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Business-as-usual is no longer a policy option for developing countries

With developing countries entering a potentially disruptive period of global financial tightening, maintaining a business-as-usual policy stance is no longer an option. Policy complacency risks a further accumulation of domestic vulnerabilities likely requiring larger adjustments down the road, and at greater economic cost given the closer scrutiny of domestic risks by financial markets.

However, the already daunting political challenge represented by implementing necessary measures—both short term to boost macroeconomic stability during the transition to higher global interest rates and longer term to raise growth potential—may be made even more difficult given upcoming elections in several of those countries that were most tested during the summer, including South Africa, Thailand, Turkey, Indonesia, Brazil and India.

Furthermore, indications of policy complacency also appeared once financial market pressure subsided after the summer sell-off. Although there have been positive developments, credit continues to expand too quickly in several of the countries hardest hit by markets during the summer, a factor that may be adding to vulnerabilities. For example, despite rate hikes in Brazil, lending by state-owned banks and quasi-sovereign institutions continues to remain strong and may be adding to vulnerabilities.

Similarly, although inflation expectations remain entrenched, the Indian central bank is only gradually tightening policy—raising its main policy rate by a cumulative 50 basis points to 7.75 percent since September—so that real rates remain firmly in the red at 2.1 percent currently. Meanwhile, the ratio of restructured advances to gross advances plus the nonperforming asset ratio reached 10.2 percent of loans in September 2013, prompting the Reserve Bank of India to warn recently of the stress on banks' asset books. In particular, the bank warned of lending to the iron and steel, and infrastructure sectors, which have the highest levels of stressed assets. The authorities’ recent decision to allow increased foreign participation and private-sector competition in the banking sector is a good initial step in the right direction.

In Turkey, although credit is growing at an annual rate of nearly 30 percent, overall monetary policy continues to be stimulative with the central bank missing its inflation target for the third consecutive year in 2013. Mexico has eased policy, cutting rates (by 100 basis points in total during 2013 with the most recent cuts in September and October) recently, but this step is easier to justify in light of reforms that have already begun to address some of the structural issues in that economy.