Step 1: Identification of Members

Step 2: Arrangement Size

17. The next step is to make assumptions regarding the size of members’ financing needs. Different scenarios can be built based on the historical distribution of arrangement sizes as a share of members’ GDP. Table 2 shows average and standard deviations of the annual series over different periods. It suggests that on average, the size of Fund arrangements (as a share of a member’s GDP) has tended to increase over time, as also underscored in Box 2. With crises evolving from stresses on the current to the capital account, this could imply larger arrangement sizes in the future, unless the Fund or other tools are effective in limiting contagion.

^{Table 2.}

Size of GRA Arrangements

(In percent of a member’s GDP)

Source: IMF staff estimates.

^{Table 2.}

Size of GRA Arrangements

(In percent of a member’s GDP)

	Average	Average +1STD
Last 20 years	3.5	6.2
Last 15 years	4.1	7.0
Last 10 years	5.3	8.0
Since 2008	5.8	8.1

Source: IMF staff estimates.

View Table

^{Table 2.}

Size of GRA Arrangements

(In percent of a member’s GDP)

	Average	Average +1STD
Last 20 years	3.5	6.2
Last 15 years	4.1	7.0
Last 10 years	5.3	8.0
Since 2008	5.8	8.1

Source: IMF staff estimates.

18. The results are summarized in a matrix. Table 3 summarizes potential calls on Fund financing under the different scenarios and assumptions discussed in this section. The rows correspond to the five scenarios discussed in Step 1, identifying the members hit by a crisis (ordered by their impact on the size of the Fund). The first rows correspond to large global crises, while the last row reflects a much more limited crisis event. The latter in particularly is likely to underestimate potential calls on Fund financing in a sizable crisis, especially in cases where some of the larger past borrowers were to experience a need for Fund financing. The columns show different assumptions for the size of arrangements, ranging from 4 to 8 percent of members’ GDP in one-percentage point increments. It is worth noting that normal access limits of 435 percent of quota correspond on average to 6.9–7.4 percent of members’ GDP identified by the panel logit approach depending on the threshold; and 3.9 and 4.9 percent of GDP for the top 12 and top 32 past borrowers, respectively. For ease of comparison, cells in dark green flag scenarios that could potentially be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, NAB, and BBAs. Scenarios in white exceed the current overall lending capacity. All these scenarios are based on the Fund’s overall lending capacity and do not take account of existing loan commitments, which reduce the Fund’s resources available for new commitments as reflected in the FCC.

^{Table 3.}

Potential Calls on Fund Financing Under the Access-Based Approach ^1/

(In SDR billions)

Sources: Staff estimates based on data from IMF Finance Department, WEO, IFS, WDI, BIS, Federal Reserve Bank of St Louis, U.S. Energy Information Administration, U.S. Federal Reserve, CBOE and ICRG.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current overall lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

^2/See Table 2 to map these sizes to the historical distribution of arrangement sizes.

^3/Scenarios a, c and e use the panel logit approach. Scenarios b and d are explained in paragraph 13.

^{Table 3.}

Potential Calls on Fund Financing Under the Access-Based Approach ^1/

(In SDR billions)

	Arrangement Size as Percent of Member’s GDP 2/
Scenarios 3/	4	5	6	7	8
a. 1:1 Threshold (4.8 percent)	588	735	882	1,029	1,176
b. Top 32 Past Borrowers	462	578	694	809	925
c. 2:1 Threshold (6.4 percent)	460	575	690	805	920
d. Top 12 Past Borrowers	371	464	557	650	743
e. 3:1 Threshold (16.1 percent)	282	352	423	493	564

Sources: Staff estimates based on data from IMF Finance Department, WEO, IFS, WDI, BIS, Federal Reserve Bank of St Louis, U.S. Energy Information Administration, U.S. Federal Reserve, CBOE and ICRG.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current overall lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

^2/See Table 2 to map these sizes to the historical distribution of arrangement sizes.

^3/Scenarios a, c and e use the panel logit approach. Scenarios b and d are explained in paragraph 13.

View Table

^{Table 3.}

Potential Calls on Fund Financing Under the Access-Based Approach ^1/

(In SDR billions)

	Arrangement Size as Percent of Member’s GDP 2/
Scenarios 3/	4	5	6	7	8
a. 1:1 Threshold (4.8 percent)	588	735	882	1,029	1,176
b. Top 32 Past Borrowers	462	578	694	809	925
c. 2:1 Threshold (6.4 percent)	460	575	690	805	920
d. Top 12 Past Borrowers	371	464	557	650	743
e. 3:1 Threshold (16.1 percent)	282	352	423	493	564

Sources: Staff estimates based on data from IMF Finance Department, WEO, IFS, WDI, BIS, Federal Reserve Bank of St Louis, U.S. Energy Information Administration, U.S. Federal Reserve, CBOE and ICRG.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current overall lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

^2/See Table 2 to map these sizes to the historical distribution of arrangement sizes.

