Markets at risk of ‘disorderly’ sell-off, says IMF

Risks to the stability of the global financial system have “worsened significantly”, the IMF warned, warning that markets face the risk of a “disorderly re-pricing” that will hit emerging and developing economies hardest.

In its twice-yearly Global Financial Stability Report, the multilateral lender said rising global borrowing costs combined with poor trading conditions and bleak growth prospects threatened to reveal the vulnerability of the financial system.

“There are certainly a lot of vulnerabilities out there,” Tobias Adrian, head of money and capital markets at the IMF, told the Financial Times. “If interest rates rise very quickly, these vulnerabilities will be exposed.”

The report adds to a chorus of warnings that one of the most aggressive monetary tightening campaigns in decades could trigger further volatility and a broad-based sell-off in asset markets.

The first signs of financial strain are already being seen around the world. Bond and stock prices have fallen sharply as central banks in both developed and emerging markets are raising interest rates to combat the worst inflation in decades. The dollar has appreciated sharply against most currencies, forcing investors to pay a higher premium for funding in US currency.

Adrian said global financial markets have been doing well so far, but cautioned that “pockets of disorderly tightening” could turn into something more worrying.

“We saw differentiation across the risk spectrum today,” he said in an interview. “What I’m concerned about is that there could be a broader base — a risk-off event — where not only do the riskier spectrum see wider spreads or higher risk premiums, but also the safer issuers.”

UK financial markets were on the brink of collapse recently after the government announced a plan to implement £45 billion of debt-financed tax cuts late last month. The resulting fall in sterling and the rise in the cost of borrowing forced the Bank of England to step in to avert even worse financial damage led by pension funds using liability-based investment strategies.

While the central bank’s interventions initially helped calm markets, the measures, combined with those of the government, failed to fully reassure investors and sparked a further rise in government bond yields on Monday.

Adrian said the IMF, which had criticized the UK government’s plan, “fully supports” the BoE’s moves and said its efforts to stabilize the financial system are not at odds with its monetary policy goals of keeping inflation at 2 percent Target reduced from the current almost five times.

“It is possible to ensure financial stability while tightening monetary policy,” he added. “They should be able to target specific segments of the market with financial stability issues while also raising public stance.”

Noting their role as lenders of last resort, Adrian said central banks should intervene if a shock becomes a “systemic problem”.

Indebted emerging and frontier countries are particularly vulnerable to a shock to global financial conditions. The government bonds of 14 countries in this category are already trading in distressed territory, which means that spreads are more than 1,000 basis points higher than US Treasuries. Another six have already defaulted or are working on debt restructuring agreements with creditors, including Zambia and Sri Lanka.

Last week, IMF chief Kristalina Georgieva said further defaults were “inevitable”.

“Both official creditors and the private sector, please come together. Face the music.”

According to IMF stress tests – which assessed countries’ ability to weather a “severe” economic downturn with a global recession in 2023, unanchored inflation expectations, disorderly tightening in financial conditions and prolonged supply chain disruptions due to Covid-19 and the US War in Ukraine – almost a third of emerging market banks will be undercapitalised. Lenders in advanced economies fared far better, the researchers found.

Non-bank financial institutions also needed increased oversight, the fund said, calling for increased scrutiny of leverage exposure and more transparency.