Here Is The IMF's Global Financial Crash Scenario

Hidden almost all the way in the end of the first chapter of the IMF's latest Financial Stability Report, is a surprisingly candid discussion on the topic of whether "Rising Medium-Term Vulnerabilities Could Derail the Global Recovery", which is a politically correct way of saying is the financial system on the verge of crashing.

In the section also called "Global Financial Dislocation Scenario" because "crash" sounds just a little too pedestrian, the IMF uses a DSGE model to project the current global financial sitution, and ominously admits that "concerns about a continuing buildup in debt loads and overstretched asset valuations could have global economic repercussions" and - in modeling out the next crash, pardon "dislocation" - the IMF conducts a "scenario analysis" to illustrate how a repricing of risks could "lead to a rise in credit spreads and a fall in capital market and housing prices, derailing the economic recovery and undermining financial stability."

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From the IMF's Financial Statbility Report:

"Could Rising Medium-Term Vulnerabilities Derail the Global Recovery?"

This section illustrates how shocks to individual credit and financial markets well within historical norms can propagate and lead to larger global impacts because of knock-on effects, a dearth of policy buffers, and extreme starting points in debt levels and asset valuations. A sudden uncoiling of compressed risk premiums, declines in asset prices, and rises in volatility would lead to a global financial downturn. With monetary policy in several advanced economies at or close to the effective lower bound, the economic consequences would be magnified by the limited scope for monetary stimulus. Indeed, monetary policy normalization would be stalled in its tracks and reversed in some cases.

The Global Macrofinancial Model documented in Vitek 2017 is used to assess the consequences of a continued buildup in debt and an extended rise in risky asset prices, from already elevated levels in some cases. This dynamic stochastic general equilibrium model covers 40 economies and features extensive macro-financial linkages—with both bank- and capital-market-based financial intermediation—as well as diverse spillover channels.

This scenario has two phases. The first phase features a continuation of low volatility and compressed spreads. Equity and housing prices continue to climb in overheated markets. As collateral values rise, bank lending conditions adjust to maintain steady loan-to-value ratios, facilitating favorable bank lending rates and more credit growth. As discussed, leverage in the nonfinancial private sector has already increased over the past decade across major advanced and emerging market economies. In the scenario, a further loosening in lending conditions, combined with low default rates and low volatility, leads investors to drift beyond their traditional risk limits as the search for yield intensifies despite increases in policy rates.

As presented earlier, market and credit risk premiums are close to decade-low levels—leaving markets exposed to a decompression of risk premiums. Thus, the second phase begins with a rapid decompression of credit spreads and declines of up to 15 and 9 percent in equity and house prices, respectively, starting at the beginning of 2020. This shift reflects debt levels breaching critical thresholds, prompting markets to grow concerned about debt sustainability, while risk premiums jump, aggravating deleveraging pressures.

As risk premiums rise, debt servicing pressures are revealed as high debt-to-income ratios make borrowers more vulnerable to shocks. The asset repricing is moderate in magnitude, but is broad-based across jurisdictions and leads to a tightening of financial conditions. Flight to quality flows reduce long-term bond yields in safe havens and raise them in the rest of the world. Segments with higher leverage and extended valuations are hit particularly hard, leading to higher funding costs and debt servicing strains.

Underlying vulnerabilities are exposed, and the global recovery is interrupted. Figure 1.30 summarizes the main impacts and spillovers:

  • The global economic impact of this scenario is broad-based and significant, about one-third as severe as the global financial crisis. The level of global output falls by 1.7 percent by 2022 relative to the WEO baseline, with varying cross-country impacts.
  • The severity of the economic impact on the United States is cushioned by stronger bank buffers, milder house price declines, and more monetary policy space compared with other advanced economies, despite relatively high equity valuations. The Federal Reserve reverses interest rate hikes during the second phase of the scenario, cutting the policy rate by 150 basis points to 1.75 percent by 2022.
  • The euro area suffers a larger output loss because the policy rate is at the effective lower bound and—as a result of renewed financial fragmentation—term premiums rise in high-spread euro area economies. Government debt ratios climb because nominal output is lower and debt service costs are higher for these economies.
  • Emerging market economies are disproportionately affected by the correction in global risk assets. The flight to quality prompts outflows from their equity and bond markets, putting pressure on currencies and challenging countries with large external financing needs.
  • Corporate and household defaults rise on the back of higher interest costs, lower earnings, and weaker growth. Default rates do not breach global financial crisis levels but return to levels consistent with prior cyclical peaks. Firms in some euro area countries and China with excessive debt overhangs are more sensitive to the increase in credit costs. Household leverage and high house prices in Australia and Canada make these economies more  susceptible to risk premium shocks.
  • Higher credit and trading losses, in turn, reduce bank capital ratios to varying degrees worldwide. Banking systems in advanced economies are healthier compared with the precrisis period, while leverage is less of a potential amplifier. Chinese banks suffer outsize declines in capital, but strong policy buffers could be used to mitigate the financial and economic impacts.

