Special Focus: The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?

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1 For more information, visit Overview Table of Contents Mixed signals on the trajectory of U.S. economic growth are complicating the Fed interest rate decision. Euro Area industrial production declined at the fastest pace in a year in the third quarter, but economic activity may be rebounding this month. Slowing or contracting growth in emerging markets in Q2 has been followed by slackening high frequency data. Trade is contracting in many large economies. Commodity prices remain weak, and the medium-term outlook softened further. Monthly Highlights.2 Special Focus...6 Major data releases...8 Other reports from Prospects Group...8 Recent WB country reports...8 Annex table: economic developments 9 Annex table: financial markets..1 Chart of the Month Gross private capital flows to EFEs during Q3 fell by almost half compared with the same quarter in 214. About 6 percent of the drop in gross flows was accounted for by China. Bond and equity issuance showed signs of improvement in mid-october, with emerging market bond and equity funds seeing inflows for the first time in three months. Gross capital flows to EFEs US$, billions Bank Bond Equity 212 Q1 212 Q2 212 Q3 212 Q4 213 Q1 213 Q2 213 Q3 213 Q4 214 Q1 214 Q2 214 Q3 214 Q4 21 Q1 21 Q2 21 Q3 Source: Bloomberg. Special Focus: The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters? If the lift-off proceeds at the pace reflected in current market expectations, then it should have limited implications for the global economy. The impact of increasing U.S. yields on emerging and frontier economies will depend on its trigger, with more benign effects expected if liftoff is associated with a robust recovery in the United States. Important risks persist, however. Interest rate increases could be associated with sudden bouts of volatility. These raise the risk of capital outflows from emerging and frontier economies, which could be amplified by lingering vulnerabilities and weakening growth prospects. Prepared by a team led by Christian Eigen-Zucchi (3496), comprising John Baffes, Mai Anh Bui, Xinghao Gong, Eung Ju Kim, Trang Nguyen, Marc Stocker and Ekaterine Vashakmadze. DECPG - October 21

2 Monthly Highlights October 21 Global growth: further signs of weakness in Q3. Preliminary GDP data for Q3 is beginning to emerge, and in those countries where estimates have been published, growth is slowing (U.S., China and the U.K.). Industrial production decelerated in much of the world during Q3, especially the U.S., Japan and China (Figure 1A). Other indicators, such as retail sales, also point to a softening of growth in several countries (Argentina, Brazil, Indonesia, and Russia). Commodity prices eased further and capital flows to emerging markets have stabilized but remained weak. The contraction in global trade is continuing, with sharp declines in imports in major economies, led by falls in BRICS (Figure 1B). Looking ahead, initial Purchasing Managers Indexes (PMIs) for October are in expansionary territory in the U.S. and Euro Area, indicating that activity in advanced economies may be picking up going into Q4 (Figure 1C). United States: signs of softening after a strong second quarter. Preliminary estimates for Q3 show that GDP growth softened to 1. percent (q/q saar) from an upwardly revised 3.9 percent in Q2, as manufacturing activity was temporarily held back by a significant decline in inventories while the strength of the dollar and soft external demand continued to weigh on exports. Retail sales growth was sluggish in September (.1 percent, m/m, sa), after remaining flat in August. U.S. industrial production fell by.2 percent in September (m/m), as the strength of the dollar and weak external demand weigh on durable goods output, low energy prices induce a scaling-back in extraction and drilling activity, and inventories are drawn down. Activity may be gaining momentum at the start of Q4, with a higher-thanexpected increase in the flash U.S. Manufacturing PMI (Markit) to 4 in October. New applications for jobless benefits in the U.S. fell to 232,883 in the week ending October 17, more than expected and close to a 42 year low. Overall, the data create uncertainty about the growth trajectory, complicating the Federal Reserve s decision on when to start raising policy interest rates, which were left on hold in October. The U.S. budget deficit narrowed to 2. percent of GDP in fiscal-year 21, the lowest level since 27, as revenues were boosted by rising incomes and corporate profits