CAPE TOWN -- Investors should prepare for the risk of a serious shock in case current favourable conditions in the world economy go into reverse, top central bankers said on Tuesday.
In a joint panel discussion, central banks chiefs for the world's three largest economies, the United States, the euro zone and Japan, said investors should guard against complacency.
"It's not necessarily the case that the current benign conditions will continue forever," U.S. Federal Reserve Chairman Ben Bernanke told the International Monetary Conference here, via satellite link.
European Central Bank President Jean-Claude Trichet endorsed that view, saying: "We have to continue to be very vigilant."
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"Complacency would be the worst possible advice for all of us, for central bankers and private institutions," he added.
The warnings came as global stocks stalled after hitting a record peak for a fourth day, as wild trade in Chinese shares sounded a note of caution.
Central bankers are concerned that high levels of liquidity in markets and a quest for higher returns are causing riskier behaviour that could unleash a chain reaction on global markets.
Trichet, Bernanke and Bank of Japan Governor Toshihiko Fukui — who together oversee almost 60 percent of the global economy — pointed to global trade imbalances, oil prices, a rise in protectionism and low pricing of risks on credit markets as potential risks to the current run of solid global growth.
An economic or political shock could push up the current low price of risk "and we might see some responses in the financial markets that are more serious than the ones we've seen in the last couple of years," Bernanke said.
Japan's Fukui said a shock could be sparked by something like a shift in market perceptions of inflation, which all three central banks are trying to control with tighter interest rates.
"If the benign picture changes for some reason ... (it could) affect global capital flows and market price formation, thereby undermining the foundation of the global economy," Fukui said.
"TRIANGLE OF VULNERABILITY"
Trichet said the low risk pricing was not necessarily sustainable in the longer term, and the triggers for any potential adjustment could not be accurately foreseen.
Low risk premia, along with the explosion of unregulated hedge funds and private equity firms combined with their widespread use of complex new credit derivative instruments. had created a "a triangle of vulnerability" for debt markets.
"A shock at any corner of this triangle could have implications for the other two," Trichet said.
"For instance, a significant turn in the credit cycle could mean that credit protection-sellers, such as hedge funds, could become unable to make due payments to banks."
"Similarly if widespread problems were to emerge at hedge funds or private equity firms, which are active in the CRT (credit risk transfer) markets, this could even spark a downturn in the credit cycle," he said.
Trichet urged private firms to cooperate with governments and public officials to oversee these risks in order to manage any market adjustment smoothly.
A voluntary set of principles could be a suitable way to better assess the risks from hedge funds, he said, backing the recommendations of a Financial Stability Forum report prepared for this week's Group of Eight leaders' summit.
Bernanke said the Fed still saw market discipline as the best approach to overseeing hedge funds. They, like the new financial instruments, had helped make global systems more resilient as well as creating new risks, he said.
Fukui said financial institutions should strengthen their risk management in dealing withe hedge funds.
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