Central Bank Normalization in Advanced Economies: Walking a Tightrope amid Stubbornly High Inflation

With higher commodity prices expected to add to inflation pressure that has been accelerating since the October GFSR, central banks are faced with a challenging trade-off between fighting multiyear-high inflation and safeguarding the recovery at a time of heightened uncertainty about prospects for the global economy. Bringing inflation down to target and preventing an unmooring of inflation expectations require careful communication and actions to prevent a disorderly tightening of financial conditions. Such a tightening, especially if interacting with financial vulnerabilities, could pose risks to financial stability and weigh on growth.

After rising early in the year on concerns about the inflation outlook, advanced economy nominal bond yields increased sharply in March amid heightened interest rate volatility, reflecting an increase of both breakevens and real rates (Figure 1.7, panel 1). The yield increase accelerated in early April as investors reassessed their outlook for monetary policy following the formal commencement of the normalization process by the Federal Reserve at its March Federal Open Market Committee (FOMC) meeting.

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Drivers of Advanced Economy Bond Yields

Sources: Bloomberg Finance L.P.; Goel and Malik (2021); and IMF staff calculations.Note: In panel 4, probabilities are derived from inflation caps and floors. EA = euro area; 5yr5yr = 5-year, 5-year forward; H1 = first half of the year; GFSR = Global Financial Stability Report.

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Inflation breakevens (a market-implied proxy for future inflation) have risen significantly since the beginning of the year on the back of sharply higher commodity prices (Figure 1.7, panel 2). Real rates have also increased in a number of advanced economies, on expectations of tighter monetary policy.

The increase in inflation breakevens across countries has been very pronounced at the five-year horizon. In the euro area, such an increase appears to reflect significantly higher expected inflation, while in the United States higher inflation risk premia—an estimated proxy for inflation uncertainty—seem to have also played a role (Figure 1.7, panel 3). Meanwhile, the rise in inflation breakevens at the five-year, five-year forward horizon has been more contained so far, driven primarily by higher inflation risk premia, suggesting that longer-term inflation expectations continued to be largely anchored despite the jump in commodity prices. However, pricing in inflation options markets points to a notable increase in the probability of high inflation—specifically, inflation outcomes greater than 3 percent—since the time of the previous GFSR (Figure 1.7, panel 4).

The market-implied expected path of policy has risen significantly in advanced economies since the beginning of the year and moved further upward since the Russian invasion of Ukraine, as central banks have taken steps to normalize monetary policy amid record-high headline inflation (Figure 1.8, panel 1). In the euro area, the European Central Bank (ECB) has accelerated the pace of tapering its asset purchase program, noting that interest rate increases could follow some time after the end of asset purchases. The Bank of Japan, by contrast, has maintained its ultra-loose policy as inflation has remained subdued.

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Increase in Advanced Economy Policy Rates

Sources: Bloomberg Finance L.P.; national authorities; US Federal Reserve; and IMF staff calculations.Note: BOE = Bank of England; ECB = European Central Bank; FED = US Federal Reserve; FOMC = Federal Open Market Committee.

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The Federal Reserve delivered its first policy rate hike at its March FOMC meeting. In addition, the median FOMC participant now anticipates the federal funds rate to approach 2 percent by the end of the year (Figure 1.8, panel 2). In real terms, however, the FOMC-implied stance of policy is expected to remain accommodative at least through 2023 (Figure 1.8, panel 3). Even though the market-implied policy path in 2022 is now above the FOMC participants’ assessment of appropriate monetary policy, there is still a risk of a possible repricing of the magnitude of the policy cycle. Historically, once tightening is under way, long-term interest rates eventually tend to move higher (Figure 1.8, panel 4). Such an increase, especially if driven by real rates, may lead to a sudden repricing of risk that may weigh on economic prospects. Reportedly reflecting concerns about the economic outlook, the US Treasury yield curve has fattened significantly since the beginning of the year, and certain segments of the curve have inverted (Figure 1.8, panel 5).

The normalization of balance sheet policies may present additional challenges to central banks. While policy rates remain the main monetary policy tool, clear communication on plans to unwind the unprecedented expansion of central bank balance sheets—in terms of timing, speed of reduction, and composition of both the asset and liability sides—will be crucial to avoid unnecessary market volatility. To gauge the impact of balance sheet normalization on long-term interest rates, investors have focused on the 2017–19 quantitative tightening (QT) experience, highlighting the risk of a sudden increase in term premia given the larger size of the Federal Reserve’s balance sheet and its footprint in some market segments (Figure 1.9, panel 1). The unwinding of the Federal Reserve’s balance sheet is expected to be fast, with more than $1 trillion of assets (approximately 20 percent of the Treasury securities held in the Federal Reserve System Open Market Account portfolio) maturing in 2022 (Figure 1.9, panel 2).

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A Challenging Normalization Process

Sources: Bloomberg Finance L.P.; Federal Reserve; national authorities; and IMF staff calculations.Note: ECB = European Central Bank; QE = quantitative easing; TIPS = Treasury Inflation Indexed Securities; T-sec = Treasury securities.

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While still low by historical standards, southern European countries’ spreads have widened since the ECB’s announcements of its intention to scale back asset purchases, underscoring the risk of market fragmentation in the euro area. Between 2020 and 2021, accommodative and supportive market conditions brought about by the ECB’s asset purchase programs have helped push spreads lower (Figure 1.9, panel 3). With fiscal deficits and debt levels remaining relatively high in some countries, additional fiscal stimulus in Europe is being considered to cushion the impact of the war in Ukraine (including future defense and climate spending) (Figure 1.9, panel 4). The wind-down of asset purchases may contribute to a tightening of financial conditions.