^3/Scenarios a, c and e use the panel logit approach. Scenarios b and d are explained in paragraph 13.

Demand for Financing

20. Potential financing needs of members are determined in a three-step approach.

• First step: Pervasiveness of the crisis. Members are selected based on thresholds for crisis probabilities, which are estimated in the staff’s Vulnerability Exercises for advanced economies (AEs), emerging markets (EMs), and low-income countries (LICs).²¹ The lower the threshold, the larger the number of members experiencing a crisis and thus the more pervasive the crisis. As in the March paper, four systemic crisis scenarios—members with crisis probabilities of more than 1, 3, 5, and 10 percent in a given year—are considered. The scenarios range from an extremely pervasive global systemic crisis affecting a large number of members (crisis probability of 1 percent) to a crisis that would affect only a relatively small subset of the membership (crisis probability of 10 percent; Table AIII.1, where fewer members would potentially require Fund financing than during the GFC). While it may not be likely that all members would come to the Fund in one year, the probability of this happening is substantially larger over a longer period. For instance, for a member with an annual crisis probability of 1 percent, under unchanged policies over five years, this probability would increase to almost 5 percent. As a result, additional members may seek Fund financing over time while credit remains outstanding for members with balance of payments needs during year one of a crisis, and these considerations strengthen the plausibility of the scenarios.

• Second step: Severity of the crisis. For members identified in the first step, potential financing needs are estimated based on the severity of a crisis and its impact on: (i) FDI inflows; (ii) rollover rates for short-term and medium-term debt; and, for EMs only (iii) deposit outflows. The crisis is assumed to persist for two years (2017–18) with declining intensity (see Annex III). For EMs, the severity of a crisis is calibrated based on the empirical distribution of financial crises over the past 30 years using Kernel density estimators.²² Simulations are then provided for crisis broadly in the 90th, 85th, 75th, and 65^th percentiles of the distribution. The higher the percentile, the higher is the severity of the crisis with all countries being hit by the same size shock. As an example, a crisis in the 75th percentile would imply, for an EM, that its FDI declines by 20 percent in both crisis years; its rollover rate for short-term debt is 80 percent in the first year and 85 percent in the second year (for medium-term debt, the rates are 50 percent and 65 percent, respectively); and that it would experience deposit outflows of 5 percent in the first year of the crisis.

• Third step: Domestic adjustment. This step is new compared with the March paper. Responding to suggestions from Directors, the model now allows for a member’s policy response to the crisis. Specifically, a member is expected to make a fiscal adjustment of 1.4 percent of GDP (0.7 percent of GDP each year), consistent with the average adjustment in members with Fund-supported programs during 2002–14.²³ The model assumes, for simplicity, that the adjustment translates into an external adjustment of the same magnitude, which is larger than the expected typical fiscal-external multiplier and is meant to capture also other factors contributing to the external adjustment.

Financing Global Crisis Scenario

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Source: IMF staff.

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Financing Global Crisis Scenario

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Financing Global Crisis Scenario

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Source: IMF staff.

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21. The demand for financing depends on the pervasiveness and intensity of a crisis.²⁴ In the scenarios considered in Table 4, it ranges from SDR 186 to SDR 2,237 billion. In Scenario “d” where the crisis is the least pervasive and the shocks are the smallest (65th percentile), the demand for financing needs is the smallest. At the other extreme is the most pervasive and intense crisis in the upper right corner. These estimates are somewhat lower than the ones presented in the March paper, mostly because the model now assumes that a member undertakes policy adjustment (there are also changes in the member groups based on the updated vulnerability exercises but that does not materially affect the estimates).

^{Table 4.}

Total Demand for Financing in Various Stress Scenarios

(In SDR billions)

Source: IMF staff estimates.

^{Table 4.}

Total Demand for Financing in Various Stress Scenarios

(In SDR billions)

	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	768	1,209	1,787	2,237
b. Very pervasive systemic crisis	583	885	1,302	1,653
c. Pervasive systemic crisis	440	674	1,002	1,286
d. Systemic crisis	186	287	398	468

Source: IMF staff estimates.

View Table

^{Table 4.}

Total Demand for Financing in Various Stress Scenarios

(In SDR billions)

	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	768	1,209	1,787	2,237
b. Very pervasive systemic crisis	583	885	1,302	1,653
c. Pervasive systemic crisis	440	674	1,002	1,286
d. Systemic crisis	186	287	398	468

Source: IMF staff estimates.