whereas expenditures were constrained by the sequester. A tentative budget agreement has been reached (approved by the House but still to be considered by the Senate) to extend the Treasury s borrowing authority to March 217. Euro Area: sluggish growth. Indicators of economic activity in the Euro Area are mixed, complicating policy formulation to support the recovery. At its October 22 meeting, the ECB decided to leave its monetary policy stance unchanged, but noted that the asset-purchase program will need to be reevaluated in December with a view to further expansion. Although inflation returned to zero in October (y/y), from -.1 percent in September, it remains far below the 2 percent target. Industrial production slowed to. percent (m/m) in August, consistent with expectations, following a revised.8 percent rise in July. Other indicators suggest that the recovery is still on track, however, as retail sales remained solid through August, consumer confidence is still robust, and car sales continue to increase. The ECB s Bank Lending Survey also showed that credit standards improved further in the third quarter, with low interest rates contributing to stronger loan demand. Euro Area headline consumer price inflation was confirmed at -.1 percent (y/y) in September. Momentum may be firming going into Q4, however, and the flash Euro Area PMI Composite Output Index (Markit) increased more than expected to 4 in October, signaling broad-based expansion in services and manufacturing. The index rose ahead of expectations in the region s two largest economies, Germany and France. China: financial market stabilization amidst slightly stronger-than-expected growth. Third quarter GDP growth was marginally stronger than expected, expanding by 6.9 percent (y/y) compared to a consensus forecast of 6.8 percent, but continuing on a slowing path (Figure 1D). CPI inflation eased to 1.6 percent in September (y/y), about half of the People Bank of China (PBoC) target of 3 percent for 21. The government and PBoC implemented a wide range of stimulus measures throughout 21 to support demand and avoid a sharp slowdown, including lowering interest rates and reserve requirements, boosting fiscal stimulus, implementing a debt-for-bond swap to support local government spending, and easing regulations. At its October 23 meeting, the PBoC lowered policy interest rates by 2 basis points to 4.3 percent (the sixth reduction this year), reduced reserve requirements to 17. percent for commercial banks, and removed the deposit rate ceiling. Activity data point to continued rebalancing from industrial production towards services. On the demand side, consumption remained resilient and investment growth rebounded from a dip in Q1, but the contribution from net exports turned negative for the first time since Q2 of 214. Despite continued capital outflows, the renminbi has been stable since mid-august, supported by a reserve drawdown. In September, foreign reserves declined by $43 billion, bringing the total stock of foreign reserves to $3. trillion (about 34 percent of GDP). Stock markets have also been stable since late August, following a 4 percent correction which started in mid-june. The 13 th five year plan (216 22) is to be approved at a plenary of the Central Committee, and will include new annual GDP growth targets, as well as policy initiatives on yuan convertibility, the environment, and SOE reform. 2

3 October 21 South Africa: slowest growth in 7 years. South Africa s GDP contracted in the second quarter, but high-frequency data points to a modest rebound in the third quarter. Growth of about 1. percent is expected for the year as a whole, the slowest since 28. The combination of weak domestic demand, power sector challenges and low commodity prices is weighing heavily on growth. The power supply bottlenecks are the accumulated result of several years of underinvestment in new capacity, compounded by difficult labor relations and a drought. Gross capital flows: sharply down amid global volatility. Capital flows to developing countries fell sharply in Q3, down 49 percent compared with Q Bond and equity flows were particularly weak in August/September on heightened uncertainties about the Chinese economy and the U.S. interest rate outlook (Chart of the Month). The sharpest declines were in flows to Brazil and China. The Q3 decline in bank lending was less severe than in equity and bond flows, amid strong loan activities in Brazil, Mexico, Turkey and several African countries (including Ghana and Nigeria). In October, bond and equity issuance activity showed signs of improvement as market