The relatively weak economic growth outlook, particularly for emerging and developing economies (EMDE), provides an important backdrop for the financial challenges that some of them currently face.
By Erik Feyen
Recently, financial volatility returned because of various concerns in the marketplace – including (just to name a few) shifting expectations of the shape of the Federal Reserve’s exit path from ultra-low interest rates and the rapid strengthening of the US dollar; the launch of quantitative easing by the European Central Bank and its impact on inflation expectations and bond markets; low and volatile oil prices; China’s growth slowdown, additional stimulus and financial-sector challenges; the standoff between the new Greek government and its creditors; and continuing geopolitical turmoil.
In this context, EMDEs face six interrelated financial challenges, although it is important to note significant differences between countries exist.
First: Prolonged extraordinary monetary policies (EMPs) in developed countries and the prospect of asynchronous exits create a wide range of global financial market challenges. EMPs in developed economies created an environment of ultra-low interest rates, as policymakers have aimed to rekindle economic growth and battle disinflationary pressures. Three key risks have emerged:
- Low rates and excessive risk-taking have contributed to very high asset valuations, compressed risk spreads and term premiums, and stimulated non-bank-sector growth, boosting leverage, illiquidity and collateral shortages. That exposes the financial system to shocks. This has weakened risk pricing and contributed to the “illusion of liquidity,” raising the risk of pro-cyclical “fire sales” with global spillovers.
- Sudden shifts in market expectations or a bumpy trajectory of the U.S. Federal Reserveexit path to normalized interest rates could trigger volatility in currency, equity and capital-flow markets – similar to the “Taper Tantrum” of 2013, when the Federal Reserve openly contemplated scaling back its asset purchases.
- Increasing divergence between central bank policies in developed economies has already had significant implications for currency markets, particularly for the euro-dollar pair. Divergence creates an interference risk and the possibility of miscommunication, which could trigger new bouts of global financial market volatility.
There are four direct implications for EMDEs:
- The exit from EMPs will tighten international funding conditions and could prove disruptive for currencies, balance sheets, and funding capacity in EMDEs The “Taper Tantrum” showed that changing expectation about EMPs matter.
- The anticipated Federal Reserve exit created pressure on EMDE currencies. EMDE currencies depreciated significantly, for oil exporters in particular, as the US dollar strengthened.
- Normalization of global rates will affect monetary policy in EMDEs. Some central banks in EMDEs will need to balance raising interest rates to manage capital flows, reserves and currencies, while at the same time avoiding choking off economic growth.
- EMPs can lead to “beggar-thy-neighbor”-like currency tensions. EMPs are associated with currency depreciation and can trigger easing responses of other central banks to avoid an erosion of their competitiveness, particularly if domestic demand is already weak. This creates additional uncertainty and volatility.
Second: EMDE external debt exposures have grown to record highs, making some EMDEs more vulnerable to shocks. Since 2009, large search-for-yield flows from developed markets reached EMDEs, in part driven by EMPs. As a result, portfolio investors current allocate more than $4 trillion, or 13 percent of their investments, to EMDEs. This is not driven by a singular region or country, but is a broad-based trend. Cumulative issuance in the six post-crisis years is 6.7 percent of GDP for the median EMDE, up from 4.3 percent in the six pre-crisis years. At the same time, bond-fund allocations from developed markets to EMDEs almost quadrupled, to $385 billion, since 2009; equity-fund allocations expanded by 70 percent to $985 billion; and foreign participation in some local bond markets increased to 26 percent of volume outstanding. Four challenges stand out:
- Large search-for-yield inflows might have introduced new fragilities, or exacerbated existing fragilities, in financial systems of EMDEs as they set in motion a potentially unsustainable financial feedback loop. That loop produces short-term economic growth, but it can put pressure on currencies; interfere with the local credit cycle and monetary policy; produce shadow-banking risks; distort asset prices; and have an impact on incentives for structural reform.
- The recent trend of a rapidly strengthening U.S. dollar against most EMDE currencies is another risk factor. It affects external-debt sustainability in EMDEs, since most external debt is denominated in foreign currencies.
