ECB sees risk of disruptive unwinding of imbalances, severe pressure on dollar
05.31.2005, 01:45 PM

FRANKFURT (AFX) - Global current account imbalances pose a threat to financial market stability, the European Central Bank said.

'Large and growing financial imbalances continue to pose medium-term risks for the stability of foreign exchange and other financial markets,' the ECB said in its latest Financial Stability Review.

It said a disorderly correction of the large US current account deficit and surpluses in Asia remains possible, particularly as the imbalances could increase further.

'The risk of a disruptive unwinding of global imbalances remains, especially because these imbalances could widen further,' it said.

It said the US' propensity to import out of income and expectations that US economic growth will exceed that of the rest of the world in the coming year both point to a further widening of global imbalances.

Asian central banks have so far been willing to continue financing the US deficit, but if they lose their appetite for US assets, this could trigger a disorderly correction, it said.

'Such concerns could increase the likelihood of a disorderly rebalancing, involving a capital account adjustment and/or the possibility of severe downward pressure on the US dollar, coupled with significant upward pressure on long-term interest rates,' it said.

The ECB reiterated that global imbalances, high and volatile oil prices and weak private consumption also represent a risk to the euro zone growth outlook.

It also said that an underestimation of risk has pushed the prices of bonds and some other assets 'beyond their intrinsic value'.

This perception that financial market risks are low has increased investors' willingness to hold risky assets and led to a 'hunt for yield' over the past two years, it said.

This has recently spread from bonds to other asset markets, including small and mid-cap stock markets, and fuelled the growth of hedge funds, it said.

But a correction of these price rises is possible in the period ahead, the ECB said.

'A reappraisal of risk -- involving adverse market dynamics in the euro area as well -- cannot be excluded in the coming period,' it said.

It said the banking sector is particularly vulnerable to a rise in bond yields.

'Some euro area financial institutions, including banks, would likely endure losses -- at least in the short term -- from any upturn in long-term interest rates,' it said.

Banks would be vulnerable to such disturbances because provisioning levels have declined, it said.

And while banking profitability has improved overall, there may still be pockets of fragility in the euro zone banking sector, it said.

Anaemic domestic demand may have left small and medium-sized firms vulnerable to adverse disturbances, it said.

In particular, the surge in oil prices seen over the past six months could test the robustness of smaller companies' finances, if it lasts, the ECB said.

Household financing problems could also be a risk in those countries where real estate prices have risen beyond their intrinsic value, where debt is high and where mortgages are primarily at floating rates, it said.

But, overall, reasonable interest rate swings would be unlikely to hit household finances so hard as to significantly increase credit risks, not least because many mortgages are set at fixed rates, it said.

steve.whitehouse@afxnews.com

 

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