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Risks and vulnerabilities

High-income country based tail risks to the global economy have been largely eliminated, reflecting the substantial restructuring that has already occurred in both Europe and the US - although more needs to be done. Risks and challenges are increasingly of a medium term nature, while short term risks are less pressing and more balanced than before.

For developing countries, short term risks have declined but prospects remain sensitive to developments in financial markets, growth in major economies, and geopolitical risks. To the extent the recent easing in global financial conditions reverses some of the adjustment that occurred since mid-2013, developing countries may find themselves once again exposed to substantial volatility when policy in high-income countries eventually normalizes.

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Acute global risks emanating from high income countries have subsided considerably in terms of likelihood and potential impacts, in part because some of them materialized in less virulent forms than anticipated earlier.

  • In the Euro Area, sliding inflation has raised real interest rates, potentially slowing the recovery. Inflation expectations remain anchored so far, but downward adjustments could unleash a pernicious debt-deflation cycle and undermine the ability of monetary policy to support the economy.
  • In Japan, the key risks are that the sales tax hike might significantly dent the domestic recovery, while medium-term prospects will depend on the degree to which supply-side reforms succeed in boosting growth.
  • In the US, there are signs that the recovery in some asset markets is running ahead of the economic cycle, driven in part by very low interest rates. If conditions stay very loose too long some of the same kind of vulnerabilities that built up prior to the crisis of 2008 could re-emerge.

Increasingly, these risks are being balanced by the possibility of better than expected growth, particularly in the Euro Area, in light of recent monetary support measures announced, and the US. A quickening of the pace of reforms in Japan could also bolster confidence, improving firms’ incentives to invest and increase wages, boosting household incomes and willingness to spend.

Although risks are reduced compared to last year due to financial and policy adjustments, developing countries remain vulnerable to volatility in global financial markets and other risks.

Tail risks include the rebalancing of China’s economy amid a cooling property market, and an intensification of country-specific problems in other systemically important large middle-income economies such as Turkey that could be the spark for volatility in global financial markets, with contagion spreading to other developing economies with similar weaknesses.

Geo-political risks remain elevated, including the conflict in Syria. A further sustained escalation in tensions in Ukraine — either militarily or in the form of tit-for-tat sanctions — could have significant impacts on global economic confidence, especially if they increase uncertainty to the point that investors and consumers hold back on spending. A physical disruption of energy and grain supplies would take a further toll on the already weak economies of Russia and Ukraine, and set back a nascent recovery in the Euro Area (a major buyer of Russian energy) although significant mutual interdependence in energy markets reduces the likelihood of such disruptions (see box 8).

As financial conditions tighten interest rates will rise

Tighter global financial conditions over the next five years as monetary policy is normalized in high income economies is inevitable (although the timing and extent of the tightening remain uncertain). And it will imply weaker financial flows and rising costs of capital for developing countries.

As discussed earlier, with less than half of the potential increase in long term US rates having occurred so far, much more financial sector tightening is yet to come, pushing up borrowing costs and spreads for developing countries. If interest rates rise too rapidly or there are sharp pullbacks in capital flows, economies with large external financing needs or rapid expansions in domestic credit in recent years could come under considerable stress. Moreover, market sentiment could become unsettled around key decision points associated with the normalization of high-income monetary policy, for instance the timing of the first policy rate hikes in the US.

The degree to which interest rates in developing countries will rise is uncertain. However, there is a large literature documenting the sensitivity of financial conditions in developing countries to changes in global liquidity conditions. In particular, estimates based on Agosin and Diaz-Maureira (2013) Kennedy and Palerm (2013) and Kennedy (2014) suggest that a tightening of global financial conditions could cause interest rates spreads in more than half of developing countries studied to rise by more than 100 basis points (figure 14).4 While striking, these estimates could prove conservative, if tightening financial conditions lead to a deterioration in domestic factors such as sovereign ratings fiscal deficits, current account balances and international reserves.

