligation to undergo the financial stability assessment program every five years, namely the following 29 countries (S29): Germany, Australia, Austria, Belgium, Brazil, Canada, China, Korea, Denmark, Spain, United States, Finland, France, Hong Kong SAR, India, Ireland, Italy, Japan, Luxembourg, Mexico, Norway, the Netherlands, Poland, United Kingdom, Russia, Singapore, Sweden, Switzerland and Turkey.
While some stock markets have recovered all of their losses, others are only around 75 1TP1Q from where they were in mid-January. Along with the rally in prices, equity market volatility has eased after peaking in March, although it still exceeds its long-term average.
The rapid and unprecedented action of central banks has played a large part in the recovery of the markets. For example, in the United States, the prices of risky assets began to turn around March 23, after the Federal Reserve announced the establishment of credit mechanisms to fight the crisis worth 2,300 billions of dollars. A similar trend can be seen in the financial markets as a whole.
In credit markets, credit spreads have narrowed considerably after reaching record highs. On average, about 70 % of the excavation observed at the start has resolved. However, the spreads vary depending on the credit score and location. Bond issuance is on the rise among higher-rated borrowers and the markets are also once again open to speculative borrowers.
Investor confidence in emerging countries has also improved markedly. Portfolio investment flows to these countries stabilized after the record capital outflows at the start of this year. However, investors continue to differentiate within the group of emerging and pre-emerging countries, as evidenced by capital inflows in some countries and for certain asset classes. Higher-rated countries have also been able to issue hard currency debt at a historically high rate since the start of this year, and faster than lower-rated countries. This difference highlights the external tensions that some emerging countries are still facing.
The widespread recovery in financial markets is accompanied by growing investor optimism about the prospects for a rapid economic recovery. Market confidence has been boosted by the reopening of some countries and the relaxation of containment measures related to COVID-19. In addition, investors seem to expect a more accommodative monetary policy than ever to continue to support the global economy for a long time to come.
Actions taken by central banks have whetted investor appetite for risk.
Some countries have lowered their key rates further and investors expect interest rates to remain very low for several years. The balance sheets of monetary authorities in advanced countries have swelled after new waves of asset purchases, liquidity injections into the banking system, as well as the establishment of dollar swap agreements and other instruments intended to promote the flow of credit to the economy. Aggregate assets of the Group of Ten (G-10) central banks have increased by around $ 6 trillion since mid-January, more than double the increase seen during the two years of the global financial crisis as of December 2007. This growth in assets represents almost 15 % of the G-10 GDP.
A number of central banks in emerging countries have adopted unconventional measures for the first time. In some countries, these asset purchase programs have been launched in support of monetary policy. In others, they were intended to supply the market with liquidity (Chart 7). These include the purchase of a variety of assets, including government bonds, government guaranteed bonds, corporate debt and mortgage-backed securities.
Fiscal and monetary measures have also helped to maintain investor confidence. Governments around the world have deployed massive emergency packages, amounting to nearly $ 11 trillion, to support households and businesses (as shown in the IMF on fiscal measures countries have taken in response to COVID-19) 2. Financial authorities have also boosted market confidence by providing government credit guarantees, facilitating loan restructuring, and encouraging banks to use their buffers of available capital and liquidity to make loans (see IMF COVID-19 response inventory) 3.
This unprecedented combination of supportive measures appears to have been successful in preserving credit flows. The increased risk appetite of investors helped increase bond issuance in the markets, and banks also continued to extend loans in most major countries.
A gap appears between the optimism of the financial markets and the evolution of the world economy.
The rebound in investor confidence is based on robust support measures, in a context of great uncertainty around the extent and speed of the recovery. Markets appear to be expecting a rapid rebound in activity (in V), as illustrated by the noticeable improvement in the consensus S&P 500 forecast for corporate earnings.
However, recent economic data and high frequency indicators point to a deeper-than-expected recession as noted in the June 2020 Global Economic Outlook Update. This creates a divergence in the price of risk on financial markets and economic outlook, with investors appearing to bet on continued and unprecedented support from central banks. One example of this tension is the recent surge in the US stock market, on the one hand, and the sharp drop in consumer confidence, on the other. This decoupling raises the question of whether the current recovery in the stock markets would be sustainable without the renewed optimism caused by the support of central banks.
This mismatch between the markets and the real economy raises the specter of a further correction in the prices of risky assets if investors' appetite for risk worsens, which would jeopardize the recovery. For example, bearish equity markets have sometimes recovered in the past during times of high economic stress, but often reversed later. In corporate bond markets, investment grade corporate credit spreads are relatively small at the moment, contrasting with their strong expansion during previous severe economic shocks.
In fact, valuations appear excessive in many equity and corporate bond markets. According to staff models, the difference between market prices and fundamental values is approaching historic highs in most stock and bond markets in advanced countries, the opposite being true for stocks in some emerging countries.
A number of factors could trigger a revaluation of risk assets, which would add financial strains to an already unprecedented economic recession. For example, the recession could be deeper and longer than investors currently expect. A second outbreak of the virus could occur, forcing the return of containment measures. Market expectations for the extent and duration of central bank support to financial markets may turn out to be overly optimistic, leading investors to reassess their risk appetite and re-price it. A recent resurgence of trade tensions could erode market confidence, undermining the recovery. Finally, a generalization of social tensions across the world in reaction to rising economic inequalities could cause a reversal in investor confidence.
