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Latest Global Financial Stability Report says higher interest rates could weigh on recovery in emerging markets.

VIEW IN BROWSER Global Financial Stability and Interest Rates While emerging markets suffered huge portfolio outflows at the beginning of the pandemic, the latest Global Financial Stability Report (GFSR) shows capital flows have returned and the outlook continues to improve, partly because of low interest rates in countries such as the United States. The new report takes a close look at the possibility of rising interest rates and what that would mean for emerging market economies trying to recover from the pandemic. Fabio Natalucci is Deputy Director of the Monetary and Capital Markets Department and heads the GFSR. In this podcast, he says a lagging recovery in emerging markets is a risk to global financial stability. Transcript Read the report Read the blog Transcript The latest IMF analysis of global economics, finance, development and policy issues shaping the world //   Dear maria, We just published a new blog—please find the full text below. Translations coming soon. An Asynchronous and Divergent Recovery May Put Financial Stability at Risk By Tobias Adrian After enduring a tumultuous 2020, the global economy is finally emerging from the worst phases of the COVID-19 pandemic, albeit with prospects diverging starkly across regions and countries—and only after a “lost year” spent in suspended animation. The economic trauma would have been much worse if the global economy had not been supported by the unprecedented policy actions taken by central banks and by the fiscal measures implemented by governments. Global markets are watching the current rise of US long-term interest rates, worried that a rapid and persistent increase may result in tighter financial conditions, potentially hurting growth prospects. Since August 2020, the yield on the US 10-year Treasury note has risen by 1¼ percentage points to around 1¾ percent in early April 2021, returning close to its pre-pandemic level of early 2020. The good news is that the rising rates in the United States have been spurred in part by improving vaccination prospects and strengthening growth and inflation. Both nominal and real interest rates have risen, although nominal yields have risen more, suggesting that market-implied inflation—the difference between yields on nominal and inflation-indexed Treasury securities—is recovering. Allowing a modest amount of inflation has been an intended objective of easy monetary policy.   The bad news is that the increase may reflect uncertainty about the future path of monetary policy and possibly investor concerns about the increased supply of Treasury debt to finance the fiscal expansion in the United States, as reflected by sharply rising term premia (investors’ compensation for interest-rate risk). Market participants are beginning to focus on the timing of the Federal Reserve’s tapering of its asset purchases, which could push long-term rates and funding costs higher, thereby fueling a tightening of financial conditions, especially if associated with a decline in risk assets’ prices.   Global implications To be clear, global rates remain low by historical standards. But the speed of the adjustment in rates can generate unwelcome volatility in global financial markets, as witnessed this year. Assets are priced on a relative basis, and the price of every financial asset—from a simple mortgage loan to emerging market bonds—is directly or indirectly linked to benchmark US rates. The rapid and persistent rise in rates this year has been accompanied by an increase in volatility, with a risk that such fluctuations might intensify. Any abrupt and unexpected increase in rates in the United States may translate into a tightening of financial conditions, as investors shift into “reduce risk exposure, protect capital” mode. This could be a concern for risk asset prices. Valuations appear stretched in some segments of financial markets, and vulnerabilities are rising further in some sectors. Thus far, overall global financial conditions have remained easy. But in countries where the recovery is slower and where vaccinations are lagging, their economies may not yet be ready for tighter financial conditions. Policymakers may be forced to use monetary and exchange-rate policies to offset any potential tightening. While government bond yields have also risen somewhat in countries in Europe and elsewhere, albeit less so than in the United States, the greatest concern comes from emerging markets, where investor risk appetite may shift quickly. With many of those countries confronting large external financing needs, a sudden sharp tightening in global financial conditions could threaten their post-pandemic recovery. The recent volatility in portfolio flows to emerging markets is a reminder of the fragility of these flows. Meeting the needs of tomorrow While several emerging market economies have adequate international reserves, and external imbalances are generally less pronounced as a result of the large import compression, some emerging market economies may face challenges in the future, especially if inflation rises and borrowing costs continue to grow. Emerging market local currency yields have risen meaningfully, driven importantly by an increase in term premia. Our estimate is that a 100 basis point rise in US term premia is associated, on average, with a 60 basis point rise in emerging market term premia. Many emerging markets have sizeable financing needs this year, so they are exposed to the risk of higher rates once they refinance debt and fund large fiscal deficits in the months ahead. Countries that are in weaker economic positions, for example owing to limited access to vaccines, may also face portfolio outflows. For many frontier market economies, access to funding remains a primary concern given limited access to bond markets.   