External financing needs have declined in some countries, but remain a risk in others

Heavy external financing needs (high current account deficits, and large amounts of short-term debt) make a country more vulnerable to reversals in international capital flows and increases in interest rates. The most vulnerable to a deterioration in financing conditions include countries that rely more on portfolio flows (as opposed to less volatile remittances and FDI) to furnish foreign currency. Some 18 developing countries find themselves with external financing needs that exceed their foreign currency reserves, with requirements exceeding 10 percent of GDP in many cases (figure 15).

High current account deficits and deep financial markets were among the factors that contributed to the strong reversal of capital flows in those developing countries that experienced them during the summer of 2013 (World Bank, 2014B; Eichengreen & Gupta, 2014). Brazil, India, Indonesia, Turkey and South Africa bore the brunt of financial market pressure during that period.

Exchange rate depreciation (averaging 14.5 percent in nominal effective terms by year-end for these countries) and the policy tightening that ensued reduced import demand and improved export competitiveness. This in turn contributed to a narrowing of trade and current account deficits and supported a rebound in capital flows that diminished their vulnerability to future shocks. Overall, the trade balance in these countries improved by 1.8 percent of their combined GDP between Q2 and Q4 of 2013, with two-thirds of it accounted for by a compression of imports (figure 16), and the largest adjustments occurring in India, Indonesia, Thailand and more recently South Africa.

However, the sustainability of these improvements is unclear. For instance, a significant portion of the improvement in trade deficits last year in Indonesia came from favorable commodity price movements and a surge in mineral-ore exports ahead of a ban on unprocessed exports that came into effect in January and the trade deficit has begun to widen again. In India, nearly half of the narrowing of the goods trade deficit last year was due to measures to reduce gold imports. Although export momentum increased in April, the trade deficit has remained broadly stable since November 2013. Meanwhile in Brazil and Turkey, current account improvements have been less marked than in India, Thailand and South Africa.

FIGURE 14 As and when global financial conditions tighten, developing country bond spreads could increase significantly for some
Source: World Bank, Agosin and Diaz-Maureira, 2013, Kennedy and Palerm, 2013, and Kennedy 2014).
FIGURE 15 Countries with large funding needs and low reserve cover may be most vulnerable to a tightening of financial conditions
Source: World Bank, BIS. External financing needs measured as current account balance less short term debt coming due in 2014 minus estimated principal repayments on medium and long-term debt coming due in 2014.
FIGURE 16 Weak imports have helped improve trade deficits in countries that felt significant financial market pressure in mid-2013
Source: World Bank. Change in trade balance & current account balance for Turkey and South Africa between Q2 and Q4 2013

4. Assuming that global financial conditions return to long-run normal (TED spreads in the US double to 50 bp; the term premium in the US rises 90 basis points; and US monetary policy returns to neutral; Kennedy, 2014).

The past several years of low interest rates have been periods of rapid domestic credit growth, some of it fueled by capital inflows and cheap finance from abroad.

At one level, increased local-currency bonds issuance is a positive development, speaking to enhanced domestic intermediation and reduced exchange rate risk due to currency mismatch. However, countries remain exposed to shifts in investor sentiment because much of this locally issued debt is nevertheless held by overseas investors (figure 17).

So far, institutional investors, who hold much of this debt, have not cashed in their positions in the face of volatility. However, a further bout of global risk aversion could lead to pullbacks from these market, especially since developing-country credit ratings have deteriorated lately — reversing an earlier trend toward improvement. Since the beginning of the year, developing-country sovereign debt downgrades have exceeded upgrades 13 to 3. Downgrades were concentrated in Ukraine, South America and Sub-Saharan Africa.

Corporate debt issuance by private and state-owned corporates in international markets has also increased substantially in recent years (figure 18). Much of the increase has occurred in Latin America as a substitute for bank lending and has involved firms in the resource sector. Among investment grade borrowers, corporate leverage has increased significantly in Turkey (mainly intermediated through the banking sector). In India, a significant part of corporate debt in recent years has been accounted for by overseas borrowing of relatively short maturity (World Bank 2014B).

