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Cyprus crisis
A Laiki Bank manager tries to calm depositors. The IMF said the Cyprus crisis was a reminder of the continued fragility of market confidence. Photograph: Reuters
A Laiki Bank manager tries to calm depositors. The IMF said the Cyprus crisis was a reminder of the continued fragility of market confidence. Photograph: Reuters

IMF warns world economy risks chronic new phase of financial crisis

This article is more than 10 years old
Report finds financial system is only part-fixed and further action is needed to tackle underlying threats to stability

The International Monetary Fund has warned that new risks to global financial stability are already emerging before the problems left by the deepest slump since the 1930s have been sorted out.

In its half-yearly healthcheck on the financial system, the Fund said failure to deal with old and new risks risked propelling the five-year old crisis into a fresh chronic phase.

José Viñals, the IMF's financial counsellor) said the improvement in financial markets seen over the past six months would not be sustained unless policy makers addressed "key underlying vulnerabilities".

The Fund's Global Financial Stability Report (GFSR) identified the euro area as one of the two significant legacy risks from the crisis. It said EU banks might need to reduce their leverage by a further $1.5tn (£0.9tn), and that credit was still not flowing to the countries on the periphery of the single currency zone.

Viñals said that the repair job on banks around the world was only partially completed, with a need to strengthen balance sheets and complete reforms of regulation.

He added that the three new risks were the US, where corporate debt underwriting standards were "weakening rapidly"; the possibility that a flood of cheap money from developed countries could de-stabilise emerging markets; and the dangers involved in unwinding prolonged monetary easing in America. "Put simply, we are in uncharted territory", Viñals said.

"A key message of this report is that addressing the old risks is essential to leave the crisis behind. But it also reduces the need for continued accommodative monetary policies. This will prevent the new risks from growing and from becoming systemic."

The GFSR noted that global financial market conditions had improved appreciably in the past six months, providing support to growth and prompting a sharp rally in a willingness to hold riskier assets.

"These favourable conditions reflect a combination of deeper policy commitments, renewed monetary stimulus, and continued liquidity support," it added.

"Continued improvements will require further balance sheet repair in the financial sector and a smooth unwinding of public and private debt overhangs. If progress in addressing these medium-term challenges falters, risks could reappear. The global financial crisis could morph into a more chronic phase marked by a deterioration of financial conditions and recurring bouts of financial stability."

It added that a higher appetite for risk could lead to exaggerated valuations and rising leverage, which could become systemic and spill over into emerging market economies. "Most sectors exhibit few clear signs of asset price bubbles just yet, despite relatively rapid price gains. However, signs of overheating in real estate markets are evident in some European countries, in Canada, and in some emerging market economies."

The IMF said the recent problems in Cyprus were a reminder of the continued fragility of market confidence, but Viñals stressed that the bail-out for the Mediterranean island – under which there will be massive losses on bank deposits of more than €100,000 (£86,000) – was a one-off.

"Cyprus was unique. Deposit holders in the rest of the euro area should not be concerned, Vinals said.

The GFSR noted: "The potential for contagion from developments in Cyprus is an important reminder of the fragility of market confidence. Although the adverse reaction to increased risk has not been intense in all markets, there was a renewed flight to safe assets and a sell off in some euro area assets."

It said balance sheet weaknesses remained in the UK banking system, where buffers against impaired loans were not as strong as in some other countries.

"While major UK and core euro area banks have been actively de-risking and de-leveraging more needs to be done to complete the repair of balance sheets."

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  • IMF cuts growth forecasts and urges George Osborne to rethink fiscal plans - as it happened

  • Eurozone crisis clouds IMF's improving outlook

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