Current Challenges to World Financial Stability: To What Extent is the Past a Guide for the Future?

Abstract

The chapter discusses current challenges to world financial stability in light of lessons that have been learned from past financial crises. Although there are parallels between the current situation and some of the previous crises, the current situation differs in several important respects. It comes after a decade of extremely low nominal and real interest rates along with subdued inflation and, due to fiscal and monetary policy measures deployed during the GFC and the COVID-19 pandemic, debt/GDP ratios and central banks (CBs) balance sheets are at historically high levels. The recent upsurge of inflation prompted a worldwide process of increase in policy interest rates and reduction in CB assets. An undesirable side effect of this process is that it may trigger several mechanisms that endanger world financial stability. Recent developments in Fintech and the global economic disruptions caused by the war in Ukraine create novel financial vulnerabilities that differ from previous financial crises. The rapid growth of fintech institutions poses new regulatory challenges at the national and international levels. Although no crisis has materialized to date, those developments have increased the odds of a systemic global crisis. Measures designed to mitigate financial vulnerabilities are briefly discussed in the concluding section.

1. Introduction

A common thread of past financial crises is that they all occur following a period of (expost) exaggerated economic optimism characterized by rapid credit expansion against a backdrop of underdisciplined fiscal/monetary policies and lax regulatory institutions. The credit expansion is accompanied by high investments, high economic activity, and increased prices in assets and real estate markets. In the absence of sufficiently large economic or political shocks, this happy state may last for a while.

However, when an unanticipated adverse shock materializes, lenders stop lending and demand immediate repayment on short-term loans triggering default, panic, contagion, and ultimately runs also on some solvent institutions. This leads to violent reversals in asset markets and contraction in real economic activity. The mechanisms through which this process materialized in past crises differ depending on a country’s institutions, level of development, depth of the capital market, structure of the banking system exchange rate arrangements, inflation differentials, central bank independence, and political stability.

The chapter discusses current challenges to world financial stability in light of the lessons that have been learned from past financial crises, such as the global financial crisis (GFC), and some of the older crises in Asia, Latin America, and Russia. Although there are parallels between the current situation and some of the buildup toward those previous crises, the current situation differs in several important respects. First, it comes after a decade of extremely low nominal and real interest rates along with subdued inflation. Second, due to fiscal and monetary policy measures deployed during the GFC and the COVID-19 pandemic, debt/GDP ratios and central banks (CBs) balance sheets are at historically high levels. The recent upsurge of inflation (due to both supply and demand factors) prompted a worldwide process of increase in policy interest rates and a gradual reduction in CB assets. Those policy trends are likely to intensify over the foreseeable future. An undesirable side effect of this process is that it may trigger several mechanisms that endanger world financial stability.

Recent developments in Fintech and the global economic disruptions caused by the war in Ukraine create novel financial vulnerabilities that differ from those of previous financial crises. The rapid growth of fintech institutions in banking and other financial intermediaries poses new regulatory challenges at the national and international levels, and none of the previous crises was triggered by war. Although no crisis has materialized as of yet (July 2022), those developments have increased the odds of a systemic global crisis.

The chapter is organized as follows: Section 2 describes the major financial crises in the post-World War II (WW-II) period. Section 3 draws lessons from those crises for the future, and Section 4 discusses the new risks created by the recent acceleration in the growth of fintech, by the reduction in world trade and rising commodity prices due to the Russian invasion of Ukraine, and the rise of Chinese overseas lending for global financial stability. This is followed by concluding remarks.

2. An overview of post-world war II financial crises

2.1 The 1980s Latin American debt crisis¹

The 1973 and 1979 oil shocks created current account deficits in many Latin American (LA) countries. In parallel, these shocks created substantial current account surpluses in the oil-exporting countries. With the encouragement of the US government, large banks became intermediaries between the two groups, providing the oil-exporting countries with a safe dollar-denominated, liquid asset and lending those funds mostly in dollars to Latin America (FDIC).