sentiment began to turn more favorable. Emerging-market bond and equity funds recorded inflows for the first time in at least three months in the week ending October 14 th (Figure 2A). Furthermore, emerging-market assets have rallied this month amid revised expectations on the timing of the Fed s rate hike, rebounding from sharp losses in the summer. However, questions remain about how long the current turnaround will last given the weak growth outlook for emerging markets and heightened political risks in a series of EM countries such as Brazil and Turkey. Emerging market foreign exchange reserves: decline led by China. Emerging-market foreign-exchange reserves fell by more than $2 billion in Q3, compared with a $12 billion accumulation in Q2 (Figure 2B). The decline in reserves was driven mostly by a $17 billion decline in China. The drawdowns reflected central banks efforts to stem depreciation pressures; nevertheless, EM currencies, on average, depreciated by 9 percent. Most EM countries still have ample reserve cushions to cover temporary shortfalls in financing flows, but several countries have increasingly limited buffers against a sustained reversal of capital flows. Remittances: slowing growth. The growth of remittances to developing countries is projected to fall from 3.3 percent in 214 to 2. percent in 21 (Figure 1E). The slowdown in remittances is largely due to weak growth or contractions in the major remittance-source countries, especially Russia. Depreciation of the euro and the ruble against the U.S. dollar further dampened remittance flows in US dollar terms, especially to countries in Europe and Central Asia (Migration and Development Brief 2 - October 21). Poverty: estimates revised lower. The international poverty line was raised to $1.9 at 211 purchasing power parity conversion factors (PPPs), from $1.2 at 2 PPPs, all the while seeking to keep the real purchasing power of the line constant. The global number of extreme poor was 897 million in 212, and is estimated to have fallen to 72 million in 21, bringing the global poverty headcount ratio into single digits for the first time, at 9.6 percent (Figure 1F) (Policy Research Note October 21). Commodity prices: continued weakness. With global commodity markets well supplied and demand subdued, especially for industrial commodities, commodity prices slid by an average of 2 percent in the third quarter of 21 (Figure 2C). Annual price forecasts for 21 and 216 have been revised downwards, and only a modest recovery is projected for 216. Oil prices: the agreement with Iran. The international agreement on Iran s nuclear program to be implemented in the first half of 216 could lead to a suspension of sanctions and termination in 223. Shipments from Iran s 4 million barrels of floating storage of oil could start immediately, and Iran could increase crude oil production by.-.7 mb/d within a few months of sanctions being lifted, potentially reaching a 211 pre-sanctions level of 3.6 mb/d (Figure 2D). Iran accounts for 9.3 percent of the world s proven oil reserves, and the long-term impact could be significant if Iran is able to attract foreign investment and technology into the sector. With the world s largest known gas reserves, Iran also has the potential to export large volumes of natural gas (Commodity Markets Outlook - October 21). Agricultural commodities: strongest El Niño on record but limited global impact. The El Niño phenomenon is characterized by the winds of the equatorial Pacific slowing or reversing direction, in turn raising the temperature of waters over a vast area of the Pacific Ocean. The current episode could be the strongest on record and is projected to peak between December and February, though it could extend into early summer of 216. While El Niño typically reduces agricultural production in the Southern Hemisphere and may have strong local impacts, especially in Australia, East Asia, and Latin America, upward pressure on global commodity prices in 216 is likely to be limited (Figure 2E), as markets are well-supplied (Figure 2F) and the transmission from spikes in local food prices to global markets is weak (Commodity Markets Outlook - October 21). 3

