Islamabad, The International Monetary Fund has raised concerns about the impact of prolonged high interest rates on the banking sectors in the Middle East, North Africa, and Pakistan. Their latest Regional Economic Outlook for the Middle East and Central Asia, these regions could experience financial stress, which might affect their economic stability and growth.
According to International Monetary Fund, The report points out that central banks in these areas might maintain elevated interest rates due to persistently high core inflation, excluding food and energy prices. This situation, already causing distress in some advanced economies, could lead to tighter financial conditions, credit stress, and reduced funding for financial institutions in the Middle East, North Africa, and Pakistan. Banks in these regions could face a decline in profits and willingness to lend, significantly impacting financial stability and economic growth.
A particular concern is the high reliance of banks on external funding, which makes them vulnerable to sudden changes in investor sentiment. In addition, the substantial holding of domestic sovereign debt by lenders could lead to significant losses if the interest rates remain high for an extended period, especially if the market value of this debt falls.
The IMF’s first region-wide stress test, included in the outlook, uses four scenarios to evaluate the risks of higher-for-longer interest rates in emerging market and middle-income countries, along with the six Gulf Cooperation Council economies. The results indicate that while most banks could withstand individual stress scenarios, they could be challenged by a combination of high interest rates, corporate sector stress, and liquidity pressures. State-owned banks, in particular, are more vulnerable than private banks due to lower profitability and higher securities holdings, increasing interest-rate risk.
Despite these challenges, few banks are expected to breach minimum regulatory capital ratios in a combined shock scenario. However, a reduction in capital could lead to decreased lending to the private sector and a decline in economic activity. The IMF estimates an inflation-adjusted economic output loss of up to 1.5 percent over two years for the region, with the Gulf economies facing a loss of about 0.9 percent.
The outlook underscores the difficult policy tradeoffs faced by central banks in these countries. While measures of core inflation remain above target, policymakers must balance financial stability with inflation control. In high-inflation environments, cutting interest rates to respond to financial stress is challenging.
To tackle potential banking sector turmoil, the IMF recommends strengthening prudential standards, such as encouraging banks to accumulate capital during expansions to sustain lending during downturns. Additionally, vulnerabilities from bank holdings of government debt should be incorporated into stress testing. Policymakers are advised to continue efforts to foster a diversified investor base and reduce the interconnectedness between the banking system and sovereign entities.
The establishment of emergency liquidity tools, like central bank emergency lending, is crucial to managing systemic financial stress. Clear communication from governments is necessary to align liquidity support with monetary policy objectives. Developing effective plans for winding down distressed firms is also essential to minimize risks to financial stability and economic growth.