Navigating Financial Stability Amid Higher Interest Rates in the Middle East, North Africa, and Pakistan

The financial landscape in the Middle East, North Africa, and Pakistan is navigating a period of significant uncertainty due to a confluence of factors, including higher interest rates, corporate sector stress, and liquidity pressures. Central banks in these regions are likely to maintain elevated interest rates to combat persistently high core inflation (excluding food and energy prices). However, this high-interest-rate environment, which recently triggered banking sector stress in some advanced economies, could signal more systemic risks ahead.

Financial Conditions and Risks

Higher interest rates could tighten financial conditions, potentially leading to credit stress and reduced funding for financial institutions in the region. Such conditions could threaten bank profits and willingness to lend, thereby impacting financial stability and economic growth. Financial stability risks, such as a high reliance on external funding, can leave banks vulnerable to sudden changes in investor sentiment. Moreover, where lenders hold a significant share of domestic sovereign debt, prolonged higher interest rates could result in losses, particularly if the market value of that debt declines.

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Regional Stress Test Insights

Our recently published Regional Economic Outlook for the Middle East and Central Asia includes the first region-wide stress test, using four scenarios to assess the risks of prolonged high interest rates in the region’s emerging markets, middle-income countries, and the six Gulf Cooperation Council (GCC) economies. The results indicate that while most banks could withstand individual stress scenarios, a combination of higher interest rates, corporate sector stress, and liquidity pressures could test their resilience.

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State-owned banks are identified as more vulnerable than privately-owned banks due to their lower profitability and higher securities holdings, which raise interest-rate risk. Though few banks would breach minimum regulatory capital ratios under the combined shock scenario, reduced capital would likely result in decreased lending to the private sector and a decline in economic activity, reminiscent of previous credit contraction episodes. For instance, the inflation-adjusted economic output loss in the combined shock scenario could be as high as 1.5 percent over two years, with an estimated loss of 0.9 percent for the Gulf economies.

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Policy Tradeoffs and Tools

Monetary policy remains a crucial factor in these countries, where central banks face difficult tradeoffs as core inflation rates (excluding volatile food and energy prices) remain above target. In a low-inflation environment, central banks can mitigate financial stress by cutting interest rates. However, during periods of high inflation, policymakers must balance the dual objectives of maintaining financial stability and controlling inflation.

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To address potential banking sector turmoil and safeguard financial stability, policymakers need a range of tools:

1. Strengthening Prudential Standards: Encouraging banks to accumulate capital during economic expansions can help sustain lending during downturns and better manage risks.

2. Stress Testing: Incorporating vulnerabilities from bank holdings of government debt in stress testing can improve resilience to shocks.

3. Diversifying the Investor Base: Efforts to foster a deep and diversified investor base should continue, especially in markets dominated by state-owned entities, to reduce the interconnectedness between the health of the banking system and sovereign debt.

4. Emergency Liquidity Tools: Establishing central bank emergency lending facilities to address systemic financial stress is critical. However, clear communication is essential to ensure that liquidity support does not conflict with monetary policy objectives.

5. Effective Resolution Plans: Developing plans to wind down distressed firms can help mitigate risks to financial stability and economic growth.

Conclusion

As central banks in the Middle East, North Africa, and Pakistan navigate the complexities of a high-interest-rate environment, it is crucial to adopt robust policies and tools to ensure financial stability. By strengthening prudential standards, enhancing stress testing, diversifying the investor base, and establishing emergency liquidity tools, policymakers can mitigate potential risks and support sustainable economic growth in the region.

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