The United States is poised to raise rates much more sharply than markets expect, risking a potential storm for global asset prices and a dollar shock for much of the developing world, the International Monetary Fund has warned.
The IMF fears a "cascade of disruptive adjustments" as the US Federal Reserve finally pulls the trigger for the first time in eight years, ending an era of cheap and abundant dollar liquidity for the international system.
The Fed's long-feared inflexion point is doubly treacherous because investors seem ill-prepared for what lies ahead, and levels of dollar debt outside the US have reached an unprecedented extreme. The Fund said future contracts are pricing in a "much slower" pace of monetary tightening than the Fed itself is forecasting.
The crunch comes as the world economy remains becalmed in 2015 with stodgy growth of 3.5pc, held back by another set of brutal downgrades for Russia and string of countries in Latin America. Emerging markets face a fifth consecutive year of slippage as they exhaust the low-hanging fruit from catch-up growth and hit their structural limits.
The IMF's World Economic Outlook forecast that rich economies will clock up respectable growth of 2.4pc this year after 1.8pc in 2014 as fiscal austerity fades and quantitative easing lifts the eurozone off the reefs, but there will be no return to the glory days of the pre-Lehman era.
"Potential growth in advanced economies was already declining before the crisis. Ageing, together with a slowdown in total productivity, were at work. The crisis made it worse," said Olivier Blanchard, the IMF's chief economist.
"Legacies of both the financial and the euro area crises — weak banks and high levels of public, corporate and household debt — are still weighing on growth. Low growth in turn makes deleveraging a slow process."
The world will remain stuck in a low-growth trap until 2020, and perhaps beyond. The Fund called for a blast of infrastructure spending by Germany and others with fiscal leeway to help break out of the impasse.
The report said markets may have been lulled into a complacency by the lowest bond yields in history and a strange lack of volatility, seemingly based on trust that central banks will always come to the rescue. Any evidence that the fault lines of the global financial system are about to be tested could "trigger turmoil", it warned.
"Emerging market economies are particularly exposed: they could face a reversal in capital flows, particularly if US long-term interest rates increase rapidly, as they did during May-August 2013," it said.
The IMF said the probability of recession had risen in a number of countries, including most of Latin America (Source: IMF)
The Fund said yields on 10-year US Treasuries had fallen 80 basis points from October to January due to spillover effects from QE in Europe and Japan, but this sets up the potential for an even sharper spring-back once the Fed tightens in earnest.
The big worry is what will happen to Russia, Brazil and developing economies in Asia that borrowed most heavily in dollars when the Fed was still flooding the world with cheap liquidity. Emerging markets account to roughly half of the $9 trillion of offshore dollar debt outside US jurisdiction.
The IMF warned that a big chunk of the debt owed by companies is in the non-tradeable sector. These firms lack "natural revenue hedges" that can shield them against a double blow from rising borrowing costs and a further surge in the dollar. There has already been a trial run of what can go wrong with the much smaller scale of borrowing in Swiss francs.
"The balance sheet shock generated by the sudden large appreciation of the Swiss franc on some countries in central and eastern Europe with sizable domestic mortgage lending in that currency highlights the nature of these risks," it said.
The BRICS club is no longer in a fit state to handle the full consequences of a dollar shock, with the exception of India, the lone star with 7.5pc growth this year and next. India will overtake China in 2015 for the first time in modern memory.
Russia's economy will contract by 3.8pc this year as the full impact of the oil price crash and Western sanctions both bite deeper. Brazil faces a long slump, shrinking by 1pc in 2015, with barely a flicker of recovery in 2016.
While China is expected to avoid a hard-landing, its growth will slow yet further to 6.3pc next year. The Fund hinted that the much-trumpeted reforms so far add up to little and have yet to put the country on a viable course.
"Vulnerabilities have been building. Rebalancing toward domestic demand has so far been driven primarily by rapid growth in investment and credit, an unsustainable pattern of growth," it said.
The IMF said shifting exchange rates are usually a good thing, so long as they are not too violent. It disputed claims by other global watchdogs that "currency wars" amount to a race to the bottom with no net benefit for the world as a whole.
It calculates that global GDP is boosted by an extra 0.5pc over a two-year period if exchange rates are allowed to take the strain. Devaluations tend to work asymmetrically. They act as a shock absorber, helping to avert extreme stress that could spin out of control in the most vulnerable economies.
Deflation poses less of a risk to the economy as it did six months ago, although Japan's battle with falling prices continues (Source: IMF)
They also "redistribute demand" towards those countries - chiefly in Europe at the moment - that need stimulus but cannot act because rates have already hit zero. The countries on the other side of the ledger with a rising exchange rate have the luxury of offsetting the blow to growth by tightening more slowly. The net outcome is that monetary policy is relaxed for the world as a whole.
Whether intended or not, the IMF has just outlined why it would be an extremely bad idea if the international system returned to the fixed exchange rigidities of the Bretton Woods era.
Credit to The Telegraph
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