4 October 21 Figure 1: Selected Activity Indicators A. Industrial production B. EME Volume of Imports Year-on-year, percent United States Euro Area Japan 2 EME BRICS Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-1 May-1 Sep-1 C. Manufacturing PMI D. China GDP growth Index Year-on-year, percent US Japan Euro zone 8. 6 France Germany Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 Jul-14 Dec-14 May-1 Oct Q1 212Q3 213Q1 213Q3 214Q1 214Q3 21Q1 21Q3 E. Remittances F. Share of the population below $1.9 per day US$, billions Percent * DEV EAP ECA LAC MNA SAR SSA EAP ECA LAC SAR SSA World Sources: World Bank, Bloomberg, Haver Analytics, CPB World Trade Monitor, Markit. Panel A: The latest available observation is September 21 for United States, August 21 for all others. Data are year-on-year growth rates, seasonally adjusted. Panel B: The last observation is August 21. Panel C: The last observation is for October 21 (Markit). Panel D: The last observation is 21Q3. Panel E: Migration and Development Brief 2 October 21. Panel F: Estimates based on the $1.9 poverty line and 211 PPPs. 4

5 October 21 Figure 2: Selected Financial and Commodity Indicators A. Flows to EM bond and equity funds B. Monthly changes in official reserves Weekly flows US$, millions Change in reserves US$, billions 12 1, EM equity funds EM bond funds 8 1, 4, , China -1, -2-1, -24 Other EM economies* Jan-1 Feb-1 Mar-1 Apr-1 Apr-1 May-1 Jun-1 Jul-1 Aug-1 Sep-1 Oct-1 Mar-7 Aug-8 Jan-1 Jun-11 Nov-12 Apr-14 Sep-1 C. Commodity price indices, monthly D. Iran oil production US$ nominal, 21= Energy mb/d 7 Iranian Revolution 6 4 Consumption Net exports Real oil price (RHS) Iran-Iraq War US$/bbl Sanctions 14 Escalation Agriculture Metals 1 2 Jan-11 Jan-12 Jan-13 Jan-14 Jan E. Monthly agriculture prices and El Nino episodes F. Stock-to-use ratio 2 17 Index, deflated by U.S. CPI, Agriculture price index ENSO Index peaks Percent yr average % -19.6% 1.4% -2.9% -.9% -2.2% -6.% -7.3% 1.4% 9.8% 3.8% -3.% -7.1% -14.8% Sources: World Bank, Bloomberg, Haver Analytics, BP Statistical Review of World Energy. Panel A: The last observation is October 21. Panel B: The last observation is October 21. Panel C: Commodity Price Indices, 21=1. The last observation is September 21. Panel D: Includes crude oil and natural gas liquids. The bar for 21 is based on the first nine months. Panel E: The ENSO index peaks reflect values greater than 1. The numbers denote percent changes of the six-month average price index leading to the episode compared to the previous six-month period (bold) and the corresponding six-month period of the previous year (italic). The last observation for both agricultural price index and El Niño is September 21. Panel F: The value reflects the October 21 update. Maize Wheat Rice

6 October 21 Special Focus: The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters? If the timing of the liftoff and subsequent path of policy rates are accurately reflected in market expectations, the normalization of U.S. policy rates could be part of a smooth transition for the global economy. Barring a sudden acceleration in inflation or an unexpected change in the Fed policy stance, U.S. long-term yields should rise only modestly as the U.S. yield curve is expected to flatten. Although conditions differed during previous monetary tightening cycles, these generally had mild initial repercussions for emerging and frontier economies (EFEs). The U.S. yield curve usually flattened and term premia rose only slowly, if at all, during the first year of the tightening cycle (Figure 3A). In 24, term spreads even narrowed dramatically (dubbed the conundrum ), partly reflecting ample global liquidity and declining medium-term inflation expectations. This tightening episode which, like the upcoming one, also started at very low U.S. policy interest rates was fairly benign for EFE currencies and capital flows. In contrast, a rapid tightening cycle, as in 1994, would lead to greater bond market stress, capital flow declines and a more pronounced depreciation of EFE currencies (Figure 3B). The impact of increasing U.S. yields on EFEs depends on the trigger of the increase. Rising U.S. yields that reflect a strengthening U.S. economy would likely have more benign consequences for EFEs, as the positive growth spillovers would offset the effects of higher borrowing costs. In contrast, rising U.S. yields that purely reflect a perception of accelerated monetary tightening would likely be accompanied by weakening activity, tighter financial conditions, bouts of volatility and sudden adjustments in capital flows. A panel vector autoregression (VAR) model was estimated to examine the diverging impacts of different types of U.S. shocks on measures of real activity and financial market conditions in EFEs. As expected, the results suggest that a U.S. yield increase triggered by a favorable real shock has a considerably more benign impact on EFEs than one resulting from an adverse monetary shock. Higher U.S. yields supported by a perceived improvement in