Monetary tightening in the U.S. threatens to expose financial excesses and vulnerabilities that could wipe trillions of dollars off bond markets, the International Monetary Fund warned on Wednesday.
If the Federal Reserve's likely move to start scaling back its asset purchases or fallout from a possible U.S. failure to lift its ceiling on public debt raise long-term interest rates by 1 percentage point, the IMF's Global Financial Stability Report (GFSR) estimates that the market losses on bond portfolios could reach $2.3 trillion.
In a world of heightened financial stability risks, demonstrated by the flight to safety from emerging markets in the summer, the fund is concerned that large elements of the world's financial system remain vulnerable to stresses that might ensue as the extraordinary policies of the post-crisis period are scaled back.
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Describing the process of normalizing U.S. monetary policy as "unprecedented and complex", José Viñals, financial counselor to the IMF, said that "containing longer-term interest rates and market volatility has already proven to be a substantial challenge".
The fund estimates the potential damage from a spike in long-term bond yields from investor fire-sales, a loss of liquidity in certain markets such as real estate investment trusts and contagion could lead to large losses.
In addition, the fund's GFSR warned that if the U.S were to default on some of its obligations after a failure to raise its debt ceiling, it "could seriously damage the global economy and financial system".
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The potential consequences of higher long-term interest rates need to be managed carefully, the IMF said, requiring focus by the U.S. authorities on ensuring a smooth exit. This needs "a clear and well-timed communication strategy by the Federal Reserve to minimize interest rate volatility, as well as effective execution in line with economic developments".
The prospect of higher interest rates also raises the possibility of capital flight from emerging economies, which the fund says are "highly vulnerable to sudden outflows that would further strain liquidity conditions".
"The episodes of financial market turmoil in the second and third quarters of 2013 underscore that some emerging market economies need to address macroeconomic imbalances, enhance policy credibility and rebuild policy space to reduce vulnerabilities as financial conditions normalize," it added.
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Outside the immediate concerns over the U.S. debt ceiling and vulnerability to sudden interest rate rises, the GFSR also attempts to assess the vulnerability of banks in the euro-zone's periphery to weak companies to whom they have lent.
The IMF said that a vicious circle between weak companies that found it difficult to service their debt was undermining the health of banks, forcing them to raise interest rates and further weakening the corporate sector in Italy, Spain and Portugal.
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In prepared remarks, Mr Viñals said that even if bank lending rates to companies were common across the euro-zone, "a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal and Spain".
According to IMF estimates, this would be sufficient to absorb a large proportion of future bank profits in these countries and require additional buffers of capital in Portugal and Italy.
The fund called for urgent action to assess the bank-by-bank vulnerabilities in the European bank asset quality review and credible backstops, preferably on a euro-zone-wide basis, to recapitalize vulnerable institutions.
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For this, it urged euro-zone countries to make concrete progress towards achieving banking union in a way that would reassure markets about the stability of banks and the credibility of backstops to their capital.