5. Near-Term Risks to the Financial System
The Federal Reserve routinely engages in discussions with domestic and international policymakers, academics, community groups, and others to gauge the set of risks of particular concern to these groups. As noted in the box "Survey of Salient Risks to Financial Stability," contacts were mostly focused on the possible adverse effects of the Russia–Ukraine war, the downside risks of persistent inflation and monetary policy tightening, and an abrupt correction to valuations of risky assets. For the United States, concerns over cyber risk have increased following the invasion. Shocks caused by cyber events, especially cyberattacks, may spread through the financial system through complex and often unrecognized interdependencies across financial firms and market participants and, if sufficiently disruptive, can affect financial stability. Various U.S. government agencies and their private-sector partners are taking steps to further protect the financial system and other critical infrastructures against the increased risk of cyber-related incidents.
The following analysis considers possible interactions of existing vulnerabilities with four broad categories of risk, some of which were also identified in the survey conversations: risks emanating from the Russian invasion of Ukraine; the potential for a marked worsening of the U.S. economic outlook; stresses in China, including in the real estate sector; and stresses in other emerging market economies (EMEs).
Russia's ongoing war in Ukraine could affect U.S. financial stability through multiple channels
The Russian invasion of Ukraine roiled financial markets, disrupted international trade, and prompted sharp increases in prices for oil and other commodities, pushing up global inflation further. (For more details on the associated stresses to financial market functioning, see the boxes "Recent Liquidity Strains across U.S. Treasury, Equity Index Futures, and Oil Futures Markets" and "Commodity Market Stresses following Russia's Invasion of Ukraine.") The hostilities have led to escalating sanctions on Russia and Russian countermeasures. Most U.S. and European banks and investors have modest direct exposures to Russia and Ukraine and to commodity prices. But a prolonged conflict, particularly if accompanied by severe and widespread commodity shortages, could lead to substantial volatility in commodity and financial markets, a downturn in economic activity concentrated in Europe, higher inflation and interest rates worldwide, and a broad pullback from risk-taking, transmitting stress to institutions that are exposed. Through declines in both asset prices and the repayment capacity of borrowers, European banks would be particularly affected. Stresses in European financial institutions could affect U.S. financial institutions through their strong interconnections to European banks, including via dollar funding markets, and could transmit to U.S. financial conditions through a pullback in lending from European banks to U.S. businesses and households.
Elevated and persistent inflation combined with a sharp rise in rates could pose risks to the economy and the financial system
In the United States, inflation has been higher and interest rates have risen more than was expected at the time of the last Financial Stability Report. Further adverse surprises in inflation and interest rates, particularly if accompanied by a decline in economic activity, could negatively affect the financial system. This combination could weaken the balance sheets of households and businesses, leading to an increase in delinquencies, bankruptcies, and other forms of financial distress. In particular, households could be affected by job losses, higher interest payments, and a reduction in house prices caused by higher mortgage rates and decreased housing demand. The resulting stresses may be especially pronounced for homeowners currently in mortgage forbearance or in the subprime and near-prime risk categories. Also, business credit quality could be eroded by a steep rise in rates that would increase business borrowing costs, which in turn could have negative consequences on employment and business investment. Additionally, a sharp rise in interest rates could lead to higher volatility, stresses to market liquidity, and a large correction in prices of risky assets, potentially causing losses at a range of financial intermediaries, reducing their ability to raise capital and retain the confidence of their counterparties.
Stresses in China, including in the real estate sector, could spill over to the United States
In China, debt levels are high in the real estate sector, where activity and prices turned down significantly last year (see the box "Stresses in China's Real Estate Sector"). If this downturn intensifies, its effects on Chinese markets and financial institutions could be amplified by lockdowns or other disruptions to the economy from further flare-ups in COVID-19 cases, new regulatory restrictions (including further actions to curb the tech sector), or any pullback in trade or investment from other countries due to geopolitical motives or risk concerns. Given the size of China's economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment and disruptions to economic activity, potentially affecting the United States.