World economic expansion and low real rates on short-term loans made this situation tenable during the seventies. But this changed when Federal Reserve (Fed) chairman Volcker and other Western CBs raised interest rates to contain the inflation of the seventies, creating a worldwide recession in the early eighties. Commercial banks raised rates and shortened repayment periods. As a result, LA countries discovered that their debt burdens were unsustainable.

The crisis erupted in August 1982, when the Mexican finance minister informed US authorities and the International Monetary Fund (IMF) that Mexico would no longer be able to service its debt. Other countries quickly followed this path. Ultimately 16 LA countries and 11 less-developed countries (LDCs) in other parts of the world rescheduled their debts. In response, many banks stopped new overseas lending and tried to collect and restructure existing debt portfolios. Funds scarcity in the debtor countries plunged them into recessions and triggered devaluations of domestic currencies and inflation.

Initially, US banking regulators allowed lenders to delay recognition of the full extent of overseas lending in their loan loss provisions. By 1989, US Secretary of the Treasury Brady proposed a plan that would permanently reduce loan principal and debt service obligations conditional on the undertaking of domestic structural reforms in debtor countries. The plan was backed and partially financed by the IMF and the US Treasury. Ultimately about one-third of the total debt of the 18 countries that signed on to the plan was forgiven.

2.2 The 1997/98 Asian financial crisis²

Prior to the crisis, most of the Far Eastern countries that were involved in the crisis did very well. Business-friendly policies and cautious fiscal and monetary policies had translated into high rates of savings and investment, supporting GDP growth rates exceeding 5% and often approaching 10%.

However, as the crisis unfolded, it became clear that the strong growth record of these economies had masked important vulnerabilities. Years of rapid domestic credit growth and inadequate supervisory oversight had resulted in a significant build-up of leverage and doubtful loans. Industrial policies of governments led corporations and banks to believe that, in case of financial difficulties, they will be bailed out in spite of the fact that there was no official commitment to such bailouts (see Ref. [4]).

Overheating domestic economies and real estate markets added to the risks and led to increased reliance on foreign savings. This was reflected in mounting current account deficits and a build-up in external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations and banks to exchange rate and funding risks. Prior to the crisis, those risks had been masked by longstanding currency pegs. When the crisis erupted, most of those pegs proved unsustainable and firms saw sharp increases in the local currency value of their external debts, leading many into distress and even insolvency.

The crisis burst into the open on July 2 1997 when, following months of speculative pressures that had depleted its foreign exchange reserves, Thailand devalued its currency relative to the U.S. dollar. In subsequent months, Thailand’s currency, equity, and property markets weakened further as its difficulties evolved into a twin balance-of-payments and banking crisis. Malaysia, the Philippines, and Indonesia also allowed their currencies to weaken in the face of market pressures, with Indonesia gradually falling into a financial and political crisis. Severe balance-of-payments pressures in South Korea brought the country to the brink of default. Hong Kong faced several large but unsuccessful speculative on its peg to the dollar, the first of which triggered short-term stock market sell-offs across the globe. Across East Asia, capital inflows slowed or reversed direction, and growth slowed sharply. Banks came under significant pressure, investment rates plunged, and some Asian countries entered deep recessions, producing important spillovers to trading partners across the globe.

In response to the spreading crisis, the IMF, the World Bank, the Asian Development Bank, and governments in the Asia-Pacific region, Europe, and the U.S. provided large loans to help the crisis countries rebuild official reserves and buy time to restore confidence and stabilize their economies, while also minimizing lasting disruptions to countries’ relations with their external creditors. To address the structural weaknesses exposed by the crisis, aid was conditional on substantial domestic policy reforms. These included measures to deleverage, clean up and strengthen weak financial systems and improvement of competitiveness. Countries hiked interest rates to help stabilize currencies and tightened fiscal policy to speed external adjustment and cover the cost of bank clean-ups. But, as markets began to stabilize, the macro policy mix evolved to include some loosening of fiscal and monetary policies to support growth.

