Bracing for the bust

The message from the IMF’S October meeting suggests that a return to recession is a real possibility, but this time around the crisis could also hammer the emerging markets that are already financially volatile.

THE message from the October meetings of the International Monetary Fund (IMF) and the World Bank, which normally exude optimism, is glum. In January this year, the IMF noted that “the cyclical upswing under way since mid-2016” was growing stronger, contributing to “the broadest synchronised global growth upsurge since 2010”. It now feels that while “the global economic expansion remains strong”, it has “become less balanced and with more downside risks”. This does not just mean that one more sighting of the “green shoots of recovery” is proving to be premature. Given the IMF’S predilection for underplaying bad news, it suggests that a return to recession is a real possibility.

The IMF points to two factors— rising interest rates in the United States and a stronger U.S. dollar— that are contributing to downside risks, while throwing in rising trade tensions as an additional cause for concern. However, these factors in themselves are not recovery-threatening.

The first, namely rising interest rates as part of a dose of monetary tightening, was long overdue. For almost a decade now, the U.S. Fed and Central banks in other developed economies have been focussed on quantitative easing and interest rate reduction as antidotes for the recession triggered by the 2008 financial crisis.

In the event, Central bank balance sheets were overly fat, the global economy was awash with liquidity and interest rates were near zero. There was little disagreement on the need to unwind balance sheets, rein in liquidity infusion and raise interest rates. The only question was when and how fast. The signs of a recovery in the U.S. offered as good an opportunity as any to begin this long overdue exercise. To the extent that the rise in U.S. interest rates and the improved performance of the U.S. economy trigger a shift of investment in favour of dollar-denominated assets, a strengthening of the dollar would follow, making that too an expected outcome.

The reasons why these inevitable movements in interest rates and the dollar are identified as sources of concern relate to the consequences they have in the current global environment.

Rising interest rates in advanced nations are reversing the flow of capital from developed to developing markets. This is because much of the portfolio investment in “emerging markets” undertaken during the years of easy money reflected the “carry trade” encouraged by differences in interest rates.

INTEREST RATES

Investors borrowed cheap in dollar and euro markets and invested in emerging markets that offered much higher interest rates. When those interest rate differences narrow, portfolio capital tends to flow out from developing countries. That outflow, besides limiting liquidity, weakens currencies, triggers speculation, and leads to a collapse (as happened in Argentina and Turkey) or a significant fall (as seen in Brazil, South