economic conditions in the United States tend to be followed by stronger activity in EFEs (Figure 3C), higher equity market valuations, and more stable borrowing conditions (Figure 3D). Since the taper tantrum in 213, monetary conditions are perceived to be more favorable. Looking forward, upward pressure on long term yields that reflect a strengthening U.S. economy would likely have manageable if not positive effects on EFEs, but important risks persist. Three factors currently heighten the risk of volatility from the tightening cycle. First, U.S. term premia are well below their historical average, reflecting a modest assessment of inflation risks and strong global demand for U.S. Treasuries as safe assets. Second, market expectations of future policy interest rates are currently significantly below those of members of the U.S. Federal Open Market Committee (Figure 3E). While Fed policy makers could continue to adjust their expectations down in coming months, markets could also revise theirs up significantly, depending on data outcomes. Third, several factors make liquidity conditions more fragile than before the global financial crisis. These include reduced dealer inventories and market-making activities by banks, diminished risk appetite, and tighter regulatory requirements (Figure 3F). During episodes of financial stress, fragile liquidity conditions tend to amplify market reactions and increase the risk of contagion effects. The upcoming U.S Federal Reserve tightening cycle will take place in a challenging environment for EFEs. Global trade has been subdued in recent years, commodity prices have declined substantially, and the U.S. dollar has appreciated significantly. Domestically, productivity growth in EFEs has slowed while corporate leverage increased substantially in the post-crisis period, and countries facing bank asset quality problems have seen little improvement. Weakening growth could reduce resilience to external shocks as well. Concerns about growth prospects in major emerging markets and reduced credit worthiness could potentially raise the risk of capital outflows associated with tighter global financing conditions. In the event that risks surrounding the upcoming tightening cycle materialize, exchange rate flexibility could buffer shocks in some countries but may need to be complemented by monetary policy measures and targeted interventions to support orderly market functioning. Emerging and frontier market economies may hope for the best during the upcoming tightening cycle, but given the substantial risks involved, they need to prepare for the worst (Policy Research Note September 21). 6

7 October 21 Figure 3: Impact of U.S. monetary policy tightening on emerging and frontier markets If the tightening cycle comes in response to strengthening U.S. economic conditions, the term spread could remain narrow and U.S. long-term interest rates would rise slowly from current low levels, with more benign effects on EFEs. Still, EFE currencies could remain under pressure and risks remain of spikes in long-term U.S. rates and bouts of volatility, especially since term premia are well below historical averages and market expectations of future interest rates are below those of Fed policy makers. A.U.S. term spreads around previous U.S. B. EFE Nominal effective exchange rates tightening cycles Basis points; deviations from t = Feb-94 Jun-99 Jun-4 May Quarters C. Response of EFE industrial production to rising U.S. yields Percent change Monetary shock Real shock Percent, deviations from t = Feb-94 2 Jun-4 D. Response of EFE bond yields to rising U.S. yields E. Gap between FOMC and market expectations F. U.S. 1-year treasury term premium Basis points Mar-14 Jun Sep-14 Dec-14 Mar-1 Jun-1 Latest Sources: Haver, Bloomberg, World Bank estimates, IMF, Federal Reserve Bank of New York, Panel A: Term spread denotes the difference between 1-year U.S. Treasury and 6-month T-bill yields. Panel B: A decline denotes a depreciation of the nominal effective exchange rate. The x-axis shows the number of months before and after t =, where t = is February 1994, June 1999, June 24, and May 213. Panels C & D: Impulse responses after 12 months from a panel VAR model including EFE industrial production, long-term bond yields, stock prices, nominal effective exchange rates and bilateral exchange rates against the U.S. dollar, and inflation, with monetary and real shocks estimated from a separate model as exogenous regressors. All data are monthly or monthly averages of daily data, for January 213-Sep 21 for 23 EFEs. For comparability, the size of the U.S. real and monetary