World Set For Emerging Market Mass Default——Even The IMF Sees It

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.”

Bond inventories have fallen considerably since the financial crisis. However, regulators have argued that this position was unsustainable.

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.

A ban on some debt default insurance instruments had drained liquidity from some markets, the IMF found

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.