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Prospects Weekly: Financial market volatility remains sharply elevated

Global Macroeconomics Team's picture

Financial market volatility remains sharply elevated this week as market attention shifted from Greece, to Italy and even France. Concern about counterparty risk kept European banking-sector spreads high, even as banks mark-down and sell-off distressed Euro Area sovereigns to repair their capital base. Continued turbulence and credit tightening could prompt sudden reversals in global capital markets. In 2012, developing country external financing requirements are estimated at $1trn (7.1% of GDP), of which two-thirds is accounted for by short-term debt. Developing Europe and Central Asia, with debts coming due equal to 7.6% of GDP, is the developing region most vulnerable to a tightening of financial conditions. Worries about faltering world demand, led by expectations of recession in Europe, have contributed to deep declines in international commodity prices.

Amid crises in Greece and Italy and worries about potential spillovers to the rest of the Euro Area, European banks saw further spikes in interbank overnight spreads in recent weeks, indicating heightened concern about counterparty risk. Increased turbulence in global financial markets stems largely from worries that Italy will also need a bail-out package, and that even an expanded €1trn European Financial Stability Facility would be overstretched. Concerns of contagion have led to a rise in the cost of insuring against default for French sovereign debt to a record CDS spread of 203 basis points on Thursday. While European banks have been selling distressed Euro Area sovereign bonds at a loss and writing-down the value of the retained holdings in an effort to repair their capital base, concerns about counterparty risk remain high—raising the prospect of a possible lending freeze.

 

If global risk aversion escalates, contagion could be substantial and affect a wide set of developing countries. Recent market turbulence has already led to outflows from developing country equity markets. A further deterioration in sentiment could accelerate outflows and raise borrowing costs for many countries. Fifty four developing countries are likely to require external financing of 5% or more of their GDP in 2012 to meet current account and maturing debt obligations. To the extent that funding comes from relatively stable sources such as FDI, official aid, or remittances, this need not present a problem. However, vulnerability rises when countries are reliant on volatile sources of external funds, such as short-term debt, new bond issuances, and equity inflows. Overall, 17 developing countries are expected to require short- and long-term financing of 5% or more of their GDP to meet their obligations in 2012. If such financing is not forthcoming amidst deepening market turmoil, these countries could be forced to cut sharply either into reserves or domestic demand to make ends meet.

 

The World Bank’s three major commodity price indices fell in October—with non-energy commodities down 7.6%—on concerns about faltering global demand and improved supplies. Declines were heaviest for metals and minerals, which plunged 11.2% in the month, given worries about the tenor of global industrial output. Agriculture prices also fell markedly (5.9%) on expanding supplies. Low stocks and rising seasonal demand continue to underpin crude oil prices, which weakened by only 1%, with the WB price averaging $99.9/bbl in October. The spread between Brent and WTI, which had reached $30/bbl in September, has nearly halved in early-November, as crude shipments to the Gulf coast have relieved excess stocks in the U.S. mid-continent that are at the heart of the price gap. Offsetting earlier 2011 gains, the volatile Baltic Dry Index of dry bulk shipping-costs sank in recent weeks to 1,802—well below the 2010 average (2,755), and sharply off the 2008 average of 6,348 (1 May 1985=100).

 

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