Emerging Market Central Banks Face Further Inflation Pressure

Even before the Russian invasion of Ukraine and the associated surge in commodity prices, emerging market central banks in Latin America and Europe were facing rising inflation pressure. Inflation prints came in well above central bank targets last year, outpacing inflation forecasts (Figure 1.10, panel 1). To maintain market confidence in their ability to meet their mandates, many central banks responded decisively and front-loaded policy tightening—a crucial step, as evidenced by the relative stability of longer-term inflation expectations.⁶ Market participants were already pricing that central banks in Latin America and eastern Europe would be able to halt or even reverse earlier hikes within a one-year horizon on the back of an improvement in the inflation outlook (Figure 1.10, panel 2). Meanwhile, investor flows in local currency markets were experiencing a nascent recovery.

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Inflation and Interest Rates in Emerging Markets

Sources: Bloomberg Finance L.P.; Consensus Forecasts; and IMF staff calculations.Note: Both charts are based on a sample of countries from CEE = Central and Eastern Europe; EM Asia = emerging market Asia; LatAm = Latin America. Panel 1 uses the upper limit of the inflation targeting framework where available. GFSR = Global Financial Stability Report.

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However, the Russian invasion of Ukraine has adversely affected the outlook for many emerging markets. As indicated in the April 2022 WEO, relative to the January 2022 WEO Update, the inflation forecast for emerging market and developing economies for 2022 has been revised up 2.7 percentage points to 8.6 percent, while the GDP forecast for 2022 has been revised down 0.9 percentage point to 3.9 percent. The war in Ukraine has had a larger impact on economies in central and eastern Europe, where a notable tightening of financial conditions has been accompanied by currency interventions (and restrictions such as by Russia and Ukraine), and a shift to an even more hawkish monetary policy stance in some cases. The rise in commodity prices has been swiftly felt in most countries with direct trade links to Russia and Ukraine, creating further upside risks to inflation. In addition to a shift to a more hawkish stance of monetary policy, some countries (such as Egypt) have also taken the opportunity to use the exchange rate as a shock absorber.⁷ By contrast, commodity exporters across emerging markets, such as Brazil, Chile, and South Africa have

Foreign Banks’ Direct Exposures to Russia and Ukraine: Relatively Modest, in Aggregate

Direct exposures of foreign banks to Russia and Ukraine appear to be relatively modest, in aggregate (Figure 1.11, panel 1).⁸ As of the third quarter of 2021, claims of foreign banks on Russian residents totaled about $120 billion, with 60 percent in foreign currencies. For Ukraine, exposures were relatively small at $11 billion. The vast majority of these exposures were held by euro area banks. For some countries, these exposures were economically significant, as individual banks play an active role in the Russian banking system (Figure 1.11, panel 2). Because they operate as subsidiaries, however, they typically fund themselves locally; as a result, intra-group loans are generally small.

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Foreign Bank Exposures to Russia and Ukraine

Sources: Bank for International Settlements, Consolidated Banking Statistics; European Banking Authority; Bloomberg L.P.; individual bank disclosures; and IMF staff calculations.Note: In panel 3, the blue-colored lines on the right chart refer to three different banks with material exposures to Russia and Ukraine. In panel 4, see footnote 15 for

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The market capitalization of European banks declined sharply after the Russian invasion (Figure 1.11, panel 3). While banks with large exposures to Russia and Ukraine experienced the largest declines, an index of European bank equity prices fell over 20 percent after February 24, reflecting in part concerns about a deterioration of the economic and profitability prospects.⁹ By contrast, equity prices of US banks dropped only about 8 percent at the worst point.

Meanwhile, the increase in European bank credit default swap (CDS) spreads has been more modest, suggesting that investors expect the impact of the war and sanctions on banks’ balance sheet and capital to be manageable. Banks with Russian subsidiaries can choose to either exit the market entirely or maintain their presence but prepare for a sharply worsening revenue and asset quality outlook. The exit strategy is estimated to reduce the common equity Tier 1 (CET1) ratio at the group level by an average of 20 basis points, with an impact about four times larger for the most exposed bank (Figure 1.11, panel 4).¹⁰ However, cross-border exposures are likely to be either pulled back or experience some losses, in which case the total impact could reach an average of 80 basis points (about 2½ times the impact for the most exposed bank).

Indirect Exposures: More Difficult to Assess

Banks’ indirect exposures are more difficult to identify and assess because they are less well known (especially the extent of interconnectedness) and hard to quantify in the absence of detailed and consistent disclosures by country or specific activity types. The risk is that indirect exposures could be meaningful and surprise investors once revealed, leading to a sharp rise in counterparty risk and risk premia. These exposures could result from activities such as investment banking and wealth management, derivatives (including commodity derivatives),¹¹ and off-balance-sheet exposures related to supply chain or commodity financing, as well as contingent liabilities and guarantees.¹² In some cases, these exposures to Russian counterparties could be large. For example, foreign exchange swap and forward contracts, unlike other derivative instruments, involve the exchange of notional amounts and are akin to collateralized lending. As such, gross positions matter, as they expose institutions to significant counterparty and settlement risks, notably in situations where foreign currency settlement is restricted.

Before the war, Russian banks had entered into foreign exchange swaps and forwards contracts with foreign dealer banks. Typically, Russian banks would lend US dollars against a pre-agreed amount of Russian rubles (the gross notional amount), as they received large amounts of dollar deposits (and, to a lesser extent, euros) from their clients.¹³ The total gross notional amount of over-the-counter foreign exchange swaps and forwards between Russian banks and foreign dealer banks amounted to about $69 billion at the end of 2021 (Figure 1.12, panel 1, first bar, black diamond). To the extent that foreign dealer banks have received dollars, a default by Russian banks would have limited spillovers in the foreign exchange derivatives market, as foreign banks would be left holding US dollars. Even if that is the case, however, the termination of the foreign exchange derivatives exposures may leave both foreign and Russian banks with unhedged exposures. The Russian banks would be left with a currency mismatch against their domestic depositors, while foreign banks would have to find new instruments to hedge any outstanding ruble exposures. Outstanding amounts of over-the-counter interest rate derivatives, which require only an exchange of interest payments, are generally lower than foreign exchange gross notional amounts, and clearing requirements help to contain counterparty risk exposures (Figure 1.12, panel 2).

