ECB’s Knot: ‘Unexpected Deterioration in Economic Conditions May Test Financial Resilience’

13 July 2022

By David Barwick – FRANKFURT (Econostream) – Suddenly worse economic conditions could strain the resilience of the financial system, European Central Bank Governing Council member Klaas Knot said Wednesday.

In a letter to G20 finance ministers and central bank governors, Knot, who heads De Nederlandsche Bank but was writing in his capacity as chair of the Financial Stability Board, cautioned that ‘[t]he combination of lower growth, rising inflation and tighter global financial conditions may crystallise pre-existing vulnerabilities in the global financial system or give rise to new ones.’

Markets have adjusted in an orderly way so far to changing circumstances, with no major financial institution at clear imminent risk, he said.

‘However, vigilance is required as an unexpected deterioration in economic conditions may test financial resilience’, he said. ‘The rise in indebtedness across sovereigns, non-financial corporates and households in response to Covid-19 exposes these sectors to rising debt service costs, especially as market interest rates have risen in many jurisdictions.’

Tighter financing conditions have had a higher impact on emerging markets and developing economies, which in conjunction with high economic heterogeneity across regions could lead to volatility in capital flows, he wrote.

Knot warned of the possibility of financial strains on commodity markets and broader financial secondary effects from these.

‘The centrality of key energy, metals and food commodities to the functioning of the global economy means that any disruptions to the financing of producers or traders in these markets could have an outsized impact’, he said.

As one way of avoiding adverse market reactions to policy exit strategies, Knot suggested that ‘clear and consistent messaging on central bank actions may help market participants to appreciate the motivation for, and drivers of, differences in policy normalisation across jurisdictions.’