Global financial markets remain strong but risks of an economic slowdown have increased, which could trigger corrections more severe than the one in May, the International Monetary Fund said on Tuesday.
The IMF's semi-annual Global Financial Stability Report said the correction in emerging markets, triggered by inflation and interest rates fears, was modest and reduced excessive valuations in some sectors.
But markets could react more forcefully if increased risks were to materialize due to growing inflation pressures, higher oil prices and a more rapid cooling of the U.S. economy, the fund said.
In our view, financial stability conditions remain underpinned by the favorable outlook for the global economy, Jaime Caruana, director of the IMF's monetary and capital markets department, told a news conference.
Markets appear to price in little provision for these risks, so if one or some combination of these risks materializes, financial markets could experience greater turbulence that places stress on international financial markets, possibly with a wider impact on the global economy, he added.
He said the rapid growth of hedge funds and credit derivative mechanisms had added new, complex layers to financial markets and these had not yet been stress-tested.
The report said the recent market turbulence was a timely reminder to governments to strengthen their economic policies.
The fund warned that a disorderly unwinding of global economic imbalances, although unlikely, remained a concern because it could send the dollar sliding. It urged officials in leading economies to fix the problem through corrective policies.
However, it added: The dollar's real effective exchange rate is expected to remain relatively stable across all major trading partners, but Asian currencies are expected to appreciate over the medium term while non-Asian currencies are expected to weaken.
Caruana said markets were more focused on the possibility of a slowdown in growth than on the imbalances problem.
Still, there are risks there and it is important to be ready, he added.
So far, the confidence of international investors in U.S. markets had underpinned the prospect of an orderly adjustment to trade imbalances, the IMF said.
Although the baseline market view is that the dollar adjustment will remain orderly, the risks of a disorderly adjustment would be reduced by appropriate policy actions by the authorities in countries that are the main counterparts to global current account imbalances, the IMF said.
Economists remain uncertain how the massive deficit on the U.S. current account, the broadest measure of trade, will resolve itself. The picture is skewed by massive surpluses elsewhere, including emerging Asian nations, such as China, and oil exporters like Russia and Saudi Arabia.
Even so, the IMF said the global economy and markets had been resilient in the past few years and had brushed off concern about energy prices and the imbalances.
Corporate fundamentals were still solid, equity valuations were not stretched in most markets and major financial institutions were profitable and well capitalized, the fund added.
In these circumstances it is reasonable to wonder whether financial markets might react to less favorable developments in a way that would amplify, rather than dampen, the emerging risks, the fund said.