IMF warns global financial system faces repercussions from Ukraine war

BY CHARLES ABUEDE

Global financial conditions have tightened and downside risks to economic outlook have increased as a result of the war in Ukraine, the International Monetary Fund (IMF), one half of the global Bretton Woods institutions, has warned in its just published Global Financial Stability Report (GFSR).

The IMF also warned that financial stability risks have risen on several fronts, even though so far, no global systemic event affecting financial institutions or markets has materialised, adding that a sudden repricing of risk resulting from an intensification of the war and associated escalation of sanctions may expose, and interact with, some of the vulnerabilities built up during the pandemic, leading to a sharp decline in asset prices.

The IMF is, therefore, calling for a decisive action by the world’s central banks to prevent inflation pressure from becoming entrenched and avoid an unmooring of inflation expectations while also advocating that policy normalisation or further rates increase, with respect to other measures taken during the pandemic (such as asset purchases), should continue as warranted according to the country-specific inflation and economic outlook to anchor inflation expectations and preserve policy credibility.

It also noted that central banks are faced with a challenging trade-off between fighting record-high inflation and safeguarding the post-pandemic recovery at a time of heightened uncertainty about prospects for the global economy, as a result of the sharp rise in commodity prices which is anticipated to add to preexisting inflation pressure.

Meanwhile, bringing inflation back down to target and preventing an unmooring of inflation expectations require a delicate act in removing accommodation while preventing a disorderly tightening of financial conditions that could interact with financial vulnerabilities and weigh on growth, it said.

The report shows how higher commodity prices — together with prolonged supply disruptions — have made pre-war inflationary pressures worse, adding that the war has also caused spikes in volatility across asset classes, reflecting greater uncertainty about the underlying global economic outlook.

Tobias Adrian, director, monetary and capital markets department at the IMF, said the major theme of this latest report is the implications of the war in Ukraine on the global financial system, noting that while as of now, the war is not seen as a “global systemic event” that poses an immediate threat to financial stability, it was having repercussions globally.

Adrian said: “Since the beginning of the year, financial conditions have tightened significantly across most of the world. Rising inflation, together with the rapid decline in equities’ prices and the expectation of rate hikes, have led to a notable tightening in advanced economies and in some emerging markets with close ties to Russia and Ukraine.

“The challenge for central banks, in advanced economies in particular, will be to bring inflation back to target while avoiding an excessive tightening of global financial conditions that would put their economies’ growth at risk.

“Emerging markets face an especially challenging environment going forward. Inflationary pressures were already high before the war in many economies across Latin America and Eastern Europe. But emerging and frontier markets now also face higher risks of capital outflows, as investors re-assess their exposures to emerging markets in light of US monetary policy tightening and the heightened geopolitical uncertainty. European markets also face special challenges in the current environment given the dependence on energy trade with Russia,” he concluded.

In the report, the IMF said policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a disorderly tightening of financial conditions.

Striking a balance between containing the buildup of vulnerabilities and avoiding procyclicality appears important given uncertainties about the economic outlook, the ongoing monetary policy normalisation process, and limits on fiscal space in the aftermath of the pandemic, the report stated, and further asserted that to avoid unnecessary volatility in financial markets, it is crucial that central banks in advanced economies provide clear guidance about the normalisation process while remaining data dependent.

The IMF further noted, on the matter of maintaining financial stability globally while lending voice to the trading of crypto assets, that crypto asset trading volumes against some emerging market currencies have spiked following the introduction of sanctions against Russia and the use of capital restrictions in Russia and Ukraine.

This is occurring against a longer-term increase in such cross-border transactions, bringing to the fore the challenges of applying capital flow measures and sanctions, said the IMF.

“Policymakers should develop comprehensive global standards for crypto assets along the activity and risk spectrum. A more robust oversight of fintech firms and decentralised finance (DeFi) platforms is needed to take advantage of their benefits while mitigating their risks. To preserve the effectiveness of capital flow management measures in an environment of growing usage of crypto assets, policymakers need to pursue a multifaceted policy strategy.

“Recent measures taken in markets and exchanges in response to elevated volatility in commodity prices highlight the need for regulators to examine the broader implications, including exchange governance mechanisms, resiliency of trading systems, concentration of risk, margin setting, and trading transparency in exchange and over-the-counter markets,” the report stated.

The Bretton Woods institution maintains that regulators should assess the implications of increased volatility in commodity markets on how the markets are functioning and on how risk is managed.