Inflationary pressures and adverse external shocks could lead to stresses in other emerging market economies that could affect the United States
Increased debt levels in many EMEs since the onset of the pandemic have made these economies more vulnerable to adverse shocks. More recently, higher food and energy prices have worsened the terms of trade for some EMEs—particularly commodity importers—and could exacerbate social and political stresses and trigger a downturn in investor risk sentiment and capital outflows. Meanwhile, ongoing policy rate hikes by many EME central banks, while necessary to reduce inflation to target levels, have been leading to tighter financial conditions and are weighing on economic activity. Reduced repayment capacity and higher debt-servicing costs for EME sovereigns and businesses could stress EMEs' financial systems. Widespread and persistent EME stresses could adversely affect the U.S. financial system, primarily through indirect channels, via effects on U.S. businesses with strong links to EMEs; direct financial exposures to EME businesses and sovereigns are small.
Box 5.1. Stresses in China's Real Estate Sector
For the past several decades, expansionary policies in China have helped sustain rapid economic growth, which has outpaced that of most other countries. China's share of world GDP has reached about 17 percent (figure A). Credit to Chinese businesses has increased even faster, supporting GDP growth, but the resulting leverage in the corporate sector makes it increasingly vulnerable to shocks. Nonfinancial business credit in China has reached about 160 percent of GDP, a level that is much higher than in most other EMEs (figure B). Corporate indebtedness has become particularly high in China's real estate sector—which has been a key engine of China's rapid growth—and lending for property development and related activities has grown rapidly.
Figure A. Share of world gross domestic product
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Note: National gross domestic product figures are converted to U.S. dollars at market exchange rates. The European Union (EU) aggregate continues to include the United Kingdom in 2020.
Source: World Bank, World Development Indicators Online, https://databank worldbank org/source/ world-development-indicators.
Figure B. Credit to the nonfinancial business sector
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Note: Credit is defined as total credit to the private nonfinancial business sector. The "Other EMEs" category consists of Argentina, Brazil, Chile, Colombia, the Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Poland, Russia, Saudi Arabia, South Korea, Thailand, and Turkey. GDP is gross domestic product; EMEs are emerging market economies.
Source: Bank for International Settlements.
In the past few years, the Chinese government has tightened regulation of property markets, including the imposition of new constraints on home purchases, banks' property-sector exposure, and mortgage lending in some markets.1 In August 2020, regulators announced further measures directly focused on property developers: progressively tighter restrictions on borrowing, based on specific prudential limits for leverage and liquidity (commonly known as "the three red lines"). In the longer term, these constraints should help keep leverage in check and increase the resilience of the property sector and the financial system.
Not long after these initiatives were implemented, property sales slowed sharply (figure C).2 Home prices and construction activity also declined. Customers typically make payments to construction companies in advance of project completion, and adverse dynamics could be amplified if buyers lose confidence in developers' ability to complete housing units. There have already been payment defaults by several property developers and a sharp liquidity crunch for others with respect to both domestic and offshore funding. After years of robust growth, domestic bank loans to property developers are declining, and bonds issued by some of the larger Chinese property developers in the offshore dollar market are trading at increasingly distressed levels this year (figure D).
Figure C. New property sales
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Source: National Bureau of Statistics of China via Haver Analytics.
Figure D. High-yield corporate bond yield spreads to similar-maturity U.S. Treasury securities
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Note: As of March 2022, the ICE China Dollar High Yield Index (ticker ECNH) contained $58.9 billion in property-firm bonds out of a total face value of $80.4 billion for bonds in the index.
Source: ICE Data Indices, LLC, used with permission.
