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Turbulence could be approaching as the US central bank prepares to wind back its massive stimulus programme, and emerging economies would be in the front line.
The International Monetary Fund has warned this morning that emerging markets could suffer painful spillovers once the US Federal Reserve starts to tighten monetary policy. With US inflation hitting near 40-year highs, US interest rates could rise soon.
Those spillovers could include capital surging out of emerging markets, dragging down their currencies. That would be particularly serious for countries with large debts or high inflation.
The IMF explains in a new blogpost this morning:
Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally.
These developments could come with a slowing of US demand and trade and may lead to capital outflows and currency depreciation in emerging markets.
The Fed is on track to end its asset-purchase programme in March, and expects to raise interest rates three times this year.
The minutes of its December meeting show that it could start to cut its balance sheet, known as quantitative tightening (QT), soon too — news that rattled the markets last week.
Such tightening could have more severe implications for vulnerable countries, the IMF adds:
In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower current-account balances saw already larger movements of their currencies relative to the US dollar.
The combination of slower growth and elevated vulnerabilities could create adverse feedback loops for such economies.
So, with the Fed sounding hawkish, and omicron hitting supply chains and pushing up costs, emerging market policymakers need to prepare for a storm.
Several emerging economies, such as Brazil, Russia, and South Africa, raised their interest rates in 2021, due to high inflation.
But more action may be needed. Those with high debts denominated in foreign currencies should look to reduce, or hedge, that exposure, while those with high debts may need to cut spending or lift taxes faster, the IMF says.
Such ‘fiscal tightening’ would weigh on growth and employment, of course, which highlights the dilemma facing emerging market politicians and central bankers.
Worryingly, the IMF also warns that there could be bank failures in some weaker countries, saying:
For countries where corporate debt and bad loans were high even before the pandemic, some weaker banks and nonbank lenders may face solvency concerns if financing becomes difficult. Resolution regimes should be readied.
The ongoing Covid-19 pandemic also threatens emerging markets — many of whom have not benefitted from the mass vaccination rollouts seen in advanced economies.
The IMF concludes:
While the global recovery is projected to continue this year and next, risks to growth remain elevated by the stubbornly resurgent pandemic.
Given the risk that this could coincide with faster Fed tightening, emerging economies should prepare for potential bouts of economic turbulence.
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