Financial shocks may grow as liquidity shrinks, IMF warns

Rising US interest rates will expose gaps in liquidity that could make markets prone to deeper and wider shocks, the International Monetary Fund said in a report on Wednesday.

The IMF's twice-yearly Global Financial Stability Report also warned that financial risks have increased in the last six months and shifted more to emerging markets and the "shadow" banking sector, or non-bank financial intermediaries.

The warnings from the Washington-based institution come as the US Federal Reserve is expected to raise interest rates later this year for the first time in nine years, prompting fears of market gyrations and capital outflows from developing countries.

The IMF said the Fed's pullback from monetary stimulus is likely to expose deeper factors that have already sapped market liquidity, including the rise of high-frequency trading and increased regulation.

"Markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes," the IMF said in the report.

It pointed in particular to two recent examples of market jolts that could be a harbinger of more to come, echoing warnings from the Bank of England.

In October last year, concerns about the global economy triggered a "flash crash" in U.S. Treasury yields, and in January this year the Swiss franc jumped sharply after it was unpegged from the euro.

The IMF said illiquid markets could also magnify shocks and worsen contagion, particularly to developing countries with exposure to foreign debt.

Emerging markets are already struggling with the fallout from lower commodity prices and a higher U.S. dollar, which exacerbates existing problems for some corporations or banks, the IMF said.

It focused in particular on countries like Nigeria, Peru, Turkey and Ukraine, where banks are more likely to lend to corporations, and suffer if the firms fail.

The IMF also highlighted issues in Europe's life insurance sector, where companies may have difficulty making guaranteed payouts to holders of their policies when interest rates are low.

"Prompt regulatory and supervisory actions are needed to mitigate damaging spillovers from potential difficulties of individual insurers," the Fund said.