Central bank policy makers had one common theme when they addressed the World Economic Forum in Davos last week. While all of them referred to the relatively stable and benign conditions in financial markets, they also drew pointed attention to various potential problems. Volatility, which is the accepted measure of risk, has been unusually low for some time now, in almost all financial markets, including bonds, equities and currencies.

Regulatory concerns include, first, mispricing of credit in the face of a record volume of leveraged buyouts last year. The average debt levels in LBO financing reached 5.4 times the Ebitda (earnings before interest, tax, depreciation, and amortisation).

Lenders remain enthusiastic, something which Indian companies too have experienced lately. (Neither Tatas nor Reliance nor Essar have faced problems in finding willing lenders to finance their comparatively large takeover bids.)

The lenders' enthusiasm has brought down the prices of credit derivatives very sharply. The strong economic growth experienced worldwide in recent years has perhaps bred complacency: when things are good, credit does not look risky.

Central bankers have also expressed concerns about the explosive growth in outstanding derivatives contracts: $450 trillion, a four-fold jump since 2000. The amount represents the notional principal, and not the amount at risk, and includes almost $30 trillion of outstanding credit derivatives.

A reference was also made to the $1.7 trillion of assets managed by the hedge fund industry, which translates into total risky positions of something like $7-8 trillion, even at a relatively modest gearing of 3 to 4.

Among those who made cautionary statements were Jean-Claude Trichet, President of the European Central Bank, and Zhu Min, Executive Vice President of the Bank of China. Malcolm Knight, managing director of the Bank for International Settlements, warned, "Financial innovation has produced vehicles for leverage which are very hard to measure."

Even discounting the traditional caution of central bankers, will the benign conditions in financial markets continue? There are several major imponderables, which could lead to financial instability.

The possibility of a further slowdown in the US economy. Most measures of domestic demand are showing signs of continued slowdown. The persistent inverse yield curve in the dollar bond market, is also an indication of a slower economy in 2007. In the medium term, the Fed chairman has warned of a 'fiscal crisis'. US slowdown will affect growth in East Asia.

n This may not have too big an impact unless accompanied by lower capital flows in the United States from private investors, not enamoured of a slower economy, leading to lower bond and equity prices. Lower capital inflows, and hence a sharp correction in the dollar's exchange rate, could also arise from the announced desire of major holders of foreign currency reserves to diversify investments.

The middle eastern oil exporters and Russia have announced their desire to do so, and so has China with its trillion dollar hoard. To be sure, it is not clear whether the Chinese diversification would be in the form of currencies or investment instruments, or both. Incidentally, any fall of the dollar is likely also to lead to a steepening of the yield curve.

n A reversal of the so-called 'carry' trade involving borrowing yen at still very low interest rates, and investing the proceeds in higher yielding currencies like the pound, dollar or euro. The exact amount of outstanding carry trade is not known, but seems to be the highest since 1998. This is the principal reason for the strange weakness of the yen which, by some estimates, is now much more undervalued than even the Chinese yuan, in real effective terms.

The yen touched a four-year low last week -- but the price of call options on the yen has gone up sharply, evidencing market expectations of a reversal. (Incidentally, our finance minister has remarked more than once that inflation is a monetary phenomenon; the Japanese do not seem to have heard it; inflation remains extremely modest despite egregious fiscal and monetary excesses over more than a decade, and an undervalued currency.)

n A major default in the credit or credit derivatives market.

Tailpiece: The oil price is down almost 30 per cent from its peak. I wonder whether this is a part of US strategy to put financial pressure on Shiite Iran by persuading Sunni Saudi Arabia to increase production and bring down prices. Not so incidentally, this also helps the United States, the world's largest importer of oil, in economic terms. The US is also pressuring Europe to isolate Iran by cutting trade and freezing Iranian assets. Will Iran retaliate by changing the oil price to euro?