- “Overshooting”: market reactions are assumed to be more abrupt, resulting in a sharp (200 bp) increase in long-term interest rates in first half of 2014, followed by a more protracted adjustment back to the baseline;

# **Box 4  A live experiment: tapering expectations and capital inflows during the summer of 2013**

The simulations derived from the vector autoregression (VAR) model can be compared with actual developments following the Fed tapering announcement in May 2013. After the conditions for the unwinding of quantitative easing were outlined by the Fed chairman in a congressional testimony on May 22 2013, the U.S. long term interest rates suddenly shot up by 100bp and the VIX index initially rose from 15 to 20. Emerging market bond spreads increased significantly, and issuances of developing-country bond, equity, and syndicated bank loans dropped by around 50 percent during the summer (Figure 4. 1).

Although bond, equity issuances and syndicated bank flows are conceptually different from the private capital inflow data reported in the balance of payment statistics and used in our modeling strategy, the observed deceleration of flows during the summer of 2013 appear largely consistent with the elasticities estimated in the VAR model. Counterfactual simulations show that the decline predicted by the VAR model would have been of similar magnitude albeit more gradual than actually observed (Figure 4. 1). As presented in the “fast adjustment” scenario , a 100bp shock to the yield curve generally translates within two quarters into a drop in inflows of around 50 percent, with the VIX index predicted to increase by six points.

The observed impact of financial market tensions during the summer was also reflected in a deteriorated outlook for many developing economies, particular among those considered most vulnerable (Figure 4. 2).

The vector autoregression (VAR) model described in Box 3 was used to explore inter-temporal adjustments between capital inflows, growth and global financing conditions, in order to assess the risk of a disorderly transition and sudden stops in financial inflows.

Figure 8 illustrates the adjustment path for three of the co-determined variables (capital inflows to developing economies; long-term interest rates and the VIX index of stock market volatility) under different scenarios.

In the baseline, the capital flow projections resulting from the VAR simulations are very similar to those drawn from the panel regression, with the share of capital inflows to GDP in developing countries declining by 0.5 percent over the projection horizon.

In the two more extreme scenarios, deviations from the baseline are pronounced.

In the “fast normalization” scenario, the resulting increase in market volatility and rising risk aversion leads to a sharper but partially temporary correction in flows. In this context, private capital inflows drop by an average 30 percent in 2014, with a peak impact of 50 percent toward the end of the year.

As discussed in Box 4, the magnitude of these simulated effects is broadly consistent with the adjustments observed during May-September 2013, a period that lies mainly outside of the estimation period of the model.

In the “overshooting” scenario, where long-term interest rates spike initially by 200 bp, flows would then drop by 45 percent in 2014 as whole and up to 80 percent at the peak impact.

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