- Spillovers of vulnerabilities in the asset-management industry in developed markets.Fund allocations to EMDEs have grown significantly. In a search-for-yield environment, this industry has taken on less liquid exposures and in some cases took on leverage. At the same time, fund investors typically expect to be able to redeem their investments on short notice. Therefore, in a worst case scenario, this liquidity mismatch could produce a fire-sale cycle in which investors run for the exit and cause prices to drop, which could be triggered, for example, by an interest-rate increase (or fear of such an increase). Spillover effects to other markets and across borders may directly affect asset prices and funding costs in EMDEs.
- EMDE fragility is compounded by less developed financial frameworks including shallow local financial markets and a lack of strong institutions, supervisory and surveillance capacity, technical experience and (macro)prudential tools.
Third: The impact of the oil-price decline and increasing oil-price volatility will produce winners and losers in EMDEs with implications for financial markets and flows. Oil prices fell from more than $100 a barrel in the summer of 2014 to about $50 at the start of 2015. The shift in wealth from oil exporters to importers could add up to about $750 billion annually. Persistent low oil prices will boost consumption, investment and external positions in net importers as balance sheets and income positions improve and as lower inflation provides central banks with policy space. For net oil exporters, the opposite is true. Their dilemma is compounded by price volatility, which erodes debt sustainability. Oil exporters’ vulnerabilities differ, depending on the external account, exchange-rate regime, their type of exposure to foreign creditors, their overall public debt position, and the strength of their domestic banks and markets.
Fourth: The process of global rebalancing has produced weak aggregate global demand with potentially disruptive implications for global financing patterns and growth prospects. Before 2008, distorted global savings and investment dynamics produced record-high current-account imbalances, triggering unsustainable cross-border financing patterns. Post-crisis, imbalances have fallen at the cost of demand compression in deficit countries and little offset in surplus countries. This form of adjustment contributed to falling inflation, rising unemployment, slowing global trade and rising trade tensions, and a weakening growth performance and outlook. Indeed, disinflationary pressures have been evident on a global scale. A lack of global demand deprives some EMDEs of an external growth driver as well as of a source of foreign exchange, which can help them service external debt. This is important because global stock imbalances (i.e. net foreign liabilities to GDP) have continued to grow – a factor that contributes to rising external financial vulnerabilities. In this context, global imbalances could widen again due to surplus economies that pursue EMPs, which weaken their currencies and widen their surpluses further.
Fifth: High global debt levels pose challenges to an orderly deleveraging process and exacerbate weak growth and disinflation pressures. Total debt in developed and emerging markets (public and private) has continued to rise to 212 percent of GDP in 2013 (excluding financials) – up by 38 percentage points since 2008. Most of the post-crisis leverage growth occurred in EMDEs as they pursued their own debt-fueled, countercyclical measures to support growth. Such high levels of global debt could produce debt-overhang effects that adversely affect a wide range of economic behaviors and incentives. That could produce a feedback loop in which debt-sustainability concerns undermine nominal economic growth and create deflationary pressures – which, in turn, cast additional doubt on debt sustainability.
Sixth: Continuing geopolitical and idiosyncratic risks pose contagion challenges that could trigger spikes in global financial market volatility. Turmoil in the Middle East, along with the Russia-Ukraine crisis, are key drivers behind geopolitical volatility. That could lead to regional spillovers, as well as disruptions in the global energy markets, causing increased risk aversion in financial markets. Tensions surrounding Greece and the future of the European monetary union have also recently increased.
These interrelated financial challenges compound the relatively weak economic growth outlook – causing continuing headwinds for emerging and developing economies (EMDE).
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Erik Feyen is a Lead Financial Economist in the Finance & Markets Global Practice of the World Bank Group. He heads the Practice’s global financial systems monitoring team and has led banking and capital market work for client countries in Asia, Latin-America, sub-Saharan Africa, the Caribbean, and the Middle-East. He previously worked as a management consultant. Erik holds a PhD in Finance from the University of Amsterdam and studied at Toulouse School of Economics and Delft University of Technology. Erik’s work has appeared in professional and academic publications including the Journal of Financial Economics, World Bank Economic Review, and the Journal of Financial Perspectives.
Courtesy of The World Bank, © 2015 The World Bank Group