As emerging markets (EM) continue to recover from the ramifications of the pandemic downturn, they now face the expected start of a tightening cycle by the U.S. Federal Reserve (Fed). The U.S. Federal Open Market Committee (FOMC) statement on Jan. 26 made it clear that the Fed's interest rate rocket is heading to launchpad and is preparing for "lift off" (see "The Federal Open Market Committee's Policy Rocket Heads To The Launchpad," published Jan. 26, 2022). After already announcing that it reached its inflation goal, the Fed has now confirmed that it has also met its "maximum employment" target, positioning it to begin to raise rates as soon as its March meeting. (S&P Global now expects the Fed to raise rates in March, the first of at least three 25-basis-point rate hikes this year.)

Past Fed tightening cycles have been at times associated with potential turbulence in some EMs, especially in those with high external financing needs or weak debt profiles. Fed tightening, or even the expectation of it, alters relative investment prospects, making EMs less appealing at the margin. Currency depreciation ensues in the debtor countries, and volatility rises due to an increase in the real (inflation-adjusted) value of foreign currency-denominated debt. Not surprisingly, local central banks feel compelled to "follow the Fed" and raise interest rates to entice capital to return.

However, not all Fed tightening cycles are bad for EMs--they can also be the result of an underlying period of rapid strengthening in U.S. demand, which benefits exports across several major EMs. If well telegraphed, the adjustments in EMs' asset prices in reaction to tighter Fed policy, in variables such as exchange rates and domestic interest rates, can be an orderly process. This can help EM short-term domestic demand growth to also adjust gradually to higher interest rates, with no major negative implications for long-term growth.

In our view, the current tightening cycle is likely to be an orderly adjustment process for most EMs. Much of the repricing in EM interest rates and exchange rates to higher U.S. interest rates has been already unfolding over the last year, and central banks' forward guidance has improved over recent tightening cycles. This reduces the likelihood (and magnitude) of future destabilizing market-related adjustments in EMs as the Fed goes through its actual lift-off process.

However, given the current high levels of uncertainty regarding U.S. inflation, it's possible that a faster-than-expected U.S. monetary policy normalization would not be accompanied by an improvement in global GDP growth prospects. Certain EMs are more vulnerable to such a scenario, and they could experience periods of relatively high volatility in exchange rates and interest rates, with negative implications for domestic growth. It certainly helps that external accounts are in generally better shape for most EMs than in previous Fed tightening cycles, assisted by robust exports and the sharp decline in imports throughout the pandemic, with a handful of notable exceptions (more on that later). However, a worsening in debt burdens, challenging social and political dynamics that can lead to weaker fiscal accounts, and high levels of uncertainty regarding inflation and growth are key variables to watch across EMs.

By these metrics, our analysis suggests that external imbalances will be the main channel of transmission of a faster-than-expected Fed tightening cycle for Argentina, Chile, Colombia, and Turkey, while fiscal imbalances will be the main channel for Brazil, India, and South Africa. The other EM countries in our sample (Malaysia, Indonesia, Mexico, Russia, Poland, China, Philippines, Thailand, and Saudi Arabia) have lower external and fiscal imbalances, or indeed strong external and public balance sheets--like, for example, Russia--suggesting a weaker direct channel of transmission of higher U.S. interest rates. Turkey's external financing needs remain large due to a high level of external debt, even if the current account is in stronger shape compared with previous Fed tightening cycles, and the country's unusual "new economic model" will test its vulnerabilities. Of course, the impact of unexpected increases in U.S. interest rates on EM economic performance will depend on many other factors beyond fiscal and external vulnerabilities, such as the policy response of governments and central banks.

To be sure, it is likely that idiosyncratic factors will play a large role in how vulnerabilities unfold under a scenario of faster-than-expected Fed tightening that's dominated by upside surprises in inflation rather than in growth.