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Over-the-Counter Derivative Exposures of International and Domestic Banks in Russia, End-2021

Sources: Central Bank of Russia; and IMF staff calculations.Note: As foreign exchange swap and forward contracts involve the exchange of two currencies, the sum of outstanding notional amounts across individual currencies (for either leg of the contract) in panel 1 is exactly double the total outstanding amount. Foreign dealer banks include the subsidiaries and branches of these banks located in Russia. Over-the-counter interest rate derivatives are generally subject to clearing requirements, although for contracts in Russian rubles clearing has only been mandatory for interest rate swaps since the last quarter of 2021. Such swaps typically constitute the bulk of outstanding amounts (>75% of the global total). CNY = Chinese yuan; EUR = euro; RUB = Russian ruble; USD = United States dollar.

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Nonbank Financial Intermediaries: Coping with a Potential Russian Default

Foreign nonbank financial intermediaries (NBFIs) had sizable investments in Russian assets, holding about one-fifth of its total sovereign debt, half of its corporate debt, and more than 40 percent of Russian equities as of the fourth quarter of 2021 (Figure 1.13, panel.1).¹⁴ Within the NBFI sector, open-end investment funds (OEFs), which offer mostly daily liquidity and are therefore at greater risk of redemption pressures, have exposures to Russian equities of about $100 billion, the vast majority of which is held by US funds (Figure 1.13, panel 2). OEFs also have a combined $34 billion in fixed-income assets, about two-thirds of which is held by European funds. As a share of total assets, however, their exposure to Russia is small. Even for European funds, which display the largest portfolio shares in Russian debt and equities, aggregate exposures are less than 2 percent of funds’ assets.

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Exposure to Russian Assets by Foreign Nonbank Financial Intermediaries

Sources: Arslanalp and Tsuda (2014, updated); Bloomberg Finance LP; Haver Analytics; JPMorgan Chase & Co.; Morningstar; and IMF staff calculations.Note: In panel 1, the “other foreign NBFIs” category for corporate bonds includes all intermediaries that are not open-end funds, including sovereign wealth funds, close-end funds, pension funds, hedge funds, and others. The “rest” category in panel 1 for equities also includes foreign NBFIs outside of open-end funds due to the lack of available data. The market cap of the MOEX index is used as a proxy for the total value of Russian equities. The total value of both Russian sovereign and corporate bonds outstanding includes both foreign and domestic currency bonds. EM = emerging markets; EU = European Union; NBFIs = nonbank financial intermediaries; OAE = other advanced economies; US = United States.

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Within the OEFs, emerging-market-dedicated funds hold the vast majority of Russian debt and equity. However, even these funds have maintained a cautious stance on their exposures to Russian debt since the Crimea occupation in 2014, particularly for the hard-currency bond funds subcategory (Figure 1.13, panel 3). Emerging market dedicated funds reduced their share of Russian debt from over 10 percent prior to 2014 to just over 4 percent in 2022. In fact, heading into the 2022 Russian invasion, these funds had (on average) an underweight position compared to their emerging market benchmark (more on this follows). In contrast to emerging-market-dedicated funds, funds benchmarked to global indices had a much smaller exposure to Russia (in both absolute and relative terms), with an average 0.2 percent of their assets invested in Russian debt in 2022.¹⁵ On equities, the share of Russian exposure in emerging-market-dedicated funds stood at 4 percent of total assets before the invasion, while for global equity funds it was less than 0.2 percent. Since the Russian invasion of Ukraine, the very sharp drop in valuations of Russian assets has dramatically reduced the market value of investment funds’ exposures to Russia. Some regulators have started to consider options to isolate Russian assets from broader portfolios by, for example, allowing the separation of the Russian exposures into so-called side pockets, which are portfolio tranches exclusively owned by existing investors and are temporarily not available for redemption.¹⁶

Some NBFIs, such as specialized insurers and leasing companies, may also be facing greater risks in the areas of cyber underwriting, trade credit, and aircraft leasing. The war in Ukraine has intensified the risk of offensive cyber operations, with a potentially adverse impact on financial stability in the region and beyond. Despite the relatively small size of cyber insurance (estimated at $8 billion globally), it has experienced rapid growth amid concerns about the uncertainty of expected losses against which insurers have to reserve and hold cap-ital.¹⁷ Aircraft leasing companies, many of which are domiciled in Ireland, are also exposed to potential large losses if Russia refuses to return leased aircraft. Finally, foreign providers of trade credit are also exposed to Russia, with an estimated $16 billion of trade credit as of the last quarter of 2021.

Foreign sanctions as well as capital controls and other retaliatory measures imposed by Russia have increased risks for foreign investors in Russian securities. Payments to foreigners are not explicitly forbidden by the current set of sanctions, but actions taken by Russian and other international securities depositories (ICSDs), along with the freezing of some of Russia’s international reserves, have made payments more difficult.¹⁸ At the time of writing, Russian authorities have continued servicing Russia’s foreign law debt in hard currency but have suspended the transfer of payments to foreigners on local law ruble-denominated bonds. The latter action has not created major complications to foreign law debt given that foreign law bonds and CDS do not contain cross-default terms with local law bonds (Figure 1.14, panel 1). However, further sanctions could prevent bonds from trading in the secondary market, which would hamper the CDS settlement process.

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Investor Challenges in Russian Security Markets

Sources: Bloomberg Finance L.P.; and IMF staff calculations.Note: In panel 1 “RUB fallback” refers to a provision that allows these bonds to be repaid in rubles under certain conditions. NSD = Russian National Settlement Depository; RUB = rubles.