As countries adjust policies to overcome the pandemic, major central banks will need to carefully communicate their policy plans to prevent excess volatility in financial markets. Emerging markets may need to consider policy measures to address excessive tightening of domestic financial conditions. But they will have to be mindful of policy interactions and their own economic and financial conditions, as they make use of monetary, fiscal, macroprudential, capital-flow management, and foreign-exchange intervention. Continuing policy support remains necessary, but targeted measures are also needed to address vulnerabilities and to protect the economic recovery. Policymakers should support balance-sheet repair—for example, by strengthening the management of nonperforming assets. Rebuilding buffers in emerging markets should be a policy priority to prepare for a possible repricing of risk and a potential reversal of capital flows. As the world begins to turn the page on the COVID-19 pandemic, policymakers will continue to be tested by an asynchronous and divergent recovery, a widening gap between rich and poor, and increased financing needs amid constrained budgets. The Fund remains ready to support its member nations’ policy efforts in the uncertain period ahead. Tobias Adrian is the Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department. ****** Thank you again for your interest in IMF Blog. Read more of our latest content here. Take good care, Glenn Gottselig Blog Editor, IMF GGottselig@IMF.org Dear maria, We just published a new blog—please find the full text below. Translations coming soon. Also, starting right now: the April 2021 World Economic Outlook (WEO) growth forecasts. Managing Divergent Recoveries By Gita Gopinath It is one year into the COVID-19 pandemic and the global community still confronts extreme social and economic strain as the human toll rises and millions remain unemployed. Yet, even with high uncertainty about the path of the pandemic, a way out of this health and economic crisis is increasingly visible. Thanks to the ingenuity of the scientific community hundreds of millions of people are being vaccinated and this is expected to power recoveries in many countries later this year. Economies also continue to adapt to new ways of working despite reduced mobility, leading to a stronger than anticipated rebound across regions. Additional fiscal support in large economies, particularly the United States, has further improved the outlook.  In our latest World Economic Outlook, We are now projecting a stronger recovery for the global economy compared with our January forecast, with growth projected to be 6 percent in 2021 (0.5 percentage point upgrade) and 4.4 percent in 2022 (0.2 percentage point upgrade), after an estimated historic contraction of -3.3 percent in 2020.   Nonetheless, the future presents daunting challenges.  The pandemic is yet to be defeated and virus cases are accelerating in many countries. Recoveries are also diverging dangerously across and within countries, as economies with slower vaccine rollout, more limited policy support, and more reliant on tourism do less well. The upgrades in global growth for 2021 and 2022 are mainly due to upgrades for advanced economies, particularly to a sizeable upgrade for the United States (1.3 percentage points) that is expected to grow at 6.4 percent this year. This makes the United States the only large economy projected to surpass the level of GDP it was forecast to have in 2022 in the absence of this pandemic. Other advanced economies, including the euro area, will also rebound this year but at a slower pace. Among emerging markets and developing economies, China is projected to grow this year at 8.4 percent. While China’s economy had already returned to pre-pandemic GDP in 2020, many other countries are not expected to do so until 2023.  Daunting challenges ahead These divergent recovery paths are likely to create wider gaps in living standards across countries compared to pre-pandemic expectations. The average annual loss in per capita GDP over 2020-24, relative to pre-pandemic forecasts, is projected to be 5.7 percent in low-income countries and 4.7 percent in emerging markets, while in advanced economies the losses are expected to be smaller at 2.3 percent. Such losses are reversing gains in poverty reduction, with an additional 95 million people expected to have entered the ranks of the extreme poor in 2020 compared with pre-pandemic projections.   Uneven recoveries are also occurring within countries as young and lower-skilled workers remain more heavily affected. Women have also suffered more, especially in emerging market and developing economies. Because the crisis has accelerated the transformative forces of digitalization and automation, many of the jobs lost are unlikely to return, requiring worker reallocation across sectors—which often comes with severe earnings penalties. Swift policy action worldwide, including $16 trillion in fiscal support, prevented far worse outcomes. Our estimates suggest last year’s severe collapse could have been three times worse had it not been for such support. Because a financial crisis was averted, medium-term losses are expected to be smaller than after the 2008 global financial crisis, at around 3 percent. However, unlike after the 2008 crisis, it is emerging markets and low-income countries that are expected to suffer greater scarring given their more limited policy space.   