shocks is normalized such that each shock raises EFE bond yields by 1 basis points on impact. List of countries is: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Arab Rep., Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Romania, Russian Federation, South Africa, Thailand, Turkey, Ukraine, and Venezuela, RB. Bond yields refer to the yields on 1- year (or nearest equivalent) government treasury bonds. Panel F: Term premium estimates are obtained from the model described in: Adrian, T., R. Crump, and E. Moench Pricing the Term Structure with Linear Regressions. Journal of Financial Economics 11 (1): Jun-99 May Months Basis points Monetary shock Percent Average since 2 Real shock Historical average ( )

8 October 21 Major data releases Other reports from the Prospects Group Global Economic Prospects June 21: The Global Economy in Transition Global Monitoring Report 21/216 Development Goals in an Era of Demographic Change Commodity Markets Outlook October 21 Policy Research Note March 21: The Great Plunge in Oil Prices Policy Research Note September 21: The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters? Policy Research Note October 21: Ending Extreme Poverty and Sharing Prosperity: Progress and Policies Recent World Bank Working Papers The Impact of Investment Policy in a Changing Global Economy: A Review of the Literature The Impact of China s Slowdown on the Asia Pacific Region: An Application of the GVAR Model A Global Count of the Extreme Poor in 212: Data Issues, Methodology and Initial Results Recent World Bank Country Updates Moldova: Economic Update Turkey: Economic Activity Slowdown Due to Political Uncertainty Myanmar: Economic Monitor 8

9 October 21 Economic Developments indicators expressed as %ch y/y, except Industrial Production quarterly figures are %ch q/q, annual Q1 Q2 Q3 Q4 Q1 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Industrial Production, S.A. World High Income Countries Developing Countries East Asia and Pacific East Asia x. China Europe and Central Asia Latin America and Caribbean Middle East and N. Africa South Asia Sub-Saharan Africa Inflation, S.A. 1 High Income Countries Developing Countries East Asia and Pacific Europe and Central Asia Latin America and Caribbean Middle East and N. Africa South Asia Sub-Saharan Africa Inflation is calculated as the GDP-weighted average for all groups. Trade and Finance indicators expressed as %ch y/y, except International Reserves are %ch p/p and trade quarterly figures are %ch q/q, annualized Q1 Q2 Q3 Q4 Q1 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Exports, Nominal, US$, S.A. World High Income Countries Developing Countries East Asia and Pacific Europe and Central Asia Latin America and Caribbean Middle East and N. Africa South Asia Sub-Saharan Africa Imports, Nominal, US$, S.A. World High Income Countries Developing Countries East Asia and Pacific Europe and Central Asia Latin America and Caribbean Middle East and N. Africa South Asia Sub-Saharan Africa International Reserves, US$ High Income Countries Developing Countries East Asia and Pacific Europe and Central Asia Latin America and Caribbean Middle East and N. Africa South Asia

10 October 21 Financial Markets MRV 1 Q3 Q4 Q1 Q2 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Interest rates and LIBOR (%) U.S. Fed Funds Effective ECB repo US$ LIBOR 3-months EURIBOR 3-months US 1-yr Treasury yield German Bund, 1 yr Spreads (basis points) JP Morgan Emerging Markets Asia Europe Latin America & Caribbean Middle East Africa Stock Indices (end of period) 2 Global (MSCI) High-Income ($ Index) United States (S&P-) Euro Area (S&P-3$) Japan (Nikkei-22) Developing Markets (MSCI) EM Asia EM Europe EM Europe & Middle East EM Latin America & Caribbe Exchange Rates (LCU / USD) High Income Euro Area Japan Developing Brazil China Egypt India Russia South Africa Memo: USA nominal effective ra MRV = Most Recent Value. 2 MSCI Indices for Asia, Africa, and Europe and C. Asia, for 28 are calculated from February-December, due to data availability. 3 Change expressed in levels for interest rates and spreads; percent change for stock market and exchange rates. Commodity Prices MRV Q3 Q4 Q1 Q2 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oil price, $/b, nominal Non - Oil Index Metals and Minerals Index Baltic Dry Index Simple average of Brent, Dubai and WTI. 2 Base Date = Jan 3, 211 due to data availability. The Index component combination in the Weekly tables differs from 3 Base Date = Jan 4, 21 due to data availability. The Index component combination in the Weekly tables differs from 4 Base Date = May 1, 198 1