Developing countries warned to brace for possible tremors as US tightens monetary policy

Developing economies, like those in the Caribbean, should brace for possible financial market turbulence from the upcoming U.S. monetary policy tightening cycle, according to a new World Bank policy research paper released ahead of this week’s meeting by the U.S. Federal Reserve’s policy-setting Federal Open Market Committee.
The new paper “The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?” suggests that while a likely rise in US interest rates, which would be the Fed’s first rate hike since 2006, has been widely telegraphed to world financial markets and the public, it nonetheless runs a risk of being associated with market volatility.
The Fed has set the stage for the tightening cycle carefully and there is every reason to envision a smooth transition with benign effects on emerging and frontier markets. However, there can be financial market volatility even around a long-anticipated Fed policy change. This could lead to a sizable drop in capital inflows to emerging and frontier markets.
The new research paper assesses the potential impact on developing economies if financial market reaction to Fed tightening mirrors the upheaval that occurred after the U.S. central bank signaled in May 2013 that it was poised to taper its pace of quantitative easing.
“Financial stress in global markets tends to disproportionately affect emerging and frontier economies,” said Kaushik Basu, World Bank Chief Economist and Senior Vice President. “This paper explores how market volatility resulting from the upcoming tightening cycle could relay significant adverse implications for growth and financial stability. This would fall the most heavily on the most vulnerable countries.”
Volatility and disruptions are particularly likely in a global economy that is adjusting to weakening growth prospects, slowing international trade, and persistently lower commodity prices. In the current environment, some emerging and frontier markets are more vulnerable than, for example, during the taper tantrum in 2013. Activity has slowed in many emerging markets in recent years, and growth in emerging markets in 2015 is expected to be the weakest since the global financial crisis.
“Risks are compounded by recent spikes in volatility in global financial markets and deteriorating growth prospects in developing economies,” said Ayhan Kose, Director of the World Bank’s Development Prospects Group. “An abrupt change in risk appetite for emerging market assets could become contagious and affect capital flows to many countries.”
A sudden drying up of capital flows to emerging markets could create formidable policy challenges for vulnerable countries.
To brace for possible shocks triggered by the Fed’s policy tightening, developing countries need to strengthen the resilience of their economies and take steps to speed growth. Countries facing high inflation should implement credible monetary policies to contain it. Regulators should maintain close oversight over banks with large foreign currency liabilities.
Fiscal policies can support growth if budgets permit. Structural reforms can be slow to show benefits, but decisive reform agendas can signal to investors that growth prospects are improving. Exchange rate flexibility can buffer against shocks, but need to be complemented by monetary policy measures or targeted interventions to support orderly market functioning.
Lead Economist in the World Bank’s Development Prospects Group, Carlos Arteta, said 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”.