The International Monetary Fund (IMF) warns of global economic stagnation and worldwide stability risks in its Global Financial Stability report for October.
The report highlights that, although the short-term risks have declined since the April report, medium-term risks have notably increased due to the continued slowdown in global growth and rise in inequality, thus opening the door for populist policies, which could limit or reverse international trade and financial integration.
On the other hand, emerging markets are adapting to an environment of lower global growth and their rate of risk has declined, led by a modest recovery in commodity prices and improved external financial conditions, fuelling a pickup in capital flows.
In the past six months, the Brexit vote was the main catalyst for the rise of short-term risk. Brexit caught investors by surprise and initially roiled global markets. But the global financial system has been strengthened since the crisis, and the political shock was absorbed by markets
In contrast with past episodes of global turbulence, flows into emerging markets were resilient and have, in fact, increased since the referendum.
Yet, emerging market economies remain vulnerable to shifts in investor sentiment and changes in policies of major central banks. Growth prospects for emerging market economies were given only modest improvements in the report. The recent rebound in capital flows appears to be driven more by external developments than by better economic fundamentals.
As a result, a shock or sudden shift in market sentiment could quickly reverse these benign conditions and capital flows. The past year has seen major political events trigger increased uncertainty about the direction of policies and the prospects for reform.
Moreover, according to the report, the increased financial links between emerging markets and advanced economies have resulted in increased risk of spill over effects between the two, leaving some countries particularly exposed to political risks from abroad.
Financial markets have benefited from renewed risk appetite in the wake of unprecedented central bank actions. But there is an urgent need to increase global growth, strengthen the foundation of the global financial system, and bolster confidence to avoid slipping into a state of economic and financial stagnation.
As a result of the weak economic environment, discontent over income growth and inequality are on the rise, leading to unearthing protectionist and populist sentiment which, in turn, makes a consensus on growth-enhancing reforms and additional supportive policies more difficult to achieve.
In the case that such a scenario comes about, it would likely lead to a marked shift into safer assets in financial markets. Loss of confidence could cause firms and households to postpone spending, and reduce private investment and consumption.
Furthermore, banking systems profitability would increase significantly and experience widening funding spreads. This could hasten de-risking by global banks, with implications for the corresponding banking activities in emerging markets and developing economies.
Moreover, capital flows would steer towards safer assets, undercutting the supportive external environment that is benefiting emerging markets. Tighter global financial conditions and high corporate leverage would exacerbate the credit cycle downturns in emerging market economies.
In Egypt’s case that might prove to be very troublesome, as Egypt aims to attract $10bn in foreign direct investment (FDI) in the fiscal year (FY) 2016/2017, in order to achieve the targeted GDP growth of 5.2% in the same fiscal year.
Implementing such a scenario using the global macro-financial model suggests that, in aggregate, world output would fall 3% by 2021.
The IMF report suggests that emerging market economies should take advantage of supportive external conditions to achieve a smooth path of deleveraging to enhance resilience and preserve financial stability. In order to achieve that emerging markets should proactively monitor and address corporate vulnerabilities, particularly those arising from excess leverage and foreign exchange exposures.