An international market monitoring group co-chaired by former Bank of Canada governor David Dodge is warning policy makers and investors about the growing risk of asset price distortions, particularly in emerging markets.
Policy makers in many emerging market economies, notably in Asia and Latin America, are seeing strong inflows of foreign investment dollars that are helping boost their stock markets and, in some cases, their property markets, as stimulus money flows, Mr. Dodge said.
"We believe that both financial market participants and supervisors need to be acutely sensitive now to both the potential for further divergence between market trends and economic fundamentals and the risk of sharp swings in investor sentiment," he said in a statement Thursday.
It's the first warning bell that's been sounded by the group that he chairs, which was created by the Institute of International Finance in March to identify risks in the global financial and banking system and sound the alarm when necessary.
(The IIF is an international association that includes the world's largest banks).
Along with Mr. Dodge, the group is co-chaired by Jacques de Larosiere, who is former managing director of the International Monetary Fund and former governor of the Banque de France.
"Growing concerns about asset price distortions in an environment of plentiful liquidity call for caution by investors and risk managers to avoid widespread and substantial under-pricing of risk," Mr. de Larosiere said, adding that this issue should now also become a priority for regulators.
The difficult dilemma that governments in many emerging countries face is that the rapid gains in the price of assets, including stocks and houses, suggests the need for tighter financial and monetary conditions in order to cool things off. But increasing interest rates right now could prompt even more capital, or foreign investment money, to flow in, compounding the situation.
The group is recommending that a series of policy tools be considered, including, in certain emerging markets, the curtailment of government-sponsored credit expansion and the timely exit of fiscal support. Governments instituted measures to ease the flow of credit and spur economies following the severe financial crisis that peaked last fall, but the group is suggesting that in certain economies it's time for those measures to cease.
More broadly, the group believes that a number of macroprudential measures should be taken to reduce the incentives for investors to take on too much risk. Those might include short-term measures such as increased margin, collateral or loan-to-value requirements.