Credit crunch worries IMF

Global economic instability stemming from credit market turmoil in the U.S. is “likely to be protracted,” the International Monetary Fund said Monday, five months after predicting little chance of a “major dislocation.”

“The potential consequences of this episode should not be underestimated,” the IMF said in its Global Financial Stability Report, released in Washington. “Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change.”

The worst housing slump in 16 years is contributing to a surge in foreclosures that has slowed U.S. economic growth and was a key reason the Federal Reserve lowered interest rates last week. The tightening of credit has made it harder for banks worldwide to raise cash. British lender Northern Rock last week asked the Bank of England for emergency funding.

In April, the IMF reviewed rising mortgage delinquencies and credit conditions more broadly, concluding that a “major dislocation still appears to be a low-probability event.” Since then, “downside risks have increased significantly and even if those risks fail to materialize, the implications of this period of turbulence will be significant and far reaching,” Monday’s report said.

There is likely to be some slowdown in global economic growth, which “remains solid.” Emerging markets are likely to suffer disproportionately, given the relative lack of available capital, the report said.

“Private-sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing,” the report said. “Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital market financing to help finance credit growth.”

In the U.S., tougher borrowing conditions could further hurt the housing market, while falling stock prices may reduce consumer spending. Corporate investment may be “curtailed, owing to a higher cost of capital,” the report said.

The IMF, which is charged with promoting global economic stability and lends to financially distressed nations, blamed the crisis on “benign economic and financial conditions” that “weakened incentives to conduct due diligence on borrowers and counterparties.”

The fund also said the methodology of credit-rating companies, some of which gave high ratings to sub-prime mortgage securities that have plummeted in value, needed to be examined. The complexity of many of these securities may have made it difficult for investors to assess their worth based on the assigned ratings.

“In the case of complex structured credit products, investors need to look behind the ratings,” the report said.

Regulators and investors will have to work together to strengthen financial markets to prevent a recurrence as well as develop ways to improve the spread of accurate and timely information to help markets assess risk, the report said.

The report concluded that companies have mostly been able to secure financing.

“However, the adjustment period is continuing, and if the intermediation process stalls and financial conditions deteriorate further, the global financial sector and real economy could experience more serious negative repercussions,” the report said. “The chances of a more severe tightening of credit conditions cannot be dismissed.”