Emerging markets face a benign outlook, but IMF says risks still remain

By Reshmi Basu

New York, April 6 - Financial markets face a benign outlook as they enjoy the current "sweet spot," but that could be undermined by "delicately balanced" risks, the International Monetary Fund said in its Global Financial Stability Report released Tuesday.

The fund said the "continued abundance of liquidity and the perception that interest rates will remain low" could lead to the overvaluation of some financial assets.

"The main risk to the benign outlook for global financial markets is that such an outlook rests on a very fine balancing of opposing economic forces," the IMF said in the report.

Terrorism, interest rate hikes and the falling dollar are the three main threats to the markets.

The orderly adjustments to the dollar exchange rate have not stirred volatility because of the policy coordination among world central banks and policy makers.

But if this "delicate balance were to be impaired, leading to a reduction of the official and private inflows, the dollars could weaken more pronouncedly" as investors demand a premium for holding dollars.

"This would have a negative spillover effect on other asset markets, including pushing up yields in Europe and emerging markets. This adverse development could reverse the strengthening of financial institutions' balance sheets and create headwinds to the economic recovery," the report said.

This in turn could "expose remaining structural weaknesses in several emerging market countries, so far masked by buoyant market conditions," said the report.

While the IMF lauds emerging market countries for their improved economic fundamentals, it also warns of the "widening gulf between countries that have made significant progress and those that have not."

Capital flows up, borrowing costs down

High liquidity, the search for yields and the improved credit quality of sovereign and corporate borrowers have fueled emerging bond markets.

The EMBI yield spread has declined to near record lows, the IMF noted.

Furthermore, capital flows into emerging markets have increased while borrowing costs have declined, compared to recent years.

However, the IMF noted that countries that have had lackluster progress are "those whose levels and currency-mismatched nature of public debt would make them vulnerable to a deterioration in the external financing environment."

Given the high liquidity, these weaker performing nations have had a "degree of yield spread compression comparable to that of the improving countries.

"Overall, many market indicators suggest that the current benign financial conditions in mature and emerging markets will likely continue for the time being," said the IMF in the report.

The IMF called for credit rating agencies to adopt new procedures to monitor global ownership structure and a strengthening of national securities regulators.

The IMF also called for better standards of disclosure from hedge funds, particularly on the amount of debt they use.

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