What is the outlook on the global economy?
What are the risks and vulnerabilities the International Monetary Fund has warned about in its latest nancial stability report? Is the threat of a global recession waning? Is the American economy doing well? Will it have a spillover e ect on emerging markets?
The story so far:
The International Monetary Fund (IMF) released the latest global nancial stability report on Tuesday warning about the risks to the global nancial system from persistent high in¡ation, rising lending in the unregulated credit market, and increasing cyber-attacks on nancial institutions.
What is the IMF’s worry about ination?
The IMF has ¡agged rising enthusiasm among investors that the ght against high in¡ation over the last few years has almost come to an end. Investors have been pushing up the prices of nancial assets such as stocks in recent months in the hope that central banks will soon begin lowering interest rates as in¡ation comes under control. It should be noted that central banks generally try to lower interest rates by injecting more into the economy when in¡ation falls in an attempt to boost economic growth. Although central banks are yet to lower interest rates, investors may take falling in¡ation as a cue that central banks will soon ¡ush the markets with more money to lower interest rates. So they go ahead and purchase nancial assets in anticipation of greater demand for these assets when banks actually lower interest rates, thus pushing up the prices of these assets right now.
The IMF, however, believes that investor enthusiasm about slowing in¡ation and a possible cut in interest rates by central banks may be quite premature. It has noted that the fall in in¡ation has probably stalled in some major advanced and emerging economies where core in¡ation in the most recent three months has been higher than in the previous three months. The IMF has also warned that geopolitical risks such as the ongoing war in West Asia and Ukraine could a ect aggregate supply and lead to higher prices. This, it believes, might stop central banks from lowering rates anytime soon.
If these risks persist, the IMF believes, investors who have been bidding up asset prices expecting fresh money from central banks to push up asset prices in the near future may change their mind. This could cause a sharp correction in the prices of various assets and leave many investors with signicant losses.
What does it mean for India?
The IMF notes that fund ¡ows into emerging markets have been strong till now due to optimism over central banks easing interest rates. In fact, in calendar year 2023, India was the second-largest recipient of foreign capital after the U.S., according to Elara Capital. But things could change quickly if western central banks signal that they could keep interest rates high for a long time. This could cause investors to pull money out of emerging markets like India and increase pressure on their currencies. The Indian rupee has already been depreciating and traded at a new low of 83.57 against the U.S. dollar last week despite likely intervention by the Reserve Bank of India (RBI). A severe out¡ow of capital if western central banks fail to lower interest rates could cause further depreciation of the rupee and have e ects on the country’s nancial system. In such a scenario, the RBI is likely to defend the rupee by curbing liquidity to raise interest rates, which could cause the economy to slow down.
What about the private credit market?
The IMF in its report also noted that the growing unregulated private credit market, in which non-bank nancial institutions lend to corporate borrowers, is a growing concern as troubles in the market might a ect the broader nancial system in the future. It estimates that the private credit market globally grew to $2.1 trillion last year. The non-bank nancial institutions lending to corporate borrowers include institutional investors such as pension funds and insurance companies. Institutional investors are investing in the private credit market because they o er higher returns than normal investments. Meanwhile, the borrowers benet as they cannot get convenient long-term funds through other venues.
The IMF, however, is worried that the borrowers in the private credit market may not be nancially sound and noted that many of them do not have current earnings that exceed even their interest costs. It also argues that since these loans rarely trade in an open, liquid market like many other securities do, it might be hard for investors to really gauge the risk involved in these loans. Thus private credit assets have signicantly smaller markdowns in their mark-to-market value during times of stress, the IMF notes. In a highly liquid market where securities are traded frequently, the real risk behind a loan is priced in more immediately and also more accurately by investors. Nevertheless, it may be the case that institutional investors are fully willing to bear the risk in return for higher returns.
India has also seen the growth of a small private credit market with the rise of Alternative Investment Funds (AIFs). These funds lend money to high-risk borrowers who are not catered to by the traditional banking system and non-bank nancial companies. They have also invested in distressed assets that have come up for sale under the Insolvency and Bankruptcy Code regime. The Securities and Exchange Board of India (SEBI) notes that investments made through these funds, although still small, has more than tripled from ₹1.1 lakh crore in 2018-19 to ₹3.4 lakh crore in 2022-23. As nancial regulators, both the RBI and SEBI have been noticing this trend and tried to increase scrutiny over these funds.
An outow of capital if western central banks fail to lower interest rates could cause further depreciation of the rupee