IMF warns of growing emerging-market risks as Fed nears liftoff

WASHINGTON – The IMF warned officials to protect their financial systems from possible instability as the U.S. Federal Reserve prepares to raise interest rates, saying shocks or policy missteps risk derailing the global economy and triggering equity market sell-offs.

High debt levels at banks and other companies have left developing economies susceptible to financial stress and capital outflows, just as the Fed prepares to raise interest rates for the first time since 2006, the International Monetary Fund said Wednesday in its International Monetary Fund.

“Emerging markets face substantial challenges in adjusting to the new global market realities from a position of higher vulnerability,” the fund said, describing the preconditions for a Fed rate rise as “nearly in place.”

China, in particular, faces a “delicate” task in shifting to more consumption-driven growth without exposing the weaknesses of highly indebted companies and banks saddled with rising non-performing loans. “Recent market developments underscore the complexity of these challenges, as well as potentially stronger spillovers from China,” the fund said in the periodic report.

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Meanwhile, problems lingering from the financial crisis still pose risks to advanced nations, including elevated public and private debt, and “remaining gaps in the euro area financial architecture.” Changes to the structure of the world’s bond markets, including a reluctance by traditional dealers to serve as market makers, may leave investors starved for liquidity when interest rates rise, according to the Washington-based fund.

Cutting growth

Failure by policy makers to address this “triad” of challenges would reduce global output by 2.4 percent by 2017, as tightening credit conditions undermine confidence among businesses and households, the IMF estimated.

In an adverse scenario that the fund examines to study potential risks, long-term government bond yields would increase rapidly, while stock values in the U.S., U.K., euro area and Japan would slide about 20 percent, the IMF said. Energy prices would drop 22.7 percent, while the prices of non-energy commodities would slump 11.8 percent under the scenario, which the IMF called plausible but “not extreme.”

“Shocks may originate in advanced or emerging markets and, combined with unaddressed system vulnerabilities, could lead to a global asset-market disruption and a sudden drying up of market liquidity in many asset classes,” the IMF said.

The rate of corporate defaults would rise, particularly in China. To reduce debt risks, China should gradually withdraw government support from broad swaths of its financial system, a move that implies greater tolerance for defaults and volatility, the fund said. Even with the government’s substantial tools to absorb shocks, there could be “bouts of financial volatility” as China shifts to a new growth model.

Preventing a global financial shock will require the Fed to be “clear and consistent” in the communication of its plan to raise rates, while authorities in emerging markets will need to closely monitor the foreign-currency exposures of companies, the IMF said.

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