Financial stability risks have risen along many dimensions, although no global systemic event affecting financial institutions or markets has materialized so far, the International Monetary Fund (IMF) has said.
“Global financial conditions have tightened notably” and downside risks to the economic outlook have increased as a result of the Russian-Ukraine war, according to the newly released Global Financial Stability Report (GFSR).
The tightening has been “particularly pronounced” in eastern Europe and Middle East countries with close ties to Russia, reflecting lower equity valuations and higher funding costs, the IMF report was quoted as saying by Xinhua news agency.
Emerging and frontier markets are facing tighter financial conditions and “a higher probability of portfolio outflows,” with forecast at 30 per cent now, up from 20 per cent in the October 2021 GFSR.
The latest report warned that a sudden repricing of risk resulting from an intensification of the war and associated escalation of sanctions may expose, and interact with, some of the vulnerabilities built up during the pandemic, leading to a sharp decline in asset prices.
The sharp rise in commodity prices, “which has exacerbated preexisting inflation pressure, poses challenging trade-offs for central banks,” between fighting record-high inflation and safeguarding the post-pandemic recovery, the report said.
The report urged policymakers to “take decisive actions” to rein in rising inflation and address financial vulnerabilities while “avoiding a disorderly tightening of financial conditions” that would jeopardize the post-pandemic economic recovery.
“It is extremely important to tighten monetary policy at this point, in order to prevent an unmooring of inflation expectations,” Tobias Adrian, director of the IMF’s Monetary and Capital Markets Department, said at a virtual press conference during the 2022 spring meetings of the IMF and the World Bank.
“At the moment, medium-term inflation expectations are well anchored, but of course there’s a risk of de-anchoring, so there’s a risk that expectations would move beyond the target level in a markable manner,” Adrian said in response to a question from Xinhua.
The IMF official noted that the intended consequence of monetary tightening is to get to a tightening of financial conditions that slows down aggregate demand, slows down economic activity, which in turn brings down inflation.
“So some tightening of financial conditions is intended,” Adrian said. “But of course you don’t want a disorderly tightening of financial conditions. So disorderly is the kind of sell off and dash for cash that we saw in March 2020 at the onset of the Covid pandemic.”
To avoid unnecessary volatility in financial markets, it is crucial that central banks in advanced economies, including the US Federal Reserve, provide clear guidance about the normalisation process while remaining data dependent, the IMF report added.
In the coming years, the report said, policymakers will need to confront a number of structural issues brought to the fore by the war in Ukraine and the associated sanctions against Russia, including the trade-off between energy security and climate transition, market fragmentation risks, and the role of the US dollar in asset allocation.