War, Chinese developments risk financial stability

The Bank of Portugal (BoP) noted on Wednesday that the war in Ukraine and economic developments in China have had consequences on monetary policies and established a “high uncertainty of economic projections”, putting financial stability at risk.

“The invasion of Ukraine and economic developments in China, impacting economic activity and inflation, create uncertainty with consequences for the conduct of monetary policies around the world,” the Financial Stability Report (REF), presented today, said.

According to the report, this intensification of geopolitical tensions “has materialised in a strengthening of inflationary pressures, particularly through rising energy and food costs that spill over to the prices of other goods and services”.

Added to this factor are things such as the acceleration of the financing costs of various institutional sectors and consequent conditioning of their capacity to service debt and the lower confidence of economic agents.

“These factors, when combined, attest to the substantial volatility observed in international financial markets, where any sign of economic slowdown or acceleration is absorbed and reflected in the main stock indexes, as well as in the yields of sovereign debt securities,” the document published on Wednesday stated.

The Bank of Portugal lists six “vulnerabilities and risks to financial stability.

The first is “the risk of an additional reassessment of risk premiums,” which, in a context of high volatility, additional shocks “could cause greater risk aversion, generating a devaluation of asset portfolios and increasing market funding costs for new issues.

This is followed by “the trajectory of reduction of public debt”, which “may be challenged by the increase in interest expenses and by the real and nominal slowdown of the economy”.

The BoP noted that “economic deceleration and rising inflation, combined with additional increases in market interest rates, may deteriorate the financial situation of individuals,” especially among the most vulnerable and in a context of reduced savings that may increase the risk of default.

The central bank also warned of the vulnerability of the “materialisation of credit risk associated with the banking sector’s exposure to the companies most affected” by the Covid-19 pandemic and the increase in energy and raw material costs and that have less market power or a weaker balance sheet structure.

The BoP also saw the “risk of falling prices in the residential property market” as a vulnerability to financial stability.

Finally, “persistent high inflation, a sharp rise in interest rates and a strong slowdown in economic activity” are the main risk factors for the banking sector through credit risk and market risk.

In addition to these six things, the BoP pointed out that, in parallel to these risks, “more structural challenges” should be considered, highlighting the implications of climate transition, digital transformation, which includes operational resilience and minimising cyber risks, and the change in the economic and financial globalisation process on economic and financial flows and production costs.