Via Financial Times

Persistently low interest rates are encouraging investors to take dangerous risks in a quest to maintain their financial returns, the IMF said on Wednesday, raising concerns that even the current lacklustre performance of the global economy may not be sustainable.

Policymakers should urgently seek to extend banking regulations introduced after the financial crisis to other parts of the financial sector such as insurers, asset managers and pension funds, the IMF recommended in its annual Global Financial Stability Report. Regulators should demand greater oversight of these companies and disclosures about the risks they are running, the IMF said.

Tobias Adrian, the IMF’s financial counsellor, said: “The search for yield among institutional investors — such as insurance companies, asset managers and pension funds — has led them to take on riskier and less-liquid securities. These exposures may act as an amplifier of shocks.”

Low interest rates were supporting growth “for now”, but were “putting growth at risk in the medium term”, he added.

Lending to companies that would struggle to repay their borrowings if a downturn hit has surged, Mr Adrian said, highlighting the global economy’s increasing vulnerability to this part of the financial system.

He also noted the fragility of parts of the financial system, including insurance companies and pension funds, and some of the world’s poorest countries where foreign debts have hit historic highs.

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Central banks have pursued low interest rates to encourage borrowing and spending, in a bid to raise economic performance and lower the cost of servicing debt, but the flipside of this policy is that the more successful it is, the more dangers mount in some pockets of the financial system.

“Accommodative monetary policy is supporting the economy in the near-term, but easy financial conditions are encouraging financial risk-taking and are fuelling a further build-up of vulnerabilities in some sectors and countries,” the IMF said.

About $15tn worth of public and private sector bonds have negative yields, implying that investors are willing to receive less when the bonds mature than they paid for them. That total has risen since the start of the year, indicating financial markets expect interest rates to stay lower for longer.

Low rates have pushed up other financial market prices so that many bonds and shares now appear overvalued, raising the chances of a sudden correction, the IMF warned.

Markets which are most at risk include financial companies other than regulated banks; in 80 per cent of the world these companies are at least as vulnerable to a correction as they were at the height of the financial crisis, the fund said.

Although the IMF did not predict a recession, its modelling work suggests that non-financial companies’ profits would be inadequate to service their $19tn of debt if a downturn takes hold that is only half as severe as the 2008-09 financial crisis.

As a result, 40 per cent of the debt owed by companies to investors is now at risk of default in countries including the US, China and some parts of Europe, the IMF said.

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In poorer emerging markets, which the IMF labels “frontier economies”, debt owed to investors abroad now accounts for 160 per cent of the annual value of exports, up from 100 per cent in 2008. This indicates that some countries are vulnerable to a renewed debt crisis if interest rates rise or investors lose confidence in their ability to service the loans.

While banks are much safer than in 2008, the fund said the new vulnerabilities required a policy response to avoid the emergence of potentially systemic faultlines that could propagate another financial crisis.

Regulators should put in place stricter supervision to prevent corporate exposures growing even larger, blowing up in a downturn and potentially damaging the banking system, the IMF said. Frontier markets should implement more prudent debt management practices rather than loading up on new loans.

Without such action financial vulnerabilities could either trigger or exacerbate the next downturn, Mr Adrian said.