FRANKFURT, March 27 - A lengthy war in Iraq and spreading terrorism could undermine the fragile global economic recovery and further depress financial markets, the International Monetary Fund said on Thursday. A steep fall in the dollar also could destabilise markets that already are struggling to recover from the bursting of the asset price bubble, the Fund said in its Global Financial Stability Report, which monitors economic risk. In such an uncertain environment, policymakers should focus on bolstering investor confidence, the report said.
"The reversal of the fourth-quarter equity market rally... highlights the continued fragility of investor sentiment and the urgent need for policies to foster market confidence, and for a resolution of geopolitical tensions," the IMF said. "While markets may have priced in a short war, any departure from this scenario could weaken confidence further." The report's wary tone was similar to that of IMF Managing Director Horst Koehler, who told a magazine on Wednesday a lengthy war risked jeopardising the global recovery. Koehler said he could not rule out global recession.
MARKETS SLUMP
Uncertainty in the weeks leading up to the war caused global equity markets, which suffered steep losses in 2002, to fall further, while oil prices surged. And the dollar lost ground against other major currencies, losing some of its traditional safe-haven allure. The dollar seemed now more vulnerable as capital inflows into the United States no longer depended so much on the faster growth rate in America, but more on interest rate differentials, which might change rapidly, said Gerd Haeusler, the IMF director responsible for the report. "Capital inflows to the United States may be more fragile than the ones we have seen before... and therefore all other things being equal the dollar has come down somewhat and may be looking slightly more vulnerable than at a time when growth differentials were more important," he told a news conference in Frankfurt held to present the report. Even if the war were to end quickly, the geopolitical situation might remain troubled for a while, he added. "What will it mean for the region, whether or not the likelihood of terrorist attacks might diminish or, some say, even increase... are issues which are far more important than the question of whether the war may take a week longer or not." Moreover when growth prospects do improve, there is the potential for significant interest-rate risk, the Fund said.
Market sources say that many financial institutions have invested substantially in long-term Treasury and agency securities funding these positions with cheap short-term money, but these positions are unhedged. "Consequently, the potential for sizeable losses could exist for some market participants," the report said.
BRIGHT SPOTS
But all was not doom and gloom. A collapse in the financial system was unlikely and low interest rates are helping to boost confidence, the IMF said. Maintaining confidence now is paramount and ample capital parked in cash assets should drive a rebound once the war uncertainty lifts, the Fund said. In fact, households and companies in the United States already have started to repair their financial balance sheets. It is essential that policymakers aim their efforts at bolstering investor confidence, and thus the current low official interest rates -- meaning borrowing is cheap -- are appropriate. "The supportive monetary stance has facilitated the gradual improvement in the financial conditions of key sectors of the economy, and the sizeable buildup in liquidity positions among households and financial intermediaries," the report said.
There should also be renewed efforts to reform the Japanese banking sector, which remains a matter of concern, and to improve profitability at German banks. But worries about a collapse in the financial sector are unwarranted, the Fund said. "While individual banks have difficult adjustments to make, and many even become takeover targets, systemic problems are unlikely to arise as long as the global recovery is sustained. "But a deterioration in the global economy or further revelations of hidden corporate losses could lead to problems." A string of poor earnings and huge bad debt provisions at Germany's banks has raised concern among investors over their health, pushing their shares to new lows. Japanese banks are under heavy pressure to write off huge bad loans to struggling corporate borrowers, while their sliding shares threaten to drag their capital levels below international standards, despite a recent drive to raise capital through share issues.//