The event, which has come to be known as tapering, prompted a sharp, negative response from financial markets (the so-called taper tantrum): US long rates rose by almost one percentage point between late May and August, and the concomitant rebalancing of global portfolios away from emerging-market assets resulted in capital outflows and currency depreciations in several large emerging-market countries. Brazil, India, Indonesia, South Africa and Turkey were particularly affected.
Surprised by the strength of the market responseand further bolstered by somewhat tepid labour market datathe Fed held back on actual tapering action over the course of the rest of the year. In the interim, it pressed on with conditioning market expectations for an eventual slowdown in large-scale asset purchases. The long-awaited taper eventually began in early January 2014.
How will Fed policy normalisation unfold in the years ahead
This question is crucial for developing economies, since they have benefited substantially from increased inflows over the period in which QE policies have been in placetotal gross inflows as a share of GDP appear to have picked up over the course of all three QE episodes (figure 1). The risk of reversals in such inflows is therefore a genuine concern as the Fed embarks on its normalisation plans.
Much work has been done on identifying factors associated with financial inflows. Our recent research builds on this to address the effects of monetary policy normalisation on financial flows to developing countries (World Bank 2014). Our approach relies on a suite of three models for financial flows and crisis that incorporate elements designed to capture the effects of QE unwinding.
The first model that we use to establish our baseline scenario is a dynamic panel model. This model allows for the tremendous cross-country heterogeneity in gross financial flows, while also accounting for the effects accruing to global and domestic factors that can potentially affect inflows. These include real (growth and growth expectations) and financial (interest rates, interest rate differentials, and the VIX index) conditions, alongside institutional drivers (such as country credit ratings). Crucially, in addition to (time-invariant) country fixed effects, we also include a series of indicator variables that are designed to capture whether episodes of QE may have had an effect on financial flows over and above the observable channels.
The estimates from this model are summarised in figure 2, which shows the response of capital inflows to a change of one standard deviation in each of the explanatory variables. The estimateswhich are broadly consistent with the existing literature on factors associated with financial inflowsindicate that while observable factors at both the global and domestic level account for much of the cross-country variation in flows, an (unobservable) QE-specific effect remains, which can account for the larger-than-expected financial flows during the period in which unconventional monetary policies were in place. Between the first half of 2009 and first half of 2013, our estimates indicate that observable global factors explained slightly less than two-thirds of the increase in inflows, of which around a fifth was due to this QE-specific effect (figure 2).
We then use this model to simulate a baseline scenario for financial flows as global conditions normalise. These simulations are conditioned on the following underlying assumptions: Developing and high-income country GDP growth gradually strengthens in line with the projections reported in World Bank (2014); QE tapering by the US Federal Reserve spans from January to December 2014, and has a very gradual effect on market conditions. It adds 50 basis points to US long-term interest rates by the end of 2015 and a cumulative 100 basis points by the end of 2016. Policy rates in the US start to increase in Q3 2015, from 0.25% to 2% by the end of 2016;
The results for the baseline are a decline of capital inflowsrelative to a no change status quoof about 10% by 2016, or 0.6% of developing-country GDP by 2016.
The foregoing results assume that monetary authorities in high-income countries are able to engineer a gradual increase in long-term interest rates as quantitative easing is withdrawn in line with improved growth conditions. However, the taper tantrum in the middle of 2013 suggests that a smooth market reaction to the actual tapering of quantitative easing is far from assured. The second model we consider is a six-dimensional vector autoregression model (VAR)comprising gross inflows, developing-country GDP growth, G4 GDP growth, short-term interest rates, yield curves, and the VIXthat offers greater flexibility in capturing such disequilibrium scenarios. The two scenarios that we explore with this model are:
n Fast normalisation: long-term interest rates snap up by 100 basis points in the first half of 2014, before gradually converging back to baseline levels over the subsequent two years; and n Overshooting: market reactions are assumed to be more abrupt, resulting in a sharp, 200 basis-point increase in long-term interest rates in first half of 2014, followed by a more protracted adjustment back to the baseline.
In the fast normalisation scenario, the resulting increase in market volatility and rising risk aversion leads to a sharper but partially temporary correction in flows. In this context, private capital inflows drop by an average 30% in 2014, with a peak impact of 50% toward the end of the year. In the overshooting scenario, flows drop by 45% in 2014 as whole, and up to 80% at the peak impact. These simulations are captured in figure 3.
The preceding analysis suggests that in the long run, the withdrawal of quantitative easing and a return to a tighter monetary policy in high-income countries will have a relatively small impact on capital inflows, reducing them from 4.6% of developing-country GDP in Q3 2013 to 4.0% by the end of 2016. However, the path to this new normal level of flows will matter. If market reactions to tapering decisions are precipitous, developing countries could see flows decline by as much as 80% for several months. That would raise the likelihood of abrupt stops at the country level, with more than 25% of individual economies experiencing such an episode in these circumstances.
We thus rely on a third model, a (pooled) Probit for banking crises, to examine the vulnerability of countries in the extreme case where monetary policy normalisation precipitates crises in emerging markets. The probability that a country suffers a banking crisis is modelled as a function of global factors (such as global risk appetite and liquidity), contagion factors (such as trade and financial linkages), and domestic factors (such as the current account and fiscal balance).
The model points to all three of these sets of factors contributing to increased banking crisis risk. Although conditions on the ground will vary and the indicators need to be interpreted with caution, the results are suggestive that: In the East Asia and Pacific region, rapid credit expansions over the past five years and a rising ratio of short-term debt to total debt are common areas of concern.
n A high external debt to GDP ratio, which exposes countries to exchange-rate and rollover risk, is an issue in several Central and Eastern European economies.
n In Latin America and the Caribbean, fewer countries appear to be at immediate risk, with rapid credit growth combining with significant short-term debt ratios as the main sources of risk.
n In the Middle East and North Africa, risks stem mainly from exposure to domestic credit quality and government financing needs, against the background of a deterioration in current-account positions.
n Based on existing data, risks in South Asia and Sub-Saharan Africa appear low, but there are concerns that non-performing loans in India have increased, and several Sub-Saharan African economies appear to have elevated risk, with deteriorating reserve positions a common thread.
Although the probability of disorderly adjustments remains low at present, policymakers in developing countries need to make contingency plans and be prepared for the inexorable tightening of global financing conditions. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms, and counter-cyclical macroeconomic and prudential policies, to deal with a retrenchment of foreign capital. In other cases, where the scope for manoeuvre is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows. Where adequate foreign reserves exist, these can be used to moderate the pace of exchange-rate depreciation, while a loosening of capital inflow regulation and incentives for foreign direct investment might help smooth adjustments. Eventually, reforming domestic economies by improving the efficiency of labour markets, fiscal management, the breadth and depth of institutions, governance and infrastructure will be the most effective way to restore confidence and spur stability.
Andrew Burns, Mizuho Kida, Jamus Lim, Sanket Mohapatra & Marc Stocker
(The findings expressed in this article are those of the authors. They do not necessarily represent the views of the World Bank)