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CHAPTER 1 Global Financial Stability Overview Markets in the Time of COVID-19 Full Report to Follow in May 2020International Monetary Fund | April 2020 i CUTIVE SUMMARY Confidential FOREWORD The COVID-19 Crisis The COVID-19 pandemic poses unprecedented health, economic, and financial stability challenges. The first priority is, of course, to save lives. But the necessary containment measures to limit the spread of the virus are causing a dramatic decline in economic activity. As a result, in only three months, the 2020 outlook has shifted from expected growth of more than 3 percent globally to a sharp contraction of negative 3 percentmuch worse than the output loss seen during the 2008–09 global financial crisis. The ultimate impact of the crisis on the global economy, as well as the timing of a recovery, is highly uncertain. This crisis presents a very serious threat to the stability of the global financial system. Following the COVID-19 outbreak, financial conditions tightened at unprecedented speed, exposing some “cracks” in global financial markets. Market volatility spiked and borrowing costs surged on expectations of widespread defaults. Signs of strain emerged in major funding markets, including the global US dollar funding market. Historically large capital outflows exacerbated domestic shocks in emerging market economies. These developments have raised the risk that the inability of borrowers to service their debts would put pressure on banks and cause credit markets to freeze up. A prolonged period of dislocation in financial markets could trigger distress among financial institutions, which, in turn, could lead to a credit crunch for nonfinancial borrowers, further exacerbating the economic downturn. To safeguard economic and financial stability and to prevent the emergence of adverse macro- financial feedback loops, countries are taking decisive actions. Central banks have eased monetary policy and are providing liquidity to the financial system, including through foreign-currency swap lines, to maintain the flow of credit to the economy. Thanks to these efforts, funding markets have remained functional and investor sentiment has shown signs of improvement. Supervisors are encouraging banks to prudently renegotiate loan terms for those struggling to service their debts in order to help bridge the period of economic inactivity, and to use existing capital and liquidity buffers, as well as other flexibility in their regulatory and accounting frameworks, to absorb losses. Country authorities are supporting people and companies through sizable, timely, temporary, and targeted fiscal measures to put a limit on defaults of firms and households via payment moratoriums and guaranteed credit. Multilateral cooperation has increased the resources available to support the most vulnerable countries and communities. The IMF, with 1 trillion in available resources, is actively supporting its member countries. These policies are essential to ensure that a temporary shutdown of production does not lead to more permanent damage to the productive capacity of the economy, to the financial system, and to the fabric of society. Once the virus outbreak is under control, policies should be aimed at fostering the recovery, as well as assessing and healing the damage inflicted by the pandemic on the balance sheets of non-financial firms, financial institutions, and governments. Tobias Adrian Financial Counsellor ii International Monetary Fund | April 2020 CUTIVE SUMMARY Confidential CUTIVE SUMMARY The April 2020 Global Financial Stability Report at a Glance The outbreak of COVID-19 has dealt an unprecedented blow to global financial markets. Risk asset prices have plummeted and borrowing costs have soared, especially in risky credit markets. Emerging and frontier markets have experienced the sharpest portfolio flow reversal on record. The priority is to save lives and to support the people and companies most affected by COVID-19. Fiscal, monetary, and financial policies should be used to support economies stricken by the pandemic. International cooperation is essential to tackle this extraordinary global crisis. The coronavirus COVID-19 pandemic presents a historic challenge. In mid-February, when market participants started to fear that the outbreak would become a global pandemic, the prices of equities fell sharply, from previously overstretched levels. In credit markets, spreads skyrocketed, especially in risky segments such as high-yield bonds, leveraged loans, and private debt, where issuance essentially came to a halt. Oil prices plummeted in the face of weakening global demand and the failure of the OPEC countries to reach an agreement on output cuts, adding a further leg to the deterioration in risk appetite. These volatile market conditions led to a flight to quality, with yields on safe-haven bonds declining abruptly. A number of factors amplified