Financial stability risks rise as war in Europe complicates efforts to contain inflation

Source: AdobeStock / Vitalii Vodolazskyi

Tobias Adrian is a financial advisor and director of International Monetary Fund (IMF) Monetary and Capital Markets Department.


While no systemic events materialized, the balance of risks shifted more to the downside.

Russia’s invasion of Ukraine raises risks to global financial stability and raises questions about the longer-term impact on economies and markets. The war, amid an already slow recovery from the pandemic, is expected to test the resilience of financial markets and threaten financial stability, as discussed in our latest Global Financial Stability Report.

Ukraine and Russia face the most pressing risks. Yet it is already clear that the severity of disruptions in commodity markets and supply chains creates downside risks by weighing negatively on macro-financial stability, inflation and the world economy.

Since the beginning of the year, financial conditions have tightened significantly in most parts of the world, particularly in Eastern Europe. Against a backdrop of rising inflation, expected interest rate hikes led to a noticeable tightening in advanced economies in the weeks following the Russian invasion of Ukraine. Even with this tightening, financial conditions are close to historical averages and real rates remain accommodative in most countries.

The tightening of financial conditions contributes to slowing demand, as well as preventing a stall in inflation expectations (i.e. the expectation of continued price increases in the future becomes the norm) and bring inflation back to target.

Many central banks may need to go further and faster than what is currently priced in the markets to contain inflation. This could take policy rates above neutral levels (a “neutral” level is a level at which monetary policy is neither accommodative nor restrictive and is consistent with maintaining full employment and stable inflation). This will likely lead to even tighter global financial conditions.

The new geopolitical reality complicates the work of central banks, which already face a delicate balancing act with stubbornly high inflation. They must bring inflation back to its target, bearing in mind that an excessive tightening of global financial conditions is detrimental to economic growth. In this context, and in light of heightened risks to financial stability, any sudden reassessment and reassessment of risk resulting from an intensification of war in ukraineor an escalation of sanctions against Russia, could reveal some of the vulnerabilities accumulated during the pandemic (soaring property prices and stretched valuations), leading to a sharp drop in asset prices.

Transmission of shocks

The repercussions of the war and subsequent sanctions continue to be felt. The resilience of the global financial system will be tested through various potential channels of amplification.

These include financial institutions’ exposures to Russian and Ukrainian assets; market liquidity and funding constraints; and the acceleration of encryption—residents choosing to use crypto assets instead of local currency—in emerging markets.

Europe poses a higher risk than other regions due to its geographical proximity to the war, its dependence on Russian energy and the significant exposure of certain banks and other financial institutions to financial assets and markets. Russians. Additionally, the continued volatility in commodity prices could put severe pressure on commodity finance and derivatives markets and could even cause more disruptions like the wild swings that halted some nickel trading last month. Such episodes, in a context of heightened geopolitical uncertainty, could weigh on liquidity and funding conditions.

Emerging and frontier markets now face higher risks of capital outflows, with a differentiation between countries between importers and exporters of commodities. In a context of geopolitical uncertainty, the interaction between the tightening of external financial conditions and the United States Federal Reserve normalization (first rate hike delivered in March and faster expected unwinding of the balance sheet), should increase the risk of capital flight.

Following the Russian invasion of Ukraine, the number of emerging and frontier market sovereign issuers trading at distress levels (i.e. spreads greater than 1,000 basis points) surged to more than 20% of emitters, surpassing pandemic peak levels. While worrying, this has limited impact on systemic concerns given that these issuers represent a relatively smaller proportion of total debt outstanding to date.

In China, the recent sell-off in equities, particularly in the tech segment, combined with ongoing tensions in the real estate sector and further lockdowns, raised fears of a slowdown in growth, with possible spillovers to emerging markets. Financial stability risks have increased amid continued stress in the struggling real estate sector. Extraordinary financial support measures might be needed to ease pressures on balance sheets, but they would further aggravate debt vulnerabilities.

Policy measures

In the short term, central banks should take decisive action to prevent inflation from taking hold and contain expectations of future price increases. Interest rates may need to rise beyond what is currently priced in the markets to bring inflation back to target in a timely manner. This may involve pushing interest rates well above their neutral level.

For central banks in advanced economies, clear communication is essential to avoid unnecessary volatility in financial markets, providing clear guidance on the tightening process while remaining dependent on data.

In emerging markets, many central banks have already significantly tightened policy. They should continue to do so, depending on individual circumstances, to preserve their inflation-fighting credibility and anchor inflation expectations.

Policymakers should tighten some macroprudential tools to tackle pockets of high vulnerability (for example, to deal with soaring property prices), while avoiding a broad-based tightening of financial conditions. It is important to strike the right balance here, given the uncertainties surrounding the economic outlook, the ongoing monetary policy normalization process, and the limits of post-pandemic fiscal space.

Policymakers will also face structural issues such as the fragmentation of capital markets, which would have implications for the role of the US dollar. Payment systems face similar risks as central banks seek to establish their own digital currencies independent of existing international networks.

Regulators will also be under pressure to close regulatory loopholes to ensure integrity and protect consumers in the rapidly changing world of crypto assets.

At the same time, the trade-offs between energy security (adequate and affordable supplies) and climate (regulatory mechanisms intended to raise oil and gas prices) are laid bare as the effects on supply and prices international sanctions against Russia reverberate throughout Europe and beyond. There could be setbacks in the climate transition in the immediate future, but the momentum to reduce energy dependence on Russia could be a catalyst for change. Policymakers should therefore strive to honor their climate commitments and step up efforts to achieve net-zero emissions targets, while taking appropriate additional measures to address energy security concerns.


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Mary I. Bruner