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Financial market volatility increased globally in May and June after a period of calm since last summer. Emerging market economies have generally been hit hardest. Recent increases in advanced economy interest rates and asset price volatility combined with weakness in emerging market domestic activity led to some capital outflows, equity price declines, rising local yields, and currency depreciation in the latter.
The WEO forecast assumes that the rise in volatility and yields will partly reverse, as it largely reflects a one-time reassessment of risks by investors based on the weaker growth outlook for these economies and temporary uncertainty about the US exit from monetary policy stimulus. But if the underlying vulnerabilities persist and financial market volatility remains high, this could increase capital outflows and lower growth in emerging market economies.
More generally, downside risks, old and new, still dominate the outlook. The WEO Update highlights increased risks of a longer growth slowdown in emerging market economies. These risks reflect the possibility of capital flow reversals and the possibility of more protracted effects of domestic capacity constraints, slowing credit growth, and weak external conditions.
Weaker growth prospects in emerging markets and new risks worldwide are challenging global growth, employment, and rebalancing. The report underscores the need for policymakers everywhere to increase efforts to address these challenges and restore robust growth.
The policy priorities for the major advanced economies that were outlined in the April WEO report remain relevant. These economies should continue to pursue a policy mix that supports near-term growth, anchored by measures to put their public debt levels on a sustainable path over the medium term. Clear communication on the eventual exit from accommodative monetary policies will help reduce volatility in global financial markets.
In the euro area, a bank asset review should identify problem assets and quantify capital needs, supported by direct recapitalisation by the European Stability Mechanism where appropriate. Building on recent agreements, policymakers should also make progress toward a fuller banking union, including through a strong Single Resolution Mechanism.