Accommodative Conditions Mask Long-term Risks, Says October 2024 Global Financial Stability Report
The International Monetary Fund (IMF) has released its October 2024 Global Financial Stability Report (GFSR), offering a mixed assessment of the current global financial landscape. Despite some improvements since April, the report warns that rising vulnerabilities and economic uncertainties could pose significant risks to stability in the medium term, even as near-term risks remain contained.
Accommodative Conditions Mask Underlying Risks
Since April 2024, global financial conditions have largely remained accommodative. The report highlights that economic activity has moderated and inflation has slowed, thanks to a series of monetary easing measures by major central banks, including the Federal Reserve, the European Central Bank (ECB), and the Bank of England. This has kept borrowing costs low and asset prices high, supporting a favorable environment for markets.
Yet, the IMF warns that these accommodative conditions are masking deeper vulnerabilities. “Asset valuations appear lofty, and global debt levels continue to rise, particularly among nonbank financial intermediaries,” the report states. It points to increased use of leverage among hedge funds and private credit funds, as well as concerns over maturity mismatches in some investment funds and insurers.
These imbalances, the IMF cautions, could exacerbate financial disruptions if unexpected shocks occur. The report underscores the potential for market turmoil similar to the volatility experienced in early August, when global stock prices took a sharp dive following disappointing U.S. labor market data and a policy shift by the Bank of Japan. The episode served as a stark reminder of how swiftly market calm can give way to chaos when investor sentiment shifts
Disconnect Between Volatility and Economic Uncertainty
A key concern highlighted in the GFSR is the growing disconnect between relatively low financial market volatility and elevated economic uncertainty. Much of this uncertainty stems from geopolitical tensions, including ongoing military conflicts in the Middle East and Ukraine, as well as policy shifts from newly elected governments around the world.
The IMF notes that while markets have been relatively stable, the potential for sudden shifts in volatility remains high. “The disconnect between economic uncertainty and low financial market volatility suggests that markets may be underpricing risks,” the report warns. This could result in sharp corrections if adverse events materialize, forcing leveraged investors to unwind their positions rapidly and triggering a chain reaction of asset sales.
The August market turmoil illustrated this risk. According to the report, the sudden sell-off, triggered by a combination of yen-funded carry trade unwinding and weaker-than-expected U.S. employment data, caused global equities to plummet, with Japan’s Nikkei index falling by 12 percent in a single day. The report highlights the role of certain nonbank financial intermediaries in amplifying the sell-off, suggesting the need for more active supervisory engagement in this sector.
Emerging Markets Show Resilience but Face New Challenges
Emerging markets, which have been particularly vulnerable to global economic shifts in recent years, have shown surprising resilience since the April report. The IMF attributes this to proactive policy measures by emerging market central banks, which have focused on maintaining stable domestic conditions amid global headwinds. The report emphasizes that these economies have managed to navigate pressures on their currencies and maintain access to funding.
However, the outlook is not without risks. The IMF points to slowing growth in China as a key vulnerability, warning that further deterioration in China’s real estate market could have significant spillover effects on other emerging markets. Additionally, frontier markets and countries with weaker fiscal positions may face growing challenges in accessing international funding as global liquidity tightens.
“Preserving financial stability in emerging markets could become more difficult in the months ahead,” the report warns, especially as global economic uncertainty persists and advanced economies adjust their policy stances. The IMF advises these economies to bolster their fiscal buffers and maintain flexibility in managing exchange rates to navigate potential turbulence.
Monetary Policy: A Balancing Act
The report also addresses the complex balancing act facing central banks worldwide. With inflation gradually easing in most advanced economies, many central banks have begun to shift toward a more neutral policy stance. The Federal Reserve, ECB, and Bank of England have all cut policy rates this year, aiming to support economic growth without reigniting inflation.
Yet, the IMF advises caution. For central banks in economies where inflation remains stubbornly above targets, the report suggests pushing back against market expectations for rapid monetary easing, which could further inflate asset prices and exacerbate financial imbalances. “Clear communication from central banks is critical to manage market expectations and reduce uncertainty,” the report notes.
In addition, the GFSR highlights the need for careful management of quantitative tightening. As central banks reduce their holdings of government bonds, the report warns that this could increase market volatility, particularly if investor demand shifts toward more price-sensitive sectors. The IMF underscores the importance of maintaining liquidity in government bond markets to avoid unintended disruptions.
Policy Recommendations: Addressing Nonbank Risks and Building Resilience
In response to the evolving risks, the IMF outlines a series of policy recommendations aimed at strengthening the global financial system. Key among these is the need for greater regulatory oversight of nonbank financial intermediaries, whose increased leverage and liquidity mismatches pose a growing risk to market stability. The report calls for a renewed focus on implementing international banking standards to prevent regulatory arbitrage.
Furthermore, the IMF emphasizes the need for countries to rebuild fiscal buffers, particularly those with high levels of sovereign debt. By focusing on sustainable fiscal policies, governments can keep external financing costs in check and ensure more stable economic conditions.
The report also touches on the importance of climate finance, particularly for emerging markets and developing economies. Underinvestment in this area, the IMF warns, could delay progress on climate mitigation and adaptation, adding to long-term risks for financial stability.
Outlook: Navigating an Uncertain Path
The October 2024 *Global Financial Stability Report* paints a picture of a world in flux, where financial markets enjoy a semblance of calm even as risks continue to brew beneath the surface. With global growth prospects uncertain and economic policies in flux, the IMF’s message is clear: maintaining financial stability in this environment will require vigilance, robust policy responses, and a readiness to adapt to evolving challenges.
As the global economy enters this new phase, policymakers face a difficult balancing act between sustaining growth and addressing the vulnerabilities that could threaten future stability. The IMF’s warnings serve as a reminder that while the immediate risks may seem contained, the road ahead is far from certain.
