Fed’s surprise tightening may trigger capital outflows from emerging markets: IMF

April 06, 2021 (MLN): Prospects for a multispeed recovery, with advanced economies recovering more quickly than most other economies, raise concerns for emerging markets as potential monetary surprise tightening by US Federal Reserve, tends to curb global investor risk appetite and trigger capital outflows from emerging markets.

This would potentially lead to a depreciation in emerging market currencies that exposes foreign exchange-related vulnerabilities, the IMF said Monday in an analytical chapter of its World Economic Outlook.

The IMF study found that the upbeat data on a macroeconomic front like US jobs or COVID-19 vaccines tends to increase portfolio inflows and lower spreads on US dollar-denominated debt for most emerging markets. Good economic news in advanced economies could lead to export growth for emerging markets, and the pick-up in economic activity tends naturally to lift their domestic interest rates. The overall impact is benign for the average emerging market. However, countries that export less to the United States yet rely more on external borrowing could feel financial market stress, IMF economists Philipp Engler, Roberto Piazza and Galen Sher wrote.

Emerging and developing economies are viewing rising interest rates with trepidation. Most of them are facing a slower economic recovery than advanced economies because of long waits for vaccines and limited space for their own fiscal stimulus. Now, capital inflows to emerging markets have shown signs of drying up. The fear is of a repeat of the “taper tantrum” episode of 2013 when indications of an earlier-than-expected tapering of US bond purchases caused a rush of capital outflows from emerging markets.

A stronger-than-expected inflation recovery in advanced economies could temper global financial risk appetite somewhat, but with likely limited repercussions if inflation expectations remain well-anchored. This is particularly true, given that the Federal Reserve has clearly communicated that it is targeting a temporary overshooting of its medium-term inflation goal and would not raise interest rates until inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time. However, some emerging market economies with fiscal and external vulnerabilities and a lack of trade ties to advanced economies may find that global financial tightening outweighs the benefits of stronger external demand, the research highlighted.

To avoid triggering financial disruptions to emerging markets, advanced economy central banks can help with clear, transparent communications about future monetary policy under different scenarios. The Federal Reserve’s guidance on possible future scenarios would be useful, given that the Federal Reserve’s new monetary policy framework is untested and market participants are uncertain about the pace of future asset purchases.

IMF suggested that emerging markets will only be able to continue providing policy support if domestic inflation is expected to be stable. Ideally, emerging and developing economies should seek to offset some of the higher global interest rates with more accommodative monetary policy at home. For this, they need some autonomy from global financial conditions.

In addition, taking steps to lengthen maturities on debt and smooth out concentrations in debt service obligations, manage leverage through macro-prudential measures and strong financial supervision, reduce currency mismatches, and ensure an adequate level of international reserves can also help limit the buildup of vulnerabilities.

A strong international financial architecture, including robust mechanisms for liquidity support for countries, would have a key role to play too, the research added.

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