Supply of non-Fund financing

22. Non-Fund financing would be expected to cover a significant part of the potential financing needs. First, members can draw on their international reserves. Some members also have access to RFAs or BSAs. In the following, the paper discusses access to such resources, including constraints and conditions. The calculations do not include multilateral and regional development banks: while they primarily provide financing for development purposes, their balance of payments assistance to members in crises has typically been relatively small.²⁵ Also, even though official bilateral borrowing by members can be significant,²⁶ it is not included as it usually is agreed on an ad-hoc basis and therefore difficult to forecast (i.e., there are no set rules or triggers for such arrangements). Last but not least, private borrowing by a member in a crisis is implicitly included through the assumptions on debt roll-over.

23. As a first step, the model assumes that countries make use of their international reserves. Reserves can reduce the likelihood of balance of payments pressures through their signaling effect and can also be used for intervention against sudden stops, capital flight, and deleveraging.²⁷ However, central banks are often reluctant to resort to a heavy use of reserves during crises, as this could send a negative signal to markets, and tend to rebuild their reserves after initial losses.²⁸ Indeed, during the GFC, nine of the largest EMs refrained entirely from using reserves, and many reaccumulated most of their reserve losses within one year.²⁹ As in the March paper, the model assumes that a member would not use reserves beyond 25 percent of its pre-crisis level (consistent with the share members used during the GFC). It also assumes that EMs maintain reserves at 100 percent of the Fund’s metric for assessing reserve adequacy (ARA) and that AEs and LICs maintain reserves at 100 percent of short-term debt (see Annex III for further discussion and paragraph 29 on robustness checks). In other words, a member would use reserves until it either loses more than 25 percent or reaches the relevant metric threshold.

24. The model incorporates resources from RFAs. After using its reserves, a member might still have a financing gap. As in the March paper, the model then incorporates financing from RFAs, specifically the Arab Monetary Fund (AMF), the BRICs Contingent Reserve Arrangement (CRA), the Chiang-Mai Initiative Multilateralization (CMIM), the EURASIA Fund for Stabilization and Development (EFSD), the European Union-Balance of Payments (EU-BoP) facility, the European Stability Mechanism (ESM), and the Latin American Reserve Fund (FLAR). Given the wide disparity in the modalities of RFAs, specific assumptions—including the maximum access amount and burden sharing with the Fund—are applied.³⁰ For each member, the model checks whether it is a member of an RFA and then applies the rules of the relevant RFA (see Annex III). A caveat to this calculation is the continued uncertainty about the availability of RFA resources in case of a systemic crisis. In particular, risk pooling at a regional level may not work for crises affecting an entire region. Also, most of the RFAs remain untested and RFAs might find it difficult to impose conditionality on members if adjustment is warranted (possibly requiring the involvement of the Fund).³¹

Regional Financing Arrangements

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

Source: IMF staff estimates.Note: The lending capacity of the RFAs (indicated in brackets) is the explicit capacity/limit where available (Euro Area and EU facilities, CMIM), committed resources (BRIC CRA), or the estimated capacity based on member access limit and paid-in capital (AMF, EFSD, FLAR). The ESM figure also includes outstanding loans under the European Financial Stability Facility.

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Regional Financing Arrangements

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Source: IMF staff estimates.Note: The lending capacity of the RFAs (indicated in brackets) is the explicit capacity/limit where available (Euro Area and EU facilities, CMIM), committed resources (BRIC CRA), or the estimated capacity based on member access limit and paid-in capital (AMF, EFSD, FLAR). The ESM figure also includes outstanding loans under the European Financial Stability Facility.

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Regional Financing Arrangements

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

Source: IMF staff estimates.Note: The lending capacity of the RFAs (indicated in brackets) is the explicit capacity/limit where available (Euro Area and EU facilities, CMIM), committed resources (BRIC CRA), or the estimated capacity based on member access limit and paid-in capital (AMF, EFSD, FLAR). The ESM figure also includes outstanding loans under the European Financial Stability Facility.

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25. Active bilateral swap lines are also included. In line with the March paper, the model takes into account standing unlimited BSAs among major central banks, although most beneficiaries do not have any financing needs in the simulations. The remaining agreements are largely renminbi (RMB) swaps extended by China. Since these BSAs have been established largely to facilitate trade and provide liquidity for offshore RMB transactions, it is not clear whether or how quickly they could be activated during a global crisis; the model therefore excludes them.