2.3 The 1998 Russian financial crisis³

The Russian crisis took place in the first decade of Russia’s 1991 transition from a centrally planned economy to a free market economy. During the first years of the transition, GDP declined sharply, poverty became widespread, and inflation reached hyperinflationary dimensions. Between 1994 and 1996, inflation was stabilized, fiscal policy was tightened, and there was a substantial reduction in GDP shrinkage. The willingness of the Russian government to enter negotiations about a payment rescheduling of the former Soviet debt in April 1996 along with some financial aid from the IMF and the World Bank Union signaled improving relations with the West and had a positive impact on investors’ confidence and revived the Russian capital market. This was amplified by a recovery in the international price of oil—a major Russian export product.

However, in the fourth quarter of 1997, market sentiment deteriorated drastically as a result of the Asian financial crisis. In November 1977, the Russian ruble came under speculative attack. The CB of Russia (CBR) defended the fixed peg and lost in the process a quarter of its Foreign Exchange (Forex) reserves. The Asian crisis led to a decrease in the price of oil, delivering another blow to the Russian economy. As market sentiment deteriorated, investors became aware of Russia’s domestic weaknesses. Poor tax collection, widespread tax evasion, and corruption raised the budget deficit and the balance of payments deficits. The first war in Chechnya imposed additional tax burdens.

By mid-1998, international liquidity was low and Russia’s current account deteriorated further as oil prices continued to fall. In an attempt to support the ruble and reduce capital flight, the interest rate was hiked to 150% by the CBR. In July 1998, monthly interest payments on Russia’s debt exceeded monthly tax collections. Parliamentary disapproval of an anti-crisis plan completely eroded investors’ confidence, triggering runs on domestic banks. Many banks were closed and many depositors lost their savings. The crisis resulted in a renewed strong contraction of the economy and also affected investor confidence in emerging markets worldwide.

Thanks to the depreciation of the ruble, the banks restructuring, and the increase in international oil prices, the Russian economy recovered rather quickly.

2.4 The 1998/99 Brazilian crisis⁴

In 1994, after years of failed price stabilization and high inflation, Brazil initiated a stabilization plan named after its currency—the real. Under the Real Plan, the federal government took steps to correct a large budget deficit by reducing transfers to states and municipalities and increasing federal taxes. Monetary policy was tightened, and the real was pegged to the dollar with gradual adjustments through a crawling peg. During 1998, the plan practically eliminated inflation that had reached hyperinflationary dimensions, but balance-of-payments problems persisted.

Brazil’s fundamentals on the eve of the crisis taken alone would not have necessarily deteriorated into a financial crisis. But it was affected by financial contagion from the 1997 crisis and the 1998 Russian crisis. As described above, those two crises substantially reduced international liquidity. International investors withdrew funds not only from the affected countries but also from economies with a poor past record of economic management, such as Brazil. To discourage the consequent outflow of dollars, the CB of Brazil raised interest rates sharply losing in the process half of its forex reserves. High-interest rates dramatically increased Brazil’s overall budget deficit through the debt service component.⁵ In addition, debt maturity was shortened, making this burden more immediate. This obviously spooked investors even more.

The IMF made a commitment to provide funds designed to soften forex hemorrhage, and the Brazilian government was supposed to pass legislation designed to reduce the budget deficit. When this legislation was rejected by Congress and the governor of Minas Gerais announced that he would suspend his state’s debt payments to Brazil’s national government for 3 months’ attacks against the currency intensified.

By mid-January 1999, Brazil announced that pegging was over and its exchange rate would be allowed to float.

2.5 The Argentine 2001/2 crisis⁶

Due to political and monetary instability, Argentina had a record of extremely high and persistent inflation in the post-WW II period. Numerous efforts at inflation stabilization quickly failed due to undisciplined fiscal institutions and political interference at the CB. When inflation reached over 3000% per year, plans for economic stabilization and liberalization were deployed in 1989. The reforms included the privatization of state-owned enterprises, the deregulation of the economy, lower trade barriers state reform, and, last but not least, the Convertibility Plan of 1991, which fixed the Argentine peso one-to-one to the US Dollar. Under this currency board, Argentines could now freely convert their pesos into dollars. From then on, bank deposits and loans in dollars became widespread. Moderately expansive fiscal policy stimulated the economy and helped restore economic growth.

