Watch out for asset bubbles, warns IMF

The Business Times
Author: Anthony Rowley
26/1/2011

THE danger of stock market bubbles or debt crises occurring in some leading Asian and other emerging economies - including those of India and China - is rising, the IMF warned yesterday.

The International Monetary Fund's latest Global Financial Stability Report also sounded strong warnings about the state of the global financial system in general.

This, it said, is in part caused by the uneven 'two-speed recovery' in the global economy causing private capital to flow out of advanced economies into emerging economies at a pace which they cannot easily absorb.

While equity valuations in many emerging markets are still within historical ranges, 'hot spots' are appearing in markets such as Hong Kong, India and Peru, the report said.

Retail flows into debt and equity mutual funds in these and other markets could provoke 'asset price bubbles'.

At the same time, private debt levels in some Asian and Latin American economies - such as those of Brazil, Chile, China, India and South Korea - are now approaching the peaks they reached before and after the Asian financial crisis, the IMF said.

This 'could signal an increase in risk', the report suggested, while cautioning financial authorities in these countries to 'remain vigilant'.

Debt quality is meanwhile deteriorating as debt levels pile up in emerging markets.

'A symptom of large capital inflows is that lower-rated entities gain greater market access to debt, lowering the average quality of assets held by investors,' the IMF said.

In a report characterised by stronger language than usual, the Washington-based lending institution noted that 'four years after the onset of the largest financial crisis since the Great Depression, global financial stability is still not assured'.

'Significant policy challenges remain to be addressed. Balance sheet restructuring is incomplete and proceeding slowly (while financial) leverage is still high,' it added.

In a separate World Economic Outlook Update, the IMF said that global economic output is expected to expand by 4.5 per cent in 2011 - a quarter of a percentage point higher than forecast three months ago - owing to stronger than expected consumption in the US and Japan.

'Signs are increasing that private consumption - which fell sharply during the crisis - is starting to gain a foothold in major economies (while) growth in emerging and developing economies remain robust.'

The IMF forecasts that output across advanced economies as a whole will expand by 2.5 per cent in 2011 and 2012 while in emerging and developing economies it is forecast to expand by 6.5 per cent in both years.

This 'two-track global recovery - with advanced countries growing much more slowly than the rest of the world - continues to pose policy challenges'.

Sluggish growth and weak fiscal positions in advanced economies has raised financial market sensitivities to debt sustainability risks, the IMF said. This, combined with accommodative monetary policies and low interest rates is causing money to pour out of the advanced economies.

These hot money flows 'are being driven by carry trades in which investors hope to profit from interest rate differentials and expectations of exchange rate appreciation', the IMF said while forecasting that interest rate differentials and carry trade activity are likely to rise.

'This suggests a vulnerability to reversals in response to, for instance, an unexpected rise in advanced country interests rates, a shift in growth prospects in emerging market countries, or a rise in risk aversion.'

Policy actions are needed to ensure that financial restructuring and balance sheet repair is undertaken by both banks and governments and that regulatory reforms move forward, the IMF said.

'The time purchased with the extraordinary support measures of the past few years is running out.'

All countries 'with outsize debt levels - inside and outside the euro area - must make further medium-term, ambitious and credible progress on fiscal consolidation strategies, together with better public debt management', the report added.