26. The supply of financing by non-Fund sources depends on the crisis scenario. As financing needs vary across the scenarios, so will the members’ use of reserves, access to RFAs, and drawdown of BSAs. On average, the use of international reserves, RFAs, and BSAs could jointly cover over one-third of global financial needs (Table 5), which is similar to the March paper.

^{Table 5.}

Supply of Non-Fund Financing in Various Stress Scenarios

(In SDR billion)

Source: IMF staff estimates.

^{Table 5.}

Supply of Non-Fund Financing in Various Stress Scenarios

(In SDR billion)

	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	372	582	775	846
b. Very pervasive systemic crisis	190	352	511	588
c. Pervasive systemic crisis	130	275	396	456
d. Systemic crisis	43	90	100	101

Source: IMF staff estimates.

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^{Table 5.}

Supply of Non-Fund Financing in Various Stress Scenarios

(In SDR billion)

	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	372	582	775	846
b. Very pervasive systemic crisis	190	352	511	588
c. Pervasive systemic crisis	130	275	396	456
d. Systemic crisis	43	90	100	101

Source: IMF staff estimates.

Financing needs to be covered by the Fund

27. In the final step, the model calculates the potential calls on Fund financing, as the difference between demand and supply. This is a purely mechanical calculation for modeling purposes and does not imply in any way that in practice Fund financing should be regarded as a residual. Note that only a subset of members identified in the first step will have a financing gap requiring Fund assistance. The potential call on Fund financing is then presented in matrix form, depending on the pervasiveness and intensity of a crisis (Table 6). It ranges from SDR 143 billon (lower left corner) to SDR 1,391 billion (upper right corner).

^{Table 6.}

Potential Calls on Fund Financing in Various Stress Scenarios ^1/

(In SDR billion)

Source: IMF staff estimates.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

^{Table 6.}

Potential Calls on Fund Financing in Various Stress Scenarios ^1/

(In SDR billion)

Financing gap (billions of SDRs)
	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	396	627	1,011	1,391
b. Very pervasive systemic crisis	393	533	791	1,065
c. Pervasive systemic crisis	310	399	606	830
d. Systemic crisis	143	197	298	367

Source: IMF staff estimates.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

View Table

^{Table 6.}

Potential Calls on Fund Financing in Various Stress Scenarios ^1/

(In SDR billion)

Financing gap (billions of SDRs)
	Crisis Intensity (percentile)
	65th	75th	85th	90th
a. Extremely pervasive global systemic crisis	396	627	1,011	1,391
b. Very pervasive systemic crisis	393	533	791	1,065
c. Pervasive systemic crisis	310	399	606	830
d. Systemic crisis	143	197	298	367

Source: IMF staff estimates.

^1/Cells in dark green flag scenarios that can be covered by the Fund’s current lending capacity using quota resources only; in green, using quotas and the NAB; and in light green, using quotas, the NAB, and BBAs. Scenarios in white exceed the current lending capacity. In all cases, the scenarios and shading abstract from existing loan commitments.

28. The estimates of potential calls on Fund financing are lower than in the March 2016 paper, reflecting mostly that the model now includes members’ policy response. Compared with the March paper, the lower estimates as shown in Table 6 reflect mainly the now-assumed domestic policy response. It should be noted, however, that the assumed fiscal contraction of 1.4 percent of GDP, while similar to the average for Fund-supported programs in 2002–14, would probably not be plausible (and advisable) during a global crisis scenario, when global demand is likely to be already very weak. To provide a benchmark, the GFC could have been in scenario “a” or “b” and the 85th to 90th percentile (in terms of FDI and roll-over of debt) had it not been for many members using large buffers (primarily low public debt and to a smaller extent high international reserves), which significantly reduced their financing needs. Also, the stimulus provided by many AEs and some large EMs and a commodity price boom buffeted a significant part of the membership. As a result, fewer members were affected and the GFC eventually was located toward the lower right corner. With the buffers now more depleted, including in some of the larger countries, and the high interconnectedness discussed in the next section, it seems plausible that a new crisis similar to the GFC would likely involve more and larger countries.

