Uncertainty wins the markets and optimism recedes
12 October 2021
In a context marked by the long and terrible pandemic, the risks of global financial instability have remained moderate, at least so far. Indeed, the winds of economic optimism are starting to fade and financial vulnerabilities are intensifying, which is why governments must now carefully define the direction in which they wish to take their action. For a year and a half, central banks, ministries of finance and financial institutions around the world have been making unprecedented interventions in favor of growth. Today, governments must devise strategies to smoothly bring the economy into a new era of monetary and fiscal policy.
Systemically important central banks around the world know that even the slightest negative effect of their actions could jeopardize growth and could even cause sharp corrections in financial markets around the world. The consequences of the pandemic make the uncertainties particularly acute: society is thus grappling with the problems raised by the three Cs, namely COVID-19, crypto-asset and climate change, as analyzed in the latest Report on global financial stability.
The massive support to the economy provided by fiscal and monetary policies in 2020 and 2021 helped to limit the contraction that began at the start of the pandemic and, for much of 2021, supported the strong rebound in activity. In many advanced countries, financial conditions eased in the first months of the pandemic. However, the winds of optimism that had pushed the markets in the first half of 2021 could subside.
Investors are increasingly concerned about the changing economic outlook amid growing uncertainty about the strength of the recovery. Inequalities in access to vaccine doses and mutations in the COVID-19 virus have led to a resurgence of contamination, raising fears of an accentuation of national trajectory divergences. Inflation rates have been higher than expected in many countries and the emergence of new uncertainties in some large countries has put markets on alert. These uncertainties stem from financial vulnerabilities that could amplify downside risks, rising commodity prices and political uncertainty.
The deterioration in market sentiment since the April 2021 edition of the Global Financial Stability Report led to a sharp decline in long-term nominal yields globally during the summer. The latter is also explained by the decline in real rates, due to fears about the long-term growth prospects. However, in late September, investor nervousness over inflationary pressures pushed yields even higher in a reversal of expectations of price pressures now considered more persistent than expected in some countries, completely wiping out the downside.
If, at any time, investors suddenly re-evaluate the economic outlook and the direction of public action, financial markets could undergo a sudden revision in the cost of risk. And if this review were to be long-lasting, it could combine with underlying vulnerabilities and thus lead to tightening financial conditions, which could jeopardize growth.
Risks in other strategic sectors also need to be closely monitored. The cryptocurrency markets are growing rapidly and the prices of these assets remain highly volatile. The risks of financial instability in the cryptocurrency ecosystem are not yet systemic in nature, but should be closely monitored, given the threat they pose to global monetary conditions and the gaps in operational and regulatory frameworks applicable in most jurisdictions, in particular in emerging and developing countries. At the same time, as the world continues to seek ways to accelerate the transition to a low-greenhouse gas economy in order to avoid climate change-related economic and financial instability, the financial sector offers a promising outlook. Indeed, the share of assets managed by climate-oriented investment funds remains relatively low, but the flows to these funds have increased significantly, which bodes well for a reduction in the cost of financing environmentally friendly companies and a strengthening climate stewardship implemented by investment funds.
A delicate act of balance
While financial conditions still remain broadly favorable, our analysis shows that financial vulnerabilities remain high in several sectors, but are partly overshadowed by massive stimulus measures. Policy makers must now find a compromise between two imperatives that are difficult to reconcile: to continue supporting the global economy in the short term and, at the same time, to avoid the accumulation of risks of financial instability in the medium term. In other words, they have to perform a delicate balancing act.
The persistence of extremely favorable financial conditions for a long period of the pandemic – certainly necessary to facilitate the recovery – allowed the maintenance of excessive asset valuations. If the latter persists, it could in turn exacerbate financial vulnerabilities. Various warning signs, such as intensified financial risk-taking and the emergence of fragility in the non-bank financial institution sector, point to a deterioration in the foundations of financial stability. Left unchecked, these vulnerabilities are likely to persist over the long term and develop into structural problems.
Leaders will need action plans to prevent negative effects. They will have to direct their monetary and budgetary support more and adapt it to the situation in each country, because the recovery follows multiple rhythms. Central banks will need to provide clear guidance on their vision of future monetary policy to avoid a sudden or premature tightening of financial conditions. Monetary authorities will need to remain vigilant and be ready to take ambitious steps to avert a disengagement of inflation expectations if price pressures prove to be more lasting than expected. As far as the budgetary authorities are concerned, they can usefully redirect their support towards interventions that are more targeted and better suited to the specific situation of each country.
Policy makers will need to act promptly and increase key macroprudential requirements to address the pockets of vulnerability of greatest concern. This approach is essential to correct any negative effects of their unprecedented measures, as the economy may need support for a long time to generate a sustainable recovery.
In emerging and pre-emerging countries, leaders should, as far as possible, start rebuilding fiscal buffers and implementing structural reforms. Faced with numerous internal challenges (rising inflation and budgetary concerns), some of these countries are also at the mercy of a sudden tightening of external financial conditions.
In an environment of mounting price pressures, investors are currently operating in a rapid and rather steep tightening cycle in many emerging countries, although the rise in inflation is expected to be temporary. Rebuilding reserves and implementing lasting reforms that improve growth prospects will provide key protection against the risks of a reversal of capital flows and a sharp rise in financing costs.
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Tobia Adriano he is financial advisor and director of the IMF’s money and capital markets department. In this capacity, he leads the IMF’s work on financial sector oversight and capacity building, monetary and macroprudential policies, financial regulation, debt management and capital markets. Prior to joining the IMF, Adrian was senior vice president of the Federal Reserve Bank of New York and deputy director of the research and statistics group. Mr. Adrian has taught at Princeton University and New York University and is the author of publications in economic and financial journals, including the American Economic Review and the Journal of Finance. His research focuses on the global consequences of developments in capital markets. He holds a doctorate from the Massachusetts Institute of Technology, a master’s degree from the London School of Economics, a bachelor’s degree from Goethe University in Frankfurt and a master’s degree from Paris-Dauphine University.