FIGURE 17 Foreign ownership of local government bond markets has risen sharply in recent years
Source: World Bank, Haver.
FIGURE 18 Debt issuance in international markets has increased, mainly led by corporates
Source: World Bank.

When global financial conditions tighten, the weight of debt servicing and refinancing costs on corporate balance sheets will rise and could pose risks to domestic banking sectors, notably in Turkey and India where substantial stocks of external corporate debt are coming due. Depreciations in both countries have increased borrowing costs, with some heavily indebted large firms in India having struggled to renegotiate debt repayment schedules (World Bank 2014B). In Turkey, the situation may be better as about two-thirds of external corporate debt is thought to be hedged. Nevertheless, markets remain edgy: Turkish corporate bond spreads jumped some 200 basis points last summer and some 100 basis points in January. Although spreads eased after both episodes, they remain higher than prior to May 2013 levels.

The relative inexperience of non-investment grade sovereign borrowers that have taken advantage of the surge in global liquidity and low interest rates to borrow in international markets (in some cases for the first time e.g. Mongolia) is also a source of concern. Much of the debt has been issued over relatively short maturities (typically five years), raising concerns over countries’ ability to service these debts if they roll over at higher interest rates, especially if rollovers periods coincide with periods of heightened global financial turbulence.

A downturn in credit cycles or higher costs of funding could amplify risks

Although the domestic credit cycle has begun to turn, high domestic debt stocks and/or the rapid expansion in stock levels in recent years remains a source of concern in several developing economies, including Brazil, Indonesia China, India, Malaysia and Thailand reflecting past credit-fuelled growth (figure 19). While financial crisis risks are limited in most economies (World Bank 2014B), banking systems have to go through a cooling phase of slower credit expansion, which is likely to trigger rising defaults. Moreover, tightening lending standards and higher costs of funding will weigh on activity, amplifying profit pressures. These pro-cyclical forces are already visible in India where non-performing assets (mostly located in large public sector banks) are estimated to be above 10 percent if “restructured assets” are also taken into account.

FIGURE 19 Credit growth is slowing but past buildups still pose risks
Source: World Bank, BIS.

In China, domestic leverage, at 240 percent of GDP, is one of the highest in the world making companies extremely sensitive to changes in income and interest rates. Meanwhile corporate profitability and cash flows are under pressure due to slowing growth and high refinancing needs. In addition, a massive residential and construction boom—a key driver of growth in recent years, and a major source of revenue for local governments5— is cooling and could turn into a sharp correction as credit standards are tightened.

Accordingly, the pace of deleveraging in China is a key risk. If policy makers move too slowly—or choose to support the economy using traditional credit levers as they have done in recent years —they risk compounding existing problems, exacerbating the risks of a hard landing in the medium term. If they move too fast, they risk a credit crunch which in turn could intensify existing pressures on the corporate, property and financial sectors, and rising financial sector risks.

5. Local governments in China derive some 61 percent of revenues from land sales. Land sales in the largest 20 cities last year fell by 5 percent.

List of figures and boxes you can find in this page

  1. BOX 8A severe escalation of tensions in Ukraine could lead to sharp capital outflows from developing countries and set back growth
  2. FIGURE B8.1Default risks had increased sharply in both Ukraine and Russia, but have come down in recent months
  3. FIGURE B8.2A prolonged bout of risk aversion linked to the Ukraine crisis could severely dent capital flows and developing country GDP
  4. FIGURE 14As and when global financial conditions tighten, developing country bond spreads could increase significantly for some
  1. FIGURE 15Countries with large funding needs and low reserve cover may be most vulnerable to a tightening of financial conditions
  2. FIGURE 16Weak imports have helped improve trade deficits in countries that felt significant financial market pressure in mid-2013
  3. FIGURE 17Foreign ownership of local government bond markets has risen sharply in recent years
  4. FIGURE 18Debt issuance in international markets has increased, mainly led by corporates
  5. FIGURE 19Credit growth is slowing but past buildups still pose risks