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Source: IMF in French

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The transition to economic recovery: beware of risks to financial stability

Tobias Adrian

October 13, 2020

Despite a global economic crisis that can only be compared to the Great Depression, the risks to short-term financial stability have been brought under control thanks to the unprecedented easing of monetary policies and the considerable budget support provided around the world. However, many countries had pre-existing vulnerabilities, which are now exacerbated and could slow the recovery.

The government has taken exceptional measures that have stabilized markets, reassured investors and preserved the flow of credit to the global economy. Above all, these measures have made it possible to ensure that the slowdown in economic activity and the stalling of financial markets do not foster each other in a vicious cycle of destruction.

The rebound in asset prices and the easing of global financial conditions have benefited not only advanced economies, but also emerging economies. In addition, contrary to what happened in previous crises, this time the emerging countries were also able to react by lowering key rates, injecting liquidity and, for the first time, resorting to investment programs. purchase of assets.

Beware of the gap between the real economy and financial markets

The noticeable improvement in financial conditions has helped maintain the flow of credit to economic activity, but the outlook remains highly uncertain. A shift For example, the financial markets, where stock valuations have risen (despite recent revisions), and weak economic activity and the uncertain outlook persist, for example. This gap can gradually narrow if the economy recovers quickly. On the other hand, if the recovery is slow to materialize, for example because it takes longer to bring the virus under control, investor confidence could be eroded.


As long as investors believe that the government will continue to support markets, asset values ​​may remain high for some time. Nonetheless, and especially if economic activity is slow to recover, there could be a sharp adjustment in asset prices or periodic spikes in volatility.

The vulnerabilities of companies are getting even worse

The government’s actions have enabled companies to cope with the liquidity shortages they experienced when the economy came to a standstill with further debt. While this additional borrowing prevented a wave of bankruptcies at the start of the crisis, they also increased the debt burden on companies. But many of these companies were already heavily in debt before the crisis, and debt is now reaching new heights in some sectors. As a result, insolvency risks may have been deferred, and further liquidity pressures could lead to bankruptcies, especially if the recovery is slow in coming.


The resilience of banks put to the test

When the COVID-19 crisis erupted, the banking industry had greater capital and liquidity buffers than at the start of the global financial crisis. The remarkable results stemming from the reforms carried out over the past decade have enabled it to participate in the solution rather than the problem so far, as banks have continued to provide credit to businesses and households during the pandemic. Nonetheless, IMF analysis shows that, under an adverse macroeconomic scenario, some banking systems could experience a large capital shortfall because a large number of firms and households would not be able to repay their loans (even taking into account the measures currently implemented by the public authorities) and that profitability would falter.


The proliferation of interdependencies

The unprecedented scale of the pandemic crisis is exacerbating vulnerabilities in many sectors. Public administrations have had to accumulate larger budget deficits in order to be able to support businesses and households. At the same time, banks and other financial institutions have had to buy more government bonds. In the future, the budgetary capacity needed to provide additional support may be more limited.

In addition, non-bank financial institutions, such as asset managers and insurance companies, now play an important role in credit markets, including in its riskier segments. They have managed to weather the market turmoil caused by the pandemic with government support, but vulnerabilities, such as liquidity mismatches and exposure to credit risk, remain significant. These weaknesses could sooner or later spread throughout the financial system.

Financing difficulties in emerging countries

Emerging countries and low-income countries face specific financing difficulties. The easing of global financial conditions has generally improved the outlook for portfolio investment flows to most emerging markets and stabilized their access to finance. However, some low-income countries have such debts that they could soon find themselves in debt distress due to prohibitive borrowing costs.

Policies to ensure recovery and see beyond

Going forward, policymakers should carefully stagger their response to ensure a smooth transition to recovery. They will face difficult trade-offs between short-term support and risks to medium-term macro-financial stability, and they need to closely monitor any unintended consequences of their unprecedented support.

As economies reopen, monetary policy should remain accommodative to support the recovery. The state should also continue to provide cash assistance, although its price must be gradually adjusted to encourage a return to normal market financing. A strong debt restructuring mechanism will be essential to reduce debt distress and address the problems of unsustainable businesses. Multilateral support should continue to low-income countries with financing difficulties.

Once the pandemic is contained, a solid program of financial reforms could focus on rebuilding banks’ capital buffers, strengthening the regulatory framework applicable to non-bank financial institutions and tightening prudential supervision to limit risk-taking. excessive in an environment where interest rates are expected to stay lower for longer.


Tobias Adrian is a financial adviser and director of the IMF’s Monetary and Capital Markets Department. In this capacity, he leads the IMF’s work on financial sector surveillance, monetary and macroprudential policies, financial regulation, debt management and capital markets. In addition, he oversees capacity building activities in IMF member countries. Before joining the IMF,

Mr. Adrian was Senior Vice President of the Federal Reserve Bank of New York and Deputy Director of the Research and Statistics Group. Adrian has taught at Princeton University and New York University and is the author of numerous publications in economic and financial journals, including American Economic Review, Journal of Finance, Journal of Financial Economics, and Review of Financial Studies. He holds a doctorate from the Massachusetts Institute of Technology, an MA from the London School of Economics, a diploma from Goethe University in Frankfurt and an MA from Paris-Dauphine University. He graduated from high school in literature and mathematics at the Humboldtschule in Bad Homburg.

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EDITOR’S NOTE: This article is a translation. Apologies should the grammar and / or sentence structure not be perfect.

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