IMF worries that FX markets might develop, escaping central bank control

Section:

IMF Identifies Risk of 'Disorderly' U.S. Dollar Drop

By Mark Drajem and Shamim Adam
Bloomberg News Service
Tuesday, September 12, 2006

http://quote.bloomberg.com/apps/news?pid=20601087&sid=aYXu7ScpRXC4

A "disorderly" drop in the dollar is the biggest risk to world financial markets, the International Monetary Fund said, urging policy makers to prepare and act quickly when asset prices slump.

Investors are buying U.S. bonds under the assumption that the dollar won't slide, and a drop in the currency might turn into a rout as foreign investors and central banks move to cut losses, the global financial watchdog said.

"A low-probability but potentially high-cost risk to the global financial system is that a dollar decline could become self-reinforcing and hence disorderly," the IMF said in its Global Financial Stability Report today.

Last week IMF Managing Director Rodrigo De Rato singled out lopsided global trade and investment flows, protectionist sentiment, and high energy prices as sources of concern to an otherwise benign outlook for the global economy. The IMF says the U.S. current account deficit, running at a record rate, needs to narrow.

The Washington-based lender will announce new projections for global economic growth later this week in Singapore before its annual meeting. In April the fund forecast an expansion of 4.9 percent in 2006 and 4.7 percent next year. An IMF spokesman said growth would be about 5 percent in 2006.

The dollar has fallen 6.8 percent against the euro this year. It was recently little changed at $1.2710 against the euro and fetched 117.6 yen.

The lender forecast that a drop in the U.S. dollar would affect different areas of the world differently.

"The dollar's real effective exchange rate is expected to remain relatively stable across all major trading partners, but Asian currencies are expected to appreciate over the medium term while non-Asian currencies are expected to weaken," the IMF said.

World financial markets may experience increased volatility as risks of faster inflation, higher oil prices and a slowing U.S. economy are not sufficiently priced in, the IMF said.

Global equity, bond and commodities markets plunged in May amid concern central banks will need to do more to keep inflation from accelerating. The threat of slowing growth may increase investors' aversion to risky assets, the lender said.

"There are risks to the global economic outlook that have tilted to the downside," the report said. "International financial markets could undergo more severe corrections, especially because markets appear to be pricing in the baseline growth scenario with little provision for risk."

De Rato warned last week there were "clouds on the horizon" for the global economy. Still, the outlook for world growth and inflation is one that is a "continuation of favorable developments," even as oil prices and a U.S. slowdown pose risks, the IMF said in today's report. That's a scenario that will lead to healthy corporate earnings, low default rates, and improving sovereign finances, it said.

"Global growth remained strong and continued to become more balanced, providing a broad underpinning for financial markets," today's report said. "Financial sectors in many countries are in a strong position to cope with any cyclical challenges and further market corrections to come."

Emerging-market stocks in May had their biggest monthly drop in more than three years as the prospect of higher interest rates and a slump in commodity prices prompted investors to pull out of markets from India to Russia. Stocks in Europe the same month had the worst performance in three years, while those of the U.S. dropped the most in almost two years.

Governments must improve economic policies and reforms, while investors should increase risk-management strategies, to limit volatility and mitigate the impact of risks to growth, the IMF said.

"Supply shocks and/or an increase in geopolitical tensions could lead to a renewed retrenchment in risk appetite," the IMF said. That "would likely increase volatility, force risk premiums higher, and erode business and consumer confidence, thereby testing the resilience of the global financial system."

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