29. The model results are relatively robust to alternative assumptions (see Annex III):

• Self-insurance. Assuming a crisis in the 75^th intensity percentile, relaxing the assumptions on the maximum level of reserve use, from 25 to 35 or 75 percent of total reserves, could reduce potential calls on Fund financing by up to SDR 53 billion, depending on the pervasiveness of the crisis (Table AIII.4 panel 1). Scenarios with a less pervasive crisis are not affected because members with financing needs hold already very low reserves. Relaxing the assumption on ARA to 80 percent of the metric, would lower potential calls on Fund financing by SDR 4 billion in the less pervasive crisis scenario and SDR 125 billion in the most pervasive adverse crisis scenario (Table AIII.4 panel 2)

• Fiscal adjustment. Assuming a stronger domestic policy response—an adjustment of 2 percent of GDP over the two crisis years compared with 1.4 percent of GDP during recent adjustment programs—could also substantially reduce potential calls on Fund financing, depending on the pervasiveness of the crisis (Table AIII.5 panel 2 for a crisis with an intensity at the 75^th percentile). On the other hand, and as noted above, even the assumed adjustment (1.4 percent of GDP) would probably not be plausible (and advisable) during a pervasive global crisis scenario. Assuming a weaker domestic policy response—an adjustment of 1 percent of GDP over the two crisis years—results in additional calls on Fund financing of up to SDR 79 billon (Table AIII.5 panel 1).

• Burden sharing between RFAs and the Fund. While the model takes into account each RFA’s specific modalities, a robustness check assumes equal burden sharing for illustrative purposes (Table AIII.6). Assuming a more prominent role of the RFAs in the GFSN where they cover 75 percent of a member’s net financing needs would result in somewhat lower potential calls on Fund financing (up to SDR 28 billion depending on crisis pervasiveness for a crisis with an intensity at the 75^th percentile). Assuming equal burden sharing between the Fund and RFAs, potential calls on Fund financing would increase by up to SDR 44 billion. If RFAs can cover only 25 percent of the financing needs (for instance, because they are not fully operational), potential calls on Fund financing would increase between SDR 5 and SDR 116 billion, depending on crisis pervasiveness.

Increased Interconnectedness and Other Global Economic Transitions Create Uncertainty

35. Increased interconnectedness in the global economic environment is likely to have an impact on the demand for Fund resources along two main dimensions:

• Structural changes. Global economic linkages have changed dramatically over the past two decades reflecting an unprecedented rise in cross-border trade and financial flows. Increased integration provides more opportunities for risk diversification, but at the same it tends to increase the risk of spillovers and contagion, and in turn the risk of systemic stress, with possible implications for members’ financing needs.

• Shifting of the center of global economic ‘gravity.’ EMDCs’ share in global trade increased from 15 percent in 1990 to 36 percent in 2016. While EMDCs are less financially integrated (as measured, for example, by cross-border liabilities),³⁵ that gap is closing (Figure 6). In a more multipolar world, it is also likely that the composition of global demand for reserves would evolve, which could expose the system to more frequent and more pronounced portfolio shifts.

Ongoing Transitions and Complex Financial Markets

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A reliable and predictable GFSN is therefore essential for EMs as they advance in their financial integration.

36. The nature of crises therefore continues to evolve. There has been an observed shift in the principal drivers of balance of payments stress from the current account to the capital account. Capital flows increased more than 25-fold between 1980 and 2007, compared to an eight-fold expansion in global trade.³⁶ While capital flows provide significant benefits, they also carry risks.³⁷ Moreover, the volatility of global capital flows has increased, particularly for EMDCs. This heightened capital flow volatility combined with amplified and protracted global uncertainty and with increased gross external positions could translate into intensified demand for liquidity backstops. Also, the historical pattern has been for each successive crisis to be larger than the last, and financing needs could be more persistent than in the past in view of longer program and repayment periods.

37. Other transitions are likely to work to increase interconnectedness, with implications for systemic risk. Some of the transition risks described last March—such as the unwinding of unconventional monetary policies, rebalancing in China, and the end of the commodity super-cycle—remain relevant, though their timing and outcomes remain uncertain. In addition, there will be new transitions over the medium and long term which are inherently hard to predict, including:

• Shocks of non-economic origin. Refugee flows triggered by geopolitical conflicts already have a significant effect on some members and regions and, if left unchecked, could have significant geopolitical and economic spillover effects. Global epidemics (such as Ebola) as well as emerging public health-related concerns such as antimicrobial resistance could present similar challenges. At the same time, enduring demographic challenges—such as aging in many AEs and EMs, or rapid population growth in some developing countries—will have major economic implications and could imply new risks.

• The mounting economic consequences of climate change. Climate change could increase the frequency, severity and cost of natural disasters, calling for implementing mitigating measures in member countries at risk and potentially requiring adjustment. The Fund has a role to play in helping its members address those challenges for which macroeconomic policies are an important component of the appropriate policy response.

• Adjustment to ongoing technological progress and global integration. In an era of rapid technological change and economic integration, significant efforts will be needed to address dislocations and avoid economic disruptions by ensuring that everyone can benefit. These efforts will likely include both labor market policies and enhanced public support, as social contracts evolve to meet this new reality. Some members may need support, including financial, to design and implement policies to address the effects of technological change and integration.

