THE FED SCARES THE IMF

The United States is poised to raise rates much more sharply than markets expect, risking a potential storm for global asset prices and a dollar shock for much of the developing world, the International Monetary Fund is warning in its just-issued IMF World Economic Outlook (WEO).

The IMF fears a "cascade of disruptive adjustments" as the US Federal Reserve finally pulls the trigger for the first time in eight years, ending an era of cheap and abundant dollar liquidity for the international system.

The Fed’s long-feared inflexion point is doubly treacherous because investors seem ill-prepared for what lies ahead, and levels of dollar debt outside the US have reached an unprecedented extreme. The Fund says future contracts are pricing in a "much slower" pace of monetary tightening than the Fed itself is forecasting.

The crunch comes as the world economy remains becalmed in 2015 with stodgy growth of 3.5%, held back by another set of brutal downgrades for Russia and string of countries in Latin America. Emerging markets face a fifth consecutive year of slippage as they exhaust the low-hanging fruit from catch-up growth and hit their structural limits.

The IMF’s WEO forecasts that rich economies will clock up respectable growth of 2.4% this year after 1.8% in 2014 as fiscal austerity fades and quantitative easing lifts the eurozone off the reefs, but there will be no return to the glory days of the pre-Lehman era.

"Potential growth in advanced economies was already declining before the crisis. Ageing, together with a slowdown in total productivity, were at work. The crisis made it worse," said Olivier Blanchard, the IMF’s chief economist.

"Legacies of both the financial and the euro area crises – weak banks and high levels of public, corporate and household debt – are still weighing on growth. Low growth in turn makes deleveraging a slow process."

The world will remain stuck in a low-growth trap until 2020, and perhaps beyond. Yet markets have been lulled into a complacency by the lowest bond yields in history and a strange lack of volatility, seemingly based on trust that central banks will always come to the rescue.

Any evidence that the fault lines of the global financial system are about to be tested could "trigger turmoil," warns the WEO. "Emerging market economies are particularly exposed: they could face a reversal in capital flows, particularly if US long-term interest rates increase rapidly, as they did during May-August 2013."

The Fund says yields on 10-year US Treasuries had fallen 80 basis points from October to January due to spillover effects from QE in Europe and Japan, but this sets up the potential for an even sharper spring-back once the Fed tightens in earnest.

The big worry is what will happen to Russia, Brazil and developing economies in Asia that borrowed most heavily in dollars when the Fed was still flooding the world with cheap liquidity. Emerging markets account to roughly half of the $9 trillion of offshore dollar debt outside US jurisdiction.

The IMF warns that a big chunk of the debt owed by companies is in the non-tradable sector. These firms lack "natural revenue hedges" that can shield them against a double blow from rising borrowing costs and a further surge in the dollar. There has already been a trial run of what can go wrong with the much smaller scale of borrowing in Swiss francs.

"The balance sheet shock generated by the sudden large appreciation of the Swiss franc on some countries in central and eastern Europe with sizable domestic mortgage lending in that currency highlights the nature of these risks," it says.

The BRICS club is no longer in a fit state to handle the full consequences of a dollar shock, with the exception of India, the lone star with 7.5% growth this year and next. India will overtake China’s rate of growth in 2015 for the first time in modern memory.

While China is expected to avoid a hard-landing, its growth will slow yet further to 6.3% next year. The Fund hints that the much-trumpeted reforms so far add up to little and have yet to put the country on a viable course.  

Russia’s economy will contract by 3.8% this year as the full impact of the oil price crash and Western sanctions both bite deeper. Brazil faces a long slump, shrinking by 1% in 2015, with barely a flicker of recovery in 2016.

The bottom line for the developing world as a whole is it’s likely to limp on with average growth of just 1.6% from 2015 to 2020.

Productivity in these countries has almost halved from 4.25% to 2.25% since 2008 and is likely to fall further as they hit the "technology frontier," where the middle income trap lies in wait for any that fail to adapt in time.  

What the developing world needs, what countries the world over need – including the US – is root-and-branch reforms of their product and labor markets, and most especially an assault on excess regulation.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph

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