The pandemic could crystallize other financial vulnerabilities that have built up over the past 10 years.
First, in both advanced and emerging economies, corporate and household debt could become unsustainable for some borrowers in the event of a severe economic contraction. As noted in previous editions of the World Financial Stability Report, aggregate corporate debt has been on the rise for several years and is at record levels relative to GDP. Household debt has also increased, especially in countries that were spared the worst effects of the global financial crisis of 2007-2008. This means that many heavily indebted countries are now going to experience an extremely sharp economic downturn. This deterioration in economic fundamentals has already led to the fastest rate of corporate bond defaults since the global financial crisis, in addition to the risk of a wider impact on the creditworthiness of businesses and households.
Second, insolvency situations will test the resilience of the banking sector. Banks face the crisis with stronger buffers of liquidity and capital, thanks to post-crisis reforms, and they can tap them to make loans and absorb losses. Some banks have already started to increase their provisions for expected loan losses, as evidenced by their income statements for the first quarter. This trend is likely to continue as banks assess the ability of borrowers to repay their loans, while taking into account public support to households and businesses.
Analysts predict additional pressure on bank profitability, in addition to low interest rates.
Third, non-bank financial firms and markets may face additional strains. The events of March, when nonbank financial intermediaries received considerable government support, suggest that they are vulnerable to pro-cyclical corrections in the event of an external shock. These companies now play a larger role in the financial system than in the past, as noted in the Global Financial Stability Report
April 2020, and the behavior of this larger sector in times of deep recession is unknown. Non-bank financial enterprises are also at risk of shocks in the event of a strong wave of insolvency. They could even amplify these tensions. For example, a sharp shock to asset prices could trigger further withdrawals from investment funds, which, in turn, could lead to asset sell-offs on the part of those fund managers, thus exacerbating pressure on the funds. markets.
Fourth, some emerging and pre-emerging countries have high external refinancing needs. In the current environment, countries that need to refinance more debt run a higher risk of having to pay more for that refinancing. Some countries with high refinancing needs also have relatively low reserves. This could make it more difficult for the authorities in these countries to react to further withdrawals of portfolio investment, especially if their exchange rates are not flexible. The downgrade of credit ratings could increase pressure on financing costs and capital movements. Since the start of this year, more than a third of oil-exporting countries rated by major agencies have seen their credit rating down, while this proportion is only a quarter for other countries.
Authorities must strike the right balance in their response to the pandemic.
In this context of difficult trade-offs, the authorities must continue to support the recovery while ensuring the soundness of financial institutions and preserving financial stability (see box below "Financial sector policy priorities to fight against the crisis. "The authorities must be aware of the intertemporal risks of this support. The unprecedented use of unconventional tools has undoubtedly cushioned the impact of the pandemic on the world economy and lessened the immediate danger hanging over the world. global financial system. However, caution is required to avoid a further build-up of vulnerabilities amid loose financial conditions. Once the recovery is firmly underway, policymakers will need to urgently address financial weaknesses that may create problems for the economy. future and jeopardize medium-term growth.
Financial sector policy priorities to tackle the crisis
Central banks should maintain their accommodative monetary policy in order to seek to achieve their inflation and financial stability objectives by resorting, as long as necessary, to conventional and unconventional tools to promote the flow of credit to households and businesses. In addition, they must continue to provide liquidity to prevent a deterioration in the financing conditions and the functioning of the main money, exchange and securities markets. In addition, central banks must determine which markets are essential for maintaining financial stability and design support programs to minimize moral hazard and risks to themselves.
The authorities of emerging countries and developing countries should, as far as possible, practice flexible exchange rates to cushion external tensions. For countries with adequate reserves, interventions in the foreign exchange market can counterbalance the lack of liquidity in the market and help to mitigate excessive volatility in the market. In the face of an impending crisis, measures to control capital movements can be part of a larger package, although they must be applied transparently, be provisional and end once the crisis subsides. Sovereign debt managers must adopt contingency plans to deal with limited access to external financing markets over an extended period.
Banks must use their capital, liquidity and macroprudential buffers to absorb losses and manage the liquidity shortage, as well as to provide credit to the economy.
As long as the crisis lasts, banks must suspend dividend payments and share buybacks to consolidate their capital buffers. Where banks experience large-scale or long-lasting shocks and their capital becomes insufficient, regulators should take targeted action, including requiring banks to submit credible capital recovery plans. Throughout this process, it is important that risks are communicated in a transparent manner and that the supervisory bodies issue clear guidelines.
Regulators of insurance companies in countries experiencing periods of extreme market stress may need to use regulatory flexibility, for example, to extend the payback period for affected policyholders. Supervisors should not lower the standards, however, and should ask insurers to develop credible plans to restore their solvency position while continuing to provide essential coverage to policyholders.
Asset managers should continue to ensure that liquidity risk management frameworks are applied in a robust and effective manner. Regulators should ensure the availability of a wide range of liquidity management tools and encourage fund managers to make full use of them when it serves the interests of holders. Standardization bodies must review the macroprudential framework applicable to asset managers.
Multilateral cooperation is needed to protect the global financial system. It may be necessary to offer bilateral and multilateral swap agreements to more countries in order to ease the strains on financing in foreign currencies. Furthermore, it is necessary to refrain from any dismantling or fragmentation of the regulation of the international financial system by national measures which undermine international standards.
Read the April 2020 report and its June update
Virginie Gastine Menou
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