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In addition to disappearing liquidity and rising credit risk, investors face significant challenges in terms of the valuation of their financial instruments. For example, some foreign investors have positions in non-deliverable forwards (NDFs) that settle in dollars but use the onshore foreign exchange rate as the reference rate. The NDF positions can help them hedge their currency exposures without having to sell their highly illiquid positions in local-currency-denominated assets. Since the start of the war, the Russian central bank has kept tight control on the onshore foreign exchange market,¹⁹ and the Ukrainian central bank has not updated the daily foreign exchange rates. The Russian and Ukrainian exchange rates in offshore markets have diverged from the onshore rates, rendering the NDFs as ineffective hedges (Figure 1.14, panel 2). The sanctions and valuation differences between onshore and offshore markets can also be a problem for foreign banks that have foreign exchange derivatives exposures vis-à-vis Russian banks.

The reduced investability of Russian assets has led to their exclusion from multiple benchmark indices largely used by emerging-market-dedicated funds.²⁰ The sharp drop in the liquidity of Russian securities and the reduced convertibility of the ruble were some of the key reasons behind the decisions of benchmark providers. Global bond benchmarks (as opposed to emerging-market-specific benchmarks) are reliant on Russia maintaining an investment-grade rating, which is no longer the case. Environmental, social, and governance (ESG) related indices have also excluded Russian assets. While these ESG indices are relatively smaller in size, they are growing fast and reflect investors’ increasing focus on the ESG dynamics for emerging markets. Finally, Ukraine’s inclusion in the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) index family, which was scheduled for March 31, 2022, is now subject to a further review given the current circumstances. This inclusion was expected to bring additional flows to the local market and help with market deepening.

The index exclusion of Russia is a notable event because benchmark-driven investors have become a key source of intermediating cross-border flows to emerging markets.²¹ While the index exclusion adds to price pressures and illiquidity, Russia’s weight in the indices has declined sharply in the past few years. Its median weight across major indices dropped from 10 percent during the global financial crisis to just 3 percent before the Russian invasion of Ukraine, and less than 1 percent immediately thereafter, largely due to valuation declines (Figure 1.15, panel 1).

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Impact from Russia’s Exclusion from Global Benchmark Indices

Sources: Bloomberg Finance L.P.; JPMorgan Chase & Co.; and IMF staff calculations.Note: In panel 1, EM local currency bonds refers to JPMorgan Government Bond Index, EM hard currency bonds refers to JPMorgan Emerging Market Bond Index, global bonds refers to Bloomberg Barclays Global Aggregate Index, and corporate refers to JPMorgan Corporate Emerging Market Bond Index. Data labels use International Organization for Standardization (ISO) country codes. EM = emerging markets.

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Russia’s exclusion from benchmarks could lead to some positive portfolio reallocation flows to other emerging markets, as their benchmark weight will mechanically increase. Investors could also choose to reallocate funds to other emerging markets that shared similarities with Russia before the war. For instance, the 2014–15 Russian annexation of Crimea led to a foreign investor exit from Russian local assets, while foreign ownership in other high-yielding emerging markets rose at the same time (Figure 1.15, panel 2). Investors could also gain exposure to countries that benefit from the current macro backdrop, such as commodity exporters.

Commodity Price Volatility Amplified by Commodity Trade Finance and Derivatives Exposures

The ongoing war in Ukraine, associated sanctions, market participants’ actions in response to the global outcry, and rising counterparty risk have caused severe disruptions in commodity markets and supply chains across the globe (Blas 2022).²² Amid sharply rising volatility, prices have skyrocketed across the commodity complex, causing severe pressures in commodity financing and derivatives markets. Shipping costs of commodities have increased, and higher commodity prices have raised the financing needs of commodity traders and those involved along the supply chain. In addition, users of commodity derivatives (including commodity producers using futures or options for hedging purposes, commodity trading firms, dealer banks, levered investors like hedge funds, and investment funds) have faced massive margin calls on short positions in response to huge swings in commodity prices, testing the resilience of corners of global financial markets that were little known by the broader public only a few weeks ago (see Box 1.1 on the nickel market disruption).²³

Dealer banks play a crucial role and have significant exposures in commodity markets, so there is a risk they may become a propagation channel of commodity market disruptions. They provide collateralized funding to finance the shipment of commodities. In addition, they provide leverage to some investors and act as intermediaries in commodity derivatives markets. For example, when commodity producers enter into a (short) future position to hedge against a drop in (future) commodity prices, dealer banks take the opposite side (long) of this trade. In turn, they then hedge their book by entering into an opposite trade (for example, on an exchange).²⁴ Furthermore, they often offer lines of credit to their clients, which can be used at times of acute liquidity needs.

A concern raised by some market participants is that, in response to large swings in commodity prices, differences in initial margin modeling and the prevalence and frequency of posting variation margins appear to be incentivizing some derivative users to trade bilaterally with broker dealers instead of centrally cleared trades, because doing so may offer lower likelihood of large increases in initial margins and of demand for posting more variation margins in times of stress.²⁵ As a result, dealer banks may be exposed to higher margin calls by the exchanges and central counterparty clearing houses compared to what they collect from clients, adding to banks’ liquidity needs.²⁶ More broadly, the danger is that liquidity risk may morph into counterparty credit risk, thus lowering dealers’ balance sheet capacity and raising the cost of intermediation across a number of markets.

Another possible pressure point is related to concentration and interconnectedness. The number of dealer banks globally active in commodity markets has declined in recent years. These banks provide credit and liquidity to, among others, a small group of large energy trading firms that operate globally across a number of commodity markets. These firms are largely unregulated, mostly privately owned, and highly reliant on financing by dealer banks to operate. Market participants have also expressed concerns about dealer banks’ concentrated positions with respect to assessment of aggregate exposures and risk management practices.²⁷ In addition, available data suggest that investors may be growing concerned about credit availability and liquidity positions of commodity trading firms amid large commodity price moves (Figure 1.16, panels 1 and 2).

