Markets wary - But QE may not be so traumatic

THE World Bank is taking a sanguine, but cautious view of likely reaction to the first upward movement of US interest rates. It believes the first real impact will be on interest costs, which could impact emerging and developing economies over coming months . . .

WORLD economies, including those of Asia, await with considerable wariness the ramifications in global financial markets of the first rise in American interest rates. The World Bank, for its part, believes the impact may not be as traumatic as feared.
Looking back to when Washington first began reversing its quantitative easing (QE) back in 2013 — when there was initial panic in global markets — the World Bank says the market eventually took the move in its stride.
As with QE, the so-called liftoff (lifting of interest rates) in the US, expected some time this year, will likely be gradual. That said, there is still a need to be cautious — especially for countries with weaker economic fundamentals.
The World Bank in its latest Global Economic Prospects (GEP) report, released in June, says the first impact will be on borrowing costs. These will become more expensive for emerging and developing economies over coming months. However, the Bank adds this process is expected to unfold relatively smoothly —
because the US economic recovery is continuing, and interest rates remain low in other major economies.
It will be the first time since the Global Financial Crisis that the US Federal Reserve has increased interest rates after keeping them at record lows to stimulate the US economy.
In a world used to the liquidity generated by the US QE programme, a rate rise could ignite market volatility and reduce capital flows to emerging markets by up to 1.8 percentage points of GDP, says the Bank.
So far, global borrowing costs have remained low, partly as a result of monetary stimulus by the European Central Bank. The GEP report says that, on balance, considering the sizeable impact of US monetary policy decisions on global financial markets, global borrowing costs are expected to rise with the launch of the tightening cycle in the US.
With the US economic recovery and the prospect of an interest rate lift-off, the US dollar has been appreciating against other currencies in recent times. The GEP report says many countries will face an added debt service burden
because of the rise of the US dollar — and higher borrowing costs.
If the lift-off takes place in line with market expectations, the Bank says, US long-term yields will likely remain well contained, the term premium (the yield expected by US bond investors) will remain narrow, and movements in capital flows to emerging countries will be modest. The Bank notes that emerging markets have become more resilient since the early 2000s. Fewer have fixed exchange rates, most have sounder fiscal positions and better monetary policy frameworks, and the extent of dollarisation liability has declined.
Nevertheless, the taper tantrum in 2013 — when the US Fed indicated the end of QE — is a reminder that emerging market currencies could depreciate sharply, that local borrowing costs could rise steeply, and that balance sheets could come under pressure.
During the taper tantrum episode, a jump in US long-term interest rates led, initially, to financial stress across the entire spectrum of emerging market assets. But given that then-developing countries were in a strong economic position, they were able to adjust to withstand initial panic in the financial market.
While lessons might have been learned from the taper tantrum, the reality is that economic prospects in the developing world are somewhat weaker today.
Many developing countries are commodity exporters — and persistently lower global commodity prices –— and lower demand — are having an impact on their export incomes, and straining their fiscal positions.
The Bank says that, unless governments put in place appropriate policy measures, the sudden realisation of risks around the lift-off could potentially spark a “perfect storm” in some emerging market economies.
It says that in East Asia and the Pacific
region, growth is expected to ease to 6.7 per cent this year – and to remain stable over the next two years. The slowdown in China is the main reason for this. China is on course to ease to 7.1 per cent this year, and regional growth (excluding China) is projected to be 4.9 per cent — rising to 5.4 per cent by 2016.
China’s growth is expected to decelerate,
according to the bank — to 6.9 per cent in 2017.
The Bank has revised downwards its growth forecast for developing economies for 2015 — from 4.8 per cent forecast in January to 4.4 per cent in June. Its global forecast is for 2.8 per cent growth this year – again lower than anticipated in January. In contrast, recovery is gaining momentum in high-income countries. Economic activity in the Euro area and Japan has picked up, while the United States continues to expand, the Bank says.
The lower prices for oil and other strategic commodities have intensified the slowdown in developing countries, many of which depend heavily on commodity exports. The Bank says that while commodity importers are benefitting from lower inflation, fiscal spending pressures and import costs, low oil prices have, so far, been slow to spur more economic activity.
The reason is that these countries face persistent shortages of electricity, transport, irrigation, and other key infrastructure. They are also weighed down by political uncertainty and natural disasters – flooding and drought. By contrast, the Bank says recovery in the Euro area has been more rapid than expected since late 2014, supported by a weakening euro, declining oil prices, record-low interest rates and improving European bank credit.
Japan also started to pick up in late 2014, and was robust in the first quarter of 2015. Growth there is predicted to average 1.1 per cent this year before accelerating to 1.7 per cent next year. And despite a weak start to 2015, the US
recovery is continuing.
The high-income countries are expected to grow two per cent this year, accelerating to 2.4 per cent next year.
Their stronger growth, and improvement in the developing world generally, will lead to better growth prospects for the global economy in 2016 and 2017 – with forecasts of 3.3 per cent and 3.2 per cent respectively.