By Natsuko Waki and Stella Dawson
DAVOS, Switzerland (Reuters) - A flood of cheap money is putting pressure on the world's financial system, threatening to burst its banks and wash away five straight years of strong economic growth.
Leading financial officials discussing risks to the global economy at the World Economic Forum here say central bankers have limits to what they can achieve by raising interest rates to reduce the danger that under-priced risk and imbalances in financial markets will upset the rosy growth picture.
"Over liquidity is killing us," said Zhu Min, group executive vice president of the Bank of China, the country's second largest bank.
Policymakers have trained their sights on better monitoring of the $1.7 trillion (870 billion pound) asset hedge fund industry and the complex new financial instruments they use that are fuelling a credit problem.
"Monetary policy can play only a very small role in correcting these problems," said Wu Xiaoling, deputy governor of the People's Bank of China.
Very low bond yields, known as tight credit spreads, show investors are underpricing risk and it is "not necessarily sustainable" for global financial markets, warned European Central Bank President Jean-Claude Trichet.
"Clearly this phenomenon is not probably induced by ... good work produced by central banks," Trichet said, referring to over two years of interest rate rises by major central banks.
"Capital ... is chasing all over the world. You have to be prepared for a possible global re-appreciation of risks."
Persistently low bond yields have surprised policymakers, who had expected that over two years of major central banks pushing up financing costs would cool off bouyant financial markets and help restore a more balanced pattern of global growth with less market risk. But that hasn't happened, top International Monetary Fund official John Lipsky said.
"This has prompted a reassessment, not of global imbalances, but of the time scale for the adjustment," he said.
They also are looking at other ways of addressing the issue.
HEDGING BETS
European Central Bank Governing Council member Axel Weber told Reuters that higher official borrowing costs are not making credit more expensive partly because banks are under-pricing loans in order to win business.
Weber added they offset the risk using new instruments such as credit derivatives, which have exploded into a $27 trillion market, which also attract hedge funds looking for leverage positions and lucrative returns.
Growth of hedge funds and private equity pools, which often operate outside the reach of regulators, accelerated with cheap money put in place as a result of series of interest rate cuts after the technology bubble burst in 2001-2002.
"A lot of activities within the private sector, hedge funds, private equity -- we are not sure where it's going and what it's doing," said Andrew Crockett, the former head of the forum for central banks - the Bank for International Settlements - and now president of JP Morgan Chase International.
"You don't quite know how they are going to be exposed if there is correction in financial markets of a substantial size. We don't know how this will happen, it can happen on geopolitical risks."
"I think there is a lack of transparency there... It will take us too long to get into this."
SELF-POLICING
German Chancellor Angela Merkel, addressing the Davos gathering, called for greater transparency in hedge funds.
Bankers agreed tighter regulation was not an answer to control the emerging forces of hedge funds and private equity.
"More rigid, more intrusive regulatory regime is not easy and in many cases it's not reliable," Crockett said.
Top European Union financial regulator Charlie McCreevy said he saw no need for more hedge fund rules in Europe.
"It's not correct to say that there is no regulation of hedge funds in Europe. It's a bit of a myth," McCreevy said.
Weber said: "I prefer a market-based orientation to regulatory actions. But we have to see how deep we can wade into these waters."
