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Prospects will be sensitive to the pace at which extraordinary monetary support measures in high-income countries are withdrawn

Strengthening growth in the United States has prompted the Federal Reserve to begin reducing the support it provides to the economy in January 2014. The gradual normalization of U.S. monetary policy is welcome as it reflects increasingly convincing signs that a self-sustaining recovery is now underway.

In the baseline, the withdrawal of quantitative easing (and its effect on the long end of U.S. interest rates) is assumed to follow a relatively slow orderly trajectory as the economy improves. The corresponding increase in global interest rates is expected to weigh only modestly on investment and growth in developing countries as capital costs rise and capital flows moderate in line with a global portfolio rebalancing. In an orderly adjustment scenario, tailwinds from strengthening global trade should offset headwinds from tighter global financial conditions.

So far, market reactions to the Fed announcement are in line with such an orderly scenario. If, however, the taper is met with an abrupt market adjustment, capital inflows could weaken sharply—placing renewed stress on vulnerable developing economies. In a scenario where long­term interest rates rise rapidly by 100 basis points, capital inflows could decline by as much as 50 percent for several quarters (80 percent in the less likely but more acute scenario of a sudden 200 basis point increase). Impacts on developing countries under such scenarios are likely to be concentrated among middle-income countries with deeper financial markets and domestic imbalances.

Especially in the scenarios where interest rates adjust rapidly and capital flows weaken, financial conditions in many developing countries could tighten sharply. The ability to withstand such shocks will depend crucially on domestic vulnerabilities and policy buffers, with some countries better placed to navigate these headwinds.

Risks will be most pronounced among developing economies where short-term or foreign debt (or both) represents a large proportion of overall debt, or where credit has been expanding rapidly in recent years. Policy makers in these economies should be taking steps now to restructure debt holdings toward longer-term issues and requiring banks to stress-test their loan books and begin provisioning now (before they go bad) those loans that might be at risk.

Although major tail-risks have subsided, they have not been eliminated and include fiscal policy uncertainty in the United States, protracted recovery in the Euro Area, and possible set-backs in China’s restructuring.

In the United States the general government deficit has come down significantly, mainly due to heavy spending cuts imposed by the sequester and rising tax revenues as the economy recovers. Little progress has been made to agree to a medium-term plan for bringing the debt-to-GDP ratio under control, and the risk of additional brinksmanship and an excessive and disruptive tightening of policy remains. If upcoming debt ceiling debates in the United States prove as tense as they were in October 2013, they could hobble the recovery currently under way through negative confidence and spending impacts; at worst, a debt default could spark an acute global crisis.

In the Euro Area much has been achieved, and banks have gone a long way toward restructuring themselves. Nevertheless the banking sector is still weak and details on a fully fledged banking union are still being worked out, and the currency bloc remains susceptible to shocks. The remaining formidable challenges, including pervasive youth and long-term unemployment are raising concerns about a permanent deterioration in the job skills and employability of the jobless, which could be weakening prospects for a more solid recovery.

In China, high levels of investment and associated lending have generated significant vulnerabilities, which represent risks to the banking sector. Recognition of such risks prompted authorities to adopt a program designed to restructure the sources of demand and growth away from investment and toward consumer demand and the service sector. Successfully engineering such a restructuring of the Chinese economy represents a formidable challenge. Although a tail risk, an involuntary abrupt decline in investment rates could have significant impacts on Chinese GDP, and important knock-on effects in the region and among economies with close trading linkages (including commodity producers in Sub-Saharan Africa and Latin America).

What's new
The February 2014 Financial Markets Outlook report is now available.
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See the global outlook audio slideshow by Andrew Burns.