IMF flags growing risks from low interest rate environment

The International Monetary Fund (IMF) today issued a warning to central banks that are holding interest rates close to zero, as expectations of persistent low rates appear to be driving a rise in risk appetite among investors.

In the first chapter of the IMF's Global Financial Stability Report, published today, the Fund warned of "exaggerated valuations and rising leverage" that result from higher risk appetite, which could become systemic and spill over into emerging market economies.

At a press conference following the report's publication, José Viñals, the director of the IMF's Monetary and Capital Markets Department, said this was particularly evident in the US. Although a new credit cycle is just beginning, US banks are already showing "deterioration in the quality of issuance", which is usually seen late in the cycle.

Not all of the results of low interest rates were bad, the report said. The lower cost of debt has allowed firms to extend the maturity of their debt profiles and allowed for easier servicing. "These developments are healthy, desirable elements of the monetary transmission mechanism," the IMF said.

But other signs point to less rude health. Capital spending remains depressed relative to cash flows, while corporate bond issuance is higher than usual at this point in the cycle and more geared towards "less productive" uses such as funding equity buybacks. Leverage is rising on the back of slowing earnings and the reach for yield.

Conflicting demands

Some central banks have complained that they are simultaneously being expected to ease credit conditions to prop up growth and tighten them to protect stability. The IMF's World Economic Outlook, published yesterday, urged central banks to maintain an accommodative monetary policy stance to support the recovery, although the Fund tempered this demand today.

Responding to a question from CentralBanking.com, Viñals said "when the patient is still under treatment, you should not suspend the medicine", adding that raising rates now would be "extraordinarily detrimental". However, he stressed that central banks should be vigilant about the side effects of the medicine.

Governments should also show more consideration of the limitations of central bank action, he suggested. "Policy-makers should be very conscious that central banks cannot be the only game in town," he said.

Morphing into a ‘chronic phase'

The report also highlighted what Viñals referred to as "old risks" – namely the need for medium-term solutions to the crisis in the eurozone. He said credit was still not flowing properly to the real economy, particularly in the eurozone periphery. He added that many banks need to make further progress on strengthening their balance sheets, while others, particularly in core countries, may be becoming overly reliant on wholesale funding.

A failure to act now could have serious consequences, the IMF warned, envisaging "recurring bouts" of financial instability if reforms fell short. "The global financial crisis could morph into a more chronic phase," the report said.

Viñals was unequivocal: "I think it is clear what needs to be done, so no time to waste. Get it done."