Sep 2005 Financial News

IMF: Economies firm; risks remain

Sep 16, 2005

FRANKFURT, Germany (Reuters) -- The global financial system has strengthened over the past year, giving it a substantial cushion against potential financial shocks, the International Monetary Fund said.

"For the near term our message is a positive one. The global financial system's resilience continues to strengthen, making it less vulnerable to crises in the past," Gerd Haeusler, director of international capital markets at the International Monetary Fund said at a news conference.

Low inflation, low bond yields and solid global growth have allowed corporations to cut costs, restructure and post huge and sometimes record, profits.

Businesses and banks have repaired balance sheets severely damaged by the bursting of the high-tech bubble in 2000 and 2001.

The IMF also said some central banks faced the challenge of removing the massive monetary stimulus of recent years without strangling markets or the economy.

The U.S. Federal Reserve's path of gradual tightening "appears to have struck the right balance in this regard and should be continued," it said.

The IMF said Hurricane Katrina was likely to have a limited impact.

"At this stage its impact on global economic growth and financial markets is still uncertain but it is expected to be limited," Haeusler said.

But the IMF warned in its global financial stability report that the very factors that support a favourable short-term environment are increasing the potential vulnerability to a sharp market correction in the medium term.

"The same benign forces underpinning continued growth and buoyant financial markets, however, have also created larger global imbalances and built up higher levels of debt, particularly by the household sector," it said.

For instance, private investors' appetite for U.S. dollar assets when interest rates are rising in the United States relative to other major countries allows for a smooth financing of the massive U.S. current account deficit, which is topping 5 percent of GDP.

The willingness to finance the twin U.S. budget and trade deficit reduces the immediate urgency for policymakers to correct the imbalances, the IMF said.

But it also "increases the potential for a snap back -- a sharp reallocation of assets away from dollar assets some time in the future," it said.

While this snap back may not have a high probability, at least in the near term, it could prove nasty.

A falling dollar, rising U.S. interest rates and disorderly financial markets would slow global growth, making it all the more important that these global imbalances be addressed, the IMF said.

Greater currency flexibility by many Asian countries is needed, Haeusler said at his news conference. "We welcome what we have seen but there is more to go."

Credit risks
Similarly, the IMF report noted that exceptionally low bond yields across asset classes -- governments, emerging market debt and corporate issues -- and the flat yield curve have allowed corporate and government borrowers to lower their financing costs and improve their debt profiles.

But this also leaves financial markets vulnerable to correction. Most important on this front are prospects for global growth.

A gradual economic slowing, which has been the market response so far to the recent rise in oil prices, would produce a benign market outcome, it said. And the IMF was confident that there is sufficient financial cushion to support the financial system if the economy slowed more dramatically.

As for the credit cycle, the IMF said it may be peaking -- both in the corporate and the household sector. This exposes the markets to corrections and investors to potential losses.

"Corporate earnings growth is likely to slow from the robust rate in the past few years. Default rates of sub-investment grade borrowers are likely to increase... (and) future credit quality could be weakened through increased corporate leverage," it said.

The fast-growing credit derivatives and collateralised debt obligation (CDO) markets could be particularly vulnerable, because these complex and leveraged instruments depend on relatively untested models. This requires regulators to upgrade their skills to monitor risks, it said.

At the same time, the IMF report said that the increased presence of pension funds and institutional asset managers in financial markets increases market depth and liquidity and creates more financial stability.

Global financial assets held by non-bank institutional investors has tripled in the past 15 years to $45 trillion in developed countries.

Additionally, it said that increasingly sophisticated investors, plus greater disclosure in financial markets, can reduce the "knee-jerk" contagion seen in recent years.

The 1990s was marked by a series of financial shocks -- the Mexican peso crisis, the Asian currency crisis, the Russian debt crisis and the near-collapse of the huge U.S. hedge fund LTCM.

In contrast over the past five years, even with major corporate bankruptcies and political shocks, there has been no major market disruption.

Overall, the IMF report struck a confident note that the world financial system has grown more resilient.

Thursday, September 15, 2005
http://edition.cnn.com/2005/BUSINESS/09/15/imf.economy.reut/index.html