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

Risks to the stability of the global financial system have “materially worsened”, the IMF has warned, cautioning that markets are at risk of a “disorderly repricing” that will hit emerging and developing countries most severely.

In its twice-yearly Global Financial Stability Report, the multilateral lender said the surge in global borrowing costs, coupled with poor trading conditions and souring growth prospects, threatened to unmask the financial system’s fragility.

“There certainly are many vulnerabilities out there,” Tobias Adrian, head of monetary and capital markets at the IMF, told the Financial Times. “When interest rates increase very rapidly, these vulnerabilities are exposed.”

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

Signs of financial stress have already begun to crop up globally. Bond and stock prices have fallen sharply as central banks across advanced and emerging economies ratchet up interest rates to combat the worst inflation in decades. The dollar has soared in value against most currencies, forcing investors to pay a larger premium for funding in the US currency.

Adrian said so far global financial markets were still functioning well, but warned that “pockets of disorderly tightening” could morph into something more worrisome.

“We have seen differentiation across the risk spectrum today,” he said in an interview. “What I worry about is that there could be a broader base — a risk-off event — where it’s not just the riskier spectrum that sees wider spreads or wider risk premia, but also the safer issuers.”

UK financial markets recently teetered on the verge of collapse after the government announced a plan to implement £45bn of debt-funded tax cuts late last month. The resulting sterling crash and surge in borrowing costs forced the Bank of England to step in to avert an even worse financial fallout led by pension funds using liability-driven investing strategies.

While the central bank’s interventions helped to soothe markets initially, the measures, coupled with those from the government, have not fully reassured investors, igniting another lurch higher in government bond yields on Monday.

Adrian said the IMF, which had criticised the UK government’s plan, “fully endorsed” the steps taken by the BoE and said its efforts to stabilise the financial system did not run counter to its monetary policy goals of returning inflation to the 2 per cent target from its current level of almost five times that amount.

“It’s possible to ensure financial stability while tightening monetary policy,” he added. “You should be able to target certain segments of the market with financial stability issues, while tightening the overall stance.”

Flagging their role as lenders of last resort, Adrian said central banks should step in when a shock became a “systemic concern”.

Indebted emerging and frontier economies are particularly vulnerable to a seizing up of global financial conditions. The government bonds of 14 countries in this category already trade in distressed territory, meaning spreads are more than 1,000 basis points above US Treasuries. An additional six have already defaulted or are working out debt restructuring agreements with creditors, including Zambia and Sri Lanka.

Last week, Kristalina Georgieva, head of the IMF, said there would “inevitably” be additional defaults.

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

According to stress tests run by the IMF — which gauged countries’ abilities to weather a “severe” economic downturn featuring a 2023 global recession, unanchored inflation expectations, a disorderly tightening of financial conditions and prolonged supply chain disruptions due to Covid-19 and the war in Ukraine — nearly a third of emerging market banks will be undercapitalised. Lenders in advanced economies fared far better, the researchers found.

Non-bank financial institutions also required enhanced monitoring, the fund said, calling for increased scrutiny of leverage exposure and greater transparency.