An asynchronous and divergent recovery can put financial stability at risk






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Tobias Adrian is the Financial Counselor and Director of the Monetary and Capital Markets Department of the International Monetary Fund.

After enduring a tumultuous 2020, the global economy is finally emerging from the worst phases of the COVID-19 pandemic, albeit with outlooks that diverge markedly between regions and countries, and only after a “lost year” spent in suspended animation. . The economic trauma would have been much worse if the global economy had not been supported by the unprecedented political actions taken by central banks and the fiscal measures implemented by governments.

Global markets are watching the current rise in US long-term interest rates, concerned that a rapid and persistent rise could result in tighter financial conditions, potentially damaging growth prospects. Since August 2020, the 10-year US Treasury yield has risen 1¼ percentage points to about 1¾ percent in early April 2021, returning close to its pre-pandemic level of early 2020.

The good news is that the rate hike in the United States has been driven in part by improved immunization prospects and stronger growth and inflation. As described in the latest Global Financial Stability Report, both nominal and real interest rates have risen, although nominal returns have risen more, suggesting that market-implicit inflation (the difference between the returns on securities nominal and inflation-indexed Treasury) is recovering. Allowing for modest inflation has been an objective of loose monetary policy.

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The bad news is that the increase may reflect uncertainty about the future course of monetary policy and possibly investor concerns about increasing the supply of Treasury debt to finance fiscal expansion in the United States, as reflected in premiums. strongly growing term (compensation of investors for interest rate risk). Market participants are beginning to focus on when the Federal Reserve cuts its asset purchases, which could increase long-term rates and financing costs, fueling a tightening of financial conditions, especially if it is associated with a decrease in the prices of risk assets. .

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Global implications

To be clear, global rates are still low by historical standards. But the speed of rate adjustment can generate unwanted volatility in global financial markets, as seen this year. Asset prices are valued on a relative basis, and the price of every financial asset, from a simple home loan to emerging market bonds, is directly or indirectly linked to US benchmark rates. The rapid and persistent rate hike this year has been accompanied by increased volatility, with the risk that these fluctuations will intensify.

Any abrupt and unexpected rate hike in the United States can lead to tighter financial conditions as investors switch to “reduce risk exposure, protect capital.” This could be a cause for concern for risk asset prices. Valuations appear stretched in some segments of financial markets and vulnerabilities continue to rise in some sectors.

So far, overall global financial conditions have remained favorable. But in countries where the recovery is slower and where vaccines are lagging, their economies may not yet be ready for tighter financial conditions. Policy makers may be forced to use monetary and exchange rate policies to compensate for any possible adjustments.

While government bond yields have also risen somewhat in countries in Europe and elsewhere, albeit less than in the United States, the biggest concern comes from emerging markets, where investors’ appetite for risk can change rapidly. As many of these countries face great external financing needs, a sudden tightening of global financial conditions could threaten their post-pandemic recovery. The recent volatility of portfolio flows to emerging markets is a reminder of the fragility of these flows.

Meeting the needs of tomorrow

While several emerging market economies have adequate international reserves and external imbalances are generally less pronounced as a result of heavy import compression, some emerging market economies may face challenges in the future, especially if inflation and the costs of shipping rise. indebtedness continue to increase. Emerging market local currency yields have increased significantly, mainly driven by an increase in term premiums. Our estimate is that a 100 basis point increase in US term premiums is associated, on average, with a 60 basis point increase in emerging market term premiums. Many emerging markets have considerable financial needs this year, so they are exposed to the risk of higher rates once they roll over debt and finance large fiscal deficits in the coming months. Countries that are in a weaker economic situation, for example due to limited access to vaccines, may also face portfolio outflows. For many frontier market economies, access to finance remains a primary concern given limited access to bond markets.

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As countries adjust policies to overcome the pandemic, major central banks will need to carefully communicate their policy plans to avoid excess volatility in financial markets. Emerging markets may need to consider policy measures to address excessive tightening of domestic financial conditions. But they must take into account policy interactions and their own economic and financial conditions, as they make use of monetary, fiscal, macroprudential, capital flow management and exchange rate intervention.

Continued policy support remains necessary, but specific measures are also needed to address vulnerabilities and protect economic recovery. Policy makers should support balance sheet repair, for example by strengthening the management of non-performing assets. Rebuilding buffers in emerging markets should be a political priority to prepare for a possible change in risk prices and a possible reversal of capital flows.

As the world begins to turn the page on the COVID-19 pandemic, policymakers will continue to be tested by an asynchronous and divergent recovery, a widening gap between rich and poor, and increased financing needs in between. of restricted budgets. The Fund remains ready to support the political efforts of its member countries in the uncertain period ahead.
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