The tightening of monetary policies by the US at a time when other countries are easing theirs could make emerging economies “vulnerable” as many of their firms and banks have sharply increased their borrowings in dollars in the last five years, the IMF Chief warned today.
Speaking at the opening of China Development Forum here, Christine Lagarde said, the world has yet to achieve full economic recovery as global growth continues to be weighed down by high debt, high unemployment and lackluster investment.
Referring to IMF’s recent forecast to cut global growth to 3.5 per cent and 3.7 per cent in 2015 and 2016 despite the boost from cheaper oil and stronger US growth, she said the global recovery remained fragile because of significant risks.
“One such risk emanates from the expected tightening or normalisation of US monetary policy at a time when many other countries areÂ easingÂ monetary conditions,” she said on the US’ plans to raise interest rates.
“This asynchronous monetary policy may trigger excessive volatility in global financial markets. The divergence of monetary policy paths has already led to a significant strengthening of the US dollar.
“Emerging markets could be vulnerable, because many of their banks and companies have sharply increased their borrowing in dollars over the past five years,” Lagarde who was in India last week said.
Stating that some of the unconventional monetary policies, including large purchases of government debt, had strong, positive spillovers on the global economy after the 2007 economic crisis, she said those policies prevented a financial market meltdown and supported the recovery in advanced economies and beyond.
“I am convinced that, without these unconventional tools, the world would have sunk into a 1930s-style depression,” she said.
“Unconventional monetary policies have also led to negative spillover effects on emerging markets through a build-up of financial stability risk. These policies triggered huge capital inflows into emerging financial markets.
The IMF chief said that between 2009 and the end of 2012, emerging markets received USD 4.5 trillion of gross capital inflows, representing about half of global capital flows during that period.
“This led to a significant increase in bond and equity prices and to a strengthening of emerging market currencies. IMF studies suggest that these effects were larger than the ones that had been caused by conventional policies in the past,” she said.
These spillovers pose a risk to financial stability in emerging markets, because policy changes could easily lead to a sudden reversal of capital flows, she said.
Referring to the volatility suffered by emerging markets over the speculation of rise of US interest rates, she said, “We already saw a preview of this scenario during the so-called ‘taper tantrum’ in the summer of 2013. Merely the first hint of a change in US monetary policy was enough to trigger a surge in financial market and capital flow volatility.”
“Could this happen again? Despite the efforts of the US Federal Reserve to clearly communicate its policy intentions, financial markets may still be surprised by the timing of the US interest rate lift-off and by the pace of subsequent rate increases,” she said.
The IMF chief said the potential spillovers would affect China mostly through its trade relationships with other emerging markets.
“If spillovers were to cause a sustained weakness in demand in these countries, Chinese exports would certainly be affected,” she said.
In view of this the emerging markets should be prepared to face the risks, she said.
“Emerging markets need to ensure that their financial systems are resilient to asset price swings and a sudden withdrawal of funding liquidity. Prudential policies should serve as a first line of defense. Much thinking has been devoted in recent years to the role that macroprudential tools can play, and it is now time to put this into action,” she said.
“If market volatility materialises, central banks need to be ready to act. Temporary but aggressive domestic liquidity support to some sectors or markets may be necessary. In certain conditions, foreign exchange interventions could also be used to dampen exchange rate volatility,” she said.
“These interventions should not be used as a substitute for needed macro-economic adjustment. Moreover, foreign currency swap lines across countries have proven helpful in providing access to foreign exchange liquidity in times of market stress,” she said.
“International coordination and safety nets can also play a crucial role. For example, central banks and financial supervisors may want to share their policy thinking and contingency plans,” she said.
Lagarde stressed that closer cooperation between the IMF and Regional Financing Agreements such as the BRICS Contingency Reserve Arrangement would also be helpful.
On the slow growth of Chinese economy, she said China’s deep structural reforms will lead to slower, safer, and more sustainable growth.
“Macro prudential policies have already been playing a major role in this adjustment, and will continue to do so going forward. This is good for China and its people and it is good for the world,” she said.