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COVID-19 worsens pre-existing financial vulnerabilities

COVID-19 worsens pre-existing financial vulnerabilities

Our recently released chapters 2-4 of the Global Financial Stability Report focus on three potential weak spots: risky segments in global credit markets, emerging markets, and banks. Should the ongoing economic contraction last longer or be deeper than currently expected, the resulting tightening of financial conditions may be amplified by these vulnerabilities, causing more instability or even a financial crisis. The prolonged period of low interest rates encouraged both borrowers and creditors to take on more risk. The resulting surge of portfolio inflows into riskier asset markets contributed to the buildup of debt and in some cases resulted in stretched valuations in emerging and frontier markets. As a result, they have become more reliant on foreign portfolio flows since the global financial crisis. Our analysis suggests that both bond and equity flows are much more sensitive to global financial conditions during periods of extreme flows than in normal times, while domestic fundamentals (such as economic growth, external vulnerabilities, domestic financial market depth) matter incrementally more for equities and local-currency-denominated bond flows. Furthermore, greater foreign investor participation in local currency bond markets that lack adequate depth can greatly increase the volatility of bond yields […]