In general, countries with floating interest rates for the bulk of their mortgages have seen house prices decline significantly, as higher interest rates quickly lead to difficulties in making mortgage payments. Commercial real estate markets are facing similar pressures, as rising interest rates have dried up funding resources, slowed transactions, and increased defaults.
High interest rates also pose challenges for governments. Promising and low-income countries face greater difficulty in borrowing in hard currencies, such as the euro, yen, dollar, and pound sterling, because of the higher returns demanded by foreign investors. This year, hard currency bonds were issued with actually higher coupons – or interest rates. However, concerns about sovereign debt are not present only in low-income countries, as demonstrated by the sharp rise in longer-term interest rates in advanced economies.
In contrast, a large number of major emerging economies do not face this predicament, thanks to the strength of their economic fundamentals and financial soundness, although foreign portfolio investment flows to those countries have also slowed. In recent months, China has witnessed huge inflows of foreign investment as a result of increasing turmoil in the real estate sector, which has led to a decline in investor confidence.
Effects of fallout
Most investors appear to have paid no heed to the mounting evidence of borrowers’ difficulties in repaying. In addition to the general soundness of stock and bond markets, financial conditions have improved as investors seem to expect a soft global downturn, that is, containment of inflation thanks to higher central bank interest rates without causing a recession.
But this optimism presents two problems: the relative easing in financial conditions may continue to stoke inflation, and the tightening of interest rates could become more severe in the event of adverse shocks, such as an escalation of the war in Ukraine or worsening pressures in the real estate market in China.
A sharp tightening of financial conditions would put pressure on weak banks that already suffer from high credit risks. Surveys from several countries already point to a slowdown in bank lending, which they attribute mainly to increased borrower risk. According to one of the chapters of the soon-to-be-released Global Financial Stability Report, many banks will lose a huge proportion of their contributed capital, within the framework of a scenario that expects continued rise in inflation and interest rates and a recession in the global economy. Investors and depositors will begin to closely monitor banks’ conditions if their capital declines in stock markets below its value on the balance sheet, creating financing problems for weak banks. Outside the banking system, vulnerabilities are also evident in non-bank financial intermediary institutions, such as hedge funds and pension funds, which offer their loans in private markets. It is reassuring that policymakers can prevent any negative developments. Central banks must remain determined to return inflation to the target level, as the sustainability of economic growth and financial stability depends on price stability. Whenever financial stability becomes threatened, policymakers should quickly use liquidity support and other tools to mitigate acute pressures and restore market confidence. In conclusion, given the importance of bank safety to the global economy, work must continue to strengthen regulation and oversight mechanisms in the financial sector.
2023-10-15 20:48:48
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