Emerging Markets Would Suffer a Retrenchment in Foreign Capital Inflows

Drawing on the above scenario, the potential for emerging market stress due to pressures on portfolio inflows is examined in more detail, including by taking into account the likely reduction in these flows from Federal Reserve balance sheet normalization (as discussed earlier).

  • During the first phase of the scenario, portfolio flows to emerging market economies are supported by rising investor risk appetite. This partially offsets the drag on portfolio inflows from US monetary policy normalization observed during 2017–19. As a result, there is a (net) reduction in portfolio inflows to emerging market economies of about $25 billion a year, compared with $35 billion under the baseline (Figure 1.31, panel 1).
  • During the second phase of the scenario, the asset market correction triggers a more rapid retrenchment in capital inflows to emerging market economies of about $65 billion over the first four quarters, in addition to the projected reduction of $35 billion in inflows associated with continued Federal Reserve balance sheet normalization. The combined effect results in a reduction of portfolio inflows of some $100 billion during the first four quarters of the correction (and about $65 billion during the subsequent four quarters).
  • At the country level, the associated portfolio inflow reduction during the first two years of the shock to global risk premiums ranges from 1.6 to 2.3 percent of GDP for the most affected countries (Figure 1.31, panel 2). Such a reduction is likely to lead to an outright reversal of portfolio flows, at least during some quarters, considering that the decompression of risk premiums is likely to be more rapid in some periods than in others (rather than unfolding at a steady pace as depicted in this exercise).

The buildup in external financing pressures could be particularly challenging for countries with large and rising projected current account deficits. For example, Colombia, South Africa, and Turkey have projected current account deficits in the range of 3 to 4½ percent of GDP in 2019 (Figure 1.31, panel 3). Moreover, emerging market currencies would come under pressure, limiting space for monetary policy to ease. In turn, higher domestic interest rates would affect firms’ debt servicing capacity, hitting those with still high levels of corporate leverage and increasing risks to weaker banking systems.

Emerging Market Policies In emerging market economies, policymakers should take advantage of current favorable external conditions to further enhance their resilience, including by continuing to strengthen external positions where needed and reduce corporate leverage where it is high. Deploying policy buffers and exchange rate flexibility would help buffer external shocks, while improving corporate debt-restructuring mechanisms and monitoring firms’ foreign exchange exposures would lower corporate vulnerabilities. Advances in these areas would leave these economies better placed to cushion any reduction in capital inflows that may occur from monetary policy normalization in advanced economies.

However, capital outflow pressures could become more significant if there is a severe retrenchment in global risk appetite, as in the scenario described earlier. Such pressures should usually be handled primarily with macroeconomic, structural, and financial policies, although the appropriate response will differ across countries depending on available policy space (see IMF 2012, 2015, 2016a). Where appropriate, exchange rate flexibility should be a key shock absorber, but in countries with sufficient international reserves, foreign exchange intervention can be useful to prevent disorderly market conditions. In periods of stress, liquidity provision may also be needed to support the orderly functioning of financial markets. Capital flow management measures should be implemented only in crisis situations, or when a crisis is considered imminent, and should not substitute for any  needed macroeconomic adjustment. When circumstances warrant the use of such measures on outflows, they should be transparent, temporary, and nondiscriminatory and should be lifted once crisis conditions abate.


Escrava Isaura Looney Sun, 10/22/2017 - 16:06 Permalink

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IMF's Global Financial Crash Scenario Now Here’s My Global Crash Scenario Polish movie that went something like this: Jewish woman: Why did you kill my brother, the doctors, the teachers, …… The Christian peasant/farmer: Because we were left with nothing while they took everything.  That’s why we killed them.  

In reply to by Looney

lucitanian peddling-fiction Mon, 10/23/2017 - 11:38 Permalink

Let's make it simple for those clever economists....1, what are negative interest rates? The banks expresses the risk of owning your money with a promise only to pay you back money.2, what is QE? A way for banks to borrow at 0% or close there to, and transfer those borrowings to loans and thereby assets.3, Who do the banks lend to? Banks lend to corporate institutions who can show book assets (collateral).4, What do big corporate institutions do with the money they borrow? They buy stocks, shares and bonds from other institutions "as assets". (and on the basis of their assets can borrow more to turn over their repayments as the value of their assets ascend, on paper, nullifying their negligible repayment and interest liabilities.)5, So what is the effect? You need ever more money in the system, as the value of assets and loans increases and the real return on assets diminishes.6, When does it stop? When no more increment in the value of assets is possible and it has absorbed the same risk as the value of money that inflated it. Negative asset values accrue, in other words Babboom (you have to pay someone to hold money and/or non-productive [negatively valued] assets). Your finished, as you can only transfer one for the other - looser.At this point, the entirety of monetary values collapses as negative money follows negative asset, demand is reduced to food, shelter, and guns with ammunition to protect them. Even gold as a means of exchange has its limits. You can't eat it until someone is willing to trade it for food.