asset price moves, contributing to a sharp tightening of financial conditions at unprecedented speed. Signs of strain emerged in major short-term funding markets, including the global market for US dollarsa development reminiscent of dynamics last seen during the financial crisis a decade ago. Market liquidity deteriorated considerably, including in markets traditionally seen as very deep. Leveraged investors came under pressure, with some reportedly forced to close out some of their positions in order to meet margin calls and rebalance their portfolios. However, markets have pared back some of the losses. Decisive monetary and fiscal policy actions, aimed at containing the fallout from the pandemic, have stabilized investor sentiment. Nevertheless, there is still a risk of a further tightening in financial conditions that could expose financial vulnerabilities, which have been highlighted repeatedly in previous Global Financial Stability Reports. Emerging and frontier market economies are facing the perfect storm. They have experienced the sharpest reversal in portfolio flows on record, both in dollar terms and as a share of emerging and frontier market GDP. This loss of external debt financing is likely to put pressure on more leveraged and less creditworthy borrowers. This may lead to a rise in debt restructurings, which could test existing debt resolution frameworks. International Monetary Fund | April 2020 iii Asset managers may face further outflows from their funds and may be forced to sell assets into falling markets, potentially exacerbating price moves. High levels of borrowing by companies and households may lead to debt distress as the economy comes to a sudden stop. Banks have more capital and liquidity than in the past, they have been subject to stress tests, and central bank liquidity support has helped mitigate funding risks, putting them in a better position than at the onset of the global financial crisis. The resilience of banks, however, may be tested in some countries in the face of large market and credit losses, and this may cause them to cut back their lending to the economy, amplifying the slowdown in activity. This historic challenge necessitates a forceful policy response. The priority is to save lives and to implement appropriate containment measures to avoid overwhelming health systems. Country authorities need to support people and companies that have been most affected by the virus outbreak, as discussed in the April 2020 World Economic Outlook. To that end, authorities across the globe have already implemented wide-ranging policies. The April 2020 Fiscal Monitor describes the fiscal support packages that have been announced by governments across the globe. Large, timely, temporary, and targeted fiscal measures are necessary to ensure that a temporary shutdown of activity does not lead to more permanent damage to the productive capacity of the economy and to society as a whole. Central banks globally have taken bold and decisive actions by easing monetary policy, purchasing a range of assets, and providing liquidity to the financial system in an effort to lean against the tightening in financial conditions and maintain the flow of credit to the economy. As policy rates are now near or below zero in many major advanced economies, unconventional measures and forward guidance about the expected policy path are becoming the main tools for these central banks going forward. Central banks may also consider further measures to support the economy during these challenging times. Policymakers need to maintain a balance between safeguarding financial stability and supporting economic activity. Banks. In the first instance, banks’ existing capital and liquidity buffers should be used to absorb losses and funding pressures. In cases where the impact is sizable or longer lasting and bank capital adequacy is affected, supervisors should take targeted actions, including asking banks to credible capital restoration plans. Authorities may also need to step in with fiscal supporteither direct subsidies or tax reliefto help borrowers to repay their loans and finance their operations, or provide credit guarantees to banks. Supervisors should also encourage banks to negotiate, in a prudent manner, temporary adjustments to loan terms for companies and households struggling to service their debts. Asset managers. To prudently manage liquidity risks associated with large outflows, regulators should encourage fund managers to make full use of the available liquidity tools where it would be in the interests of unit holders to do so. Financial markets. Market resilience should be promoted through well-calibrated, clearly defined, and appropriately communicated measures, such as circuit breakers. iv International Monetary Fund | April 2020 Many emerging market economies are already facing volatile market conditions and should manage these pressures through exchange rate flexibility, where