| World Bank IMF and Dev Agencies |    1726 VIEWS  |
| World Bank IMF and Dev Agencies | |
| 1726 VIEWS | |
 |
Monday, May 04, 2020 / 08:06
AM / by Tibias Adrian and Fabio Natalucci, IMFBlog/ Header Image Credit:
Raxpixel/Istock By Getty Images
The COVID-19 pandemic has
caused an unprecedented human and health crisis. The measures necessary to
contain the virus have triggered an economic downturn. At this point,
there is great uncertainty about its severity and length. The latest Global Financial Stability Report shows
that the financial system has already felt a dramatic impact, and a further
intensification of the crisis could affect global financial stability.
Since the pandemic's outbreak, prices of risk assets have fallen
sharply. At the worst point of the recent selloff, risk assets suffered half or
more of the declines they experienced in 2008 and 2009. For example, many
equity markets-in economies large and small-have endured declines of 30 percent
or more at the trough. Credit spreads have jumped, especially for lower-rated
firms. Signs of stress have also emerged in major short-term funding markets,
including the global market for U.S. dollars.
Market Strain
Volatility has spiked, in some cases to levels last seen during the global financial crisis, amid the uncertainty about the economic impact of the pandemic. With the spike in volatility, market liquidity has deteriorated significantly, including in markets traditionally seen as deep, like the U.S. Treasury market, contributing to abrupt asset price moves.
To preserve the stability of the global financial system and support the
global economy, central banks across the globe have been the first line of defense.
First, they have significantly eased monetary policy by cutting policy rates-in
the case of advanced economies to historic lows. And half of the central banks
in emerging markets and lower income countries have also cut policy rates. The
effects of rate cuts will be reinforced through central banks' guidance about
the future path of monetary policy and expanded asset purchase programs.
Second, central banks have provided additional liquidity to the
financial system, including through open market operations.
Third, a number of central banks have agreed to enhance the provision of
U.S. dollar liquidity through swap line arrangements.
And finally, central banks have reactivated programs used during the
global financial crisis as well as launched a range of new broad-based
programs, including to purchase riskier assets such as corporate bonds. By
effectively stepping in as "buyers of last resort" in these markets and helping
contain upward pressures on the cost of credit, central banks are ensuring that
households and firms continue to have access to credit at an affordable price.
To date, central banks have announced plans to expand their provision of
liquidity-including through loans and asset purchases-by at least $6 trillion
and have indicated a readiness to do more if conditions warrant.
As a result of these actions aimed at containing the fallout from the pandemic, investor sentiment has stabilized in recent weeks. Strains in some markets have abated somewhat and risk asset prices have recovered a portion of their earlier declines. Sentiment continues to be fragile, however, and global financial conditions remain much tighter compared to the beginning of the year.
All in all, the sharp tightening of global financial conditions since the COVID-19 outbreak-together with the dramatic deterioration in the economic outlook has shifted the one-year-ahead distribution of global growth massively to the left. This points to a significant increase in downside risks to growth and financial stability. There is now a 5 percent likelihood (an event that happens once every 20 years) that global growth will fall below -7.4 percent. For comparison, this threshold was above 2.6 percent in October 2019.
As so often happens at times of financial distress, emerging markets
risk bearing the heaviest burden. In fact, emerging markets have experienced
the sharpest portfolio flow reversal on record-about $100 billion or 0.4
percent of their GDP-posing stark challenges to more vulnerable countries.
The global spread of COVID-19 may require the imposition of tougher and
longer-lasting containment measures-actions that may lead to a further
tightening of global financial conditions should they result in a more severe
and prolonged downturn. Such a tightening may, in turn, expose financial
vulnerabilities that have built in recent years in the environment of extremely
low interest rates. This would further exacerbate the COVID-19 shock. For
example, asset managers facing large outflows may be forced to sell into
falling markets-thus intensifying downward price moves. In addition, levered
investors may face further margin calls and may be forced to unwind their
portfolios; such financial deleveraging may aggravate selling pressures.
As firms become distressed and default rates climb higher, credit
markets may come to a sudden stop, especially in risky segments like high
yield, leveraged loan, and private debt markets. These markets have expanded
rapidly since the global financial crisis, reaching $9 trillion globally, while
borrowers' credit quality, underwriting standards, and investor protections
have weakened. Since early March, high-yield spreads have skyrocketed
notwithstanding recent declines, particularly in the sectors most affected by
the pandemic like air travel and energy. Similarly, leveraged loan prices have
fallen sharply-about half the drop seen during the global financial crisis at
one point. As a result, ratings agencies have revised upward their speculative-grade
default forecasts to recessionary levels, and market-implied defaults have also
risen sharply.
Banks have more capital and liquidity than in the past, and they have
been subject to stress tests and greater supervisory scrutiny in recent years,
putting them in a better position than at the onset of the global financial
crisis. In addition, the substantial and coordinated action by central banks to
provide liquidity to banks in many economies should also help alleviate
potential liquidity strains.
Nonetheless, the resilience of banks may be tested in the face of a
sharp slowdown in economic activity that may turn out to be more severe and
lengthy than currently anticipated.
Indeed, the large declines in bank equity prices since mid-January
suggest that investors are concerned about profitability and prospects for the
banking sector. For example, measures of bank capitalization based on market
prices are now worse than during the 2008 global financial crisis in many
countries. The concern is that banks and other financial intermediaries may act
as an amplifier should the crisis deepen further.
Looking Ahead
Central banks will remain crucial to safeguarding the stability of
global financial markets and maintaining the flow of credit to the economy. But
this crisis is not simply about liquidity. It is primarily about solvency-at a
time when large segments of the global economy have come to a complete stop. As
a result, fiscal policy has a vital role to play.
Together, monetary, fiscal, and financial policies should aim to cushion
the impact of the COVID-19 shock and to ensure a steady, sustainable recovery
once the pandemic is under control. Close, continuous international
coordination will be essential to support vulnerable countries, to restore
market confidence, and to contain financial stability risks. The IMF is ready
to assert the full weight of its resources-first, to help protect the world's
most vulnerable economies, and, for the long term, to strengthen the eventual
recovery.
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