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Commodity Trading Companies Have Been Exposed to a Spike in Volatility

Sources: Bloomberg Finance L.P.; and IMF staff calculations.Note: In panel 2, the bond prices of Gunvor, Glencore, and Cargill are quoted in US dollars; the bond prices of Trafigura and Louis Dreyfus are quoted in euros.

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Strains in commodity markets may also have adverse effects for end users like commodity producers and consumers, including manufacturers reliant on raw material inputs as well as ultimate consumers. Amid supply chain disruptions and large price swings, banks may become less willing to finance commodity shipments, and the cost of hedging through futures and options may become prohibitively expensive for some producers. In addition, in the event of default on a derivatives contract by a counterparty, smaller clearing members of exchanges may themselves face risk of default, adding strains to the system.

Rising Liquidity and Funding Risks

There are some signs that the sharp rise in market volatility, severe disruptions in commodity markets, and the perception of rising counterparty risk may be starting to weigh on dealer banks’ balance sheet capacity and appetite for intermediation, with implications for liquidity and funding conditions as well as broader market functioning.

Tensions in short-term dollar funding markets have been limited so far, but strains are beginning to emerge. Reportedly reflecting both precautionary motives to bolster liquidity positions as well as growing concerns about credit risk, spreads in short-term dollar funding markets have widened. In US unsecured money markets, LIBOR-OIS and FRA-OIS spreads have widened since the announcement of sanctions,²⁸ but they are still well below levels seen in early 2020. Issuance of financial and nonfinancial commercial paper has risen, leading to increased borrowing costs (Figure 1.17, panel 1). By contrast, secured US money markets (repo) have not displayed signs of stress thus far.

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Short-Term Dollar Funding Tensions and Market Liquidity

Sources: Bloomberg Finance L.P.; JPMorgan Chase & Co.; and IMF staff calculations.Note: In panel 1, commercial papers (CPs) are AA bank 90-day CPs and A2P2 nonfinancial corporate 90-day CPs. The FRA-OIS spread measures the gap between the US 3-month forward rate agreement and the overnight index swap rate. In panel 2, LIBOR-indexed cross-currency basis spreads are used for JPY and GBP prior to February 2021. In panel 4, root mean square error is the measure between fair-value model yields and actual Treasury yields observed. GBP = British pound; EUR = euros; JPY = Japanese yen; T-bill = US Treasury bill.

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Similarly, international dollar funding conditions, as measured by the cross-currency swap basis, have tightened since late February, but spreads remain well below pandemic levels (Figure 1.17, panel 2). The actions taken to freeze the Central Bank of Russia’s reserves and disconnect a number of Russian banks from SWIFT have also been mentioned as factors contributing to spread widening.²⁹ Amid rising risk aversion and strong precautionary demand for high-quality collateral, 10-year euro area swap spreads have widened to levels not seen since 2011.

Despite higher volatility and some strains in funding markets, there are no signs of the “dash-for-cash” dynamics that emerged in March 2020, and the financial system appears more resilient to withstand liquidity and funding shocks. Global liquidity remains at record high levels in advanced economies, and banks are better capitalized and more liquid with a large surplus of reserves. In addition, central banks have tools to alleviate stresses in funding markets. Activation of standing swap lines between central banks and government paper repo lines—the US Federal Reserve’s standing repo facility (SRP) and the Foreign and International Monetary Authorities (FIMA) repo facility, as well as the ECB’s Eurosystem repo facility for central banks—can act as a backstop for dollar (and euro) funding pressures.³⁰ However, the vulnerabilities identified during the COVID-19 pandemic remain largely unaddressed at this point.

Given higher uncertainty and faster Federal Reserve policy tightening, market liquidity conditions of high-quality government bond markets have deteriorated based on multiple metrics. Price-based liquidity metrics, such as bid-ask spreads and fitting errors of yield curve models, have worsened, reflecting market-makers’ unwillingness to hold inventories under a higher volatility environment (Figure 1.17, panels 3 and 4). Further deterioration of market liquidity and functioning could amplify a repricing of duration risk. There also might be a risk of tighter funding conditions due to a close link between market liquidity and funding liquidity (Brunnermeier and Pedersen 2009).³¹

Cyber Risks: A Critical Threat

The war in Ukraine has raised acute concerns about cyber operations. Cyberattacks targeting Ukraine go back several years. In 2017, the NotPetya malware attack originally aimed at critical infrastructure in Ukraine spilled over and caused supply chain disruptions and worldwide losses estimated at about $10 billion.³²

Cyberattacks intensified in the weeks preceding the current war. The coordination of attacks disrupting banks’ online services with text message (SMS) disinformation campaigns, as observed in Ukraine, increases this risk. Cyberattacks led by private actors have also been reported against Russian institutions, which may further escalate tensions on both sides.

Attacks could target systemically important financial institutions. If successful, such attacks could trigger loss of confidence in the broader financial system, with a potentially adverse impact on global financial stability. Cyber threats against SWIFT and other shared financial and non-financial market infrastructure could also increase. Intense hacktivism and false-fag operations that disguise the actual source of the attack and place responsibility on another party further complicate the situation. As cyber risks rise globally, operational costs have increased across industries, with the potential for significant economic loss in various countries.

The War and a Repricing of Risk in Markets May Put Corporate Sector Recovery at Risk

The war in Ukraine has clouded the corporate outlook. Firms most at risk are those in Russia, which will suffer trade barriers, lack of intermediate inputs, and depressed domestic demand. Additionally, more than 60 percent of Russia’s external debt of close to $500 billion is owed by nonfinancial firms. Elsewhere, the impact of heightened uncertainty, sanctions, and the anticipated slowdown of the economy is evident especially in Europe due to its greater exposure to Russia through trade and investments in energy firms and projects (Figure 1.18, panel 1). European firms have the largest direct exposures to Russia and Ukraine, as measured by revenues from the region (Figure 1.18, panel 2). Sanctions imposed on Russia, the self-imposed exodus of large firms from Russia, and a slump in demand in Russia and Ukraine are expected to result in a sharp decline in global firms’ revenues derived from the region.³³ On a sectoral basis, many large European firms have some exposures to Russia and Ukraine (above 2 percent of revenues from the region). However, the share of debt at firms with substantial exposures (above 5 percent of revenues from the region) is less than 10 percent of the total debt of all firms in these sectors. Since the Russian invasion of Ukraine, most large international companies have announced exits of various types from Russia because of the reputational risk and the difficulty of doing business in Russia related to sanctions ( Figure 1.18, panel 3).

