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Risks are building up in the global financial system, and a further escalation in trade tensions could push the situation over the edge, the International Monetary Fund warned.
Investors have appeared complacent, however, according to the IMF's latest Global Financial Stability Report, which was released on Wednesday. The report, published twice a year, contains the fund's assessment of global financial conditions and highlights risks in the system.
Stock prices — particularly those in the U.S. — have hit record-high levels multiple times over the past year, which is an indication that investors have continued to take on risks. But the uncertainties surrounding trade could cause such sentiment to turn quickly and trigger a sudden sell-off in financial markets, the report said.
"A further escalation of trade tensions, as well as rising geopolitical risks and policy uncertainty in major economies, could lead to a sudden deterioration in risk sentiment, triggering a broad-based correction in global capital markets and a sharp tightening of global financial conditions," the fund said in the report.
The IMF said on Tuesday that disruptions to global trade is threatening growth. It cut its global growth forecasts for 2018 and 2019 by 0.2 percentage points to 3.7 percent, and lowered projections for the increase in goods and services trade worldwide.
Heightened risks from the ongoing tensions between the U.S. and trading partners come at a time when emerging markets have come under pressure, the IMF noted. Countries such as Turkey and Argentina faced massive capital outflows amid rising interest rates in the U.S., which saw their currencies crashing against a strong greenback.
Problems in emerging markets have been largely country specific so far, the fund said
"For the moment, we see a lot of differentiation across countries, so when we compare advanced economies to emerging markets, we see that financial conditions remain easy in advanced economies and they have tightened somewhat for emerging markets," Tobias Adrian, director of the IMF's monetary and capital markets department, told CNBC on Wednesday. "But even across emerging markets, we see a lot of differentiation."
"There are some countries that have been hit fairly hard in terms of capital outflows, currency depreciations and, more broadly, tighter financial conditions," he added. "While other emerging markets actually have experienced capital inflows and they have seen not a material deterioration in terms of the conditions of spreads or broader financial conditions."
Still, the organization said it doesn't rule out the crisis widening to a greater number of economies.
"Robust global risk appetite has so far masked the challenges emerging markets may face should global financial conditions suddenly tighten sharply. In that eventuality, the risk of contagion to the broader emerging market universe could ensue, highlighting the importance of avoiding complacency," the fund said in the report.
An IMF analysis found that emerging economies, excluding China, could experience outflows of $100 billion or more over a period four quarters — similar in magnitude to the global financial crisis.
Financial conditions in China, which is at the center of an ongoing tariff fight with the U.S., have stayed "broadly stable" thanks to the central bank's monetary policy easing, the IMF said.
The People's Bank of China has on four occasions this year lowered the amount of reserves banks must hold, unlocking more cash to lend to businesses and households to cushion a slowdown in economic activity. But the central bank has maintained that its monetary policy has stayed "prudent and neutral," and not "accommodative."
Nevertheless, those actions by PBOC have helped to ease some pressure that was building up in the Chinese financial system, the IMF said. In addition to the trade conflict, China had also come under the spotlight for its massive shadow banking industry and the high levels of debt held by companies — issues that the government has been trying to fix.
Adrian noted that, when looking at corporate debt or the non-financial sector credit, leverage levels in China had "stabilized."
"While the past 10 years were characterized by a continuous rise in leverage in China, now it has stabilized and that's a good single for financial stability," he said.
Still, the IMF said Chinese authorities shouldn't hold back efforts to reform the economy, particularly the cutting of bad debt.
"Although these recent steps may help support economic growth in the near term in the face of rising external pressures, they may entail greater risks to financial stability over the medium term should they set back progress toward reducing financial vulnerabilities," the fund said in the report.