World Bank warns of capital flow risk to emerging markets

January 15, 2014 1:01 am

World Bank warns of capital flow risk to emerging markets

By Ralph Atkins in London

An abrupt unwinding of central bank support for advanced world economies could cause capital flows to emerging markets to contract by as much as 80 per cent, inflicting significant economic damage and throwing some countries into crises, theWorld Bank has warned.Capital flows into emerging markets are influenced more by global than domestic forces, leaving them vulnerable to disorderly changes in policy by the US Federal Reserve, concludes a study by World Bank economists.

It highlights the risk of a repeat on a larger scale of last year’s turmoil in emerging markets after Ben Bernanke, Federal Reserve chairman, first hinted in May at plans to “taper” the central bank’s asset purchase programme. The effects “are likely to be concentrated among middle-income countries with deeper financial markets and domestic imbalances”, it says.

Although the World Bank’s “baseline” scenario is for a smooth adjustment that would lead only to a “modest retrenchment” in emerging market capital inflows, it warns that last year’s experience and the unprecedented nature of central banks’ policies mean long-term interest rates in the world’s biggest economies are prone to a sudden rise – by as much as 200 basis points.

“In a disorderly adjustment scenario, financial inflows to developing countries could decline by as much as 80 per cent for several months, falling to about 0.6 per cent of developing country gross domestic product,” the report says.

It adds: “Nearly a quarter of developing countries could experience sudden stops in their access to global capital, substantially increasing the probability of economic and financial instability . . . For some countries, the effects of a rapid adjustment in global interest rates and a pullback in capital flows could trigger a balance of payments or domestic financial crisis.”

Last year’s “taper turmoil”, saw yields on 10-year US Treasuries rise by 100 basis points. Investors withdrew $64bn from developing country mutual funds between June and August. Countries such as Brazil, India, Indonesia, Malaysia, Turkey and South Africa saw sharp sell-offs in equity, bond and currency markets.

When the Fed unveiled details of the “taper” in December there was much less turmoil, which boosted confidence in markets that the Fed could ensure a smooth transition. But Andrew Burns, the World Bank’s manager of global macroeconomics, said last year’s turmoil “was a warning shot over the bows of emerging markets to address their weaknesses”.

According to World Bank calculations, global factors, including US interest rates, explained about 60 per cent of the increase in capital flows into developing countries between 2009 and 2013. Its economic model shows portfolio investment flows and flows into mutual funds would be affected much more by “tapering” than would bank lending or foreign direct investment.

The countries hit hardest would be those where portfolio flows are relatively large – such as in east Asia, Europe and central Asia. Another region likely to be heavily affected would be sub-Saharan Africa, where capital flows are equivalent to a large share of the region’s GDP even though portfolio flows are only a relatively small share of overall flows.

While the World Bank report argues the disruption caused by changes in central bank policies might be shortlived, it could still create “serious stresses” in some countries. “Crises in developing countries general follow a period of surging capital inflows, and occur in the same year as a sudden retrenchment,” it observes.