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Corporate Sector amid the War in Ukraine

Sources: Bloomberg Finance L.P.; FactSet; MSCI; Refinitiv Datastream IBES; Yale School of Management; and IMF staff calculations.Note: Panel 1 presents standard deviations in analyst forecasts of earnings per share over the next 18 months. In panel 2, foreign exposures are defined as revenues derived from abroad in percent of total revenues. In panel 2, the sample includes 529 CEE firms and 2,079 Japanese firms. CEE = central and eastern Europe and includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, Slovenia, and Turkey; EMEA = emerging Europe, Middle East, and Africa.

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Global firms have been hit by the rise in energy and raw material prices. In addition, supply chain challenges that have emerged during the pandemic have been exacerbated by the uncertainties and reductions in export quantities of agricultural commodities, energy, metals, and technology inputs affecting a variety of industries. While large firms are generally in a better position to secure shipments of rationed components and to pass on the increase in input costs to customers because of greater pricing power, even before the war analysts had noted that the pass-through to customers had become more limited and that profit margins were expected to shrink. For example, small European businesses in the transportation and agricultural sectors have already sounded the alarm about energy prices, and over half of US small businesses have voiced concerns about energy prices.

So far, analysts have maintained a positive outlook for most sectors (except airlines), with 2022 earnings projected to be well above pre-pandemic levels. However, analysts have started to substantially downgrade earnings forecasts across sectors, except for energy (Figure 1.18, panel 4). A prolonged war, an escalation of sanctions, higher commodity prices, and increased investor risk aversion could further worsen the corporate outlook. Energy and agricultural product importers in emerging markets and countries with strong trade links with Russia and Ukraine have already seen a more adverse market reaction compared to their peers, based on equity indices and credit spreads. More broadly, increased and lingering uncertainty associated with the war and elevated geopolitical risks are detrimental to corporate investment at a time when it is most needed for the transition to a post-pandemic and greener economy.³⁴ The economic impact of underinvestment could be especially detrimental for vulnerable firms that have already built up debt in the last two years.³⁵ In addition, higher inflation because of rising commodity prices, wage pressures in some regions, tighter financial conditions, and a more cautious lending posture by banks may substantially affect firms’ revenues and exacerbate funding challenges for vulnerable businesses, including small and medium-sized firms.

A repricing of risk by investors—due for example to an escalation of the sanctions, a sharper than previously expected tightening of monetary policy, or a deterioration of the economic outlook—could result in a sharp tightening of financial conditions, a development that could interact with unresolved pandemic-related vulnerabilities in the corporate sector. A deterioration in liquidity and funding conditions could be particularly challenging for risky credit markets, an important barometer of risk taking.

Spreads on high-yield bonds and leveraged loans have widened in advanced economies on the heels of rising market volatility and implications of higher energy and labor costs especially for smaller firms—and are now slightly above pre-pandemic levels. Outflows have accelerated from high-yield bond funds, and new issuance has slowed. Issuance has similarly decelerated in the collateralized loan obligation (CLO) market, as spreads have increased in both secondary market leveraged loans and CLO tranches. Should geopolitical tensions prove longer lasting than currently anticipated and if economic growth were to slow, risky borrowers could face tougher financing conditions and higher rollover risks, potentially resulting in a deeper default cycle that could severely impact the real economy. The tightening in market conditions could be amplified by the deterioration in underwriting standards and first-lien investor protections seen in recent years in both the high-yield bond and leveraged loan market—as reflected by weaker covenants and thinner loss-absorbing buffers for loans. In addition, tighter monetary policy comes in the form of higher interest costs for leveraged loan issuers and could eventually pressure debt servicing capacity.

Portfolio Flows Have Come under Pressure, with High Differentiation across Economies and Risks Tilted to the Downside

After a challenging end to 2021 for portfolio flows, flows into emerging market local currency debt and equity markets strengthened in early 2022, defying expectations of policy normalization in the United States. Fund inflows were stronger for countries in Asia, eastern Europe, and the Middle East and North Africa, reflecting subsiding concerns about the pandemic, and in some cases rising commodity prices (Figure 1.20, panel 1). Moreover, hiking cycles were already much farther along in many emerging markets, creating attractive risk compensation (carry) for investors in both real and nominal terms when compared to advanced economies. Finally, the potential for large outflows was seen as low, as the nonresident investor base had been considerably reduced in preceding years (Figure 1.20, panel 2).

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Emerging Market Portfolio Flow Pressures Have Intensified

Sources: Bloomberg Finance L.P.; JPMorgan Chase & Co.; national data sources; and IMF staff calculations.Note: In panel 3, total equity flows include Vietnam, Sri Lanka, and United Arab Emirates, which are not shown. In panel 4, the risk-off scenario assumes a global risk aversion shock with Chicago Board Options Exchange Volatility Index reaching the March 2020 peak levels. CEEMEA = Central and Eastern Europe, Middle East, and Africa; EMs = emerging markets; GFSR = Global Financial Stability Report; LatAm = Latin America.