With the implementation of the reforms, Argentina won great commendation, especially from the IMF. On Wall Street, Argentina became one of the most favorite emerging markets and became the biggest issuer of emerging markets debt in the late nineties. This made the country increasingly dependent on foreign capital. Following the implementation of reforms, the Argentine economy entered a period of economic growth between 1991 and 1997. Only in 1995 output growth was negative, due to the so-called Tequila crisis in Mexico. But the quick return of high economic growth in 1996 suggested that the Argentine economy was strong enough to counter external shocks. This further strengthened the confidence in the implemented policies, including the Convertibility Plan.

The outbreak of currency crises in Asia, Russia, and Brazil in 1997/1998 increased the borrowing costs for emerging markets, including Argentina. Furthermore, in 1998 when Brazil, a major trading partner of Argentina, ended its own peg to the US dollar, Argentina became less competitive. In addition, the prices of Argentina’s agricultural export products fell and the US dollar appreciated reaching its highest level in 15 years. All this led to a sharp reduction in exports. As a result, Argentina’s current account deficit rose and the country went into recession in the autumn of 1998.

Initially, Argentina maintained its peg, but this left it unable to respond to the growing economic imbalances. The fact that the exchange rate peg was not supported by nominal price and wage flexibility further reduced Argentina’s means to deal with the currency overvaluation and decreased the credibility of the fixed exchange rate regime. As a consequence, foreign investors lost confidence in the Argentine economy, the country experienced a strong increase in borrowing costs and, by July 2001, the country had fully lost its access to international financial markets. This untenable problem was aggravated further by a procyclical fiscal policy.

At the end of December 2001, in a climate of severe political and social unrest, Argentina partially defaulted on its USD 93 billion international debt and 2 months later formally abandoned the Convertibility Plan. The pesofication of bank deposits and loans at two different exchange rates and prize freezes for utility companies caused a wave of defaults and liquidity problems at Argentine companies as well as at domestic and foreign banks. Among others, Argentina’s largest locally owned private-sector bank, Banco Galicia, and several foreign banks, such as Bank of America, Citigroup, FleetBoston, and J.P. Morgan Chase & Co, suffered heavy losses.

2.6 The 2007/2014 global financial crisis (GFC)

Unlike all the crises described above, the GFC erupted in the US—the epicenter of world financial markets—sending shock waves throughout global financial markets. The crisis was preceded by 20 years of subdued economic fluctuations known as “the great moderation.” Between 2004 and 2007, a real estate boom swept the US and other Western economies. During that period, the volume of mortgage-backed securities (MBS) increased by leaps and bounds. MBS are bonds secured by large packages of mortgages that are divided into default risk tranches with higher risk tranches carrying higher rates. This repackaging of mortgages supplied to saving institutions a safe asset at slightly higher rates than other bonds of similar risk and dramatically increased the supply of funds to mortgage banks. Pension funds, insurance companies, and hedge funds all over the world absorbed large quantities of MBS.

The persistently rising real estate properties prior to the crisis led mortgage banks to finance most, and at time all or more, of the acquisition cost of a house. Under those circumstances, mortgage borrowers effectively borrowed with very little or no equity at all. This happy state lasted as long as real estate prices continued to rise. But, when they stopped rising and started to decline in 2006/7, the atmosphere changed. Many mortgage borrowers who had bought second and third homes stopped servicing their debt and returned the keys to their house to banks. In turn, the banks put those houses on the market at dumping prices, strengthening the decrease in prices. As this happened, the riskiness of MBS increased, and their prices decreased triggering calls for further funds from affected thrift institutions.⁷

This process was particularly devastating for highly leveraged hedge funds. Hedge funds owned by major investment banks defaulted pushing their parent companies into default. The most prominent downfalls among those were Bear-Stern in March 2008 and Lehman Brothers in September 2008. Shortly after, it became evident that the American International Group (AIG), a worldwide insurance company, and Fannie Mae and Freddie Mac, which together account for about half of the U.S. mortgage market, were on the verge of collapse endangering the entire US financial system.

