Goldilocks recovery or calm before the storm?
Extract from the Financial Markets Outlook - June 2014
External financing conditions for developing countries have been remarkably favorable in recent months, reflecting expectations of a more drawn-out period of monetary policy accommodation in high-income countries and some narrowing of external vulnerabilities. Additional easing by the European Central Bank, combined with prospects of modest growth and stable inflation in the United States (“Goldilocks recovery”), helped pull down bond yields and volatility worldwide. These benign conditions currently provide support to capital inflows and activity across developing countries, but could at the same time increase the risk of greater and potentially more abrupt market adjustments ahead. Despite some reduction of current account deficits in several developing countries, many remain vulnerable to sudden shifts in investors’ sentiment and capital outflows.
Following a brief period of market turmoil at the start of the year, global financing conditions have eased considerably from March to June. Bond spreads for developing countries (i.e. yield difference with 10-year U.S. Treasury bonds) have narrowed, bringing down average borrowing costs to their lowest level since the Spring of 2013 (figure 1). Stock markets have also recovered rapidly from a significant sell-off in January/February, despite rising geopolitical tensions and evidence of disappointing activity in the first quarter of the year. More favorable financing conditions for developing countries have already had a measurable impact on capital inflows, with international sovereign and corporate bond issuances reaching record levels since March 2014.
These developments appear closely associated with additional easing measures announced by the European Central Bank (ECB) in June, and speculations that policy rates in the United States might stabilize at a lower level over the medium-term due to both persistent slack in the economy and lower equilibrium rates. In this context, long-term interest rates and market volatility declined to unusually low levels (figure 2), triggering a renewed search for yields which supported the demand for developing-country assets and currencies. Past macroeconomic adjustments, along with improved economic prospects in some middle-income countries, also contributed to positive market sentiment.
As presented in the June 2014 edition of Global Economic Prospects, a more favorable global environment is reflected in upward revisions to capital inflow forecasts for developing countries, now projected to remain broadly stable as a percentage of GDP in 2014 and 2015, at around 5.6 percent, before declining again in 2016, to 5.1 percent. While baseline forecasts assume an orderly increase in long-term interest rates in high-income countries, the risk of more abrupt adjustments from current low levels has recently increased. Escalating geopolitical tensions or financial stress in some developing countries could also potentially trigger a sudden re-pricing of risk. Despite the recent narrowing of current account deficits in some developing countries (figure 3), many remain vulnerable to a sharp increase in borrowing costs and/or significant currency depreciations, which could put additional strain on corporate and bank balance sheets.