Rising global interest rates may cause strong capital flows away from emerging market countries, threatening their growth and stability, the Bank for International Settlements (BIS) said on Monday.
Low interest rates in rich countries such as the United States prompted investors there to boost their purchases of shares and bonds in Asia, Latin America and central Europe, which helped those emerging economies grow strongly last year.
But the BIS noted in its annual report that a "distinct reversal" of that trend started this spring, raising questions about the sustainability of capital flows into emerging markets.
"Increased financial market volatility and the sharp widening of sovereign bond spreads between mid-April and mid-May 2004 demonstrated that, for countries with an uncertain fiscal outlook or those with high public debt levels, positive market sentiment can be quickly reversed," said the BIS, the central bank to the world's central banks.
The BIS worried that some emerging market states had loosened their budgets too much, slackened the pace of adjustment or allowed private sector credit to rise too quickly.
"In these countries, underlying vulnerabilities masked by the ready access to financing are likely to become more apparent if the external financing environment turns less favourable," said the BIS in the report, which is closely watched to see how central banks view the world economy.
But the BIS report also praised highly-indebted Brazil, Mexico and Turkey for cutting their borrowing costs and re-balancing their debt burdens away from short-term external debt, often linked to short-term interest or exchange rates.
And the strengthening and broadening of the global recovery as well as a rise in global commodity prices would help to moderate the risks to emerging market countries from a reversal in capital flows, the BIS added.
Net private capital inflows to the 21 largest emerging market economies were estimated at $171 billion in 2003, up from $66 billion the year before, with investment in equities and bonds up sharply, while foreign direct investment slowed.
The BIS report also highlighted some specific worries about the economy overheating in China, which has been a major contributor to world economic activity since late 2001.
China's investment-to-GDP ratio at 0.45 is one of the highest in the world and its rapid increase not only threatens overheating the economy in the short term but could cause a build up of excess capacity in the long term, strengthening deflationary trends, the BIS said.
China's investment has also largely been financed by bank credit, raising concerns about the fragility of the financial system, and its intensive use of production resources makes high inflation another potential risk, the report added.
"Last year, China's consumption of steel accounted for 90 percent of the increase in global steel demand and outstripped domestic supply," the BIS report noted.
The BIS also noted that many emerging market economies had intervened in the foreign exchange markets to resist the appreciation of their currencies in response to large capital inflows and higher commodities prices. This had led to a large increase in foreign exchange reserves.
Total reserves in emerging Asia rose by over $350 billion between the beginning of 2003 and early 2004, with China, India, South Korea and Taiwan accounting for 85 percent of the increase, BIS said.
The BIS worried that the strong accumulation of reserves might limit the ability of central banks to contain future monetary growth in their countries. It noted that China's central bank has raised reserve requirements and asked banks to curb lending to certain sectors.
Intervention in the currency markets can also give the impression that the home currency is undervalued. This can still have significant expansionary effects on the economy if the expectation that the home currency will appreciate leads to large short-term capital inflows.
"Narrower (bond yield) spreads, related to large short-term capital inflows, have contributed to booming stock markets and rapid credit expansion in the consumer and housing sectors," the report said.
Furthermore, if countries are not able to sustain their currency intervention, it may create excess capacity in the economy and lead to a boom-and bust cycle.
"Such a risk is particularly high in economies exposed to speculative capital inflows, which could reverse, triggering a sharp fall in asset prices and the exchange rate".
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