Although the Chinese government has managed to contain its effects so far, a significant worsening of the downturn in property markets could affect China's financial system. Chinese banks have direct exposure to developers amounting to more than half of their Tier 1 capital and substantial indirect exposure to property markets from loans to other firms that are collateralized by real estate. Chinese banks are also exposed to real estate developers indirectly through bank-sponsored wealth-management products sold to retail investors. Local governments are also exposed to China's property market because they generate a significant portion of their fiscal revenues from land sales, and they too are highly leveraged. A broad estimate of local government debt that includes off-balance-sheet financing vehicles exceeded 70 percent of GDP last year.3 In December, the national government announced relaxed restrictions on bond finance by local governments in the first quarter of 2022, which should partially alleviate near-term pressures and provide funding for infrastructure investment. Local-government issuance appears to have been strong in the first quarter, and growth in fixed asset investment in China accelerated at the start of the year, reflecting the heavy front-loading of fiscal stimulus this year.
Spillovers to the United States so far have been limited in scope, in part because direct U.S. exposures to mainland China are relatively modest. U.S. bank exposures amount to less than 10 percent of their Tier 1 capital. Other U.S. investors also have limited exposure: Available data suggest holdings of Chinese securities (including securities issued through offshore affiliates) represent only about 1 percent of U.S. portfolio investment.4 In addition, recent research estimates that sales to China make up less than 5 percent of U.S. firms' revenues.5
But if the property market fallout intensifies and leads to significant strains at Chinese banks that reduce bank lending and GDP growth, the transmission of stresses to the United States could be strong through both real and financial channels—notably trade and global risk sentiment. The trade channel is significant, given China's large role in the global economy, and Federal Reserve staff research finds a negative Chinese GDP surprise tends to decrease both global commodity prices and the volume of trade among other countries.6 Risk sentiment can also be a significant international spillover channel, and past periods of acute stresses in China have roiled global markets, such as in 2015, when a change in the Chinese government's exchange-rate-management mechanism heightened concerns about Chinese growth (figure E).7 The consequent acceleration of capital outflows and sharp correction in Chinese equity prices were accompanied by volatility in global and U.S. markets and a sizable appreciation of the dollar.
Figure E. S&P 500 return option-implied volatility and China events
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Note: Vertical lines indicate a currency devaluation on August 11, 2015; an 8 percent decline in the Shanghai Composite Index on August 24, 2015; and a temporary halt in equity market trading on January 4, 2016.
Source: Bloomberg Finance L.P., Bloomberg per Security Data License; Dow Jones, Wall Street Journal.
1. Concerns about large and rising financial and social imbalances, including housing affordability and the marked increase in income and wealth inequality that has occurred over time, also led the Chinese government to announce in 2021 a "common prosperity" drive for more equitable and sustainable long-term growth. Return to text
2. The International Monetary Fund demonstrated that the red lines were binding on a significant segment of the property industry when introduced. See page 9 of International Monetary Fund (2022), "People's Republic of China: 2021 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China," IMF Country Report No. 22/21 (Washington: IMF, January), https://www.imf.org/-/media/Files/Publications/CR/2022/English/1CHNEA2022001.ashx. Return to text
3. For details, see table5 in IMF, "People's Republic of China," in note 2. Return to text
4. From Treasury International Capital (TIC) data by residence, adjusted to a nationality basis using the methodology of Carol Bertaut, Beau Bressler, and Stephanie Curcuru (2019), "Globalization and the Geography of Capital Flows," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September6), https://doi.org/10.17016/2380-7172.2446. Return to text
5. This value is estimated for 2016 to 2019, with firm-level revenue shares weighted by stock market capitalization. For methodological details, see Carol Bertaut, Beau Bressler, and Stephanie Curcuru (2021), "Globalization and the Reach of Multinationals Implications for Portfolio Exposures, Capital Flows, and Home Bias," Journal of Accounting and Finance, vol. 21 (November), pp. 92–104, https://doi.org/10.33423/jaf.v21i5.4738. Return to text
