A shock to credit markets could catch investors flatfooted and derail a global economic recovery that is largely strengthening, according to the International Monetary Fund.
Near-term risks to world financial stability have declined since April amid improving macroeconomic conditions and the subsiding risk of emerging-market turmoil, the IMF said in its latest Global Financial Stability Report released on Wednesday. Major banks and insurers have bolstered their balance sheets, while credit spreads have tightened and market volatility is low, the fund said.
But rising debt and the search for yield by investors may be adding to the vulnerability of the global financial system, the Washington-based lender warned.
"A shock to individual credit and financial markets well within historical norms could decompress risk premiums and reverberate worldwide," the fund said. "This could stall and reverse the normalization of monetary policies and put growth at risk."
Signs that the global economy is strengthening have underpinned demand this year for assets such as equities, which have surged in the United States amid expectations for faster economic growth and government deregulation. The IMF on Tuesday raised its forecast for global gross domestic product amid a broad recovery from the Great Recession of 2007-09.
U.S. Federal Reserve chair Janet Yellen has indicated repeatedly this year that policy makers will continue to gradually raise borrowing rates and unwind the institution's balance sheet. The European Central Bank is also considering a withdrawal of monetary accommodation. But the IMF warned that a misstep by central bankers could sideswipe the recovery.
"Too quick an adjustment in monetary policies could cause unwanted turbulence in financial markets and set back progress toward inflation targets," the IMF said.
"Too long a period of low interest rates could foster a further buildup of market and credit risks and increase medium-term vulnerabilities."
The IMF assessed the impact of an ongoing buildup of debt and an extended rise in the price of risky assets. At first, spreads would remain compressed and volatility low, as equity and housing prices continue to rise. By 2020, however, credit spreads would widen rapidly as debt levels breach critical limits, prompting investors to grow worried about debt sustainability. Stock prices would fall as much as 15 per cent while housing prices would drop as much as 9 per cent, according to the results of the IMF's model.
The global economic downturn would be about a third as severe as the contraction that followed the 2008 world financial crisis. The euro area would take the biggest hit considering the ECB has little room to ease monetary policy, the IMF said.
The fund urged central banks to clearly communicate their plans to tighten monetary policy. Countries should follow through on commitments to have their banks meet international standards and regulators should strengthen rules for insurers, the IMF said.