After years of flushing the financial system with easy money through multiple quantitative easing programs and low interest rates, the Federal Reserve has finally started to slowly raise interest rates and begin the challenging process of unwinding its massive US$4.5 trillion balance sheet.[1] The U.S. economy has been the centre of focus in this process, with investors carefully watching for any sign of inflation or unemployment figures wavering from their targets. However, rising interest rates in the U.S. have massive implications on emerging markets that are often overlooked and this article attempts to break down these effects.
Rising U.S. interest rates have three main impacts on emerging markets – higher domestic currency value of debt, higher cost of refinancing, and lower commodity prices. A higher currency value of debt is a result of the tendency of emerging markets to issue dollar-denominated debt. Investors usually lack faith in the stability of emerging market currencies and are more likely to invest if they are repaid in dollars, which translates to dollar-denominated debt having lower yield. Higher interest rates in U.S. traditionally lead to the dollar appreciating, which would make it harder for governments to repay these dollar-denominated debts. Refinancing costs also increase not only because the dollar has increased in value but also due to investors expecting the yield provided by risky emerging market debt to increase in order to maintain their spread with risk-free U.S. treasuries. Lastly, commodity prices decrease as, although they have idiosyncratic characteristics, they are all usually traded in dollars and therefore, demand tends to decrease when the dollar strengthens as commodities become more expensive in other non-dollar currencies.
The unprecedented era of low interest rates and slow growth after the 2008 financial crisis has pumped tremendous amounts of money into emerging markets as investors desperately chase after higher yields. According to the IIF (Institute of International Finance), emerging hard currency-denominated debt, which is debt issued in stable currencies, has risen by an astounding US$200 billion in the first half of this year and 70 percent of this has been in dollars.[2] The Asian financial crisis in 1997, the Tequila crisis in 1994, and many other financial debacles have occurred as a result of rising interest rates and unsustainably high levels of emerging dollar-denominated debt. Hence, these rapid increases in debt should be a sign of caution for these countries to rein in spending and attempt to balance their liabilities with a larger proportion of local currency-denominated debt.
Furthermore, emerging markets have been on a huge bull run since early 2016, with the benchmark MSCI Emerging Markets Index rallying by almost 55 percent.[3] These figures imply growing confidence in the prospects of these markets which could potentially allow them to borrow at a cheaper rate. However, since emerging markets tend to experience large capital outflows during periods of financial turmoil, a continued increase in their borrowing rate will result in these outflows being exacerbated when a financial crisis occurs.
However, all emerging markets are not the same and the current environment of rising rates will have varying impacts on their economies. Africa, Asia and Latin America have been the largest contributors to the increases in global dollar-denominated debt and are the most vulnerable to rate hikes, with Africa accounting for the largest proportion.[4] Central and Eastern Europe (CEE) have surprisingly reduced their dollar-debt in the last few years. Furthermore, their economies have been performing well for the past few quarters with stable growth figures that will allow the governments to repay some of their debts.[5]
In conclusion, rising interest rates are usually bearish for emerging markets and it results in increased borrowing costs and larger debt repayments for governments. However, all emerging markets cannot be considered together as the impact of rate hikes varies substantially to reflect the different levels of dollar-denominated debt, reliance on commodities, and growth prospects. The unwinding of the Fed’s balance sheet may also play a part in shifting demand away from emerging markets as the increased supply in treasuries will depress U.S. bond prices and increase the yield they provide investors. Emerging markets have not suffered any loss in confidence or capital outflows so far, despite the Fed projecting to increase interest rates three times next year. However, it still remains to be seen how the end of this unrivalled credit expansion and low rate environment will actually impact emerging financial markets.
[1] Gensler, L. (2017, SEP 20) The Fed Is Ready To Begin Chipping Away At $4.5 Trillion Balance Sheet. https://www.forbes.com/sites/laurengensler/2017/09/20/federal-reserve-september-meeting-unwind-balance-sheet/#48de651c48bb
[2] Reuters Staff. (2017, JUNE 28). Emerging market borrowing spree lifts global debt to record $217 trillion –IIF. https://www.reuters.com/article/emerging-debt-iif/emerging-market-borrowing-spree-lifts-global-debt-to-record-217-trillion-iif-idUSL8N1JP1B6
[3] The Financial Times Website. MSCI Emerging Market Index, MIEF00000PUS:MSI. https://markets.ft.com/data/indices/tearsheet/summary?s=MIEF00000PUS:MSI&mhq5j=e5
[4] Keoun, B. (2017, Apr 23). These Hedge Funds (and Madeleine Albright) Are Betting on a Debt Crisis. https://www.thestreet.com/story/14086528/1/these-hedge-funds-and-madeleine-albright-are-betting-on-a-debt-crisis.html
[5] Erste Bank Research Team. (2017, Apr 24). CEE bond issuance becoming more focused on domestic markets. The FXStreet Website. https://www.fxstreet.com/analysis/cee-bond-issuance-becoming-more-focused-on-domestic-markets-201704240706
Edited by Marcus Huels (MSc International Health Policy)
