Quake-proofing the global economy

The world of finance started February 2018 with a massive tremor. The first shock sent the US stocks tumbling, with Dow Jones posting its biggest single-day drop in history on 5th February. The shock waves travelled around the world, sending stocks in Europe and Asia into a tailspin. While the disruption was short-lived, ugly visions of the earthquake-level shocks of the recent financial crisis reared their heads as risk-averse investors scrambled to understand what had hit them.

We now know that the shock was sparked by higher-than-expected wage growth in the US. Higher wages usually spell inflation. The return of normal inflation rates – after a period when deflation was a much greater concern – will prompt central banks to raise interest rates more rapidly.

In December last year, UN DESA’s World Economic Situation and Prospects 2018 report cautioned that the tightening of purse-strings by major central banks might cause sudden spikes in market volatility. But even having that knowledge, could countries have shielded themselves against these and other risks beyond their control?

The March issue of the World Economic Situation and Prospects Monthly Briefing analyses some tools that could help emerging economies brave the next such “tremor.” Chief among them are macroprudential policies – named for their objective of containing systemic risks and protecting the financial system as a whole.

These policies may soon be put to the test, as years of pumping cash into the global economy and low borrowing costs have allowed financial vulnerabilities to build up, including high levels of debt. In 2017, non-financial corporate debt in emerging economies exceeded 100 per cent of their gross domestic product (GDP).

As the US and other major economies normalize their monetary policies, emerging economies should prepare for a period of potentially more volatile and lower capital flows. For many of them, effective use of macroprudential tools could soften the blow and allow them even more policy space in the future. Be it a minor tremor or a huge shock, such quake-proofing is crucial, if the momentum of the global economy is to be maintained.

Photo: Jonathan Ernst / World Bank

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