Compared with 2023, financial markets have turned “quite optimistic” in light of a softer landing from high inflation, according to an annual report by the International Monetary Fund (IMF).

While the near-term global financial stability risks have receded in the expectation that disinflation is controlled, the medium-term picture is less rosy. “So far, cracks in the financial system—unmasked by high interest rates during the monetary tightening cycle—have not ruptured further,” the report said – citing a lack of contagion following bank collapses in the US and Switzerland in 2023. “Financial and external sectors in major emerging markets have proven resilient throughout the interest rate upswing.” 

Debt burden

In addition, since financiers are now optimistic that interest rate rises around the globe have plateaued, the price of most assets is more stable than in 2023. But the report warned that, “sizeable inflation surprises could abruptly change investor sentiment, rapidly decompressing asset price volatility and causing simultaneous price reversals among correlated markets, thus prompting a sharp tightening in financial conditions.” 

In the medium term, rising levels of public and private debt have made both advanced and emerging markets more vulnerable to adverse market shocks. 

One potential flash point is China’s troubled housing market. Expectations that property values in China would continue to rise have not materialised. As a result, large developers such as Evergrande and Country Garden face difficulties, according to recent analysis.

IMF said that woes in the property sector are being felt in the wider economy. “The downturn in Chinese property and equity markets has caused heavy losses in parts of China’s asset management industry, which could spill over to bond and funding markets,” IMF said. “The steps authorities have taken to stabilize the markets since the third quarter of 2023 have yet to turn sentiments around.”

Policy push-back

Given the prospect of global financial instability in the mid-term, IMF warned central banks to resist the pressure of “overly optimistic market expectations for policy rate cuts”. Instead, it urged governments to increase efforts to stop the potential spread of debt vulnerabilities – especially in emerging markets. 

“Given the potential risks of the fast-growing private credit market, authorities should consider a more proactive supervisory and regulatory approach,” the report added. “It is key to close data gaps and enhance reporting requirements to comprehensively assess risks. Authorities should also strengthen cross-sectoral and cross-border regulatory cooperation and make risk assessments consistent across financial sectors.”