feasible. For countries with adequate reserves, exchange rate intervention can lean against market illiquidity and thus play a role in muting excessive volatility. However, interventions should not prevent necessary adjustments in the exchange rate. In the face of an imminent crisis, capital flow management measures could be part of a broad policy package, but they cannot substitute for warranted macroeconomic adjustment. Sovereign debt managers should prepare for longer-term funding disruptions by putting contingency plans in place to deal with limited access to external financing. Multilateral cooperation is essential to help reduce the intensity of the COVID-19 shock and its damage to the global economy and financial system. Countries confronting the twin crises of health and external funding shocksfor example, those reliant on external financing or commodity exporters dealing with the plunge in commodity pricesmay additionally need bilateral or multilateral assistance to ensure that health spending is not compromised in their difficult adjustment process. Official bilateral creditors have been called upon by the IMF Managing Director and the World Bank President to suspend debt payments from countries below the International Development Association’s operational threshold that request forbearance while they battle the pandemic. The IMF, with 1 trillion in available resources, is actively supporting member countries. International Monetary Fund | April 2020 1 GLOBAL FINANCIAL STABILITY OVERVIEW GLOBAL FINANCIAL STABILITY OVERVIEW 1 CHAPTER CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEW MARKETS IN THE TIME OF COVID-19 ________________________ 2 FIGURES 1.1. Financial Market Developments Adding Oil to the Fire __________________________ 3 1.2. Advanced Economy Government Bond Markets Lower for Even Longer ____________ 4 1.3. Corporate Credit Markets Pricing Higher Default Risk ___________________________ 6 1.4. Short-Term Funding Markets Under Stress ___________________________________ 7 1.5. Market Liquidity Conditions Under Strain ____________________________________ 9 1.6. Asset Valuations Wild Swings _____________________________________________ 10 1.7. Emerging Equity and Bond Markets Facing the Perfect Storm ____________________ 12 1.8. Portfolio Flows to Emerging Markets A Big Reversal ___________________________ 13 1.9. Global Financial Conditions Getting Tighter _________________________________ 15 1.10. Global Financial Vulnerabilities Preexisting Conditions ________________________ 17 1.11. Investment Funds Losses and Redemptions _________________________________ 19 1.12. Banks in Large Economies Resilience Tested ________________________________ 20 1.13. Commercial Real Estate and Commercial Mortgage-Backed Securities _____________ 21 1.14. Insurance Companies Worries about Potential Losses _________________________ 23 1.15. Emerging and Frontier Markets 2008 versus 2020 ____________________________ 25 1.16. Main Vulnerabilities of Emerging and Frontier Market Economies ________________ 26 1.17. Shrinking Monetary and Macroprudential Policy Space ________________________ 31 TABLES 1.1. Monetary and Financial Policy Responses to COVID-19 ________________________ 28 1.2. Selected Central Bank Facilities to Support Funding Markets _____________________ 29 References _______________________________________________________________ 36 CONTENTS GLOBAL FINANCIAL STABILITY REPORT 2 International Monetary Fund | April 2020 Markets in the Time of COVID-19Chapter 1 at a Glance Global financial conditions have tightened abruptly with the onset of the COVID-19 pandemic. Risk asset prices have dropped sharply as investors have rushed for safety and liquidity. Emerging and frontier markets have experienced a record portfolio flow reversal. A further tightening of financial conditions may expose financial vulnerabilities o Asset managers may become distressed sellers, exacerbating asset price declines. o Leveraged firms may lose market access and defaults may spike. Banks’ resilience may be tested as economic and financial market stress rise. Strong policy response and international cooperation are needed to tackle these challenges. The COVID-19 Pandemic Triggered a Sharp Market Correction The coronavirus COVID-19 pandemic is a historic challenge. The necessary measures imposed by country authorities to slow the spread of the virus and to bolster the capacity of health systems have led to a sudden stop in economic activity and a sharp deterioration of the economic outlook. Global growth is now expected to decline by 3 percent in 2020, which is worse than during the global financial crisis see the April 2020 World Economic Outlook [WEO]. The timing and the shape of future recovery remain highly uncertain. Early in the year, financial markets were buoyed by a widespread sense of optimism on the back of supportive monetary policies, reduced trade tensions, and tentative signs of stabilizati