On October 3 2008, following desperate and well-documented pleas for fiscal bailouts by Fed Chair Bernanke and Secretary of the Treasury Paulson, Congress created a $700 billion Troubled Asset Relief Program (TARP) to bailout failing institutions by buying MBS and other securities whose value had decreased dramatically and which became known as “toxic assets.”⁸ In parallel, the Fed reduced the federal funds rate (FFR) to zero and engaged in large scale asset purchases (LSAP) also known as quantitative easing (QE). Since the FFR had been reduced to the zero lower bound (ZLB), QE became the main instrument of monetary policy and was used extensively during the six or so years of the GFC. Congress also approved a separate package to bailout Fannie Mae and Freddie Mac. Within several months, those extraordinary rescue operations stabilized the financial panic that engulfed markets following Lehman’s collapse, and within a couple of years, Fannie Mae, Freddie Mac, and AIG repaid all their debts to the federal government. However, unemployment remained above 5% until the end of 2014 ([8], Figure 1). New bond issues and banking credit were also depressed till at least the end of 2014 and, except for an upward blip in 2011, inflation was well below 2%.

In parallel, the Eurozone (EZ) had its own crisis. Summary information on the evolution of the GFC in Europe appears in Ref. [9]. Following the near meltdown of their financial systems, regulators in the U.S. and the EZ recognized the damages that can be inflicted on the economy via the failure of a “too big to fail” institution and the importance of systemic supervision and regulation. This led to a series of regulatory reforms on both sides of the Atlantic, the most important of which is the creation of systemic regulators and the exante identification of systemically important institutions (SIFI). Further details appear in Ref. [10].

3. The legacy of past crises and current challenges

3.1 Lessons from Volcker’s disinflation for the present

During the GFC, the balance sheets (BSs) of Western CB expanded at rates never seen before. In particular, between 2008 and 2014, the BS of the Fed increased by a factor of 4.5. In 2016, the Fed made a modest effort at tapering but, as soon as the COVID-19 pandemic hit the globe at the beginning of 2020, substantial QE operations were resumed in order to help the Treasury finance huge aid packages to individuals and corporations in the economy. As a consequence, between the end of 2019 and the end of 2021, the BS of the Fed doubled. This policy paid off for the US as it stimulated the economy and reduced unemployment in spite of the obstacles posed by the pandemic.⁹ However frequent lockouts in China and elsewhere along with the war in Ukraine revived inflation prompting CBs in many countries to increase policy rates. Initially, the Fed did not move the FFR away from the vicinity of the ZLB. But as U.S. inflation accelerated to around 8%, it finally engaged in a gradual process of rates lifting in March 2022.

The current situation is reminiscent of Volcker’s disinflation at the beginning of the eighties. In both cases, an important portion of the inflation is due to aggregate supply factors; a dramatic increase in the price of oil by OPEC then and, currently, an increase in this price due to sanctions on Russia in response to the invasion of Ukraine. As Ukraine and Russia are major suppliers of cereals and wheat, the war also reduces world supplies of those staples causing a general increase in food prices. In both cases, CBs respond to rising inflation by raising policy rates. As recounted in Section 2.1, Volcker’s disinflation was one of the factors contributing to the LA crisis in the early 1980s.

But there also are differences between those two episodes. Most importantly, due to fiscal and monetary policy measures deployed during the GFC and the COVID-19 pandemic, debt/GDP ratios, private debts, and CBs balance sheets of the U.S. and other Western economies are at historically high levels. By contrast, the levels of public and private debt in the early eighties were much lower. In addition, the current round of rate lifting comes after a decade of extremely low nominal and real interest rates along with subdued inflation. By raising the debt service of private and public borrowers and depressing the value of assets, overly quick lifting of rates, may create strains on business and public finances pushing marginal borrowers to the brink of default. The experience of the LA crisis in the 1980s suggests that this risk is relatively more important for emerging markets with limited access to international capital markets than for developed economies. For advanced economies, such risks are mitigated by the comprehensive regulatory reforms that have been implemented during the GFC.