Most EMs Have Spent The Last Year Adjusting To The Eventual Normalization Of U.S. Monetary Policy

As U.S. monetary policy expectations shifted significantly over the last year, the same happened in EMs--a sign that the adjustment in financial variables in EMs has been relatively orderly and gradual so far. At the beginning of 2021, the market was pricing in the Fed's fund rate to start increasing in late 2022 to early 2023. Today, the market is pricing in four 25-basis-point (bps) hikes this year, with the first one in March. In tandem, exchange rates in most EMs versus the U.S. dollar weakened. The median EM currency depreciated 7% in 2021, after falling 4.5% in 2020 (with a large variation across EMs).

Furthermore, several major EM central banks have already started lifting interest rates (Brazil, Chile, Colombia, Mexico, Poland, Russia, and South Africa). As a sign of proactive monetary policy in the EMs, most of the EMs that have started hiking rates did so around the time when markets began to bring forward their expectations for the Fed to start lifting rates in the first half of 2021 (see chart 1). A rise in inflation in several EMs, observed and expected, created a strong impetus for central banks in those countries to start tightening sooner, rather than later. This is similar to recent Fed hiking cycles. For instance, in the previous Fed tightening cycle, which started in December 2015 and accelerated as President Donald Trump's tax cuts came to fruition in 2017-2018, several EMs started to hike interest rates roughly a year before the Fed, tracking movements in U.S. monetary policy expectations at the time, following the Fed communication about tapering of large scale asset purchases (LSAP). In some EMs, LSAPs have also been utilized--for the first time--and that has likely contributed to lower volatility at the margin than otherwise would have been.(1).

Chart 1

Importantly, expectations for future interest rates in EMs have also moved upward. The typical EM outside of Asia has at least 200 bps in rate hikes priced in this year, according to interest rate swaps (see chart 2). As a result, future abrupt market adjustments would take place if EMs underdeliver market expectations for monetary tightening (via a weaker exchange rate), if there is a further repricing in Fed policy pointing toward a more aggressive normalization process, or if idiosyncratic factors trigger capital outflows from a given EM.

Chart 2

Are EMs Placed Differently In This Fed Tightening Cycle Than Past Ones?

By several measures, most EMs seem to be better prepared to weather the upcoming tightening Fed cycle than past ones. The differential in EM inflation with that of the U.S. is much lower today than it was during the most recent previous Fed tightening cycle (late 2015 to early 2019). Inflation in the median EM just before the Fed started increasing rates at the end of 2015 was running almost 4 percentage points (ppts) above U.S. inflation; today it is running over 1 pp below it (although with a lot of variation across EMs). This has more to do with U.S. inflation, which is at a multidecade high, than with current EM inflation. A narrower inflation differential typically lessens upward pressure on EM rates. However, inflation expectations will play a key role. If U.S. inflation normalizes more quickly than is currently expected vis-a-vis EMs, renewed upward pressure on EM local rates could take hold.

Chart 3

If we look at relative GDP growth between EMs and the U.S., most EMs seem to be in relatively the same shape as they were during the previous Fed tightening cycle (see chart 4). GDP growth differentials between EMs and the U.S. have been narrowing for the greater part of the last decade, and in some cases they are negative (such as in most of Latin America). However, they are not particularly different than in the previous Fed tightening cycle, with the exception of some EMs in Asia that have been transitioning from double-digit GDP growth rates to high-single digits (for example, India and China). In those cases, GDP differentials with the U.S. are lower today but still higher compared with other EMs.

Chart 4

A clear area of improvement in EMs versus the previous Fed tightening cycle is in external accounts. If we look at current account balances, the median EM has improved its position by about 1 pp of GDP compared with 2015 (see chart 5). Among major EMs outside of China, only Chile, the Philippines, and Thailand had worse current account balances in 2021 than in 2015. Admittedly, the improvement in current accounts was in most cases because of a rapid and sharp decline in imports as economic activity was severed by the pandemic, and this will be at least partly reversed as the recovery in demand continues. However, in many EMs, exports have also recovered swiftly based on strong demand for manufactured goods and commodities.

