The Bank for International Settlements (BIS) released its annual report on Sunday, using it to draw attention to the side-effects caused by the loose monetary policies being followed by central banks, particularly those in developed markets. The BIS warns that persistently loose monetary policy is supporting capital and credit flows into emerging market (EM) economies, while simultaneously placing upward pressure on these countries’ exchange rates.
Interest-rate increases from EM central banks in response to domestic macroeconomic pressures have been slow to materialize, in part, because of fears this would encourage further inflows of foreign capital.
The report notes the credit and asset price booms in EMs creates the risk of financial imbalances that look worryingly similar to the booms seen in developed markets in the years preceding the financial crisis. Given the increased prominence of EMs in both the global economy and investment portfolios, a bust could have damaging effects globally, the BIS argues.
Of course, not all markets are created equal. Certain countries will find themselves more vulnerable to the effects of a sudden stop in capital inflows than others.
“Some countries are obviously more vulnerable than others," says David Lubin, head of EM economics at Citi. "The most vulnerable ones – Egypt, Ukraine, Turkey, possibly India – tend to have large external financing requirements and relatively low levels of net foreign exchange reserves."
The other crucial factor is the complexion of foreign investors in key emerging stock and bond markets.
“To judge the significance of a sudden stop in capital flows, you need to know who is doing the stopping," says Lubin. "There is evidence to suggest that institutional investors are more resilient lenders than banks. If you look at Poland or Mexico during last year's big sell-off, for example, institutional investors largely held on to their local bond portfolios while banks took net repayments.”
Bank risk
Significantly, the countries Lubin considers the most vulnerable – Egypt, Ukraine and Turkey – are particularly reliant on bank lending as opposed to institutional investor involvement.
The looseness of global monetary policy has also encouraged strong commodity prices – something that has a particularly notable effect in EMs. Two periods of rising inflation in this group of countries since 2006 have been associated with increasing commodity prices.
While inflation across EMs as a whole has eased off somewhat since the start of the year, the BIS warns that the risks of second-round inflation effects remain – with unit labour costs edging up in the fourth quarter of 2011.
The BIS is clear that the increasing significance of monetary policy spillovers means that central banks need to have more regard to the global implications of their actions. In a globalized world, a more global monetary policy perspective is necessary to encourage financial stability.
Further bad news for EMs can be found in the projected slump in demand across slow-growing economies. Any export-driven economy is likely to suffer from this: while this isn’t limited to EMs, they make up a substantial part of this group. For example, one-fifth of Thailand’s exports are to countries that are projected to have their growth slow by two percentage points during the 2011-2015 period compared with between 2003 and 2007.
Again, while they might be the most obvious – and perhaps most vulnerable – victims, this is by no means an EM-only problem. Germany is expected to be harder hit than a number of EMs, including Brazil and Turkey.