6. For details, see Shaghil Ahmed, Ricardo Correa, Daniel A. Dias, Nils Goernemann, Jasper Hoek, Anil Jain, Edith Liu, and Anna Wong (2019), "Global Spillovers of a China Hard Landing," International Finance Discussion Papers 1260 (Washington: Board of Governors of the Federal Reserve System, October), https://doi.org/10.17016/IFDP.2019.1260. Return to text
7. See Ahmed and others, "Global Spillovers of a China Hard Landing," in note 6. Return to text
Box 5.2. Survey of Salient Risks to Financial Stability
As part of its market intelligence gathering, staff from the Federal Reserve Bank of New York solicited views from a wide range of contacts on risks to U.S. financial stability. From late January to mid-April, the staff surveyed 22 contacts, including professionals at broker-dealers, investment funds, research and advisory organizations, and universities. Since the previous survey results published in November, the Russian invasion of Ukraine has emerged as a top source of risk, raising short-term concerns over higher energy prices and cyberattacks as well as long-term concerns of foreign divestment from U.S. assets. Risks related to persistent inflation and tighter monetary policy, the most cited potential shock from the fall 2021 survey, remained top of mind in the spring 2022 survey, contributing to heightened concerns over risk asset valuations and corporate fundamentals. A number of risks that ranked highly last year declined in prominence, including diminished concern over the effect of COVID-19, climate-related shocks, and cryptocurrencies or stablecoins. This discussion summarizes the most cited risks in this round of outreach.
Russian invasion of Ukraine
A majority of respondents cited the situation in Ukraine as a substantial source of uncertainty with high potential for financial disruptions. Many were attentive to the adverse effects of a large rise in energy prices, including increased short-term inflationary pressures, negative effects on global growth, vulnerabilities at energy-sensitive corporates, and the potential for acute distress at CCPs or exchanges. Contacts also highlighted the risk of distress at European banks due to exposure to Russia or to heavily affected European firms. Additionally, while cyberattacks have appeared on the list of the most cited potential shocks in previous reports, discussion of cyber risk in this survey round was focused largely on Russian state-sanctioned cyber threats as an escalation of the conflict.
Several respondents raised concerns regarding longer-term structural consequences of sanctions on Russia, with particular attention given to the decision to restrict access to foreign reserves and the SWIFT (Society for Worldwide Interbank Financial Telecommunication) payments system. These actions were seen as increasing the risk of a retreat by some countries from reliance on the U.S. dollar and potential foreign divestment of U.S. assets, most notably sales of U.S. Treasury securities by foreign holders.
Persistent inflation and monetary tightening
Respondents remained concerned about the prospect of inflationary pressures being more persistent than anticipated, requiring a sharper tightening of monetary policy than reflected in market prices. Many observed that this tightening may occur amid a weakening economic environment, amplifying its negative effect. Several contacts noted the global nature of tighter monetary policy and the potential for tighter financial conditions to cause strains in corporate and sovereign debt markets. A number of respondents were focused on the possibility of a large correction in risk asset prices, noting that valuations in U.S. equity and corporate credit markets appeared elevated despite clear signals that monetary policy would continue to tighten.
Many respondents also highlighted the potential for longer-term structural risks to emerge as a result of persistent inflation. Chief among these risks was the possibility of a significant increase in medium- and long-term inflation expectations triggering sharp movements in financial markets, with some noting this could weigh heavily on the exchange value of the U.S. dollar. A few respondents also voiced concern over the potential for central banks to lose credibility if they are unable to rein in inflation or provide monetary accommodation in the face of weaker growth while inflation remains high.
Figure A. Spring 2022: Most cited potential risks over the next 12 to 18 months
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Note: Responses are to the following question: "Over the next 12 to 18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?"
Source: Federal Reserve Bank of New York survey of 22 contacts from January to April
Figure B. Fall 2021: Most cited potential risks over the next 12 to 18 months
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Note: EME is emerging market economy. Responses are to the following question: "Over the next 12 to 18 months, which shocks, if realized, do you think would have the greatest negative effect on the functioning of the U.S. financial system?"
Source: Figure Fall 2021 Federal Reserve Bank of New York survey of 26 contacts from August to October.