| Abstract: |
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. |