Commentary: Global shocks and resilience

Overall tone

Last week’s annual meetings of the IMF and the World Bank, held in Washington, DC, had a hint of relief with respect to global economic and financial risks. Policy makers have spent more than two years fearful of a bumpy recovery from the Covid pandemic. But despite a sharp rise in interest rates, the world has avoided a recession, the banking system has proved largely resilient, while capital flows have not dried up. The 2021/22 inflation spurt has been followed by an encouraging period of disinflation, even if consumers are dissatisfied with the high level of some prices. 

The IMF updated its growth-at-risk framework analysis, which indicated some decrease in near-term financial stability risks, which by extension points to a lessening of GDP growth risks this year.

But policy makers are not devoid of worries. Concerns remain about the steady extension of the higher-for-longer narrative, with rate cut expectations softening against the strong growth and sticky inflation narrative. A key concern is the commercial real estate (CRE) sector, where real prices have declined by 12% globally over the past year.  The distress in the sector is a function of factors that are both cyclical (rising interest rates) and structural (work from home). This weakness is most pronounced in the US and Europe.

A wide range of risk metrics suggests that banks are well-positioned to absorb CRE losses, Nonetheless, certain countries may experience more strains given that their banks hold large amounts of CRE loans, especially if demand remains weak.

Another area of concern is the high level of correlation across asset classes. As per analysis done by the IMF’s financial sector experts, average correlation across equities, bonds, credit, and commodity indices in both advanced economies and emerging markets presently exceeds the 90th historical percentile. Hence, financial shocks, including sizable inflation surprises that change investor sentiment, could cause across-the-board asset selloffs.

The list of concerns does not end there. During the meetings, we heard warnings about China’s property market, ultra narrow credit spreads, DM debt market, Chinese and US banks, and the consequence of further quantitative tightening.

A section of the IMF’s Global Financial Stability Report was focused on the nonbank financial sector. Open-end bond funds, including ones focused on less liquid assets, have received large inflows in recent years, with relatively less visibility on the vulnerabilities this development may have caused.

View from US officials

• Secretary Yellen's China trip in early April was useful in deepening dialogue with the Chinese authorities. Both sides were engaged, while many areas of disagreement remain. The media has covered the trip extensively, but did not adequately capture the constructive nature of the trip.
• Yellen's argument that China's manufacturing overcapacity is creating global deflation risks is something the Treasury feels strongly about, and it wants the IMF to examine it from a multilateral perspective. The key evidence cited by the US Treasury is that China's industrial production and industrial policy are structurally misaligned from domestic demand. Consumption boosting policies ought to help ameliorate such imbalances.
• US officials are also concerned about currency misalignment and associated financial stability risks around global markets. The recently published Japan-Korea-US ministerial statement underscored this concern, with explicit reference to the yen and won’s recent depreciation. China’s currency practice remains under scrutiny, including the data on reserves and balance of payments that are providing inadequate insights into external account dynamics.
• US officials tend to push back on concerns that US fiscal debt and deficit path pose systemic risk to the US or beyond. There remains considerable dearth of safe assets in this world, keeping US debt issuance well-bid. This dynamic is unlikely to change in the coming years.
• The Treasury and the Department of Commerce are examining the “rules of origin” around China’s offshoring of production. It is clear that some of the US imports from Mexico/Vietnam and a few other countries have substantial Chinese inputs and capital.

View from IMF staff

• The IMF is not in alignment with the US government’s push to examine China’s “overcapacity.” The fact that China is a major exporter of a wide variety of manufactured products, some of which are facilitated by industrial policy, is hardly a China-specific or a new phenomenon. Also, China’s current or trade account trends in recent years don’t reflect chronic or rising surpluses, which renders arguments related to overcapacity or exporting of deflation impulse non-tenable.
• The IMF does not consider the USD misaligned. The current account does not appear to be widening, nor is it away from the medium-term trend. It is plausible to consider US debt path as a risk to the dollar going forward, but even that seems like a stretch after two factors are considered: (i) USD’s privilege as a reserve currency and (ii) the persisting dearth of safe assets globally.
• In any case, a path toward fiscal adjustment is much surer way to rebalance the US economy than through a depreciation of the dollar, which is the more likely path of adjustment for an EM economy.
• On inflation and Fed, the IMF staff are quite relaxed. They expect inflation to ease up in the coming months on the back of rentals and fading of one-offs like auto insurance. They still see the Fed cutting rates 2-3 times in 2H24, and by 4-5 times in 2025. The expectation is neutral rate will be revised up to 3%, and the cycle can settle around that by early 2026.

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