The severe global recession triggered by coronavirus could expose “cracks” in the financial system, despite the unprecedented action taken by central banks led by the US Federal Reserve, the IMF has warned.
Central banks have rolled out radical monetary easing policies as governments launched substantial stimulus packages in an attempt to tackle what the IMF forecasts will be a lingering blow to global economic growth. But the deepest contraction since the Great Depression may still exacerbate or expose faultlines in the global financial system, the IMF said in a report published on Tuesday.
“This crisis presents a very serious threat to the stability of the global financial system,” the fund said. “Decisive monetary and fiscal policy actions, aimed at containing the fallout from the pandemic, have stabilised investor sentiment. Nevertheless, there is still a risk of a further tightening in financial conditions that could expose financial vulnerabilities.”
The fund’s annual Global Financial Stability Report highlighted several dangers, in particular high levels of corporate indebtedness — companies entered the coronavirus crisis carrying more debt than they did at the start of the 2008 financial crisis — along with potential weaknesses in the investment industry and the possibility of debt crises in the developing world.
Companies are “significantly” more vulnerable today than at the onset of the last crisis, and an extended recession and rising borrowing costs could lead to “large-scale corporate distress”, the fund warned. That would hurt investors who have piled into riskier corporate debt. This market — consisting of junk bonds, leveraged loans and more bespoke private credit — has grown to $9tn globally, the IMF estimated.
“Vulnerabilities remain high among asset managers and close to the levels seen during the global financial crisis,” the fund said. “Asset managers in several countries — notably China and the United States — entered the Covid-19 crisis with higher leverage, maturity and liquidity mismatches.”
While central banks’ stimulus measures have eased many of the stresses that emerged last month and triggered a relief rally in financial markets over the past two weeks, the “large portfolio losses” incurred could still lead to further investor outflows, the IMF noted. This would test bond funds in particular, given trickier trading conditions.
The fund estimated that the typical open-ended bond fund has about 7 per cent of its money in cash as a buffer against outflows, but some funds carry less. More outflows could exhaust these buffers, trigger renewed turbulence and clog up credit markets.
“A prolonged period of dislocation in financial markets may result in distress among other financial institutions, including asset managers, to an extent that could lead to a credit crunch for non-financial borrowers,” the IMF said.
However, the biggest vulnerability may be the developing world, which the IMF said was “facing the perfect storm” of deep recessions, contracting export revenues, public health challenges and unprecedented investor outflows. “This may lead to a rise in debt restructurings, which could test existing debt resolution frameworks,” it warned.
Coronavirus business update
How is coronavirus taking its toll on markets, business, and our everyday lives and workplaces? Stay briefed with our coronavirus newsletter.
One positive for the health of the financial system is that most banks look more durable than in 2008, after increasing their capital buffers and being subjected to regular stress tests since the financial crisis.
Yet even banks will not prove immune if the coronavirus crisis persists. For example, the losses implied by the IMF’s global economic forecasts are greater than those modelled by the fund’s own typical economic shock stress test, and the “downside risks around the forecasts are significant”, the fund said.
“The resilience of banks . . . 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,” it reported.
The IMF estimates that total undrawn bank lines of credit to companies in G7 countries amounted to $10tn at the end of 2019. While the new array of central bank funding facilities will help to ease strains, a large-scale drawdown could “impair banks’ ability or willingness to maintain the flow of credit to the economy”, the fund warned.