3.2 The sovereign-Bank nexus¹⁰

The pandemic has left emerging-market banks holding record levels of government debt, increasing the odds that pressures on public-sector finances could threaten financial stability. According to Chapter 2 of the IMF’s April 2022 Global Financial Stability Report [12], the average ratio of public debt to gross domestic product rose to a record 67% last year in emerging market countries. Emerging-market banks have provided most of that credit, driving holdings of government debt as a percentage of their assets to a record 17% in 2021. In some economies, government debt amounts to a quarter of bank assets. As a result, emerging-market governments rely heavily on their banks for credit, and these banks rely heavily on government bonds as an investment that they can use as collateral for securing funding from the central bank.

This interdependence carries the seeds of financial instability. Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines. That could force banks—especially those with less capital—to curtail lending to companies and households, weighing on economic activity. As the economy slows and tax revenues shrink, government finances may come under even more pressure, further squeezing banks. The sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop that ultimately could force the government into default triggering a, so-called, “doom loop” between domestic banks and government debt. Such a loop reinforced the 1998 Russian crisis and the 2001–2002 Argentinian crisis.

Emerging-market (EM) economies are at greater risk to experience this “doom loop” than advanced economies for two reasons. First, their growth prospects are weaker relative to the pre-pandemic trend compared with advanced economies, and governments have less fiscal firepower to support the economy. Second, external financing costs of EM have generally risen, so governments have to pay more to borrow. The recent sharp tightening of global financial conditions—resulting in higher interest rates and weaker currencies on the back of monetary policy normalization in advanced economies and intensifying geopolitical tensions caused by the war in Ukraine—could undermine investor confidence in the ability of EM governments to repay debts. A domestic shock, such as an unexpected economic slowdown, could have the same effect.

3.3 Strains on public finances in emerging markets

More generally, strains on public finance in EM with limited access to credit constitute another vulnerability. For example, Government programs, such as deposit insurance, intended to support banks in times of stress may trigger systemic financial fears. Strains on government finances could hurt the credibility of those guarantees, weaken investor confidence, and ultimately hurt banks’ profitability. Troubled lenders would then have to turn to government bailouts, further straining public-sector finances.

Another risk channel works through the broader economy. A blow to public finances could push economy-wide interest rates higher, hurting corporate profitability and increasing credit risk for banks. That in turn would limit banks’ ability to lend to households and other corporate customers, curbing economic growth and making the economy more vulnerable to unexpected shocks. Further details appear in chapter 2 of the April 2022 Global Financial Stability Report.

3.4 Risks to financial stability in the presence of substantial public and private forex debt

In many emerging markets, such as LA countries and Eastern European economies, a non-negligible part of both the public and the private debt is denominated in forex. In the past, the debt was usually owed to financial centers in developed economies. This phenomenon is known as “the original sin.” In some of the financial crises described in Section 2, persistent inflation differentials between such an EM and the economies of the lenders, or any other adverse shock to the domestic economy, may trigger downward pressures on the local currency. This risk is mitigated by persistent balance-of-payments surpluses and adequate forex reserves. However, previous experience suggests that in the absence of such cushions, an EM is likely to experience capital outflows, increases in the cost of debt, shortening of maturities, and downward pressures on the exchange rate. On the other, a new data set suggests that in many EMs, this risk is currently substantially lower than in the past for several reasons. External financing has shifted from forex debt to foreign direct investments (FDI), portfolio equity investments, and local currency debt, and most EMs possess now larger amounts of forex currency assets (details appear in Ref. [14]).

4. Financial stability implications of Fintech, the war in Ukraine, and the rise of Chinese overseas lending

The financial stability risks posed by Fintech and the war in Ukraine are relatively novel. The current level of digitization and technological innovations in financial activities—Fintech in short—is a relatively new phenomenon and the Russian invasion of Ukraine was a largely unanticipated event at the beginning of 2022. Chinese overseas lending expanded vigorously during the last decade, and as of 2017, it became the largest global official lender.

