BIS warns of vulnerabilities

The global economy is strong and will continue to grow, according to the Bank for International Settlements (BIS), which published its annual report on June 26. But the bank warned that a rapid change in credit quality could leave investors with unanticipated losses. It also expressed concern about the rapid growth of the structured product market.

The bank expects growth to continue and inflation to remain low, although 2007 will see an orderly deceleration, it says. Japanese recovery and growth in Europe, particularly in Germany, mean that the global economy is now less reliant on the US and China to continue its progress. Tighter monetary policy in the US and Europe has slowed inflation without disturbing the financial markets, the BIS says - although it adds that tighter fiscal policy is desirable, especially in the US.

However, the BIS cautioned that the credit markets could be susceptible to a re-pricing. Credit spreads have remained close to cyclical lows, despite increases in leveraging. Merger and acquisition activity has continued to accelerate in 2006, and leveraged buyouts have become larger and more leveraged. The BIS warned that if the credit cycle were to turn more quickly than expected, it could lead to a rapid deterioration in corporate financing conditions.

The growing use of structured products also worries the bank. "The performance of many of these new products has yet to be tested during an economic downturn," it says, adding that structured products are heavily reliant on modelling and risk management techniques that could turn out to be flawed.

Investor demand for emerging market debt is also a concern. Capital has rushed to emerging markets, on the belief that improved fiscal and monetary policies have increased their resilience and reduced the risk of more crises. But the drop in spreads seems to be at odds with fundamentals and has not been justified by improved credit ratings. Either rating agencies have become more conservative in rating emerging markets or investors have become over-eager. The BIS believes both could be true, and warns that this means emerging markets are "becoming more vulnerable to a re-pricing". Indeed, the past month has seen a sharp sell-off in emerging markets, with some posting their worst performances since the 1998 Russian crisis.

Alexander Campbell.