Fed tightening no longer spells doom in emerging markets

Hardliners to control inflation are about to get what they want from the Federal Reserve, which, in turn, means that the emerging markets you are about to receive what you have traditionally feared.

The prospect of interest rate hikes in the United States, which the Fed promises to make this year and next, has generally been a recipe for trouble in developing economies, especially when translated into a stronger dollar. The so-called “taper tantrum” of 2013 and the financial crisis in Mexico during the 1990s are clear examples.

The good news for 2022 is that there are reasons to think that this time the consequences may be less severe.

Emerging markets appear to be better positioned to weather a storm. Many have accumulated foreign exchange reserves in the last decade. Those who produce raw materials can sell their output at rising prices. And the underlying cause of rate hikes in the developed world—booming economies that have caused inflation spikes—are helpful to developing countries because they ensure a strong market for exports.

The opposite scenario, of a weak post-Covid recovery in rich countries, would be worse, according to Maurice Obstfeld, a former chief economist at the International Monetary Fund. “It would be cold comfort to emerging markets if advanced central banks abandon monetary tightening in the face of recessions in advanced economies,” he says.

The most affected

That doesn’t mean there’s nothing to worry about.

As harsh as the pandemic has been in rich countries, it has been harsher in poor ones, which are lagging behind in vaccination rates and lack the necessary resources for their economies to cope with the effects of covid. Many have fallen into significant debt.

Policy tightening by the Federal Reserve and other major central banks may make that bad situation worse. Unless emerging markets also raise rates, halting their own recoveries, there is a risk of capital flight weakening currencies and making it difficult to service debt.

The International Monetary Fund and the World Bank have warned about this scenario. So has Chinese President Xi Jinping in an unusually forceful video address to the World Economic Forum on January 17.

“If major economies hit the brakes or do a 180-degree turn in their monetary policies, there will be serious negative side effects,” the president said. “They would present challenges to global economic and financial stability, with developing countries bearing the brunt.”

For the Fed and its peers, the main task is to keep their own economies out of harm’s way. That means containing inflation. But they also generally keep a close eye on the overall impact of their money plans, not least because they can cause a boomerang effect.

“Their main mandate is internal,” says Carmen Reinhart, chief economist at the World Bank. “But it is not unprecedented that international conditions influence.”

The Fed Backlash

One need only look back six years to find a precedent, when the Fed was forced to change course due to international pushback on its own policy.

In December 2015, the US central bank raised rates for the first time since the global financial crisis and announced four more increases for the following year. Concerns about the impact of a stronger dollar on China were dismissed.

However, the worsening of China’s growth prospects triggered a sharp depreciation of the yuan and a sell-off in local stock markets that spread across the world. The Fed backtracked and did not raise rates again until December 2016.

This time things are very different. The Fed and other major central banks are reacting to a serious bout of real inflation, not the possibility of its coming. His hardening has more urgency and momentum.

Furthermore, while emerging markets are clearly in a difficult situation – and some are at risk of default—, debt problems are less likely to build up to the point of jeopardizing global growth or triggering widespread market turmoil.

Interest rates are low in both advanced and developing nations, meaning there is room for rates to rise before credit is severely affected. And Reinhart points to the commodity boom that has been going on since 2020, in contrast to the bust in the middle of the last decade.

“For emerging markets, there are not two shoes, there are three,” he says. “There are international interest rates, international capital and commodity prices. Higher commodity prices help a lot.”

‘More Sustainable’

How Xi’s China, a massive commodity importer, navigates the Fed’s tightening cycle will be crucial. The People’s Bank of China has started an easing cycle to avoid crisis in an over-leveraged real estate market, in the opposite direction to that of the Federal Reserve.

So far, the yuan has remained resilient, helped by rising exports and an influx of foreign investors, offering support to other emerging currencies.

Elsewhere in the Asia-Pacific region, many investors remain relatively optimistic despite the current jitters, in part because countries have beefed up their defenses since the taper tantrum of 2013: piling up reserves, cutting deficits on account current and clinging to the power of monetary policy.

While Fed tightening has historically been bad for emerging markets, “we expect growth to be more sustainable in Asia,” says Damian Sassower, chief emerging markets credit strategist at Bloomberg Intelligence. He points to Indonesia, Malaysia, Thailand and the Philippines as leading prospects.

Watch out for the BEASTS

There are potential stress points. Latin America is one of the regions most affected by the pandemic and has already seen a series of debt defaults. Brazil, the region’s largest economy, is mired in recession and beset by fiscal and political tensions.

More worrying still is Turkey, whose President Recep Tayyip Erdogan has bullied the central bank into lowering interest rates even as prices soar. Some Wall Street banks expect Turkish inflation to top 50% this year, a dangerous pace for a country whose business sector has a large dollar-denominated debt load.

The Bloomberg Economics studies place Argentina, Egypt and South Africa alongside those two nations — a group called “BEAST” — at the top of its list of most vulnerable countries.

Mark Sobel, a former Treasury official and now US chairman of the OMFIF think tank, acknowledges that the Fed’s tightening will affect emerging markets and that there are many countries with “idiosyncratic problems.” He just doesn’t think those cases add up to much risk.