4.1 Financial stability implications of Fintech¹¹

Fintech reduces costs and frictions, increases efficiency and competition, and broadens access to financial services. But this new organization of banks and other financial firms raises new regulatory challenges. Digital banks, also known as “neobanks,” are growing in systemic importance in their local markets. Neobanks are fintech firms that offer software and other technologies to streamline mobile and online banking. They generally specialize in a limited number of products, such as checking and saving accounts. They also tend to be nimbler and transparent than their megabank counterparts, even though many of them partner with such institutions to insure their financial products.

Preliminary evidence suggests that neobanks take higher risks in retail credit originations without appropriate provisioning and that they underprice credit risk. They also take higher risks in securities portfolios and do not maintain sufficient liquidity.

By taking innovation to a new level, a form of financial intermediation based on crypto assets, known as decentralized finance (DeFi), has enjoyed extraordinary growth between 2020 and 2022. DeFi is increasingly interconnected with traditional financial intermediaries. While its market size is still relatively small, unregulated DeFi poses market, liquidity, and cyber risks, against a backdrop of legal uncertainties. The absence of centralized entities governing DeFi is a challenge for effective regulation and supervision. This challenge is amplified by the international nature of those institutions—a fact that requires the cooperation of regulatory and supervisory agencies across different jurisdictions. The 2022 Global Financial Stability Report recommends that regulation and supervision should focus on issuers of stable coins and centralized exchanges, and should encourage the development of industry codes of conduct and self-regulation.

4.2 Impact of the war in Ukraine on global financial vulnerabilities¹²

Russia’s invasion of Ukraine is causing an intense humanitarian crisis. More than 12 million people are estimated to have been displaced and more than 13 million require urgent humanitarian assistance. Ukraine’s economy is being devastated and the acute trauma suffered by the population will have enduring consequences. The war in Ukraine has set back the global response to—and the recovery of the global economy from—the COVID-19 pandemic.

Prior to the invasion, the world was focused on the health and economic challenges caused by the pandemic. In particular, supporting the global economy amid an uneven recovery characterized by lingering supply bottlenecks; the withdrawal of policy support; and rising inflation, including for food and energy. The war has added a global adverse impact, especially through the prices of commodity markets. Russia is the world’s largest exporter of wheat, accounting for 18% of global exports. Ukraine accounts for a further 7%. Russia is also the largest exporter of natural gas (25%), palladium (23%), nickel (22%), and fertilizers (14%). It also accounts for 18% of global exports of coal, 14% of platinum, 11% of crude oil, and 10% of refined aluminum.¹³

Europe’s dependence on Russia for energy renders its economy vulnerable. Russian exports account for more than 35% of the euro area’s imports of natural gas, more than 20% of oil, and 40% of coal (Figure 3.E in Ref. [16]). Russia is also dependent on the euro area for its exports, with around 40% of its crude oil and natural gas going to the euro area. While Russia may eventually be able to redirect some of its exports of gas and oil to others, this will be constrained by the existing pipeline infrastructure. Some emerging markets and developing economies (EMDEs) rely heavily on Russia and Ukraine for food and fertilizer. Russia and Ukraine account for more than 75% of imports of wheat in many countries. Logistics relating to transporting crops also remain a challenge; about 90% of Ukraine’s grain trade flows through Black Sea ports that are currently blocked by the Russian navy. Russia has recommended that fertilizer manufacturers halt exports of fertilizer, which will hinder food production in parts of the world, since Russia is the largest exporter of fertilizers, accounting for 14% of global exports.

Although no global systemic event affecting financial institutions or markets has materialized so far, the war raised financial stability risks along several dimensions. Equity market volatility has risen markedly, especially in Europe. The European VSTOXX index shot up briefly in early March and remains unusually elevated. Equity volatility in the United States (as proxied by the VIX Index) also increased substantially in the month following the start of the war, though has since declined somewhat. Sovereign borrowing costs have increased since the start of the war. U.S. 10-year government bond yields have risen considerably, reflecting a range of factors including higher expected inflation.

