IMF warns of risks from weak dollar and rising interest rates

A sharp fall in the dollar and possible spikes in interest rates pose key risks to the global financial system, even though its resilience has improved in recent months, according to the International Monetary Fund.

A sharp fall in the dollar and possible spikes in interest rates pose key risks to the global financial system, even though its resilience has improved in recent months, according to the International Monetary Fund.

In its biannual Global Financial Stability report, the IMF called on the world's central banks to continue their policy of raising interest rates gradually towards a neutral level.

The Bank of England is widely expected to leave rates unchanged this week, but could nudge them higher after the general election next month. The US Federal Reserve has so far lifted its rates gradually to prevent future inflation, though analysts believe they still have a long way to go before they reach a level where they neither stimulate nor restrain the economy.

Gerd Haeusler, the IMF's director of international capital markets, said that while the state of global financial stability was "as good as it gets", a key risk was that long-term market interest rates and credit spreads could rise beyond current expectations.

The report warned: "While financial markets have largely priced in a moderate and gradual monetary tightening, they might be less prepared if market interest rates - especially long-term rates - were to go up more abruptly, either because of a sharp decline of the dollar or worse-than-expected inflation data."

Such a scenario could lead to an economically-damaging sell-off in bonds and other assets, it said. The IMF also voiced concerns about possible negative surprises for corporate earnings and downgrades to major companies - such as General Motors, whose debt has recently been downgraded to one notch above junk.

Sustained rises in commodity and oil prices feeding through to inflation remain a threat to the outlook - US crude oil futures climbed to a new record of above $58 a barrel on Monday - although the IMF directors sought to downplay it. Hung Tran, the deputy director for international capital markets, described the impact from high oil prices as "quite limited" as "many countries have become more efficient in the use of energy".

Mr Haeusler said that when adjusted for inflation, oil prices were still lower than in the Seventies, when they wreaked havoc on the world economy.

However, the IMF was worried about a possible sharp slide in the dollar if Asian central banks' appetite for holding dollars fades. "This could trigger a further significant decline of the dollar and an increase in US interest rates that might reduce US domestic demand." It urged the US to boost national savings and reduce its huge current account deficit, while calling on the eurozone and Japan to carry out overdue reforms to boost growth.

Mr Haeusler reiterated that Asian central banks should move towards letting their fixed exchange rates float. "It is in the interest of Asian central banks to loosen up the corset of their fixed exchange rates," he said.

He noted that financial risks had partly shifted from banks to insurance companies, pension funds and households. Households are taking more responsibility for their financial affairs, especially to provide for their retirement income, and have thus become more directly exposed to market risks. Mr Haeusler described households as "shock absorber of last resort", and stressed the need for better financial education and advice. In addition, the IMF report warned of the risks from runaway house prices and high consumer debt in the UK, US and the Netherlands, which leave households vulnerable.

Emerging markets have enjoyed favourable financing conditions over the past couple of years, with many pension funds investing in emerging bond markets, which should bring a measure of stability to them, the IMF noted approvingly. But those countries still need to implement urgent reforms to improve their economies.

The reportconcluded that global growth was "quite solid", with inflation under control.