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World Bank warns on contagion risk

Photo: Getty Images

Global growth decelerated to just 2.4% in 2015, down from 2.6% in 2014, according to the World Bank.

That’s largely because of “continued growth deceleration in emerging and developing economies amid post-crisis lows in commodity prices, weaker capital flows and subdued global trade,” the Bank said in the latest edition of its Global Economic Prospects.

Growth is expected to lift in 2016 to 2.9% and then 3.1% in 2017.

But these growth rates have been lowered from previous forecasts and are “subject to substantial downside risks, including a disorderly slowdown in major emerging market economies, financial market turmoil arising from sudden shifts in borrowing costs amid deteriorating fundamentals, lingering vulnerabilities in some countries, and heightened geopolitical tensions,” the bank said.

That’s a neat summary of the fears that have already gripped markets in the first week of 2016.

Source: World Bank Global Economic Prospects January 2016

The bank highlights that emerging market growth has, in the post-GFC world, been an important stabiliser to global growth as developed economies grapple with the economic fallout of the sub-prime crisis and the Great Recession.

That means that after being “powerful contributors to global growth for the past decade” the World Bank’s fears that there will be “simultaneous weakness in most major emerging markets” which is a real concern for the global growth outlook.

“Stronger growth in advanced markets will only partially offset the risks of continued weakness in major emerging markets,” Ayhan Kose, World Bank Development Economic Prospects Group Director, said.

But the bank goes further. While they view a faster-than-expected slowdown in Chinese growth as a “low-probability scenario”, its potential combination with a “protracted” slowdown in other emerging markets is a real source of potential contagion for markets.

That scenario might be low probability but already credit and debt markets are building such an outlook into market prices. That’s another source of risk the Bank says. But it’s a source of risk which is unlikely to be easily quarantined. Emphasis added below:

An abrupt increase in risk aversion—triggered, for instance, by a sudden increase in global interest rates, by heightened concerns about debt in key developing countries, by a credit event in a major emerging market, or by rising geopolitical tensions—could lead to contagion affecting other economies, even if they have limited vulnerabilities. In particular, further credit downgrades in large emerging market economies could cause a general reappraisal of risk. Market-implied ratings, based on credit default swap prices, indicate heightened investor concerns about exposures to weak commodity prices, soft growth, and political risks. In a financial stress situation, pro-cyclical behavior of asset managers could amplify asset price movements and contagion effects.

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