Tai Hui

Macroscope | UK turmoil shows how market stress can amplify policy errors

Amid global uncertainty, deteriorating market liquidity could pose risks and amplify shocks, as in the case of the UK mini-budget, which sparked a gilt sell-off and pound plunge

The war in Ukraine is the primary source of uncertainty but developments such as the US tech war on China could add pressure and financial market volatility

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A woman walks past a headline posted on a wall in London on September 27. The British pound has stabilised since but the episode is a good example of an event that could set off a chain reaction in financial markets. Photo: AP

Tai Hui

Published: 4:30pm, 21 Oct 2022

The annual meetings of the International Monetary Fund and World Bank typically come with volumes of research on the global economic outlook and assessments of financial stability. Most of the world’s economic challenges are well documented, indicating that slower growth, high inflation and tighter monetary policy are expected to extend into the next year.

In the latest Global Financial Stability Report, the IMF offered an important reminder that deteriorating market liquidity could pose risks and amplify shocks. The recent market turmoil in Britain is a good example of how a policy error could lead to unforeseen market volatility and economic impact.

It should be said, the architecture of the global financial system has been reinforced since the 2008 global financial crisis. With banks reducing their risk exposure and a stronger capital base acting as shock absorbers, central bankers have more tools to ensure financial stability. The US Federal Reserve was quick to introduce various funding facilities in March 2020 when the start of the pandemic led to an increase in bond market volatility.

Still, just because we have seat belts and airbags does not mean we can drive recklessly. Shocks and their agents of transmission often come from areas few anticipate. A good illustration is the recent market turbulence in Britain.

The country’s financial stress began with the newly installed government announcing a series of fiscal measures to boost its long-term economic growth. But it was unclear how the tax cuts could be funded. This mini-budget had also not been independently assessed by the Office for Budget Responsibility, which further undermined its credibility.

All these weakened investors’ confidence in the government’s fiscal discipline and raised concerns that inflation could be fuelled further by tax cuts. This led to a sell-off in UK government bonds, also known as gilt, and the British pound in the past weeks.