RIO DE JANEIRO, BRAZIL – The impact of tightening by the Federal Reserve (Fed) could be significant for the most vulnerable emerging economies, warns the International Monetary Fund (IMF). In a publication on its blog, the organization points out that in recent months, emerging markets with high public and private debt, currency exposures, and lower current account balances have already seen greater movements in their currencies against the dollar.
The combination of slower growth and high vulnerabilities may create adverse cycles for these economies, the IMF assesses.
The IMF continues to expect robust US growth, with inflation likely to moderate later this year. Interest rates are likely to rise, and history shows that the effects for emerging markets are likely to be benign if tightening is gradual, well telegraphed, and in response to a strengthening in the recovery, it assesses. Emerging market currencies may still depreciate, but the Fund points out that foreign demand would offset the impact of rising financing costs.
On the other hand, faster interest rate increases could shake markets and tighten conditions worldwide, developments that could come with a slowdown in US demand and trade, and could lead to capital outflows and currency depreciation in emerging markets, it warns.
In response to tighter financing conditions, emerging markets must tailor their response based on their circumstances and vulnerabilities, the IMF points out. Those with credibility to contain inflation may tighten monetary policy more gradually, while others with stronger inflation or weaker institutions should act quickly and comprehensively, it says. The report says that responses should include depreciating currencies and raising benchmark interest rates in both cases.
Such actions may represent difficult choices while supporting a weak domestic economy. Similarly, extending support to firms beyond existing measures may increase credit risks and weaken the long-term health of financial institutions by delaying loss recognition, the IMF warns, noting that reversing the measures could further tighten conditions, weakening the recovery.
For Central Banks to contain inflationary pressures, clear and consistent communication of plans can improve public understanding of the need to pursue price stability. At the same time, countries with high levels of foreign currency debt should seek to reduce these mismatches and protect their exposures, the IMF says.
The Fund says that highly indebted countries may also need to begin fiscal adjustment sooner and faster. Ongoing support for businesses should be reviewed, and plans to normalize that aid should be calibrated carefully for the outlook and to preserve stability, it says.