In reply to by peddling-fiction

Latitude25 Sun, 10/22/2017 - 16:09 Permalink

"declines of up to 15 and 9 percent in equity and house prices, respectively, starting at the beginning of 2020"  By 2020 both of those assets will be up another 100% so what's a 15% correction?  Propaganda by the IMF.

Batman11 Sun, 10/22/2017 - 17:19 Permalink

Alan “Kamikaze” Greenspan on how not to do tightening. have you forgotten Alan?He’s forgotten the delays in the system.There were delays while the teaser rate mortgages reset; the new mortgage repayments became unpayable; the defaults and other losses accumulated within the system until everything came crashing down in 2008.The FED had tightened much too fast by not appreciating the delays in the system.Greenspan was on a suicide mission; luckily he bailed out before his mistake became apparent.What a fucking moron.

Batman11 Batman11 Sun, 10/22/2017 - 17:23 Permalink

Ben Bernanke can’t see any problems ahead in 2007. going exponential, a credit bubble is underway (debt = money) and 2008 stick out like sore thumbs.What a fucking moron.Where do they get these clueless arseholes from?

In reply to by Batman11

Batman11 Batman11 Sun, 10/22/2017 - 17:29 Permalink

“Can we avoid another financial crisis?” by Steve Keen is the must read book for Central Bankers.China, Ireland, Hong Kong, Norway, Sweden, Belgium, Australia and South Korea are in trouble due to their debt.Perhaps China’s central banker purchased a copy and looked in horror at the diagram on page 97, China was due for a Minsky Moment. I had purchased the book some time ago and was well aware of its plight. The BIS popped up about a month ago with the warning I was expecting, they are a bit slow.China's central banker - What a fucking moron.Where do they get these clueless arseholes from?

In reply to by Batman11

Stud Duck Sun, 10/22/2017 - 17:20 Permalink

Let me give ya'all my prediction. The Russians, Iraq and Iran will finally decide thay have had enough of this shit, embargo the US on oil imports or push a tax/tarriff on oil into the US to pay for war reperations.. they will give us the choice. When we refuse the tax, they will embargo, Iran will start blocking the strait again so any other mideast oil can get out oil to us, pushing them into their sphere or purchase all their oil with us dollars to prevent any coming our way. Gas prices will got to a minimum of $6.50 per in no time at all, and any oil we import will have to be purchased with gold..Imagine that senario for just a moment, then realize how vernable this economy is and  how little we will be able to do about it!They play?? Buy storage for gas and diesel , fill the storage  up, and wait.. If you need fuel to operate your business, you will use it anyway and is a super tax deduct before the first of the year!It can;t hurt to consider how fast this could happen!!  

bass ackwards Stud Duck Mon, 10/23/2017 - 18:53 Permalink

If Iran blocked the strait it would be the last thing they do. The US navy alone could destroy everything in Iran that floats inside of week..with a little help from the air force,  the Iranian missile sites and air force would be obliterated at the same time. ..and Russia isn't going to ww3 for Iran.

In reply to by Stud Duck

hooligan2009 Sun, 10/22/2017 - 17:45 Permalink

the IMF, populated by failed libatrd demoNrats with a degree in the bleeding obvious, but only after it has happened..bleh. (including vomit)show us the way forward IMF, not your version of the apparent, which is that liberal socialism fails on every level

VIS MAIOR Sun, 10/22/2017 - 17:50 Permalink

hmm . ZH produce some "generic articles" just to keep site running. now pro trump- to keep some income. becouse after trump vote and his turning against whole world. people stoped visiting here.. i don see many hundreds nick wich no more discus  here..  becouse chess is finnished. cards are on table..  trump junta shake with their "investment" an rigged WAllSt. and fed  in pain agony of near dead horse 

Griffin Sun, 10/22/2017 - 18:26 Permalink

During the last crash, the politically correct term was a "Credit Event".Crash sounded so terribly scary, it might spook the markets using language like that.

Sudden Debt Sun, 10/22/2017 - 18:39 Permalink

one third as severe.... that's like a titanic lifeboat plan... won't ever be needed... just decoration... the rest will be able to swim I guess...

illuminatus Mon, 10/23/2017 - 07:54 Permalink

Seems to me that if the powers that be along with their central banks want to keep the "debt as money system" going, they will have to let the air out of the balloon somtime. Either that or go back to some value based monetary system altogether. Either way, it seems unlikely that they can keep inflating the debt balloon indefinitely.

Falconsixone Mon, 10/23/2017 - 08:33 Permalink

We're off to see the wizard, The Wonderful Wizard of Oz We hear he is a whiz of a wiz, if ever a wiz there was If ever a wonderful wiz there was, The Wizard of Oz is one becauseBecause, because, because, because, because Because of the wonderful things he does We're off to see the wizard, The Wonderful Wizard of Oz 

seataka Mon, 10/23/2017 - 11:53 Permalink

If gold were to rise dramatically it would fund a French style revolution."If the people were to ever find out what we have done, we would be chased down the streets and lynched." -- George H. W. Bush, cited in the June, 1992 Sarah McClendon Newsletter”