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The eventual tightening of monetary policy in high-income countries may slow growth in developing countries

Although much of the current debate in developing countries concerns the potential impacts of Japanese quantitative easing (see earlier discussion), the implication for developing countries of backing away from current levels of stimulus and even the withdrawal of stimulus are at least equally important. Although Japan has embarked on a new stimulus policy, there are increasing signs that the United States will soon either reduce the size of or stop its QE efforts. If that happens, not only will the net effect of Japanese easing likely be offset (at least partially) by tighter policies in the United States, but over the medium term, developing countries are likely to face tighter financial conditions, with potentially important real-side implications.FN9

As monetary policy in high-income countries begins to be less accommodative, long-term interest rates can be expected to rise. Currently, U.S. long-term interest rates are some 110 basis points below their pre-crisis level and 140 basis points lower than their long-term average in real terms. Assuming that a relaxation of quantitative easing leads U.S. long-term interest rates to rise to their long-term average in real terms, and that developing-country interest rate spreads remain constant, developing-country borrowing costs would rise by the same amount as long-term U.S. rates.

Econometric evidence suggests, however, that developing-country spreads tend to rise when base rates increase. Work done for the 2010 edition of Global Economic Prospects suggests that a 100-basis-point increase in high-income-country base rates is associated with a 110 to 157 basis point increase in developing-country yields (World Bank 2010; Kennedy and Palerm 2010, 2013and IMF 2013a).

If real base rates return to their long-term averages, they would rise from about 188 basis points today to around 322 basis points (the mean level between 1990 and 2007). Based on historical experience, that could cause developing-country yields to rise by between 150 and 270 basis points, with countries with relatively good credit histories and low spreads at the bottom end of the range and those with less good records toward the upper end of the range. This is broadly in line with recent IMF (2013a, 38–39) estimates that suggest that three-fourths of the 465 basis point decline in developing-country yields since December 2008 has been caused by external rather than domestic factors.FN10

Simulations suggest that the associated increase in the cost of capital would cause desired capital-to-output ratios in developing countries to decline, resulting in slower investment growth for an extended period as well as a slower rate of growth of potential output of around 0.6 percentage points per annum after three years during the transition period to a lower capital-output ratio. Longer term, potential output could be lower by between 7 and 12 percent unless measures are undertaken to reduce domestic factors that contribute to the high cost of capital in developing countries. Efforts in this regard could more than completely offset the impact of tighter global conditions.

9. See World Bank 2010, chapter, 3 for a more detailed discussion of the impact of higher borrowing costs.

10. The IMF work differs from the World Bank work in citing high-income-country stock market volatility as the main external factor underpinning the decline in spreads. The World Bank (2010) includes high-income stock-market volatility with a much wider range of risk appetite indicators to derive a synthetic price-of-risk indicator that simultaneously determines developing country and high-income country risk premiums.




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