Developing economies enjoying “remarkably favorable” financing conditions in recent months remain susceptible to changes in investor sentiment that could crimp capital inflows, a World Bank report said.
“Current market conditions are supportive to developing-country prospects in the short term, but could encourage investors to underprice risk and borrowers to increase leverage,” the Washington-based lender said in a report today. “This might set the ground for sudden spikes in volatility and sharp adjustments to adverse news.”
Since March, long-term interest rates and market volatility declined to “unusually low levels,” narrowing bond spreads and putting downward pressure on borrowing costs, the report said. This triggered “a renewed search for yields which supported the demand for developing-country assets and currencies,” according to the report.
If long-term U.S. bond yields rise 100 basis points, or 1 percentage point, developing economies could experience a 50 percent drop in capital inflows, which would have “potentially destabilizing consequences” for some, the report said.
Global financial markets have shown resilience against geopolitical tension in the second quarter as conflict in Ukraine, Syria and Iraq failed to rattle investors, the report found. Worsening conditions could have “more severe repercussions,” it said.
The U.S. economy has modest growth and stable inflation, the lender said in the report. Coupled with additional easing by the European Central Bank, the medium-term outlook for U.S. monetary policy has supported the flow of capital to developing countries.
Capital inflows to developing countries will be 5.6 percent of gross domestic product this year, the same level as a year ago, the bank said. That’s projected to decline to 5.4 percent in 2015 and 5.1 percent in 2016, as financial-market conditions are expected to tighten in the next two years, the report showed.
The report also cited China’s corporate debt levels as a concern, as a cooling real-estate boom presents increased risk of a market correction. Total debt for the world’s second-largest economy is 240 percent of GDP, according to the World Bank.
China is equipped deal with the build-up, the report said, noting authorities’ recommitment in May to reforms that “should help rein in shadow banking activity and help contain the concentration of credit risks.”