Spreads on EMDE bonds have not widened significantly on average, although bond issuance by EMDEs across February–March was weaker than in the same period of any year since 2016. For some financial institutions, a recession in Russia is likely to result in substantial losses. Some European banks have material linkages with Russian entities facing severe losses, such as Sberbank. The majority of European banking exposures to Russia are through the claims of Russia-based subsidiaries, however, which are primarily funded by local creditors and depositors. Combined with the healthy capitalization of European banks prior to the war, this should reduce the probability of losses being amplified into European bank funding markets.

Nonetheless, large equity losses for exposed banks seem probable, as implied by drops in the equity prices of European banks perceived to be exposed to Russia following the introduction of sanctions. The profits and liquidity positions of institutional investors will also be impacted by write-downs on Russian assets with encumbered liquidity and by the need to hold additional margin against implicated exposures.

4.3 Implications of the rise in China’s lending¹⁴

In contrast to global lending by advanced economies that originates in private banks and private capital markets, Chinese international lending originates in official sources. By 2017, China has become the largest official creditor surpassing the World Bank and the IMF. China has been lending to well over 100 countries. As of 2017, the highest ratio of official lending to local GDP was around 70% for Djibouti and about 6% for Ghana, which occupies the fiftieth place in this ranking (Figure 6 in Ref. [17]). The terms of Chinese official lending typically resemble those of commercial banks and about 50% of such loans to developing countries are not reported in standard debt statistics. Loans are denominated in USD or in local currencies. They are usually secured by means of domestic real assets or receipts owned by the borrower’s country public or private entity that received the loan.

In case of default, the Chinese government takes over those assets. Essentially, potential financial difficulties are resolved directly through debt-to-equity swaps. It is probable that in some cases, Chinese authorities extend official loans to relatively risky ventures hoping that the borrowers will be unable to repay in order to expand China’s control of world real resources. Although this is likely to be disliked by borrowing countries, these built-in debt-equity swaps reduce the likelihood of an open financial crisis triggered by defaults. On the other hand, the opaqueness of Chinese official lending statistics makes it difficult, if not impossible, to evaluate other potential risks embedded in those loans.

5. Concluding remarks

Through description and analysis, this chapter has illustrated the causes and the variety of mechanisms through which past financial crises erupted. Although all crises are ultimately associated with loss of confidence in the financial system and evaporation of liquidity, the nature of crises varies across time as well as across countries. Future surprises are inevitable, but the experience accumulated from past crises suggests that the following safeguards can reduce the probability of financial crises:

• Fiscal management should prevent excessive deficits from pushing the debt/GDP ratio to the vicinity of ranges that spook both domestic and international lenders pushing up interest rates on government debt and shortening its maturity. Although it is more difficult to achieve this recommendation in EMDEs, it is particularly relevant for them since they possess relatively smaller resources and have limited access to capital markets.

• Conduct monetary policy to maintain inflation not too far from the internationally accepted norm of inflation targeting. In view of huge past monetary expansions and the current inflation, this is not an easy task but, again, is more difficult to attain for EMDEs.

• Cross-border capital flows provide significant benefits but may generate or amplify shocks. The traditional IMF view has been that this problem can be handled by using flexible exchange rates as shock absorbers cum IT. However, due to insufficient internal discipline, in many EMDEs fixed rates or crawling pegs are used as nominal anchors. Such economies should hold sufficient stock of forex reserves for intervention purposes. Those measures could be supplemented by temporary or permanent taxes on short-term capital movements.¹⁵

• Regulators and supervisors should be given enough powers and independence to identify, ahead of time, systemic and other risks and to enforce measures that can mitigate them.

• In particular, the swift growth of fintech institutions has left many regulatory voids. Filling those empty spaces soon is essential to avoid financial crises triggered by insufficient regulation and supervision in this quickly expanding area.