Emerging market rate hikes may strain banks – BIS

    Swift action by central banks in emerging market helped dampen financial market turbulence in January but higher interest rates could put strains on overextended borrowers, making it critical to strengthen financial systems in those countries, said Cladio Borio of the Bank for International Settlements (BIS).

    Some of the rate hikes were in response to external forces so any financial imbalances could unwind suddenly, rather than gradually, especially in countries where the growth of credit was already slowing after after a long financial boom, said Borio, head of BIS’ Monetary and Economic Department.

   Although some countries have already taken measures to address the systemic challenges that face borrowers from higher rates, Borio warned they “may well be insufficient.”

    “It is critical to strengthen financial systems so they can withstand losses should assets fall or loans go sour,” Borio told journalists in connection with the release of the BIS March quarterly review, adding:
    "There is a disappointing element of déjà vu in all this.”

    Emerging markets in January were hit by a second episode of market turbulence in less than a year but intervention in foreign exchange markets and resolute rate rises by the central banks in India, South Africa and Turkey helped ease strains after investors started pulling out funds from emerging markets.

   The first episode, in the summer of 2013, was triggered by news in May that the U.S. Federal Reserve was planning to wind down quantitative easing. The countries that found themselves under attack were those with current account deficits and high inflation, such as India and Indonesia.

     The turbulence in May was accompanied by a sharp rise in the yield of emerging markets’ foreign currency debt. But in January, domestic currency debt was mainly affected.

    “In other words, exchange rate risk as opposed to credit risk became more prominent recently,” Borio said, adding that financial market had also rewarded countries that had revamped their policies, such as Mexico, and India that had accelerated steps to adjust.

   The Fed's extraordinary easy policy had fueled an inflow of funds into many emerging markets, boosting their economies, lowering bond yields, boosting stock markets and housing prices.

   The BIS has long argued that interest rates worldwide have been too low for lasting monetary and financial stability due to the danger of such financial booms that eventually can bust.
    One of the lessons from the two bouts of emerging market turbulence is that the development of local currency bond markets is helpful, but it cannot be expected to insulate countries from a sudden reversal in market sentiment, Borio said.
    “There is a sobering lesson in all of this,” he added.

    Click to read the March 2014 issue of the BIS Quarterly Review.

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