IMF warns of market breakdown potential due to low rates

Financial markets face a higher risk of liquidity squeezes in a sell-off due to the effects of the long period of low interest rates, the International Monetary Fund said Tuesday.

In a semi-annual report on global financial stability, the IMF said that markets for trading equities, bonds, currencies and other instruments generally appear liquid at the moment.

But that liquidity -- the ability of traders to easily buy or sell a large volume of an asset -- could be more "prone to evaporate" in the current environment, causing more volatility and undermining financial stability.

"Central banks and financial supervisors need to be prepared for episodes of liquidity breakdowns," said IMF economist Gaston Gelos, one of the authors of the new report.

"The level of liquidity in financial markets... has not shown a marked decline in most asset classes; however, low interest rates may be masking an erosion of its underlying resilience," the report said.

It said that the low interest rates at the hands of the world's leading central banks in the United States, Europe and Japan have encouraged more risk taking.

At the same time, the central banks' quantitative easing stimulus programs have bolstered liquidity, especially in bond markets.

But other changes in market structure have heightened the risks: the investor base has become less diverse; high-frequency and computer-based trading has become more powerful; there has been a rise in small bond issues; and many banks have pulled back from actively trading in financial markets, in part due to post-financial crisis regulations.

Because of that, the IMF said, once interest rates rise, market liquidity will probably decline and could do so to an unnerving degree.

"In extreme conditions, a sharp drop in liquidity can threaten financial stability since several asset markets, for example, bond and repo markets can freeze altogether -- as seen in the global financial crisis," it said.

It noted that in that crisis in 2008, a liquidity shock in one market caused a chain reaction in other markets that led to a shock in the entire financial system.

Part of the problem, too, is that the low rates have encouraged many more companies across emerging markets to borrow funds offshore, especially via bond issues.

Borrowing by firms has quadrupled in the past decade, the IMF pointed out, with a surge tied to the ultra-low rate stance of the US Federal Reserve since 2008.

But the report asked whether borrowers, most importantly those in emerging markets, have prepared themselves for higher interest rates, and for falls in their home currencies.

"These developments make emerging-market economies more vulnerable to a rise in interest rates, dollar appreciation, and an increase in global risk aversion," said Gelos.

The report warned that emerging- market governments should prepare themselves for more corporate distress and failures, and should reform rules to make it easier to resolve corporate insolvencies.