Indian equities have bounced back smartly off their lows recently. Indeed, that is true for most markets around the globe. But does danger lurk around the corner? The International Monetary Fund (IMF) certainly seems to think so.

IMF, in its recently published Global Financial Stability Report, says emerging markets (EMs) have benefited immensely from a prolonged period of easy money policies and low interest rates worldwide. However, it also says that financial vulnerabilities that have accumulated during this period of low rates pose a threat to global economy. It points towards the risks of a sudden liquidity squeeze by global central banks which could cost EMs a fortune.

Even in a best-case scenario of a smooth tightening process by the US Federal Reserve in which there is no increase in investor risk aversion, EMs could experience a massive outflow of foreign money, says the Global Financial Stability Report.

Says the report, if “the US Federal Reserve’s balance sheet normalization proceeds as announced and the federal funds rate is raised to 3.6% by early 2020….. portfolio flows to EMs are estimated to be reduced by an average of $40 billion a year in 2018-19."

This number would look uglier if the policy tightening process is accompanied by a rise in risk aversion. In that case, portfolio flows could be reduced by a total of $60 billion a year over the same period, equivalent to one-quarter of annual inflows in 2010–17.

What would cause these scary scenarios? If inflation in the US rises faster than expected, possibly owing to recent fiscal expansion, the Federal Reserve may respond to it by tightening monetary policy more forcefully than currently anticipated.

In such a scenario, financial conditions could tighten sharply, generating adverse spillovers to other advanced and emerging market economies, as well as adversely affecting internationally active banks that rely on dollar funding, the IMF said. Consequently, it recommends that global central banks adopt a gradual pace of tightening, but it also warns investors of a nasty surprise on the inflation front.

Of course, fears of trade wars and rising protectionism do not bode well for the global economy. But even before any impact on trade, it could lead to decline in confidence and a tightening in financial conditions, making it a separate and substantial headwind to growth, said the IMF.

A strengthening US dollar and rising US bond yields on higher inflation expectations may trigger volatility in EM equities.

Although the recent bout of volatility in global equity markets did not lead to any major dislocations, the episode underscores the need for investors and policymakers to remain attuned to the risks associated with rising interest rates after years of low rates and low volatility, the IMF cautioned.

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