Global financial stability report 2022 From International Monetary Fund

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According to an article published recently by the International Monetary Fund, COVID-19 has enabled the emerging economies to hold a record level of government debt, increasing the possibility of financial pressure on the public sector to threaten financial stability. The authorities should act quickly to minimize this risk.

The article said that governments around the world have significantly increased spending to help families and businesses resist the economic impact of the epidemic. With the government issuing bonds to cover the budget deficit, public debt is also increasing.

The second chapter of the global financial stability report released by the International Monetary Fund in April pointed out that the ratio of public debt to GDP of emerging economies had risen to a record 67% on average last year.

Most of these debts are financed by banks in emerging economies. In 2021, the proportion of government debt held by banks in emerging economies in their assets has reached a new record of 17%. In some economies, government debt has reached a quarter of bank assets. As a result, governments in emerging economies rely heavily on their banks for financing, and these banks also rely heavily on their government bonds as investments – they can use them as collateral to obtain funds from central banks.

Relationship between sovereign debt and banks

The article said that if the government finance is under pressure and the market value of government bonds decreases, banks holding a large number of sovereign debt will suffer losses. This may force banks to reduce loans to businesses and households, putting pressure on economic activity. As the economy slows down and tax revenue decreases, government finance may face greater pressure to further squeeze banks.

“Sovereign bank linkage” may produce a self reinforcing negative feedback cycle, which may eventually force the government to default. This phenomenon also has a special name – “doomsday cycle”. It occurred in Russia in 1998 and in Argentina from 2001 to 2002.

Increased risk

Emerging market economies now face greater risks than developed economies for two reasons. First, compared with the trend level before the epidemic, the growth prospects of emerging market economies are weaker than those of developed economies, and the government has less fiscal space to support the economy; Second, the cost of external financing is generally rising, so the government will have to bear higher borrowing costs.

What will trigger a “doomsday cycle” in a country? In the context of the normalization of monetary policies in developed economies and the intensification of geopolitical tensions caused by the conflict between Russia and Ukraine, if the global financing environment is tightened sharply, resulting in the rise of interest rates and the weakening of exchange rates in emerging market countries, it may weaken investors’ confidence in the debt repayment ability of governments in emerging economies. Domestic shocks, such as an unexpected slowdown, may have the same impact.

Risk channel

Chapter II of the global financial stability report also outlines two other potential channels of risk transmission between the government and the banking sector.

One of these channels relates to government support arrangements for stressed banks, such as deposit insurance. Government fiscal pressure may damage the credibility of these safeguard arrangements, weaken investor confidence and ultimately damage the profitability of banks. Troubled banks will have to seek government assistance, which will further increase the financial pressure on the public sector.

The other channel conducts risk through the wider economy. If the public finance is hit, it may push up the interest rate in the overall economy, damage the profitability of enterprises and increase the credit risk of banks. This, in turn, limits banks’ ability to lend to households and other corporate customers, thereby curbing economic growth.

Sound finance and the bank’s ability to resist risks

The article said that the slow economic recovery means that the government should continue to rely on spending to support growth. However, as the central bank monetary policy of developed economies begins to return to normal, the rate of return on capital of developed economies continues to rise, which may reduce the attractiveness of emerging market debt and put upward pressure on its borrowing costs. Therefore, it is necessary to implement a prudent fiscal policy to avoid further strengthening the “sovereign bank link”. The government can also enhance investors’ confidence in its finances by formulating a credible medium-term deficit reduction plan.

The article points out that it is also important to enhance the anti risk ability of the banking industry by protecting the capital buffer that absorbs losses. Considering the high uncertainty of the economic outlook, banks can be restricted from distributing funds to shareholders in the form of dividend distribution and stock repurchase, so as to achieve the purpose of protecting the capital buffer. In addition, when the regulatory tolerance policy is revoked, it may be necessary to conduct asset quality review and provide guidance on the adequacy level of capital, so as to determine the number of hidden losses and identify weak banks.

The article said that policymakers should take a variety of countermeasures as solutions to reduce the risk of financial or economic crisis.

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