The Danger to Emerging Markets of a Federal Reserve Rate Hike
September 11, 2015
by Michael Biemann, W’17
Interest Rates in the United States Are About To Go Up
Analysts widely expect the United States Federal Reserve (the Fed) to begin raising its benchmark interest rate later this year. Interest rates in the United States have been at historic lows since the aftermath of the global financial crisis, when the Fed brought its federal funds target rate to a range between zero and 0.25% and launched an unprecedented series of direct bond purchases (so-called quantitative easing). These actions largely achieved their goals, suppressing both short and long-term interest rates and giving the country’s borrowers an incentive to begin borrowing, spending, and boosting the economic recovery. As a result, the U.S. unemployment rate has fallen to 5.3% as of June 2015, down from a high of 10.0% in October 2009, and Fed officials have begun to signal that the current extraordinarily loose monetary policy will need to be tightened. In an effort to prepare the financial markets for the policy adjustment, the Fed now regularly releases its board member and presidents’ expectations of where the federal funds will be at the end of the year (see chart below), indicating that a near-consensus expectation that the Fed will raise rates by the end of 2015.
A Fed Rate Hike Will Have Global Repercussions
As a major source of foreign investment, as well as a major destination for foreign investment, the United States serves a unique role in the global financial system. The U.S. dollar is the world’s reserve currency, and both domestic and global investors (from foreign governments to multinational corporations to private citizens) allocate a significant portion of their wealth to U.S. Treasury bonds and private sector assets, which are protected by the relative stability of the U.S. economy and dollar.
So, when interest rates (and expected return on financial assets) in the U.S. reached historic lows, investors began to look elsewhere for higher returns, and increasingly invested in the financial markets of emerging market countries where interest rates were higher and expected returns greater.
Emerging markets benefitted from the influx of foreign money – their stock markets boomed, their currencies gained value, and many governments were able to borrow money at cheaper levels than ever before. However, this dynamic will expire with higher U.S. interest rates, and global capital will start shifting back towards the United States and away from emerging markets, leading to lower asset values, falling currencies, and higher borrowing rates.
Some Emerging Markets Are Going To Be Hit Harder Than Others
While rising interest rates have the potential to devastate emerging market governments and financial systems, many countries have taken prudent steps to isolate themselves from the worst effects. China and the United Arab Emirates (UAE) have each accumulated trillions of dollars of foreign reserves, which they can use as a buffer if capital were to flee their countries. The central banks in Brazil and South Africa recently raised their target policy rates, pre-emptively maintaining the interest rate advantage they hold over the United States. Mexico and Thailand have spent years developing their local currency debt market, so that if a crisis hits, they won’t be forced to repay debt in expensive foreign currency. Many countries, such as Chile and Poland have made structural reforms and have encouraged foreign direct investment (FDI) that tends to be longer-term in nature, rather than short-term portfolio investments which are likely to be withdrawn quickly in the event of a perceived crisis.
Not all emerging economies, however, have taken the measures necessary to protect themselves. Market commentators have popularized the term “The Fragile Five” to refer to the major emerging economies they believe are most vulnerable to rising U.S. interest rates. While their specific situations vary, Brazil, India, Indonesia, South Africa, and Turkey all maintain current account deficits which leave them vulnerable to a withdrawal of foreign capital.
Financial markets got a preview of the effects a U.S. rate increase might have in the summer of 2013, when the Fed announced it would taper its massive bond purchase program. Though this was only a mention of the first step towards normalizing monetary policy, markets reacted violently with what became known as the “Taper Tantrum”, as investors rushed out of emerging markets, causing asset prices and currencies to plummet.
U.S. Policymakers Need To Be Mindful of the Dangers of the Impending Rate Hike
While the Fed is legally mandated to pursue domestic goals, it should realize that a disruption in major emerging economies will have spillover effects that can hurt the United States. It should continue its policy of transparency and forward signaling, so that when it begins its rate hike cycle, markets won’t be surprised.
Beyond the Fed, the U.S. foreign policy establishment also needs to be aware of the geopolitical consequences of tighter U.S. monetary policy. The crisis in Ukraine can be traced back to 2013’s “Taper Tantrum,” as investors lost faith in the deeply-in-debt country’s ability to pay back its loans given a lower currency value and higher borrowing costs. In return for economic aid, Ukraine was forced to make political concessions to Russia, igniting the conflict that evolved into civil war and enflamed tensions between Russia and the United States. The U.S. should strive to ensure all its economic partners are pursuing responsible economic policies, so that any economic shock from higher U.S. interest rates doesn’t lead to political turmoil.
Hopefully with global cooperation and responsible behavior from policymakers, the U.S. can help avoid a disruption that hampers the global economic recovery, inflicts real human cost on the populations of emerging economies, and damages U.S. interests.
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