Emerging Markets Warned of Capital Drought as Fed Nears Liftoff

  • World Bank says financial shock could cause capital 'stop'
  • Slowdown threatens Kim's goal of eradicating global poverty

A sudden capital drought in emerging markets could undermine the fragile global expansion, World Bank economists said in a report Tuesday that questions whether the international lender’s main poverty-reduction target is achievable given the bleaker outlook.

Now in its sixth year, the slowdown in developing economies is the broadest since the 1980s, World Bank economists said in a research paper released on Tuesday. While emerging nations are better prepared for shocks than they were in the 1980s and 1990s, the recent "rough patch" could signal a new era of slow growth, according to the Washington-based development bank.

Even worse, a surge in financial turbulence could cause capital flows into emerging markets to dry up, the World Bank said. Net capital flows in emerging markets have been declining since last year and stalled to zero in the first half of 2015.

The warning comes a little over a week before what investors expect will be the U.S. Federal Reserve’s first increase in its benchmark borrowing rate since 2006. Tightening financial conditions and a slump in commodity prices have hurt resource-rich emerging markets such as Russia and Brazil, a nation which Goldman Sachs Group Inc. has warned may be on the verge of a depression.

Perfect Storm

"Deteriorating external conditions, perhaps resulting from U.S monetary policy tightening or elevated uncertainty about growth prospects in a major emerging market, could potentially combine with domestic factors into a ‘perfect storm’ by sparking a sudden stop in capital inflows to multiple emerging markets," the World Bank said in the paper.

World Bank President Jim Yong Kim has made it part of the institution’s mission to reduce extreme poverty -- living on less than $1.90 a day -- to 3 percent of the world’s population. That milestone will be a challenge to reach "under most plausible scenarios,” the report stated.

"In light of the significant global risks going forward, emerging markets urgently need to put in place an appropriate set of policies to address their cyclical and structural challenges and promote growth," the authors wrote.

The report’s authors cite a number of reasons for the slowdown, including weak global trade, the commodities slump as demand from China has weakened, and slowing productivity growth in emerging economies.

Taper Tantrum

Emerging markets have felt the aftershocks of Fed policy before, most recently in 2013, when comments by former Fed Chairman Ben Bernanke about reducing the central bank’s bond buying set off an episode known as the "taper tantrum."

If U.S. long-term bond yields jump 100 basis points, as they did in 2013, capital inflows to emerging markets could fall by as much as 2.2 percentage points as a share of gross domestic product over the following the year, the World Bank estimated.

Historically, a sudden capital "stop" causes an economy’s growth rate to shrink by an average of almost seven percentage points over the following two years, according to the paper.

The slowdown follows a "golden era" for emerging markets in which they expanded at unprecedented rates and became a main engine of global growth. The boom also lifted many of the world’s poor out of poverty, reducing the proportion of those who live in low-income countries from 37 percent in 2000 to 8 percent.

The paper was authored by World Bank economists Tatiana Didier, M. Ayhan Kose, Franziska Ohnsorge and Lei Sandy Ye.

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