Risks to financial stability grow as the war complicates efforts to curb inflation
Russia’s invasion of Ukraine raises risks to financial stability worldwide and raises questions about its longer-term effect on economies and markets. The outbreak of war, amid an already slow recovery from the pandemic, is testing the resilience of financial markets and posing a threat to financial stability, as outlined in our latest Global Financial Stability Report.
Ukraine and Russia face the most direct risks. However, it is already clear that the severity of the turmoil in commodity markets and disruptions in supply chains create downside risks through their negative impact on macro-financial stability, inflation and the global economy.
Since the beginning of the year, financial conditions have tightened considerably in most of the world, especially in Eastern Europe. Amid rising inflation, expectations of higher interest rates led to a significant tightening of conditions in advanced economies in the weeks following Russia’s invasion of Ukraine. Even with this tightening, financial conditions remain close to their historical averages, and real interest rates remain accommodative in most countries.
A tightening of financial conditions helps to dampen demand and also prevents excessive inflationary expectations (ie when the expectation of continued high prices in the future becomes the norm) and returns inflation to the target level.
Many central banks may find it necessary to move quickly beyond current price levels in markets to contain inflation. This would raise interest rates to levels above neutral (“neutral” is one in which monetary policy is neither accommodative nor restrictive and is consistent with an economy that maintains full factor employment and stable inflation). This is likely to lead to further tightening of global financial conditions.
The new geopolitical reality complicates the work of central banks, which have already faced a delicate balancing act with chronically high inflation. It must reduce inflation and bring it back to the target level, bearing in mind that excessive tightening of global financial conditions harms economic growth. In this context, and in light of the escalating risks to financial stability, any sudden reassessment and pricing of risks as a result of the intensification of the war in Ukraine or the escalation of sanctions against Russia, may reveal some of the vulnerabilities that have accumulated during the pandemic (a boom in real estate prices and overvaluation leading to to a sharp drop in asset prices).
Transmission of shock effects
The consequences of the war and subsequent sanctions continue to shake. The resilience of the global financial system will be tested through a series of potential reinforcement channels. These channels include exposure of financial institutions to Russian and Ukrainian assets, market liquidity and funding pressures, and accelerated adoption of cryptocurrency—that is, citizens choosing to use crypto assets over local currency—in emerging markets.
Europe bears greater risks than other regions due to its geographic proximity to war zones, its dependence on Russia for energy needs, and the significant exposure of some banks and other financial institutions to Russian financial assets and markets. Moreover, the current volatility in commodity prices may put severe pressure on commodity financing and derivatives markets and may cause further disruptions such as the extreme volatility that halted some nickel trading operations last month. The occurrence of these episodes, amid growing geopolitical uncertainty, could affect liquidity and funding conditions.
Emerging economies now face greater risks of capital flight, although there are differences among countries between importers and exporters of goods. Amid geopolitical uncertainty, the risk of capital flight is likely to increase with the interplay of tightening external financial conditions and the return to normal policy by the US Federal Reserve (with the first interest rate hike in March and an expected faster withdrawal of balance sheet support).
After the Russian invasion of Ukraine, the number of sovereign bond issuers in upstream markets whose bonds were trading at inappropriate prices (ie, spreads were above 1,000 basis points) rose to more than 20% of issuers, following the peak levels of the pandemic. While this was worrisome, it had limited impact on systemic issues given that these issuers contribute a relatively low percentage of total debt outstanding to date.
In China, a recent wave of equity sell-offs, particularly in the technology sector, along with ongoing pressures in the real estate sector and renewed quarantine measures, have heightened concerns about slowing growth, with possible spillovers to emerging markets. Risks to financial stability have increased due to ongoing pressures in the crisis-hit real estate sector. Extraordinary fiscal support measures may be needed to reduce pressures on balance sheets, but they will increase future debt exposure.
Policy of action
Central banks should take decisive action in the short term to prevent inflation from taking hold and keep expectations of future price increases under control. An increase in interest rates to current market price levels may be necessary to bring inflation back to the target level in due course. This may require raising interest rates well above their neutral level. In the case of advanced economies’ central banks, clear communication is essential to avoid unnecessarily volatile financial markets, by providing clear guidance on the tightening process while remaining data-driven.
Many emerging market central banks have already tightened policy significantly. And it should continue to work in this direction – according to the circumstances of each of them separately – in order to maintain its credibility in the fight against inflation and stabilization of inflationary expectations.
Policymakers should tighten selected macroprudential tools to address large areas of vulnerability (for example, countering house price trends), while avoiding a broad tightening of financial conditions. Here, it is important to find the right balance given the uncertainty surrounding the economic outlook, the ongoing process of monetary policy normalization and the limited fiscal space after the pandemic.
Policymakers will also face structural issues such as the fragmentation of capital markets, which will have implications for the role of the US dollar. Payment systems face similar risks as central banks seek to issue their own digital currencies independent of existing government networks. Regulators will also face pressure to close regulatory loopholes to ensure integrity and protect consumers in the rapidly evolving world of crypto assets.
At the same time, the trade-offs between energy security (adequacy of supply at a reasonable price) and climate (regulatory mechanisms aimed at increasing oil and gas prices) are exposed as the effects of international sanctions against Russia spill over into supply and prices across Europe and beyond. There may be some setbacks in the climate transition in the near future, but the momentum of reducing energy dependence on Russia could become a catalyst for change. Therefore, policymakers should strive to meet the climate commitments they have made and step up their efforts to achieve net zero emissions goals, while taking appropriate additional steps to address energy security concerns.
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Tobias Adrian He is a financial advisor and director of the Department for Monetary and Capital Markets at the International Monetary Fund. In this capacity, he leads the Fund’s work on the supervision of the financial sector and oversees capacity building activities, monetary and macroprudential policy, financial regulation, debt management and capital markets. Prior to joining the Fund, he was Senior Vice President of the Federal Reserve Bank of New York and Associate Director of the Research and Statistics Group. Mr. Adrian has lectured at Princeton and New York Universities and has published numerous papers in economics and finance journals, including American Economic Review andJournal of Finance. His research work is focused on the overall effects of movements on the capital market. He received his doctorate from the Massachusetts Institute of Technology, his master’s degree from the London School of Economics, his bachelor’s degree from the Goethe University in Frankfurt, and his master’s degree from the Dauphine University in Paris.
