Unconventional Monetary Policy Normalization in High-Income Countries : Implications for Emerging Market Capital Flows and Crisis Risks
As the recovery in high-income countries firms amid a gradual withdrawal of extraordinary monetary stimulus, developing countries can expect stronger demand for their exports as global trade regains momentum, but also rising interest rates and potentially weaker capital inflows. This paper assesses the implications of a normalization of policy and activity in high-income countries for financial flows and crisis risks in developing countries. In the most likely scenario, a relatively orderly process of normalization would imply a slowdown in capital inflows amounting to 0.6 percent of developing-country GDP between 2013 and 2016, driven in particular by weaker portfolio investments. However, the risk of more abrupt adjustments remains significant, especially if increased market volatility accompanies the unwinding of unprecedented central bank interventions. According to simulations, abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50 and 80 percent for several months. Evidence from past banking crises suggests that countries having seen a substantial expansion of domestic credit over the past five years, deteriorating current account balances, high levels of foreign and short-term debt, and over-valued exchange rates could be more at risk in current circumstances. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms and countercyclical macroeconomic and prudential policies to deal with a retrenchment of foreign capital. In other cases, where the scope for maneuver is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows.
| Summary: | As the recovery in high-income countries
firms amid a gradual withdrawal of extraordinary monetary
stimulus, developing countries can expect stronger demand
for their exports as global trade regains momentum, but also
rising interest rates and potentially weaker capital
inflows. This paper assesses the implications of a
normalization of policy and activity in high-income
countries for financial flows and crisis risks in developing
countries. In the most likely scenario, a relatively orderly
process of normalization would imply a slowdown in capital
inflows amounting to 0.6 percent of developing-country GDP
between 2013 and 2016, driven in particular by weaker
portfolio investments. However, the risk of more abrupt
adjustments remains significant, especially if increased
market volatility accompanies the unwinding of unprecedented
central bank interventions. According to simulations, abrupt
changes in market expectations, resulting in global bond
yields increasing by 100 to 200 basis points within a couple
of quarters, could lead to a sharp reduction in capital
inflows to developing countries by between 50 and 80 percent
for several months. Evidence from past banking crises
suggests that countries having seen a substantial expansion
of domestic credit over the past five years, deteriorating
current account balances, high levels of foreign and
short-term debt, and over-valued exchange rates could be
more at risk in current circumstances. Countries with
adequate policy buffers and investor confidence may be able
to rely on market mechanisms and countercyclical
macroeconomic and prudential policies to deal with a
retrenchment of foreign capital. In other cases, where the
scope for maneuver is more limited, countries may be forced
to tighten fiscal and monetary policy to reduce financing
needs and attract additional inflows. |
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