• Digital disruptions. New challenges are emerging because of the rapid growth of digital technologies and increasing cybersecurity risks. The rapid increase in the use of new technologies—and the accompanying new business models—has increased the potential for digital disruption across many industries. The financial sector in particular is facing rapid advances in digital technology—from artificial intelligence to cryptography—and also novel disruptions, such as those relating to virtual currencies, peer-to-peer lending, and high-frequency trading. At the same time, with the heavy reliance of financial institutions on information technology and communication—and the highly interconnected nature of these systems—there has been a rapid rise of cybersecurity risks and their potential to disrupt global financial stability. Cyber-attacks could escalate and lead to a rapidly evolving global crisis.

Interconnected and Complex Financial Markets Require Continued Vigilance

38. Global financial cycles are growing in amplitude and duration. Financial interconnectedness has grown substantially over time and generates a potential spillover channel through which the financial conditions of systemically important members can easily and quickly propagate to the rest of the world.³⁸ This means that in the event that a crisis trigger disrupts the global financial markets, a wave of correlated crisis could occur. This can translate into sudden and potentially large calls on Fund resources. As interconnection increases, financial frictions pose larger challenges to the international monetary system. They have the potential to contribute to macroeconomic volatility through boom-bust cycles in domestic credit. In a financially-integrated world, capital flows can intensify these cycles, especially given their tendency to be more procyclical than domestic credit. Sharp reversals in capital flows have been associated with feedback loops of financial system distress, forced asset sales and pullbacks in lending, output losses, and further deterioration in balance sheets. Herding and contagion effects can exacerbate these episodes.

39. Implementation of the post-crisis global financial regulatory agenda has contributed to a more resilient financial system, but further changes are needed to keep pace with ongoing transitions. The post-crisis reform agenda has strengthened oversight of the financial system, raised capital and liquidity buffers of individual institutions, and improved cooperation among regulators. This progress has made the global financial system more resilient, especially for banks. But the reform program is not yet complete, with some key aspects unfinished—including on prudential frameworks, cross-border bank resolution, derivatives markets, market infrastructure, and market-based (non-bank) finance. And there are pressures that could stall or even roll back the reform process.³⁹ Moreover, nonbank financial institutions are participating more in financial intermediation, but they remain largely unregulated.

Increased Vulnerabilities, but Reduced Room for Policy Maneuver

40. Increased interconnectedness could interact with amplified global vulnerabilities, risking further systemic stress:

• Medium-term growth prospects are clouded by weak productivity growth and remaining vulnerabilities. Crisis legacies—including weak and uncertain economic prospects and sluggish private investment—have held back productivity growth. Vulnerabilities also persist from large public debt, large contingent liabilities including pensions, excessive private indebtedness, impaired corporate and bank balance sheets, and some overheated credit and property markets. Rising global indebtedness also represents an important vulnerability to future crisis, which also limits the future scope for policy adjustment in the event of a crisis, particularly when interest rates begin to normalize. Furthermore, the global economic environment is marked by high uncertainty; for instance, the global policy uncertainty index has trended up over the last 5 years (Figure 7).⁴⁰ These uncertainties could generate negative spillovers to EMs, prompting capital outflows and increasing financial vulnerabilities.⁴¹

• Financial vulnerabilities remain elevated. While financial stability has improved in the last year—with rising equity prices and steeper yield curves mitigating some of the negative side effects of low interest rates for banks and insurance companies—significant vulnerabilities remain. Emerging market risks remain elevated, particularly through higher external financing risks and rising financial vulnerabilities in some members.

Global Policy Uncertainty Index

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Global Policy Uncertainty Index

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41. At the same time, room for policy maneuver has narrowed. Monetary policy continues to chart an accommodative course in many AEs, often relying on unconventional strategies to help raise inflation expectations and lower the real costs of borrowing for households and firms. With an increase in debt levels, fiscal space is also not available in all members to do more to close the output gap and to share the burden with monetary policy. EMs also face challenges, including commodity exporters where the outlook for export prices remains subdued compared with the past.

42. Increased interconnectedness may also have heightened some challenges to external adjustment. In the recovery from the GFC, real exchange rate adjustments played a limited role in reducing external current account imbalances, with imbalances and subsequent exchange rate movements only loosely related, and a weak response of trade flows to exchange rate movements. While idiosyncratic factors may have played a role in post-crisis developments, some factors may be contributing to a longer-term weakening of adjustment mechanisms:

• Capital flow volatility. This has resulted at times in sharp and sudden adjustments in exchange rates and domestic demand.

