By Szu Ping Chan at The Telegraph
The International Monetary Fund (IMF) has issued a double warning over higher US interest rates, which it said could trigger a wave of emerging market corporate defaults and panic in financial markets as liquidity evaporates.
The IMF said corporate debts in emerging markets ballooned to $18 trillion (£12 trillion) last year, from $4 trillion in 2004 as companies gorged themselves on cheap debt.
It said the quadrupling in debt had been accompanied by weaker balance sheets, making companies more vulnerable to US rate rises.
"As advanced economies normalise monetary policy, emerging markets should prepare for an increase in corporate failures," the IMF said in a pre-released chapter of its latest Financial Stability Report.
Photo: International Monetary Fund
It warned that this could create a credit crunch as risks "spill over to the financial sector and generate a vicious cycle as banks curtail lending".
In a double warning, the IMF said market liquidity, or the ease with which investors can quickly buy or sell securities without shifting their price, was "prone to sudden evaporation", particularly in bond markets, when the Federal Reserve started to raise interest rates.
It said a steady growth environment and "extraordinarily accommodative monetary policies" around the world had helped to maintain a "high level" of liquidity. However, it warned that this was not the same as "resilient" liquidity that could support markets in time of stress.
Gaston Gelos, head of the IMF's global financial stability division, said these factors were "masking liquidity risks" that could trigger violent market swings.
"Liquidity is like the oil in an engine, when there's too little of it, the machine starts stuttering," he said.
The IMF said an "illusion" of abundant liquidity may have encouraged "excessive risk taking" by some investors that could cause market ructions if many investors suddenly rushed to the exit.
"Even seemingly plentiful market liquidity can suddenly evaporate and lead to systemic financial disruptions," the IMF said.
"When liquidity drops sharply, prices become less informative and less aligned with fundamentals, and tend to overreact, leading to increased volatility. In extreme conditions, markets can freeze altogether, with systemic repercussions."
Banks have scaled-back their market making activities in the wake of the financial crisis, which has reduced their ability to act as a stabilising force by absorbing excess supply.
Structural factors, such as large holdings of relatively illiquid securities by mutual funds and concentrated holdings by institutional investors, could also exacerbate a sell-off.
Market liquidity indicators for high-yield and emerging market bonds have started to weaken relative to those for investment-grade bonds.
While the IMF said central bank bond buying had been positive because it provided the market with a "committed and solvent buyer" to support the market, it said higher interest rates would "inevitably boost volatility".
"Smooth normalisation of monetary policy is crucial" to avoid "sudden drops" in risk appetite, the IMF added, as it urged central banks to stand ready to "set up policies in advance that will maintain market functioning during periods of stress", such as stepping into the short-term money markets to offer loans.
It also urged EU policymakers to "reevaluate" regulations brought in to restrict transactions on credit default swaps (CDS) of sovereign debt, which provide insurance against default but the IMF said had distorted the market.
While the IMF said tighter regulation had played a role in tighter liquidity conditions, it said evidence that it would make the next financial crisis worse was "still lacking".
"Indeed, the reforms have made the core of the financial system safer," the IMF said.