Deleveraging eases risk of market correction but high inflation still a risk, IMF says

By Reshmi Basu

New York, June 28 - The early unwinding of leveraged positions should alleviate the risk of a sharp market correction in the face of higher interest rates, according to the June financial market update from the International Capital Markets Department of the International Monetary Fund.

However, if inflation surpasses expectations, such uncertainty could lead to an overshooting of bond yields and credit spreads and making it harder for emerging markets countries to raise money on the international markets, the report warned.

It says the relatively calmness with which the market has dealt with expectations for a rise in short-term U.S. interest rates is attributable to:

* The Federal Reserve's clear communication of its intentions has resulted in anticipatory, orderly adjustments to speculative positions. Investors have been reconsidering positions based on the low cost of short-term funds, although the extent of de-leveraging is murky.

* Strong growth and rising corporate earnings in the United States and to a lesser extent in Europe have been a boon to equity and corporate bond prices.

* A persistent output gap in the major economies has contained inflationary pressure to date and moderated expectations of the degree of tightening in the United States and Europe. However, higher oil prices and the resurgence of corporate pricing power are raising eyebrows.

Since March 2004, market movements have reflected a partial unwinding of speculative positions. Riskier assets such as high yielding emerging market bonds have been struggling the most.

"However, financing conditions for emerging market borrowers are likely to remain less accommodating than in 2003 and early 2004, when primary market bond issuance by emerging market borrowers surged," said the IMF in its report.

The four main risks are an unanticipated increase in inflationary pressure, geopolitical concerns, rising short-term interest rates, and an inability to achieve an orderly adjustment of global imbalances.

An unforeseen increase in inflationary pressure would heighten concerns over the pace of short-term interest rate hikes currently discounted in the market and could result in volatility.

Geopolitical concerns have become a perennial risk. In recent months, security concerns have put pressure on oil prices.

In emerging markets, rising short-term interest rates are associated with a less-than-friendly external financing environment. Investors are more likely to discriminate as liquidity becomes less abundant.

In this environment, investors are likely to be cautious in their approach to countries facing high political risk, making these countries highly vulnerable if higher than expected inflation were to push up mature market bond yields.

The orderly adjustment of global imbalances is a medium-term challenge. For much of 2003, the level of capital inflows to finance the U.S. external current account deficit weighed on the U.S. dollar.

The concerns have eased, given that expectations for strong U.S. growth and higher interest rates are lifting the U.S. dollar. But the persistence of the imbalances in the currency market could lead to a spillover effect in the asset class.

Bond market issuance slowed in first quarter

Analysts estimate that by the end of May, emerging market sovereigns had completed 60% of their needed bond issuance for 2004. Since April, high-grade issuers appear to be the ones able to access the market.

In an environment of increased investor caution and rising bond spreads, several Asian borrowers delayed bond issues.

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