A Bridge to Economic Recovery: Be Aware of Financial Stability Risks

A Bridge to Economic Recovery: Be Aware of Financial Stability Risks

[vc_row][vc_column][vc_column_text]Despite a global economic crisis comparable only to the Great Depression, near-term financial stability risks have been contained with the help of unprecedented monetary policy easing and massive fiscal support across the globe. But many economies had pre-existing vulnerabilities—which are now intensifying, representing potential headwinds to the recovery.

Extraordinary policy measures have stabilized markets, boosted investors’ sentiment, and maintained the flow of credit to the global economy. Critically, these measures helped prevent a slowing economy and sliding financial markets from feeding on each other in a destructive vicious cycle.

The rebound in asset prices and the easing in global financial conditions have benefited not only advanced economies, but also emerging markets. In addition, unlike in previous crises, emerging markets this time were also able to respond by cutting policy rates, injecting liquidity and, for the first time, employing asset purchase programs.

Beware of the real-financial disconnect

The significant improvement in financial conditions has helped maintain the flow of credit to the economy, but the economic outlook remains highly uncertain. A disconnect persists, for example, between financial markets—where there have been rising stock market valuations (despite the recent repricing)—and the weak economic activity and uncertain outlook. This gap can gradually narrow if the economy recovers swiftly. But if the recovery is delayed, for example because it may take longer to get the virus under control, the investor optimism may wane.

As long as investors believe that markets will continue to benefit from policy support, asset valuations may stay elevated for some time. Nonetheless, and especially if the economic recovery is delayed, there is a risk of a sharp adjustment in asset prices or periodic bouts of volatility.

Corporate sector vulnerabilities are high and rising

Policy measures have allowed firms to cope with cash shortages experienced during economic shutdowns by taking on more debt. While this additional borrowing has helped avoid a wave of bankruptcies at the early stages of the crisis, it has also led to further rise in corporate debt burdens. But many of these firms already had very high levels of debt before the crisis, and now indebtedness in some sectors is reaching new highs. This means that solvency risks may have shifted into the future and renewed liquidity pressures could easily morph into insolvencies, especially if the recovery is delayed.[/vc_column_text][/vc_column][/vc_row]

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