What is the outlook on the global economy? | Explained Premium

IMF warns of risks from high inflation, unregulated credit market, and cyber-attacks, impacting global financial stability.

The story so far: The International Monetary Fund (IMF) released the latest global financial stability report on Tuesday warning about the risks to the global financial system from persistent high inflation, rising lending in the unregulated credit market, and increasing cyber-attacks on financial institutions.

The IMF has flagged rising enthusiasm among investors that the fight against high inflation over the last few years has almost come to an end. Investors have been pushing up the prices of financial assets such as stocks in recent months in the hope that central banks will soon begin lowering interest rates as inflation comes under control. It should be noted that central banks generally try to lower interest rates by injecting more into the economy when inflation falls in an attempt to boost economic growth. Although central banks are yet to lower interest rates, investors may take falling inflation as a cue that central banks will soon flush the markets with more money to lower interest rates. So they go ahead and purchase financial assets in anticipation of greater demand for these assets when banks actually lower interest rates, thus pushing up the prices of these assets right now.

The IMF, however, believes that investor enthusiasm about slowing inflation and a possible cut in interest rates by central banks may be quite premature. It has noted that the fall in inflation has probably stalled in some major advanced and emerging economies where core inflation in the most recent three months has been higher than in the previous three months. The IMF has also warned that geopolitical risks such as the ongoing war in West Asia and Ukraine could affect aggregate supply and lead to higher prices. This, it believes, might stop central banks from lowering rates anytime soon.

If these risks persist, the IMF believes, investors who have been bidding up asset prices expecting fresh money from central banks to push up asset prices in the near future may change their mind. This could cause a sharp correction in the prices of various assets and leave many investors with significant losses.

The IMF notes that fund flows into emerging markets have been strong till now due to optimism over central banks easing interest rates. In fact, in calendar year 2023, India was the second-largest recipient of foreign capital after the U.S., according to Elara Capital. But things could change quickly if western central banks signal that they could keep interest rates high for a long time. This could cause investors to pull money out of emerging markets like India and increase pressure on their currencies. The Indian rupee has already been depreciating and traded at a new low of 83.57 against the U.S. dollar last week despite likely intervention by the Reserve Bank of India (RBI). A severe outflow of capital if western central banks fail to lower interest rates could cause further depreciation of the rupee and have effects on the country’s financial system. In such a scenario, the RBI is likely to defend the rupee by curbing liquidity to raise interest rates, which could cause the economy to slow down.

The IMF in its report also noted that the growing unregulated private credit market, in which non-bank financial institutions lend to corporate borrowers, is a growing concern as troubles in the market might affect the broader financial system in the future. It estimates that the private credit market globally grew to $2.1 trillion last year. The non-bank financial institutions lending to corporate borrowers include institutional investors such as pension funds and insurance companies. Institutional investors are investing in the private credit market because they offer higher returns than normal investments. Meanwhile, the borrowers benefit as they cannot get convenient long-term funds through other venues.

The IMF, however, is worried that the borrowers in the private credit market may not be financially sound and noted that many of them do not have current earnings that exceed even their interest costs. It also argues that since these loans rarely trade in an open, liquid market like many other securities do, it might be hard for investors to really gauge the risk involved in these loans. Thus private credit assets have significantly smaller markdowns in their mark-to-market value during times of stress, the IMF notes. In a highly liquid market where securities are traded frequently, the real risk behind a loan is priced in more immediately and also more accurately by investors. Nevertheless, it may be the case that institutional investors are fully willing to bear the risk in return for higher returns.