IMF shrugs off debt fears

WITH Iraq in convulsions, the Middle East in crisis and the threat of terror everywhere, you might expect the world economy to be sickly. In fact, it is booming.

The US, in election year, is racing ahead. Asia is growing like crazy. Britain is doing very nicely. Japan has woken at last from its long slumber. And Europe ... well, Europe is Europe. But it all adds up to the world economy expanding by a healthy 4% to 5% in 2004, the best rate for a decade.

The International Monetary Fund can hardly believe its luck. Its latest Global Financial Stability Report concludes that the world economy has hit a 'sweet spot' when all - apparently - is going well.

Growth has recovered with inflation staying subdued - a happy combination.

'Emerging' countries, whose recurrent crises have rocked the system, are benefiting as interest rates fall. Four years ago, they paid an average 12.6% interest on their bonds. Today it is 8%.

This is good news. But a safe recovery, like a safe investment, is one whose dangers are not immediately apparent.

The world economy is floating on a tide of cheap money. The US is floating on a tide of cheap foreign money. It is borrowing on a scale never seen before, and needs an annual inflow of $500bn (£270bn) of foreign funds to keep going.

As IMF capital markets director Gerd Hausler points out, foreigners do not have to pull money out of the US to cause trouble. They simply have to slow the rate at which they are pouring it in.

Foreign ownership of US assets has reached a peak not seen since Christopher Columbus planted his flag. As the chart shows, foreigners now hold a third of all US Treasury bonds and close to 15% of equities.

What happens if they get scared? 'It could hypothetically lead to a risk premium on US financial assets,' says Hausler. This is central bank speak. The David Beckham text version would probably be 'the **** would hit the fan'.

US shares and bonds would slump and interest rates would be hiked sharply. Even Hausler concedes: 'Any substantial glitch could have a snowballing effect. It would not be a happy event'.

The IMF recalls 1994, when the US began raising interest rates in February. By November, they had doubled to 6%, and 10-year bond yields had reached 8%. Hopes that Europe would be unscathed were shattered as markets slumped all over.

This time round, inflation is lower and the IMF is more optimistic. But it warns people not to invest 'on the expectation that interest rates will be kept indefinitely at very low levels'. It points out that UK households' debt is 126% of their income, up from 104% in 2000.

It would be wrong to characterise this as a gloomy report. Rather, it is as if the IMF cannot quite believe how well things are working out. Let us hope its confidence is well founded.

Insurance worries

WITH the Lloyd's market poised to report record profits of £1.3bn today, it may seem perverse of the IMF to a large section of its Stability Report to insurers. But the Fund has been spooked by how fast the industry's assets melted away when stock markets collapsed. It wants them to put more funds into 'credit instruments' such as bonds.

Insurers are doing this anyway. Five years ago, UK firms had 58% of their assets in shares, 27% in bonds. By 2001 it was 43% and 39%. In Europe the figures were 26% shares, 39% bonds.

More challenges loom. Regulators are pressing companies to adopt fair-value accounting which rules out their old 'smoothing' of market swings over several years. That will make their accounts more volatile.

Regulators seem to have decided it is their job to shoo the industry out of shares and into bonds.

The next IMF report will cover pension funds and may urge them to do the same. Yet bonds can be almost as volatile as equities and a precipitate shift can be costly.

In their longing for predictability, the regulators should not go too far.