World Bank: Monetary tightening could crimp growth

When the U.S. Federal Reserve and other central banks tighten monetary policies, World Bank economists worry long-term interest rates will rise, increasing the cost of capital in emerging markets. This could be particularly challenging for developing countries with high debts.  

The World Bank said eventual monetary tightening in advanced economies could crimp growth in emerging markets as interest rates rise, lowering the nations' potential output by as much as 12 percent.

That long-term risk is likely greater than the short-term impact from volatility in emerging market currency and bond markets, as traders try to position themselves for when the U.S. Federal Reserve begins its exit from ultra-loose monetary policies, said Kaushik Basu, the World Bank's chief economist.

Basu was speaking ahead of the launch of the bank's twice-yearly Global Economic Prospects report on Wednesday.

The report argued that the euro area and fiscal uncertainty in the United States are receding as major risks to the global economy. Instead, developing nations have to be on guard against side effects from aggressive monetary expansion in advanced nations.

Japan launched a massive bond-buying program in April to prod the economy out of decades of stagnation, raising fears Japanese investors would flood into emerging markets in search of higher yields and cause overheating.

At the same time, global markets were battered this week as traders tried to read the tea leaves of when the U.S. central bank will decide to start winding down its own stimulus measures.

For emerging markets, this market volatility should not be too disruptive over the medium term, although it could cause some capital flow fluctuations in the next three to six months, Basu said.

"(The volatility) is an adjustment trauma, in anticipation of what is going to come, and as soon as the policy change is properly in place I do expect this trauma to go away," Basu said.

The Fed's exit from so-called "quantitative easing" should also cancel out some of the overheating impact from Japan's loose policies, according to the World Bank report.

What is more worrying is what happens later, as long-term interest rates begin to rise when the Fed and other central banks tighten monetary policies.

Higher interest rates would raise the cost of capital in emerging markets, leading to lower capital investment, which causes lower growth in the long run, the bank said.

"Longer term, potential output could be lower by between 7 and 12 percent unless measures are undertaken to reduce domestic factors that contribute to the high cost of capital," according to the report.

The risk is especially high for countries such as Egypt, Jamaica and Pakistan, that have run up high debt in a time of low interest rates. If interest rates surge suddenly, these countries would face sharply higher debt servicing costs that they may not be able to manage, the World Bank said.