WASHINGTON, March 27: A bogged-down Iraq war would hit gingerly recovering world financial markets hard, the International Monetary Fund warned on Thursday.

“While markets may have priced in a short and decisive war, any departure from this scenario could weaken confidence further,” the IMF said in its twice-yearly Global Financial Stability Report.

“Moreover, markets may not have yet focussed on the possibility that uncertainty could persist for some time.”

The IMF report was drawn up several weeks before US and British forces invaded Iraq.

A week after the campaign began, and despite a “shock and awe” blitz of Baghdad, the Iraqi regime still stands as US forces mass en route to the capital.

Field reports put the Third Infantry Division less than 100 kilometres (60 miles) south of Baghdad, the US 101st Airborne moving up from the southwest and US Marines to the east.

Financial markets rallied as the opening shots were fired in the Iraqi war, but they have since retreated a little as visions of an immediate collapse of the Iraqi regime vanished.

Even if US and British forces won quickly, hesitancy in financial markets could last, the IMF said.

“Uncertainty could also persist despite a short and decisive military conflict owing to the potential for continued geopolitical instability and tangible threats of terrorism,” it said.

“Prolonged uncertainty could keep risk aversion at a high level, depress financial markets and reinforce the headwinds against global economic recovery.”

Financial markets were suffering the hangover of the bursting of the late 1990s technology-driven asset bubble, leading to uneven global growth and businesses’ reluctance to invest, the IMF said.

The malaise appeared to be lifting, the IMF said.

Large cash balances had been built up by households and institutions as they resisted investing during the uncertain climate but also benefited from low interest rates. But interest rates might now present a serious risk, the IMF warned.

“When growth prospects improve and investors shift to higher-risk assets, short- and long-term interest rates will likely rise. This interest rate risk is significant at this juncture.”

Many financial institutions had snapped up higher-interest, long-term treasury bonds, funding the purchases with cheaper, short-term money, it said.

Market sources said many of those investments were unhedged, exposing in particular investors in mortgage-backed securities, the IMF said.

“Consequently, the potential for sizeable losses could exist for some market participants on top of losses experienced since the bursting of the equity price bubble and the ensuing flight from corporate risk.”

Monetary policy in the major economies was appropriate to forestall faltering consumer and business confidence and to give respite to financial markets, the IMF said.

But Japan, the world’s second largest economy after the US, should urgently take new steps to reform companies and the financial sector, it said.

“To improve their financial conditions, many Japanese financial institutions need to address their loan-loss provisions more resolutely and their high cost base more generally,” the IMF said.

“A corporate sector reinvigorated by successful restructuring is crucial for allowing Japanese financial institutions to improve their earnings,” it said.

Insurance industry regulators worldwide should step up efforts to encourage sounder asset risk management, the IMF said.

And the weakness in funding of corporate pensions revealed by declining equity prices — particularly in Britain, Japan, the Netherlands and the United States — must be addressed.—AFP