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However, following the Russian invasion of Ukraine, flows become highly volatile and reversed quickly for some economies. Flows in local currency bonds and equities have come under pressure, experiencing the largest weekly redemptions since March 2020. The first signs of differentiation across countries have emerged (Figure 1.20, panel 3). Economies benefiting from higher commodity prices, such as Brazil and Indonesia, withstood the pressure and have seen large equity inflows on net so far this year, while some energy importers have seen sharp equity outflows. Some of the outflows in more liquid markets like Chinese sovereign bonds (which saw the largest monthly outflow on record in February) in part reflect technical factors, as fund managers have reportedly raised cash holdings in expectation of possible redemption pressure. The need for short-term liquidity was further amplified by the highly illiquid market conditions in Russian markets due to sanctions and trading restrictions.

Looking ahead, the interplay of tighter external financial conditions on the back of monetary policy normalization in the United States and heightened geopolitical uncertainty is likely to increase the downside risks for portfolio flows. IMF staff analysis shows that capital flows at risk (the 5th percentile of the range of capital flow forecasts to quantify the downside risks; see IMF 2019 for more details) have increased to 2.3 percent of GDP from 1.7 percent of GDP in the October 2021 GFSR, and the probability of outflows is about 30 percent from 20 percent from the October 2021 GFSR. A sharp rise of US term premia, combined with a further rise in risk aversion, would entail more significant financing risks for emerging market economies. In such a scenario, these economies would be subject to much stronger headwinds, especially countries with lingering inflation risks and/ or elevated debt vulnerabilities. For example, a risk aversion shock similar to the one seen in March 2020 would take capital flows at risk to 2.5 percent and increase the probability of outflows to almost 50 percent (Figure 1.20, panel 4).

Risks of Cryptoization and Sanction Evasion through the Crypto Ecosystem

Crypto asset trading volumes against some emerging market currencies have increased notably since the start of the pandemic. Although a large part of this increase is due to speculative investment activities by emerging market residents, a more structural shift toward crypto assets as a means of payment and/or store of value could pose significant challenges to policymakers (see the October 2021 GFSR for a discussion on cryptoization). For example, Tether—the largest stablecoin used to settle spot and derivative trades—has seen a notable rise in trading volumes against emerging market currencies (Figure 1.21, panel 1). The most pronounced increase is in Turkey, where exchange rate volatility has been particularly high, and the overall use of crypto assets appears to have gained traction over the last few years. More recently, trading volumes spiked following the introduction of sanctions against Russia and the use of capital restrictions in Russia and Ukraine (Figure 1.21, panel 2).³⁷ However, liquidity in the ruble and hryvnia trading pairs in centralized exchanges remains limited and has even declined more recently in the case of ruble,³⁸ making large-scale transfers of value through crypto asset exchanges impractical.

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Crypto Asset Markets

Sources: Bloomberg Finance L.P., CryptoCompare; and IMF staff calculations.Note: AE = advanced economies; EM = emerging markets; RUB = Russian ruble; UAH = Ukrainian hryvnia.

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The war in Ukraine has brought to the forefront some of the challenges that regulators face in terms of applying sanctions and capital flow management measures. Crucially, the implementation of such measures requires that intermediaries verify the identities of the transacting parties. The crypto ecosystem, however, could allow users to circumvent such requirements through several means, including (1) the use of exchanges and other crypto asset providers that are non-compliant with sanctions and/or capital flow management measures; (2) poor implementation of adequate due diligence procedures by crypto asset providers; and (3) the use of technologies and platforms that increase the anonymity of transactions (such as mixers, decentralized exchanges, and privacy coins).³⁹ Regulators in the United States and United Kingdom, among others, have urged firms in their jurisdictions, including the crypto asset sector, to increase vigilance with regard to potential Russian sanction evasion attempts.⁴⁰

Over time, sanctioned countries could also allocate more resources toward evading sanctions through mining. Mining for energy-intensive blockchains like Bitcoin can allow countries to monetize energy resources, some of which cannot be exported due to sanctions. The monetization happens directly on blockchains and outside the financial system where the sanctions are implemented. Miners can also generate revenues directly from users that pay transaction fees to miners (which in this case might be sanctioned governments). At this point, the share of mining in countries under sanctions and the overall size of mining revenues suggests that the magnitude of such flows is relatively contained, although risks to financial integrity remain. For example, the monthly average of all Bitcoin mining revenues last year was about $1.4 billion, of which Russian miners could have captured close to 11 percent, and Iranian miners, 3 percent.⁴¹

Could the Geopolitics of Energy Security Put the Energy Transition and thus Financial Stability at Risk?

The Russian invasion of Ukraine, the ensuing sanctions, and the actions of market participants in response to a global outcry have wreaked havoc in commodity markets. Disruptions in supply chains, rising concerns about counterparty risk, and growing worries about energy availability have pushed commodity prices higher across the entire complex (Figure 1.2). Given Russia’s large footprint in global commodity production, not only oil and gas prices, but also widely used metals (including those used for renewables), have increased sharply (Figure 1.24, panel 1).

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The War in Ukraine Tests the Climate Challenge

Sources: Bloomberg Finance L.P.; BP Statistical Review of World Energy; International Energy Agency; UN Comtrade; US Geological Survey, National Minerals Information Center; and IMF staff calculations.Note: In panel 4, IEA’s forecasts are shown for 2026, where main case is the base case scenario, accelerated case is a more optimistic scenario, and Net-zero by 2050 case estimates capacity needed to transition to a net-zero energy system by 2050.

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Against this backdrop, the war in Ukraine has crystalized concerns about energy security across the globe. With the perception of the trade-off between energy security and transition changing rapidly, there is a risk that the transition toward renewables may become more costly, complex, and disorderly. Given that climate change poses a threat to financial stability, a delayed and disorderly climate transition may magnify risks to the financial system. There may be some setbacks in the immediate future, but the impetus to reduce energy dependency on Russia could be a catalyst for change. It is therefore crucial that policymakers intensify their efforts to achieve net-zero targets and lever up private finance to accelerate the transition toward a greener economy.

