The Russia-Ukraine war will test the resilience of the global financial system, posing a threat to financial stability and presenting policymakers with challenging trade-offs, the International Monetary Fund said.
Policymakers need to take "decisive" action to rein in rising inflation and preserve the economic recovery from the Covid-19 pandemic while avoiding a "disorderly" tightening of global financial conditions, the fund said in its latest Global Financial Stability Report on Tuesday.
"The war in Ukraine, while at this point not a global systemic event from a financial standpoint, is nonetheless anticipated to have a material impact on the economy amid heightened uncertainty about the outlook," the IMF said.
"In addition, the sharp rise in commodity prices further complicates the challenge faced by central banks in credibly bringing down inflation to target while safeguarding the post-pandemic recovery."
The severity of the disruptions in commodity markets and to global supply chains will weigh heavily on the outlook for inflation, the global economy and possibly macro-financial stability, the fund warned.
The conflict has already led the IMF to lower its global economic growth forecast this year for 143 countries, accounting for 86 per cent of the world's output, with widely varying prospects.
The war will "test the resilience of the financial system through various channels, including direct and indirect exposures of banks, non-bank financial intermediaries, and firms; market disruptions (including in commodity markets) and increased counterparty risk; acceleration of cryptoisation in emerging markets; and possible cyber-related events", the IMF said.
Emerging and frontier markets are also facing tighter financial conditions and a higher probability of portfolio outflows. The IMF forecasts outflows will rise to 30 per cent now, up from 20 per cent in October 2021.
"Amid geopolitical uncertainty, the interplay of tighter external financial conditions and the US Federal Reserve normalisation (first rate increase delivered in March and unwinding of the balance sheet expected to be faster), is likely to increase the risk of capital flight," Tobias Adrian, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in a blog post.
In China, the world's second-biggest economy, financial vulnerabilities "remain elevated" amid ongoing stress in the real estate sector and new Covid-19 outbreaks. This has raised concerns about a growth slowdown, with possible spillovers to emerging markets.
"Financial stability risks have risen amid ongoing stress in the battered real estate sector. Extraordinary financial support measures may be needed to ease balance sheet pressures, but these would add to debt vulnerabilities down the road," Mr Adrian said.
In its policy recommendations, the IMF said that central banks should "act decisively to prevent inflation pressure from becoming entrenched and avoid an unmooring of inflation expectations".
Interest rates might have to rise beyond what is currently priced in markets to get inflation back to target in a timely way, Mr Adrian said. This may include pushing interest rates well above their neutral level.
In emerging markets, many central banks have already significantly tightened policy and they should continue to do so — depending on individual circumstances — to "preserve their inflation-fighting credibility and anchor inflation expectations", he said.
In the coming years, policymakers will also need to confront several structural issues highlighted by the war in Ukraine and the ensuing sanctions against Russia, the IMF said.
These includes the trade-off between energy security and climate transition, as well as fragmentation in capital markets that would have implications for the role of the US dollar in asset allocation, it said.
While taking steps to address energy security concerns, policymakers should intensify their efforts to achieve net-zero targets, the fund said. They should take measures to increase the availability and lower the cost of fossil fuel alternatives and renewables while improving energy efficiency. They must also scale up private finance in transition to a greener economy.
"Trade-offs between energy security (adequate, affordable supplies) and climate (regulatory mechanisms intended to increase oil and gas prices) are being laid bare as supply and price effects of international sanctions on Russia ripple across Europe and beyond," Mr Adrian said.
"There may be some setbacks in the climate transition in the immediate future, but the impetus to reduce energy dependency on Russia could be a catalyst for change."
Policymakers should also develop comprehensive global standards for crypto assets, the report said. A more robust oversight of FinTech firms and decentralised finance platforms is needed to take advantage of their benefits while mitigating their risks, the report said.
"Payment systems face similar risks as central banks seek to establish their own digital currencies that are independent of existing international networks. Regulators will also be under pressure to narrow regulatory gaps to ensure integrity and protect consumers in the fast-evolving world of crypto assets," Mr Adrian said.