Emerging markets face risk of ‘flight to safety’, IMF official warns

Emerging markets that have coped well with the surge in global borrowing costs so far could find themselves in trouble if episodes such as the turbulence in the UK government bond market spread, a top IMF official has warned.

Ilan Goldfajn, head of the IMF’s western hemisphere division, told the Financial Times that, while emerging markets had so far been spared a rush into dollar-based assets, investors may flee into markets such as US Treasuries if turbulence intensifies.

“It could be the case that what we saw in the UK . . . could become a more generalised vulnerability so that markets become more disorderly,” Goldfajn said in an interview during this week’s IMF meetings in Washington. “In this world something very important will happen for emerging markets . . . the flight to safety.”

He added that, while the dollar had risen against most global currencies, this was not yet because of a shift into US safe assets. Investors tend to flock to US markets in times of turmoil owing to their liquid nature and the tendency for the greenback to appreciate in times of uncertainty.

So far, many economies in Latin America have managed to evade the worst of the turmoil in global markets triggered by higher US rates through prudent monetary policies.

Brazil’s central bank was one of the first to raise rates in March 2021, tightening monetary policy a full year before the US Federal Reserve. Mexico followed in June, then Chile, Peru and Colombia in quick succession. After aggressive rises, which have pushed rates into double digits in Brazil, Chile and Colombia, Latin America’s central banks are now at or near the peak of their tightening cycle.

However, Goldfajn — as a former head of Brazil’s central bank and ex-chief economist of Latin America’s biggest lender, Itaú Unibanco — said his past experience made him “always fearful of financial tightening”, especially when this involved US rates rising.

The Fed has this year engaged in its most aggressive monetary tightening since the early 1980s and is considering making its fourth consecutive 75 basis point increase in November.

Such an environment was “never very easy for [Latin America] to navigate”, Goldfajn said.

In a blog co-authored with IMF colleagues, Goldfajn warned that Latin America faced a “third shock” from higher global interest rates, on top of the coronavirus pandemic and Russia’s invasion of Ukraine. Scarcer and costlier financing would hit consumption and investment in a region that has consistently grown more slowly than its emerging market peers over the past decade.

These headwinds have led the fund to lower its Latin America growth forecasts for next year. It now predicts the region’s economies will expand just 1.7 per cent in 2023, down from a forecast of 2.5 per cent six months ago and well below the levels predicted for Asia, the Middle East or sub-Saharan Africa.

Brazil, the biggest Latin American economy, is now expected to grow by just 1 per cent in 2023 — a prediction that Goldfajn said was based on an expectation of lower growth in China, Brazil’s biggest export market.

However, Latin America will perform better this year than was expected in April, when the fund held its spring meetings.

Surging commodity prices, strong external demand and remittances, a rebound in tourism and solid growth momentum after the pandemic led the fund to raise its Latin America growth forecasts for 2022 to 3.5 per cent, largely because Brazil is performing much better than previously expected.

Brazil will grow 2.8 per cent this year, the IMF now believes, whereas six months ago its forecasters had expected expansion of only 0.8 per cent. Mexico’s forecast has changed less and now stands at 2.1 per cent for 2022 and 1.2 per cent for 2023.

Still under US economic sanctions, Venezuela will be one of the region’s standout performers this year and next, according to the IMF forecasts. After years of economic collapse, the fund predicts the South American oil exporter will grow 6 per cent in 2022 and 6.5 per cent in 2023, which would be its best year in a decade.

Although the growth news for Latin America this year was positive, the IMF was less sanguine about inflation.

While the region has led the world in raising interest rates and its mostly independent central banks have taken a much more aggressive stance than many peers, the fund said “Latin America will continue facing high inflation for some time”. It raised its regional inflation forecasts to 14.6 per cent for this year and 9.5 per cent next year.

“Central banks should stay the course [and] should not ease prematurely,” Goldfajn told the FT. “You need to be mindful that inflation is the most important risk now and the one that needs to be tackled . . . we want to be sure that you don’t get inflation entrenched with wage and price spirals.”

His main concern for Latin America, though, remains the risks generated by higher interest rates in the US. “It could be the case that this time around we are better off, maybe monetary policy is better, maybe we’ll have more reserves, maybe our banking systems are more healthy,” he said. “But . . . what worries me is that this tightening is there. It’s going to continue. We’re going to see deceleration, we may even see recessions globally. So that’s not an easy environment in 2023.”