• Larger cross-border liability positions. This can mute the impact of exchange rate movements on economic activity, as the contractionary effects of a depreciation via financial balance sheets can offset the expansionary effects via trade.⁴²

• Changes in the structure of trade. The concentration of trade pricing in a small number of dominant currencies can inhibit external adjustment due to an asymmetric short-run response of trade flows to exchange rate movements.⁴³ Specifically, a depreciation against the dominant currency may reduce imports on impact but not increase exports, as exporters maintain their prices in the dominant currency. This impact can be exacerbated by the rising share globally in trade of EMDCs, where the dollar is more widely used in pricing. There is also an open debate as to whether the relationship between real exchange rate adjustment and trade flows has been weakened by the build-up of global value chains.

Interconnectedness Calls for More Global Solutions

43. While interconnectedness calls for a more global approach, the GFSN has become more multilayered and regional.

• The GFSN has expanded and became more multilayered since the GFC. The growing relative importance of BSAs and RFAs—some of which are untested—has led to a more decentralized and uncertain safety net. This took place against the backdrop of an inadequately resourced Fund, and has led to the need to increase collaboration between the layers. Inadequate predictability of some GFSN resources (in particular BSAs and RFAs) and the lack of reliable coverage for the full duration of shocks (most elements provide time-bound support) also incentivize an over-accumulation of reserves (Figure 8). This self-insurance is not only costly for the members accumulating reserves, but it also entails potential systemic costs and coordination problems that can undermine the resilience of the IMS and reduce global demand (Obstfeld, 2011).

• The future development of the GFSN, including the size of the Fund, will need to take a holistic view of gaps in the system as well as the role of individual elements.⁴⁴ While the Fund has a catalytic role, given its experience in macroeconomic adjustment, lower susceptibility to political interference and universal risk pooling, the successful mobilization of the GFSN elements in a crisis requires that all elements collaborate effectively to utilize their combined firepower (Box 3). Also, for the Fund to continue to play its catalytic role, it will need sufficient firepower of its own to maintain credibility. In a future crisis, new BSAs could be established and members might rally bilateral support, but this is not a given.

Reserve Accumulation

(In trillion SDR)

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

Source: IMF staff calculations.Note: Metric for country groups based on “Assessing Reserve Adequacy-Specific Proposal”, IMF Policy Paper, April 2015.

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Reserve Accumulation

(In trillion SDR)

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

Source: IMF staff calculations.Note: Metric for country groups based on “Assessing Reserve Adequacy-Specific Proposal”, IMF Policy Paper, April 2015.

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Reserve Accumulation

(In trillion SDR)

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

Source: IMF staff calculations.Note: Metric for country groups based on “Assessing Reserve Adequacy-Specific Proposal”, IMF Policy Paper, April 2015.

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Other considerations

44. Changes in Fund policies since the GFC aim to strengthen members’ resilience and the overall IMS:

• Surveillance framework. Fund bilateral and multilateral surveillance is now better integrated and the analysis of spillovers has been deepened,⁴⁵ highlighting the interconnectedness between countries and policies. The Fund is also mainstreaming macro-financial surveillance and has adopted the institutional view on the liberalization and management of capital flows, which provides a basis for consistent advice on policies related to capital flows. And greater attention has been put on the role of macroprudential policies.

• Risk management. The Fund has expanded its approach to risk management, including its general surveillance products, which cover global and member-specific risks around the baseline; and specific risk-focused products (for instance, the VE).⁴⁶

• Lending toolkit. Since 2009, the Fund has substantially reformed its lending toolkit, including by expanding the range of crisis prevention instruments. As called for by the Executive Board, staff continues to work on a proposal for a new liquidity backstop to provide renewable and reliable liquidity support against potential short-term moderate volatility of capital flows.⁴⁷

• Changes in debt restructuring rules. Recent changes in the Fund’s policies on debt restructuring could also have implications for the size of the Fund. The reform of the Fund’s lending framework with regards to the treatment of sovereign debt—including the removal of the systemic exemption—could for example reduce the demand for Fund financing with the new rules triggering earlier action and aiming at bailing in more creditors. However, the extent of any such effects is difficult to estimate ex ante and may only become evident over time.

45. An adequately resourced Fund can help foster confidence. This has been emphasized consistently by the IMFC and the G20, with the most recent communiqués reiterating the membership’s “commitment to maintaining a strong, quota-based, and adequately resourced IMF to preserve its role at the center of the GFSN.”⁴⁸ An adequately resourced Fund can help reduce risks of spillovers, thus helping prevent negative feedback loops from taking hold and fostering more favorable outcomes in crisis times. Furthermore, it can help address broader weaknesses of the IMS such as global imbalances rooted in excessive reserves buildup. Since the GFC, anecdotal evidence suggests that announcements to expand Fund resources during periods of stress have been associated with drops in uncertainty and easing of credit spreads (Figure 9). There is also empirical work showing that larger Fund resources have a favorable effect on the risk outlook and borrowing costs of emerging markets. ⁴⁹ One would need to weight carefully whether a reduction in the size of the fund at a time of generally heightened global uncertainties could result in a loss in market confidence.

