COMPLACENCY in financial markets over mounting risks to global economic prospects means that any adverse developments could trigger a new bout of severe market turbulence, the International Monetary Fund said today.
Investors around the world appeared to have been lulled by a favourable economic outlook, and to have put too little weight on growing threats to present, benign world conditions, the Fund cap correct said in its twice-yearly Global Financial Stability Report.
Although its main forecasts, to be released in detail on Thursday, will offer a broadly upbeat view of global economic conditions, the IMF today highlighted a raft of dangers to which it believes markets must pay greater heed.
These included the threat that the US housing market downturn could trigger a sharper than hoped-for slowing of the American economy; worries that stronger inflation pressures might lead to sharper than anticipated increases in interest rates in key economies; and the potential for further, steep rises in oil prices.
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It also pointed to an “unlikely” risk that global economic imbalances, symptomised by the vast US current account deficit, might unwind in an abrupt and disorderly way, including a steep drop in the dollar.
The Fund said that world markets had weathered May’s correction in asset prices, which it saw as fairly modest.
But while this turbulence had since spelled only a limited rise in volatility, and markets had proved resilient, today’s report sounded a warning that unexpected economic upsets could now mean more severe market upheaval.
“The conclusion is that we should all be prepared for a more difficult environment if these risks that I have mentioned materialised,” Jaime Caruana, the IMF’s director of monetary and capital markets development, said.
Speaking in Singapore, ahead of the this week’s annual meetings of the IMF and World Bank, Mr Caruana said that for now, world financial stability “remains underpinned by the favourable outlook for the global economy”.
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However, he added: “Markets appear to price in little provision for these risks, so if one or some combination of these risks materialises, financial markets could experience greater turbulence that places stress on international financial markets, possibly with a wider impact on the global economy.”
He said this meant that the world’s central bank governors and finance ministers now “face renewed challenges in ensuring balanced global growth and financial stability”.
The IMF’s report marks a significant rise in its anxieties over financial stability from April, when it said that the resilience of markets and financial conditions was “as good as it gets”.
If any of the risks it outlined were to become a reality, markets could “undergo more severe corrections, especially because [they] appear to be pricing in the baseline growth scenario with little provision for risk”.
Although the Fund still sees a long-feared “disorderly unwinding” of global imbalances - implying steep falls in the dollar as well as equity and bond markets - as unlikely, it argued today that this “remains a concern”.
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There was a greater probability that the imbalances would be eliminated by a “gradual and orderly adjustment”. But today’s report argued that the danger that they might trigger economic crisis would be increased if markets did not see that credible policies were being put in place to foster such adjustments.
The IMF is presently working with the world’s key economic blocs - the US, Europe, Japan and China - to attempt to promote cooperative efforts to tackle the imbalances, though so far there have been few signs of tangible progress.
“With less accommodative external financing conditions, EM (emerging market) countries that still rely heavily on external financing need to reduce vulnerabilities and pursue reforms that will help sustain their current growth performance,” it said.
Caruana said growth in the derivatives markets has contributed to financial market stability but he voiced concerns the complex instruments have yet to be tested in times of volatility.
“We think that the growth of the derivatives market has been very positive and that it has helped to distribute risks,” Caruana said.
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“The concern would be a little bit more in case of a stress scenario,” he added.