A high degree of uncertainty surrounds our projections. Faster progress with vaccinations can uplift the forecast, while a more prolonged pandemic with virus variants that evade vaccines can lead to a sharp downgrade. Multi-speed recoveries could pose financial risks if interest rates in the United States rise further in unexpected ways. This could cause inflated asset valuations to unwind in a disorderly manner, financial conditions to tighten sharply, and recovery prospects to deteriorate, especially for some highly leveraged emerging markets and developing economies. Working together to give people a fair shot Policymakers will need to continue supporting their economies while dealing with more limited policy space and higher debt levels than prior to the pandemic. This requires better targeted measures to leave space for prolonged support if needed. With multi-speed recoveries, a tailored approach is necessary, with policies well-calibrated to the stage of the pandemic, the strength of the economic recovery, and the structural characteristics of individual countries. Right now, the emphasis should be on escaping the health crisis by prioritizing health care spending—on vaccinations, treatments, and health care infrastructure. Fiscal support should be well targeted to affected households and firms. Monetary policy should remain accommodative (where inflation is well behaved), while pro-actively addressing financial stability risks using macroprudential tools. As the pandemic is beaten back and labor market conditions normalize, support such as worker retention measures should be gradually scaled back. At that point, more emphasis should be placed on reallocating workers, including through targeted hiring subsidies, and reskilling of workers. As exceptional measures such as moratoria on loan payments are withdrawn, firm insolvencies could rise sharply and put one in ten jobs at risk in many countries. To limit long-term damage countries should consider converting previous liquidity support (loans) into equity-like support for viable firms, while developing out-of-court restructuring frameworks to expedite eventual bankruptcies. Resources should also be devoted to helping children catch-up on lost instructional time during the pandemic. Once the health crisis is over, policy efforts can focus more on building resilient, inclusive, and greener economies, both to bolster the recovery and to raise potential output. The priorities should include green infrastructure investment to help mitigate climate change, digital infrastructure investment to boost productive capacity and strengthening social assistance to arrest rising inequality. Financing these endeavors will be more difficult for economies with limited fiscal space. In such cases, improving tax capacity, increasing tax progressivity (on incomes, property and inheritance taxation), deploying carbon pricing, and eliminating wasteful expenditures will be essential. All countries should anchor policies in credible medium-term frameworks and adhere to the highest standards of debt transparency to help contain borrowing costs and eventually reduce debt and rebuild buffers for the future.  On the international stage, first and foremost, countries need to work together to ensure universal vaccination.  While some countries will get to widespread vaccinations by this summer, most, especially low-income countries will likely have to wait till end-2022. Speeding up vaccinations will require ramping up vaccine production and distribution, avoiding export controls, fully funding the COVAX facility on which many low-income countries rely for doses, and ensuring equitable global transfers of excess doses. Policymakers should also continue to ensure adequate access to international liquidity. Major central banks should provide clear guidance on future actions with ample time to prepare, to avoid taper-tantrum kinds of episodes as occurred in 2013. Low-income countries will benefit from further extending the pause on debt repayments under the Debt Service Suspension Initiative and operationalizing the G20 Common Framework for orderly debt restructuring. A new allocation of the IMF’s Special Drawing Rights will provide needed liquidity protection in highly uncertain times. Even while all eyes are on the pandemic, it is essential that progress is made on resolving trade and technology tensions. Countries should also cooperate on climate change mitigation, on modernizing international corporate taxation, and on measures to limit cross-border profit shifting, tax avoidance, and evasion.  Over the past year, we have seen significant innovations in economic policy and massively scaled-up support at the national level, particularly among advanced economies that have been able to afford these initiatives. A similarly ambitious effort is now needed at the multilateral level to secure the recovery and build forward better. Without additional efforts to give all people a fair shot, cross-country gaps in living standards could widen significantly and decades-long progress in global poverty reduction could reverse.   Gita Gopinath is the Economic Counsellor and Director of the Research Department at the International Monetary Fund.  ****** Thank you again for your interest in IMF Blog. Read more of our latest content here. Take good care, Glenn Gottselig Blog Editor, IMF GGottselig@IMF.org