BUENOS AIRES -- Investors may be underplaying the risk of a sharp market correction, European central bankers said on Monday, the same day that a slump in Chinese stocks weighed on global financial markets.

Speaking at a conference sponsored by the Argentinian central bank, European Central Bank policymakers said investors should be aware of risks, even though the global economic outlook is generally favourable.

"Uncertainty, or those risks that cannot be readily quantified, may in fact be on the rise," Finland central bank chief Erkki Liikanen told the meeting.

"The narrowing of risk premia observed in many markets and asset categories may not be fully on a sustainable basis.

"This implies the possibility of an abrupt and broad-based widening of risk premia. Given the unprecedented degree of financial interdependence, the consequences might be serious."

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A slump in Chinese stocks, down 8.3 percent on Monday in their second biggest drop this decade, dampened financial markets worldwide, although shares were still near record highs. A similar dip in Chinese stocks earlier this year prompted steep falls in global markets.

Central bankers are worried that investors buying complex new credit derivative instruments think they have insured themselves against market risk. Interest-rate spreads are very narrow and investors seek ever more risky products to boost returns, bidding up asset prices further.

Regulators are uncertain who would own the underlying asset as derivative products multiply in number and complexity should markets unwind sharply.

Italy's Mario Draghi, head of the international Financial Stability Forum, said the rise of big market players meant shocks could more easily be absorbed, but the risk of a broader shock affecting several markets at once may have increased.

"It is ... unclear whether firms have adequately protected themselves against indirect exposures to the consequences of greater leveraged activity, such as the risk of a sudden global shock to liquidity," he said.

"If in times of stress they behave like a herd, in fact liquidity dries up exactly at the time it is most needed."

Low levels of consumer inflation in many countries, which also has helped reduced risk premia on many bonds and contributed to low rates, was no reason for complacency, said Nout Wellink, who heads the Dutch central bank.

"MONEY MATTERS"

Wellink also described official ECB rates as "low", the only one of the three to comment on current economic or monetary conditions ahead of an expected rise in ECB rates to 4 percent on Wednesday.

"But having said that, these low interest rates show up in asset prices and we have seen that not only in the stock market but also the housing market and other financial markets," he said.

"In spite of consumer price stability, asset price inflation may signal underlying imbalances, such as an over-optimistic risk assessment by financial market participants that keeps long-term interest rates at unwarranted low levels."

Liikanen and Wellink said it was important in the current environment for central banks to keep an eye on money and credit trends, a topic of internal debate at the ECB after some policymakers expressed doubts about the monetary data the ECB analyses to signal long-term price risks.

"I would argue that 'money matters' especially during conditions of possibly excessively compressed risk premia," Liikanen said, defending the ECB's system of cross-checking signals from real economy data with its monetary analysis.

Wellink also said that the global neutral interest rate may have moved higher if there had been a permanent improvement in world productivity, although the jury was still out.

"Other things equal, a higher real equilibrium interest rate implies that monetary policy interest rates also have to move to a higher level, consistent with the new equilibrium," he said.

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