The International Monetary Fund (IMF) expected corporate and household debt burdens, in advanced and emerging market economies alike, could become unmanageable for some borrowers in a harsh economic contraction due to the challenges that the COVID-19 crisis imposes.

In its Global Financial Stability Report update issued on Thursday, the IMF said that aggregate corporate debt has been rising over several years to stand at historically high levels relative to GDP. Household debt has also increased, particularly in countries that managed to escape the worst impact of the 2007-2008 global financial crisis.

Accordingly, many economies currently have high levels of debt and are expected to face an extremely sharp economic slowdown and these economic fundamentals have already resulted in the highest pace of corporate bond defaults since the global financial crisis, while there is a risk of a broader impact on the solvency of companies and households, said the report.

In the banking sector, the report said that banks have entered the crisis with higher liquidity and capital buffers due to their adopted reforms, and they can lean on such buffers to support lending and absorb losses.

It added that some banks have already started to make additional preparations for expected losses on their loans, as evidenced in their first quarter earnings reports, which is likely to continue as banks assess the ability of borrowers to repay their loans, while also accounting for the support that governments have given households and companies.

“The expectation of further pressure on banks, along with the low level of interest rates, is reflected in analysts’ forecasts of bank profitability,” the report read.

Across the non-banking sector, the report stated that financial companies now have a greater role in the financial system than before, yet, the behaviour of this larger sector during a deep downturn is untested.

“There is a risk that non-bank financial companies could also face shocks in the event of a broad wave of insolvencies. These companies could also act as an amplifier of this stress. For example, a substantial shock to asset prices could lead to further outflows from investment funds, which could, in turn, trigger fire sales from those fund managers that would exacerbate market pressures,” added the report.

Currently, economies that need to refinance more debt experience a greater risk that this debt may have to be rolled over at a higher cost, while some countries with high refinancing requirements also have a relatively low level of reserve adequacy.

As a result, it could be harder for authorities in these economies to react to any further portfolio outflows, especially if they do not have an elastic exchange rate, according to the report.

Meanwhile, credit ratings downgrades could put additional pressure on funding costs and capital flows. So far this year, more than one-third of oil exporting economies that are covered by the main rating agencies have been downgraded, which compares to downgrades to about one quarter of other economies, said the report.

Over the two months since the issuance of the IMF’s April 2020 Global Financial Stability Report, global financial conditions have eased significantly following the sharp tightening early in 2020, which has been driven by the combination of a marked fall in interest rates and a strong rebound in risk asset market valuations, the report stated.

In addition, equity markets have bounced back from their March troughs, on balance, recovering to about 85 percent of their mid-January levels, on average, though there is some dispersion, according to the report.

Also, equity market volatility has fallen from its peak in March, though it remains above its long-term average.

Likewise, swift and unprecedented central bank measures have been a major factor in the market recovery, while bond issuance has surged for higher-rated borrowers, and markets have reopened for speculative grade borrowers as well.

For emerging markets, investor sentiment towards emerging market economies has also improved notably, given that portfolio flows to these economies have stabilised following the historic outflows earlier 2020.

Investors, however, continue to differentiate across emerging and frontier economies, with some inflows of capital into selected countries and asset classes, added the report.

Furthermore, higher rated countries have also been able to issue hard currency debt at a historically high pace so far, faster than economies with lower credit ratings, which underscores the external pressures that some emerging market economies are still facing, the report said.

On the other hand, market sentiment has been bolstered by the reopening of some economies and the easing of COVID-19 related lockdown measures. In addition, investors expect unprecedented monetary policy accommodation to continue to support the global economy for quite some time. Actions by central banks have boosted investor risk appetite, stated the report.

Moreover, the number of emerging market central banks have embarked on unconventional policy measures for the first time to address the challenges of the crisis. In some countries, these asset purchase programmes were started to support monetary policy, and in other countries, the motivation was to support market liquidity.

Such programmes have included purchases of a range of assets, including government bonds, state-guaranteed bonds, corporate debt, and mortgage-backed securities. Fiscal and financial policy measures have also helped support investor sentiment, according to the report.

To address the COVID-19 impacts, the report said that governments around the world have provided large emergency lifelines to people and firms amounting to near $11 trillion. Financial authorities have also bolstered market confidence through a series of policies, including government credit guarantees, support for the restructuring of loans, and encouraging banks to use available capital and liquidity buffers to support lending.

The report said that the total assets of the Group of Ten (G10) central banks have increased by about $6 trillion since mid-January, more than double the increase seen during the two years of the global financial crisis from December 2007, with the rise in assets accounting for almost 15 percent of the G10's GDP.