Financial markets have failed to price in the risk that any one of a host of threats to economic stability could materialise and deliver a massive shock to the world economy, the International Monetary Fund warned yesterday.
The world's chief financial watchdog said the financial system had so far proved resilient in the face of recent price falls but warned the risk of a crash had increased. And when it comes to worrying about a crash in the financial markets that could deliver a body blow to the world economy, it seems that all roads lead to the US.
The IMF highlighted five major risks, all but one of which can be attributed to a greater or lesser extent to the economy and foreign policies of the US administration. Not that the politically savvy IMF phrases it exactly like that.
Its message coincided with a stark warning from HSBC, one of the world's largest investment banks, that it had put the US on alert for "recession risk".
The fund, which is holding its annual meetings this week, issued its warning in its closely watched, twice-yearly Global Financial Stability Report. It highlighted a sharp slowdown in the US economy, triggered by a slump in house prices, as the major risk. Other dangers included:
* A surge in inflation that would force central banks, particularly the US Fed, to impose sharp rate rises that would ripple through emerging markets
* A rebound in oil prices on the back of mounting speculation of geopolitical tensions - a reference to a showdown between Iran and the US over nuclear technology
* A sudden unravelling of the record imbalances between surpluses in Asia and deficits in the US
* A mutation in the avian flu virus that would lead to a "sharp decline in economic activity".
Jaime Caruana, director of the IMF's monetary and capital markets department, said: "Markets appear to price in little provision for these risks. So if one or some combination of these risks materialises, financial markets could experience greater turbulence that places stress on international markets, possibly with a wider impact on the global economy."
He said markets were now much more focused on a US-led global slowdown rather than the threat from global imbalances that has worried the IMF for the past six years.
However Hung Tran, Mr Caruana's deputy, said: "Comparable countries such as the UK and Australia experienced a strong upturn in prices and then a deceleration and the process has been seen as a soft landing so there is hope - which is our central case - that the US will experience something similar.
"However, it is clear that the risks are on the downside of a sharper than expected slowdown [in house prices] that would produce weaker-than-expected growth that would have implications for global growth and financial markets." This risk segues directly into fears of a slump in the dollar. HSBC issued a "recession-risk" alert for the US economy that would trigger a sharp fall in the dollar and pound.
David Bloom, a global economist, said the US would slow sharply next year, prompting investors to pull out of their massive gambles on US assets that so far had succeeded in offsetting record trade deficits. "Once these assets stop performing well and the dollar drifts lower, the dollar and asset cycle can turn more vicious. Once one does not want to buy an asset because of the fall in the dollar then the dollar starts to impact back on assets."
The IMF said its assumption was that any decline in the dollar would be "orderly", but there could be a more pronounced drop. It warned one reason the dollar could fall would be if investors believed it was clear the world's leading economies would fail to take action to resolve the imbalances between saving and demand across the world.
"A gradual and orderly adjustment would very likely depend on a credible policy framework for resolution of global imbalances over the medium term," the report said. "Accordingly, the risk of a disorderly dollar adjustment could arise without policies being put in place to foster the needed adjustments in savings and investment imbalances."
The IMF has done its bit, setting up a multilateral consultation between China and the US, as well as Saudi Arabia, to find a way to resolve the imbalances.
Its keynote world economic outlook published tomorrow will undoubtedly reiterate that the US must cut its deficits, China must liberalise its financial system and allow its currency to appreciate, the oil-rich countries should invest their windfall for growth while Europe should do more to boost its sluggish growth rates.
A fall in the dollar would also add to the inflation in the US as import costs rose. Inflationary pressures have been rising thanks to soaring energy costs.
The GFSR report showed that while long-run inflation expectations in the US have picked up, the inflation-related risk premium that investors are forced to pay has declined. "Should these gains erode and risk premiums for unexpected inflation increase, asset markets could come under pressure with potentially negative consequences for the real economy," it said.
Meanwhile, oil prices jumped more than a dollar a barrel yesterday, ending a run of recent declines. US oil prices broke back through $66 a barrel after a foiled attack on the US embassy in Damascus.
Unsurprisingly, the IMF did not give estimates for the financial implications of a dollar crash. But last month it published research by a leading economist that found, with a 10 per cent fall in the dollar, US stocks and bonds would wipe out $1.2 trillion of wealth held for foreigners.
The research found that UK investors held $471bn of US assets, the second largest in the world behind Japan. However, a national 10 per cent slump in asset prices would wipe out the equivalent of 5 per cent of GDP compared with almost 15 per cent in Italy.
The IMF did highlight consensus forecasts yesterday showing even an orderly decline in the dollar would not be shared equally across the world. The forecasts showed the fall would be absorbed entirely by a rise in the currencies of Japan, China, Korea, Taiwan, Singapore and Malaysia. On a general note, the IMF said the financial system had withstood a fall in prices and a rise in volatility in May after an unexpectedly large rise in inflation.
The IMF said corporate fundamentals were still solid, equity valuations were not stretched in most markets and major financial institutions were profitable and well capitalised.
However, it remarked: "In these circumstances it is reasonable to wonder whether financial markets might react to less favourable developments in a way that would amplify - rather than dampen - the emerging risks." The trigger for a shock to asset prices can come out of the blue, perhaps a natural disaster or a health epidemic such as bird flu.
The IMF reiterated its fears that an outbreak would reduce investors' appetite for risky investments, cut capital flows between companies and weaken financial systems as absenteeism rose.
David Nabarro, the senior UN System Co-ordinator for avian and human influenza, is in Singapore at the weekend to meet Jim Adams, head of the World Bank's avian flu taskforce.
But could political instability - such as that at the highest levels of the Labour Government this week that knocked the pound - trigger a crash? Mr Hung dodged the specific question, but said: "In the short term, this is very noisy and can distort uncertainty in exchange rates so we try to look over the medium term." Mr Caruana added: "There will always be surprises - but surprises are surprises."Reuse content