IMF Warns Global Economy in Precarious Position Due to Credit Market Instability

Chris Gaetano
Published Date:
May 26, 2020
While stocks have risen on hopes that the economy will soon be getting back to normal, the International Monetary Fund's latest financial stability report said the pandemic has left the economy in a precarious state, as credit market shocks meet with high levels of corporate debt, promising a tightening of financial conditions that could exacerbate other systemic vulnerabilities.

The IMF noted that debt markets, which it previously stated were a major threat to global financial stability, experienced a high degree of disruption once lockdowns went into place. The IMF noted in particular that strains in the markets for high-yield corporate debt and leveraged loans are still apparent as of April, with risks for both rising sharply since February. This in turn has put further stain on general financial conditions. For example, leveraged investors in March were forced to close out some of their positions in order to meet margin calls or to rebalance their portfolios—a dynamic that likely amplified asset price declines.

Further, the IMF noted that asset valuations that had been deviating more and more from fair value saw a sharp contraction in February and March in multiple countries. This was a correction from what the IMF said last year were historically overvalued assessments, which led  equity prices to tumble virtually everywhere with one major exception: the United States. The report noted that, in contrast to the decline in most of the world, the U.S. decline in prices in March has been outpaced by a sharp deterioration in the fundamentals-based value, leading to an even more misaligned market than before. It said the biggest reason behind this has been the lack of earnings forecasts revised to reflect the new economy. While earnings revisions have traditionally lagged, the unprecedented pace of market declines have made such revisions particularly important. The IMF said once earnings forecasts have been fully revised, the dispersion in earnings forecasts may decline, likely lessening the extent of overvaluation everything else equally.

Overall, however, credit market chaos has led to a significant tightening of financial conditions, as falling equity prices and widening corporate bond spreads have created a
a significant increase in downside risks to growth and financial stability. Given this situation, the IMF has estimated that there is a 5 percent probability (an event that happens once every 20 years) that global growth could fall below -7.4 percent, compared to projections in October 2019, when the threshold was above 2 percent. Further, the balance of risk is now  skewed to the downside, with the odds of global growth exceeding zero this year close to just 4 percent. 

And this is just where we are right now. The IMF said that a further tightening of financial conditions risks exposing even more vulnerabilities in the economy, which the report terms "pre-existing conditions." While banks likely have enough capital to weather the storm, the IMF said this means the biggest risks are actually non-financial firms: Due to their high levels of debt, they could be condemned to years of negative growth and elevated funding costs. The report also pointed to asset managers, many of whom entered the crisis with higher leverage, maturity, and liquidity mismatches. The risks facing both groups have the potential to create further ripple effect through the rest of the economy.

With regard to asset managers, the IMF report warned that, while cash buffers make up 7 percent of the average open-ended fixed income fund, increasing numbers of customers withdrawing their investments could still wind up forcing essentially fire sale disposals, which could create a vicious cycle, as doing so could exacerbate asset price declines, leading to more people withdrawing their money in fear, which in turn could lead to yet more fire sale asset disposals, which further depresses prices on the open market.

With regard to corporate borrowers, the second chapter of the report notes that up to 24 percent of high-yield bonds, 27 percent of institutional leveraged loans, and 27 percent of private debt could default within three years, with investors estimated to recover between a quarter to a little less than half their principal. It noted that, as of the end of last year, there was $2.5 trillion in high-yield debt, almost $1 trillion in private debt, and about $5 trillion in leveraged loans. Overall losses in such a scenario are projected to total $1.25 trillion, or almost 20 percent of total exposures. Banks, in such a case, are expected to suffer the least losses, due to their capital buffers, but, by contrast, hedge funds and mutual funds and ETFs with CLO equity tranche holdings and mark-to-market exposures would have the highest loss rates.

In the face of these challenges the IMF called for a strong policy response focusing on loan restructurings; accounting treatment of credit losses; banks; asset managers; financial markets; and liquidity provisions. Internationally, the IMF said governments should coordinate to reduce broader capital flow disruptions, as well as bolster financial regulations, which should be maintained for the long run, with the rollbacks that occurred after the last financial crisis not being repeated.

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