US Rate Hikes Will Likely Hit Emerging Economies Hard

Researchers at the United States Federal Reserve suggest that higher US interest rates may reduce the gross domestic product of emerging nations.

Fed economists Matteo Iacoviello and Gaston Navarro presented the suggestion in their recent paper, KBS reported.

The researchers said that a monetary policy-induced rise in US rates of 100 basis points reduces GDP in advanced economies and in emerging economies by 0.5 and 0.8%, respectively, after three years. They claimed that the US rate hike of one percentage point also reduces US GDP by about 0.7% after two years.

The two economists said that their findings highlight both the bright and the dark side of foreign responses to US interest rate increases, but foreign economies, especially vulnerable, emerging economies, may react to US monetary shocks more so than the US economy itself.

The duo constructed a “vulnerability index” to measure how financial fragility might explain differing negative impacts across countries’ gross domestic products in the wake of Fed rate-hike shocks. Included in the index:

- Inflation, measured by consumer-price changes

- Current-account balance as a share of GDP

- Foreign exchange reserves as a share of GDP

- External debt, net of reserves, as a share of GDP

“In emerging economies all four indicators—inflation in particular—have explanatory power in enhancing the response of GDP to a US shock,” they wrote in the April 23 paper.

It said: Emerging markets with the weakest financial metrics, especially those with high inflation, tend to be the worst affected by US interest-rate shocks.

While the Fed economists didn’t address this year’s market volatility as the US continues with its monetary tightening, the two worst-performing emerging market currencies in 2018 so far are Argentina’s peso and Turkey’s lira. Both countries have double-digit inflation rates.

Higher Inflation

Using data from 1965 to 2016, the study found a one percentage-point “policy-induced” rise in US rates lowers emerging nations’ GDP by about 0.8%, a little more than the 0.7% reduction seen in the US. For emerging nations with high vulnerability-index readings, the impact is more than double, the economists said, according to a Bloomberg report.

“High inflation may indicate structural problems in a government’s finances, or could generate political instability which in turn acts as an amplifier of the effects of higher US interest rates”, the duo wrote. “High inflation may also increase the sensitivity of a country’s borrowing costs to changing interest rates.”

And as for the “bright side” of the findings?

"Countries that succeed in keeping their financial house in order can weather foreign shocks relatively better than their vulnerable counterparts," the economists said.

Sovereign Bond Sales

Investors who bought some of the riskiest emerging market sovereign bond sales in the past year have been left nursing paper losses as a strengthening dollar has rattled sentiment for emerging markets.

JPMorgan’s emerging markets bond index has lost 5.1% since the start of this year.

Some of the worst-hit bonds are those from countries that were rarely seen in debt markets until last year, when demand for sovereign debt paying attractive fixed yields was paramount among investors.

As the US dollar rises in value, there is a concern that indebted EM countries face a higher burden of paying back their borrowings in local currency terms.

These include Tajikistan, whose debut $500 million, five-year bond was sold last year at a coupon of 7.125% and is now trading at a 9.26% yield; and Ecuador, which sold $2.5 billion of 10-year debt in October at 8.875% coupon, is now trading at a 10.8% yield.

The hit to emerging market investors comes as fears are growing about the levels of debt that many low-income nations carry.

The International Monetary Fund recently warned of a mounting risk of debt crises in low-income economies, noting that the world’s poorest countries are increasing their borrowing at a worrying pace.

Last year saw the largest number of sovereign defaults on record, according to new research by rating agency S&P Global. There were six sovereign defaults in 2017, including Ecuador which defaulted twice.

However, Larry Witte, S&P Global fixed income research senior director, said the rise in defaults was not necessarily a cause for concern: “In early 2018, there were more sovereign ratings with positive outlooks than negative outlooks for the first time since the start of 2008.”

Many countries’ credit ratings have fallen as their debt levels have risen over the past decade, diminishing the attractiveness of some sovereign debt for investors looking for high-quality credit.