Turmoil in global credit and money markets will likely continue as investors worry about the size of financial losses and where they might appear, the International Monetary Fund warned Monday.
The effects of the turmoil, which started in earnest in August with rising defaults in the U.S. subprime mortgage market, will likely slow the global expansion, the IMF said in its twice-yearly Global Financial Stability Report.
"The global financial system has undergone an important test and the test is not over yet. Implications of this period of turbulence will be significant and far-reaching," Jaime Caruana, IMF director for monetary and capital markets departments, told a news conference.
"The coming months are likely to remain challenging for money markets and institutions, and credit conditions are not likely to normalize soon and the adjustment process may be protracted and may affect not only prices but also availability of credit," he added.
IMF Managing Director Rodrigo Rato said the impact on global growth from the credit crunch and re-pricing in credit markets will be felt in 2008 and that the United States will most likely be hardest hit.
He said world economic growth should remain strong next year but looks set to be below the levels of 2006 and 2007 and downside risks increase the longer financial markets remain in crisis, Rato told a seminar in Madrid.
Caruana said a more severe tightening of credit conditions could not be ruled out, which could exacerbate the downturn in the U.S. housing market. Falling stock prices could reduce spending and weaken consumer sentiment, he added.
"Risks have increased that the reduction in growth will be more important in the United States because this tightening of financial conditions will join the housing issue."
IMF on Emerging Markets
Risks in the world's emerging markets remain "finely balanced," the IMF said, but cautioned that some of these maturing markets could see a pullback in capital, even after difficulties in developed markets subside.
It added: "Generally benign emerging market banking system default risk indicators continue to reflect market perceptions of healthy capitalization and profitability, as well as diverse earnings sources and sound asset quality."
The IMF said the rapid spread of the U.S. subprime problem from one market to another surprised both markets and government policy-makers.
Caruana said it was too early to draw definitive policy conclusions, but urged closer scrutiny of new financial instruments such as securitization and structured products that may have contributed to the relaxation of credit standards.
He said links between systemically important financial institutions and off-balance sheet vehicles needed to be examined.
"To strengthen the financial system against future strains it will be important to draw lessons about the market practices that need to change and the regulatory frameworks that need to be revised," he said.
"Some of the practices that have developed in the structured credit markets will have to change," he added.