Emerging markets have been a favorite destination for global capital since the financial crisis, given the weak growth and low interest rates on offer from much of the developed world. Although they have taken a one-two punch of late from a strong U.S. dollar and weaker commodity prices, fears that Fed rate liftoff will be the knockout blow may be misplaced.
The U.S. dollar has appreciated by more than 20% since June of last year (trade-weighted dollar index—major currencies), which has driven up borrowing costs for emerging-market businesses, banks, and governments with dollar-denominated debt. And a drop of more than 15% in commodity prices (ex-energy) over the same period has led to falling revenues for many exporters and falling expectations for emerging-market GDP growth.
Similar developments back in the 1990s sparked financial crises in a number of emerging markets, but there’s reason to believe this time could be different. As a whole, the debt-to-GDP levels of these countries have come down, far fewer of their currencies are pegged to the U.S. dollar, and their foreign exchange reserves are much higher, all of which could help soften the blow of a stronger dollar and lower commodity prices this time around.*
And while you might expect the prospect of the Federal Reserve raising interest rates to put the brakes on capital inflows into emerging markets, thereby worsening their financing problems, our research suggests that doesn’t have to be the case.
Emerging-market capital flows seem to be driven by both “push” and “pull” factors. Factors that could pull capital flows out of EM tend to be external, such as risk aversion during periods of market stress (the dot-com bubble, the global financial crisis) and higher Fed funds rates. Factors that can push flows out of EM include poor domestic fundamentals. Poor fundamentals combined with rising Fed funds rates (or the anticipation thereof) led to 1990s crises in Latin America and Asia. That stands in contrast, however, to the most recent Fed tightening cycle from 2004 to 2006, during which emerging markets were in better fiscal shape and inflows held fairly steady, as seen in the figure below.
So while a Fed rate hike may prove unwelcome for some economies with weak fundamentals, it may not be as negative for those who stand to benefit from stronger U.S. growth.
While financial crises have coincided with a drying up of capital inflows to emerging markets, that’s been less true of monetary tightening by the Fed
Sources: Vanguard, Capital Economics, Thomson Reuters Datastream, Bloomberg, CEIC, U.S. Board of Governors of the Federal Reserve System (FRB), J.P. Morgan, and the Federal Reserve.
* For a deeper discussion of how emerging markets have matured, see our paper on the subject, Global Macro Matters: Remember the ‘90s? Emerging Markets Then and Now.