The World Bank warned on Tuesday that monetary policy tightening by the US Federal Reserve could spur a “perfect storm” of threats to growth and financial stability in developing economies.
Regardless of whether the Fed begins raising interest rates at this week’s meeting or later, World Bank economists said in a report that the shift in policy could pose huge challenges to so-called emerging and frontier economies (EFEs) that are particularly vulnerable.
It would come as both global economic growth and trade have turned down and sinking commodity prices have particularly hurt a number of developing economies, the report said, and economic growth among EFEs is already the lowest since the financial crisis.
Many have trade and budget shortfalls, and their governments and companies have high levels of US dollar debt that make them particularly vulnerable to tighter conditions in global markets and a stronger US dollar.
In the worst case, the report said, capital flows to developing economies could dry up suddenly, creating “formidable policy challenges for vulnerable countries.”
“Emerging and frontier market economies may hope for the best during the upcoming tightening cycle, but given the substantial risks involved, they would do well to buckle their seatbelts in case the ride gets bumpy,” said Carlos Arteta, lead economist in the bank’s Development Prospects Group.
The Fed’s initial hike, expected to be just 0.25 percentage points, would be the first in more than nine years and come after the US central bank held the benchmark federal funds rate at an extraordinary between 0 percent and 0.25 percent since the 2008 crisis.
However, it would likely begin a series of increases as the Fed seeks to get rates back to more “normal” levels at about 3 percent over the next couple years.
The report said that, since the Fed has already given ample warning of its plans, markets could actually stay fairly calm. It added that if a real strengthening of the US economy underpins the rate increases, that is likely good for the rest of the world.
“Since the tightening cycle has been widely anticipated and will take place gradually in the context of a robust US economy, it is expected to have a benign impact on capital inflows to EFEs,” it said.
However, the report stressed that, in the worst case, weak global conditions could lead to sudden, severe “systemic” halts to capital flows that could sharply hit growth in some countries, forcing some into contraction.
“Financial market volatility during the tightening cycle could potentially combine with domestic fragilities into a perfect storm that could lead to a sharp reduction in capital flows to more vulnerable countries,” it said.
“Emerging and frontier market economies may hope for the best during the upcoming tightening cycle but, given the substantial risks involved, they need to prepare for the worst,” the report said.
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