IMF warns major transitions in global financial system

The global financial system faces several major transitions accompanied by substantial risks, the International Monetary Fund (IMF) said Wednesday.

"The first one is the transition in the United States from a prolonged period of monetary accommodation towards a normalization of monetary conditions," Jose Vinals, head of the IMF's Monetary and Capital Markets Department, said at a press conference to unveil its Global Financial Stability Report.

"This process will be unprecedented and complex ... Containing longer-term interest rates and market volatility has already proven to be a substantial challenge, as shown by the sharp rise in bond yields and volatility since May," the IMF's financial counsellor said.

U.S. Federal Reserve Chairman Ben Bernanke laid out a tentative tapering plan to exit quantative easing (QE) three months ago and caused investors to withdraw money from emerging markets and restructure their portfolios, stoking volatility in currency, bond and equity markets around the globe.

Given the prospect of higher interest rates and greater volatility, investors will naturally adjust their portfolios by reducing their fixed income holdings. The IMF's Global Financial Stability Report estimates that a 100 basis point increase in interest rates from current levels could generate 2.3 trillion U.S. dollars losses on global bond portfolios.

"Engineering a smooth transition to monetary normalization will require a clear and well-timed communication strategy by the Federal Reserve to minimize interest rate volatility, as well as effective execution in line with economic developments," Vinals said.

Emerging economies are faced with severe capital outflows, Vinals said, urging policymakers to address domestic vulnerabilities and enhance policy credibility, in addition to facilitate an orderly adjustment in their financial markets.

Vinals also outlined other major transitions in the global financial system: a move to a more balanced and sustainable financial sector in emerging economies, the drive to bolster weak banks and address corporate debt overhang in the euro area, and efforts to reinvigorate Japan's economy through the new policy regime of Abenomics.

If these policy challenges are not properly managed, the transition towards greater financial stability could be bumpy. " Policymakers need to steer carefully to navigate the bumps in the road ahead--so that we can arrive safely at our destination," the senior IMF official said.