G7 finance ministers have begun focussing on narrow bond market spreads - a sign of what senior bankers warned yesterday could be a massive liquidity bubble in the global financial system.
'Nothing good lasts forever', William Rhodes, Senior Vice Chairman of Citigroup, said at a briefing by the Institute of International Finance yesterday. Bond market investors as well as bank lenders should start exercising caution, he added.
The warning by Rhodes, who is also IIF First Vice Chairman, came after the Institute released its latest figures on flows of private capital to emerging markets, which are expected to reach an all time high of $345 billion this year on the back of surging international liquidity.
Rhodes spoke after a senior US Treasury official revealed that G7 finance ministers had focussed quite heavily on bond market spreads at their meeting on Friday. They made no mention of this in their official communique but sources told Emerging Markets that this was probably to avoid creating instability in financial markets.
The IIF delivered its message loud and clear, however, and Rhodes told Emerging Markets he had repeatedly issued warnings about spreads not reflecting risks in financial markets. 'I am glad that the G7 is finally looking at this issue', he said.
IIF officials drew particular attention to what they perceive to be building risks in emerging markets, but they also stressed that the problem could be more widespread and that even the biggest bond markets look richly valued in terms of bond market spreads.
'As the global environment changes, caution and prudence should be the priorities for risk managers, investors and financial institutions,' Rhodes said.
He noted ominously that the last time private capital flows to emerging markets surged to levels approaching, although not equalling, current levels was in 1996 - just before a series of financial crises struck Asia, Russia and Latin America in rapid succession.
Since then, the US Federal Reserve and other central banks have pumped massive liquidity into the system to preempt financial crises.
The Fed has been raising interest rates by steady increments in the hope that this will prevent the financial market and asset bubbles swelling to a size where they are in danger of bursting, said Rhodes. But he indicated that this was not a guaranteed outcome. IIF managing director Charles Dallara suggested meanwhile that the threat to markets could only be dealt with in a 'framework' of correcting global financial imbalances.
'Many emerging market economies have put in place increasingly sound policies in recent years,' noted Rhodes. 'Nevertheless, at this time of uncertainty, emerging market governments must strengthen their efforts to sustain consistent and sound fiscal and monetary policies while deepening their efforts o structural reform. By these actions, they can strengthen investor confidence which is especially important if global economic difficulties move the world economy off course.'