The war has indeed made evident the energy dependency of Europe on Russia. In particular, Europe relies on Russia for roughly 40 percent of its consumption of natural gas and for more than 50 percent of thermal coal, (Figure 1.24, panel 2). Renewable energy currently accounts for only 22 percent of energy consumption in Europe. In response to the war, Europe is rethinking its energy landscape (for example, through the REPower EU agenda).⁴⁶ However, uncertainties remain in the short term. Physical bottlenecks are significant, for example in the context of switching to coal-fired power generation. In addition, Europe’s diversification strategy (with increased imports from the Asia, Australia, and the United States) is likely to take time to be fully implemented amid rising global energy demand (especially in Asia) and supply constraints.

The war has also made evident the urgency to cut dependency on carbon-intensive energy and accelerate the transition to renewables. However, the energy transition strategy may face setbacks for some time. Some countries have already indicated their intention to switch to domestic coal-fired power generation and fossil fuel production to secure their energy needs in the short term. Moreover, the current energy crisis is likely to weigh on the speed of phasing out fossil fuel subsidies in emerging market and developing economies and could also delay the decommissioning plans for coal-fired power plants—especially in major coal-exporting countries (Australia, Indonesia, South Africa, United States). Rising inflation pressure may also lead authorities to resort to subsidies or other forms of fiscal support to households or firms, with the risk of delaying climate transition plans.

In addition, the buildup of renewable energy infrastructure will require time and is likely to face headwinds amid rising prices and supply disruptions of critical commodities (such as cobalt, palladium, and nickel). As an indication of possible headwinds, the increased focus on energy security appears to have adversely affected the performance of clean energy indices relative to fossil fuels. This weaker performance has occurred despite strong investor demand for low-carbon assets and a substantial decline in renewable energy costs in recent years (Figure 1.24, panel 3). Meanwhile, renewable energy supply remains limited amid a shortfall in renewable energy investment, ( Figure 1.24, panel 4).

The most recent Intergovernmental Panel on Climate Change report has highlighted that fossil-fuel burning is “choking humanity,” enhancing the urgency of the energy transition to avoid carbon lock-in in infrastructure and policy, and therefore irreparable damage to our planet. Meanwhile, the war in Ukraine has brought to fore the need to ensure energy security and the mitigation of supply vulnerabilities in a world where the geopolitical landscape is rapidly changing. Policymakers need to strike the appropriate balance to achieve fundamental objectives that may at times seem difficult to reconcile.

As the Line between Geopolitics and Financial Markets Gets Blurred, New Challenges Arise

The swift imposition of sanctions and the immobilization of the assets of the Central Bank of Russia have raised a number of issues that policymakers must confront. One key issue is whether the composition of exchange rate reserves will change. Some market commentators have argued that reserve managers may opt to diversify away from currencies of advanced economies and the US dollar in particular. Potential beneficiaries of such a shift may be assets that the Group of Seven (G7) will find more difficult to immobilize if there are new geopolitical events, including the Chinese renminbi, commodities, and potentially even crypto assets.

For now, such a scenario appears distant. The composition of currencies held by central banks has remained largely steady over decades. Reserve compositional changes can be described as glacial in pace even considering the small decline of the US dollar share over the years (Iancu and others 2020). In the

medium to long term, however, geopolitical shifts and technological changes can indeed cause central banks to rethink what constitutes, and how to hold, reserves. Emerging market and developing economies could also issue more debt in the currencies of emerging creditors, such as China, to help meet increased financing needs. Countries may become more interested in ensuring critical supplies that could alter trade links and invoicing practices. In addition, a shift toward localized production would reduce the demand for international currencies. Finally, demand for alternative reserve currencies may increase in some regions. Issuers of alternative reserve currencies could increase the attractiveness of their currencies through leveraging digital technology, which could help them overcome some of the advantages of incumbent currencies.

There are strong welfare effects of sharing common payment infrastructures or critical service providers, although risks of single points of failure must also be managed in order to uphold operational resilience. Costs can be shared, and economies of scale applied. Likewise, such sharing increases compatibility between domestic payment systems, which facilitates international trade and finance. There is a risk that measures to increase a country’s resilience to sanctions could promote the development of parallel national or regional infrastructures or critical service providers. For instance, there are currently only a few international payment message providers other than SWIFT, but these are generally small and cover a limited geographical area. Users of the Chinese payment system CIPS, for instance, currently still rely partly on SWIFT. An increased ambition to allow for payment messaging outside of SWIFT could, however, lead to establishing larger and fully independent and parallel systems. Consequent loss of efficiency and cross-border payment compatibility could also undermine efforts to improve access globally to cheap, safe, and efficient cross-border payments. In particular, there is ongoing international collaboration to increase compatibility and improve cross-border payments undertaken under the aegis of the Group of Twenty (G20) (FSB 2020).

This fragmentation could also arise in emerging payment infrastructures. Many countries are currently exploring central bank digital currencies (CBDCs) and are also looking into their use for cross-border payments. Within the G20 initiative to enhance cross-border payments there is a work-stream on how CBDCs could improve cross-border payments and increase global economic integration. Efforts to increase resilience to sanctions could undermine this project, and instead lead to fragmentation as national central banks seek to establish CBDCs independent of international infrastructures. There is a risk of competing “CBDC blocs” with fragmentation across technology and design. Cross-border compatibility could work well within the bloc but have little or no compatibility with CBDCs outside of each bloc.

Finally, the imposition of unprecedented financial sanctions could also lead to more complex, bespoke, and less passive asset allocation on behalf of investors. For example, going forward investors could place greater importance in their portfolio decisions on some of the risk factors exposed by the war in Ukraine (such as currency convertibility, sanctions, and reputation risk) and less importance on the decisions of benchmark providers. Analysts have also noted the possibility of creating bespoke indices that could cater to the unique mandates of different investors. In such a scenario, markets that have a higher share of benchmark-driven investors, including some frontier economies (IMF 2019), could be especially at risk of losing portfolio inflows.