IMF’s grim forecasts show financial risks loom

by nyljaouadi1
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Never has the IMF’s World Economic Outlook made such grim reading. The sudden stop in economic activity intended to curtail the spread of coronavirus, it says, has led to the sharpest reversal in global growth since the Great Depression. After forecasting growth of around 3 per cent for 2020 in January, it now predicts a 3 per cent contraction in output — a far worse drop even than during the financial crisis. Britain’s fiscal watchdog, the Office for Budget Responsibility, forecasts an unprecedented 35 per cent drop in output in the second quarter from the first.

These forecasts may still turn out to be too optimistic. A longer-lasting lockdown or a second wave of infections would plunge the global economy into an even deeper contraction. The IMF estimates that such scenarios would reduce the world’s economic output by an additional 2 per cent and 5 per cent respectively by 2021.

Such extreme scenarios would have dire impacts on financial stability: even the IMF’s baseline scenario is worse than those typically used in stress tests that model how banks would cope with a downturn. The fund’s financial stability report, also published on Tuesday, acknowledges that fiscal and monetary stimulus have eased liquidity and reduced the pressures on the financial system. But many risks still remain — particularly highly indebted companies and leveraged investors, some of whom face liquidity mismatches.

Measures taken by the Federal Reserve, including extending swap lines to US allies, have reduced the pressures in the dollar funding market that is critical to international finance. Investor sentiment has improved since March. Government loan guarantees and direct payments have reduced worries about an imminent wave of defaults as have the Fed’s controversial moves to buy up junk bonds.

Many funds have already moved to reduce their risk and build up liquidity buffers. Sales of illiquid assets, as well as margin calls, helped exacerbate the sell-off in markets last month but will dampen volatility in future.

Yet the current calmer tone in markets — the S&P 500 has regained roughly half its losses since February’s peak — partly reflects predictions that lockdowns will soon ease and work can resume. If that proves untrue, bank balance sheets will take a hit and asset managers may be forced into fire sales. That could help turn a public health emergency into a financial crisis.

Poorer countries are in trouble either way. The IMF describes the combination of greater risk aversion, as international investors pull their funds from emerging markets, and a collapse in commodity prices, as a “perfect storm”. While developed-country banks have reduced their leverage since the last financial crisis, poorer countries have become even more dependent on external dollar funding. Oil exporters such as Colombia and Nigeria are particularly exposed.

On Tuesday the IMF announced that it had already granted debt relief to 25 of the world’s poorest countries worth an estimated $214m. More extreme measures will probably be necessary before the crisis is over, including a broader restructuring in concert with rich countries and new issuance of the IMF’s Special Drawing Rights.

Such a restructuring of debts in developed countries may be needed too, especially if lockdowns last longer than anticipated. Banks may then even need a capital injection to help them absorb associated losses.

The best policy for the world economy, as well as for humanity, however, would be to get health policies right and make the recession as shallow as possible.

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