Fund Resources Announcements, Uncertainty and Risk

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

1/ VSTOXX index measures volatility of a set of European option prices at a given maturity. 2 Comprises 10-year spreads for Greece, Portugal, Italy, Spain, and Ireland. Spreads are calculated against German Sovereign yields.Sources: VIX: Federal Reserve Bank of St Louis; VSTOXX: STOXX; Economic Policy Uncertainty; EMBIG and EU Spreads: Bloomberg.

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Fund Resources Announcements, Uncertainty and Risk

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

1/ VSTOXX index measures volatility of a set of European option prices at a given maturity. 2 Comprises 10-year spreads for Greece, Portugal, Italy, Spain, and Ireland. Spreads are calculated against German Sovereign yields.Sources: VIX: Federal Reserve Bank of St Louis; VSTOXX: STOXX; Economic Policy Uncertainty; EMBIG and EU Spreads: Bloomberg.

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Fund Resources Announcements, Uncertainty and Risk

Citation: Policy Papers 2021, 008; 10.5089/9781513571256.007.A001

1/ VSTOXX index measures volatility of a set of European option prices at a given maturity. 2 Comprises 10-year spreads for Greece, Portugal, Italy, Spain, and Ireland. Spreads are calculated against German Sovereign yields.Sources: VIX: Federal Reserve Bank of St Louis; VSTOXX: STOXX; Economic Policy Uncertainty; EMBIG and EU Spreads: Bloomberg.

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46. The risk of moral hazard related to the size of Fund resources appears low. Concerns have been raised at times that expanding Fund resources could lead to excessive risk taking by national authorities in setting policies (debtor moral hazard) or by private creditors underpricing lending risks (creditor moral hazard). It is difficult to find any substantive evidence for these concerns and, indeed, Mussa (1999) argued that the problem of moral hazard has been greatly exaggerated.⁵⁰ Also, a strong framework is in place to limit these risks. Specifically:

• A key factor mitigating debtor moral hazard is the design of Fund programs, which include conditionality and provide financing to smoothen adjustment, while ensuring the member’s capacity to repay the Fund. The FCL and PLL do not have ex post conditionality, but moral hazard concerns are addressed through strict eligibility criteria in relation to a member’s fundamentals, economic policy frameworks and policies, and track record of policy implementation.

• Some recent programs have addressed possible creditor moral hazard, notably coordinating efforts to maintain private banks’ exposure (for instance, the so-called ‘Vienna Initiative’). The aim was to prevent Fund support from being used to finance outflows to institutions that had been major sources of inflows prior to the crisis.

• There are also strong safeguards against superfluous lending, in particular the requirement of a balance of payments need and Executive Board approval. Indeed, the Fund had very low new lending commitments in the years leading up to the crisis, despite having significant uncommitted resources, and the increase in Fund resources provided by the membership since the GFC has not led to a large expansion in Fund lending.

47. Judgment is also needed to interpret the results provided by the quantitative approaches presented under the first pillar. First, the quantitative approaches themselves provide a broad range of estimates for the size of the Fund, requiring judgment to weigh the different approaches and their respective results. Second, discussions on the adequacy of Fund resources need to consider the state of the world by the mid-2020s as experience has shown that beyond the 2019 deadline for completing the Review, it will likely take some time for any quota increases to become effective and these quota increases will determine the Fund’s quota-based resources through the middle of the next decade. As a simple illustration, taking the “global scenario c” at the 75th percentile and applying the GDP deflator through 2021 as projected in the WEO (rather than 2018, which is the basis of the calculation in the scenarios) would result in an increase by 20 percent of potential calls on Fund financing. Third, in a severe crisis scenario, the Fund’s lending capacity would decline as members under stress drop out of the Financial Transactions Plan (FTP).⁵¹ This in turn would reduce the Fund’s holdings of usable quota resources and the FCC. Access to borrowed resources would also decline if the affected member is a NAB participant or has a bilateral borrowing agreement with the Fund. For example, under the “access-based scenario c,” the net reduction in the supply of usable quota resources would be about SDR 65 billion.⁵² Fourth, as the models are based on historical data, increasingly longer program periods and duration are incorporated only to some extent.