Recently, financial volatility returned because of various concerns in the marketplace – including (just to name a few) shifting expectations of the shape of the Federal Reserve’s exit path from ultra-low interest rates and the rapid strengthening of the US dollar; the launch of quantitative easing by the European Central Bank and its impact on inflation expectations and bond markets; low and volatile oil prices; China’s growth slowdown, additional stimulus and financial-sector challenges; the standoff between the new Greek government and its creditors; and continuing geopolitical turmoil.
In this context, EMDEs face six interrelated financial challenges, although it is important to note significant differences between countries exist.
First: Prolonged extraordinary monetary policies (EMPs) in developed countries and the prospect of asynchronous exits create a wide range of global financial market challenges. EMPs in developed economies created an environment of ultra-low interest rates, as policymakers have aimed to rekindle economic growth and battle disinflationary pressures. Three key risks have emerged:
- Low rates and excessive risk-taking have contributed to very high asset valuations, compressed risk spreads and term premiums, and stimulated non-bank-sector growth, boosting leverage, illiquidity and collateral shortages. That exposes the financial system to shocks. This has weakened risk pricing and contributed to the “illusion of liquidity,” raising the risk of pro-cyclical “fire sales” with global spillovers.
- Sudden shifts in market expectations or a bumpy trajectory of the U.S. Federal Reserve exit path to normalized interest rates could trigger volatility in currency, equity and capital-flow markets – similar to the “Taper Tantrum” of 2013, when the Federal Reserve openly contemplated scaling back its asset purchases.
- Increasing divergence between central bank policies in developed economies has already had significant implications for currency markets, particularly for the euro-dollar pair. Divergence creates an interference risk and the possibility of miscommunication, which could trigger new bouts of global financial market volatility.