On top of growing protectionism and inward-looking policies, the global economy faces additional risks from heightened volatility in financial markets and the potential for large asset price adjustments, according to a recent report.

Such a scenario “could amplify the effects of other risks materializing”, finds the World Bank’s Global Economic Prospects report released in Washington on June 10.

Despite recent volatility, risk premiums in key equity and credit markets, the report points out, remain historically narrow. “In this context, a material reappraisal of risk appetite could lead to sharp asset price corrections in advanced economies,” it states, “which would reverberate through global markets and might become disorderly if synchronous deleveraging by market participants leads to liquidity strains.”

Such repricing of equities in advanced as well as emerging markets and developing economies “could lower consumption through wealth and confidence effects, whereas widening corporate spreads would weigh on investment globally.”

“Banks might also retrench from riskier lending,” the report adds, “slowing credit growth and curbing some cross-border intermediation.” As an example, it points to a possible decline in trade credit that could exacerbate slowdowns in advanced economy trade and exports by emerging markets and developing economies.

“It is also possible that weakening risk sentiment might coincide with a rise in the term premium on advanced economy government bonds, given uncertainty about the outlook for inflation and policy rates in key economies,” the report warns. “This would further tighten global financial conditions.”

Vulnerable economies prone to capital outflows

With less appetite for global risk and benchmark interest rates still high, emerging markets and developing economies with heightened domestic vulnerabilities “would be prone to large capital outflows”.

Moreover, shifting interest rate differentials could constrain their central banks from supporting domestic activity, as they might slow or delay policy easing to mitigate capital outflows and inflationary pressures resulting from currency depreciation.

In emerging markets and developing economies with weak credit ratings and high debt levels, “market access for refinancing maturing debts could be disrupted, necessitating sudden fiscal adjustments,” the report says. “More broadly, higher borrowing costs would raise debt-servicing burdens over time, worsening fiscal pressures.”

With capital inflows declining since late last year, some emerging markets and developing economies “may be particularly prone to destabilizing capital outflows amid increased uncertainty, ongoing inflation risks and currency volatility,” the report reads, adding that to reduce the likelihood of such sudden shifts, “policymakers can reaffirm their commitments to price stability”.

“Monetary policy credibility can be reinforced,” the report argues, “through clear communications, robust monetary frameworks and the safeguarding of central bank independence, which has steadily improved over the last two decades, but nevertheless remains below advanced economy levels on average.”

To improve credibility, some central banks “may need to tighten monetary policy in the face of potential capital outflows and financial volatility. Doing so could help anchor inflation expectations, reinforce investor confidence and reduce domestic market volatility,” the report notes, recalling the proactive tightening of monetary policy by many central banks during the post-Covid inflationary surge.

Risk management tools

“Policy makers also need to be prepared to deploy tools that manage risks to financial stability, arising, for example, from reduced international investor risk appetite, capital outflows and rising bond yields,” the report argues, “all of which might stem from heightened trade tensions and policy uncertainty.”

Weakening growth, especially if downside risks materialize, “could imperil financial sector balance sheets, increase corporate borrowing costs and curtail funding access in the non-financial sector, particularly among economies exposed to external trade,” the report states. “Such strains could also worsen extant financial sector vulnerabilities in some countries, such as over-reliance on domestic banks for sovereign financing.

“To promote financial sector resilience, precautionary steps can include comprehensive stress tests for financial institutions and the scrutiny of bank credit quality and capital levels, as well as enhanced liquidity and liability management, among other sound macro-prudential rules.”

The report concludes: “Building on progress in recent years, continued efforts to ensure adequate foreign reserves are also important.”