Chart 5

Perhaps a better gauge of EMs ability to guard against instability arising from shifting capital flows is the central bank foreign exchange reserves. These liquid, foreign-currency-denominated assets provide foreign-currency liquidity to domestic borrowers at times when it is hard to obtain it from foreign lenders, thus enabling domestic borrowers to finance current deficits and roll over maturing debt. A simple, intuitive metric about the appropriate level of reserves introduced by Pablo Guidotti, a former deputy finance minister in Argentina, and later popularized by former Federal Reserve Chairman Alan Greenspan is the Guidotti-Greenspan rule, which calculates the foreign- exchange reserves minus the sum of short-term foreign-currency-denominated external debt and the current account deficit (2). According to 2018 Dallas Federal Reserve research, reserve adequacy of above 7% doesn't much affect the spread of average yield on a country's corporate investment-grade dollar-denominated bonds over 10-year U.S. Treasury yield (3). According to this measure, Turkey, Chile, Argentina, and Colombia stand out.

Chart 6

Areas in which EMs are undisputedly weaker today versus the previous Fed tightening cycle are fiscal and debt positions (4). Following record levels of stimulus spent to help economies recover from the pandemic downturn, debt-to-GDP ratios increased sharply, and pressure to maintain higher-than-normal fiscal spending is strong in many countries as the pandemic continues take a toll on households and businesses (see chart 7).

Chart 7

The good news is, however, that when looking at the composition of debt in most EMs, the share of foreign-currency-denominated government debt has actually fallen in recent years (see chart 8), with the exception of a handful of cases. Among these exceptions, Chile, Colombia, and Turkey stand out as having a higher share of U.S. dollar-denominated government debt than in 2015--and those are among the economies that we view as relatively more sensitive to a further repricing in U.S. interest rates (5).

Chart 8

Finally, one positive factor for EM credit during the upcoming Fed tightening cycle--slightly different from the past one--is that U.S. long-term yields have stayed relatively low. Most of the action has taken place on the front end of the U.S. Treasury curve. The U.S. 10-year Treasury yield is still below 2% and roughly 50 bps below its prepandemic five-year average of 2.25%. This has helped keep long-term financing costs at bay for most EMs, many which have pushed out their government debt maturities throughout the pandemic. Arguably, expectations for the Fed's reduction of its balance sheet to be a slow and well-telegraphed process could help keep long-term U.S. yields low as the Fed starts lifting short-term rates. However, if this changes, EMs would likely be prone to more abrupt adjustments.

So Which EMs Are More Vulnerable To A Further Repricing Of U.S. Rates?

By most metrics, except fiscal and debt dynamics, EMs tend to be equally or better positioned to face the upcoming Fed tightening cycle than in 2015. However, if the market moves to expect a faster Fed tightening process than is currently priced in (and is not driven by stronger global growth prospects), several EMs stand out as prone more abrupt adjustments, with potential negative implications for short-term growth.

There are a handful of EMs in which external accounts have actually weakened significantly throughout the pandemic--such as Chile, Colombia, and Thailand (see chart 9) (6). Among them, if central bank foreign exchange (FX) reserves are not "adequate" in terms of the "Guidoti-Greenspan" rule to cover new foreign borrowing for up to one year (to finance current account deficit and short-term debt rollovers)--such as Chile and Colombia--EMs are likely to face more abrupt pressure for weaker currencies. In this case, higher domestic interest rates could take hold, tightening financial conditions and weakening domestic demand. For Chile and Colombia, strong fiscal stimulus has driven a rapid recovery in imports, which in both countries are now well above their prepandemic levels. However, the combination of long-standing flexible exchange rates and the credibility of monetary policy should help cushion the potential negative impact. As domestic demand continues to recover from the pandemic downturn, external accounts could remain strained in these countries, under a context of rising external financing costs. In Thailand, the collapse in tourism was a main driver for having the largest deterioration in its current account balance among major EMs, and it registered its first current account deficit since 2013 last year. Ongoing negative pandemic developments could continue to keep Thailand tourism receipts weak for some time, keeping its current account in deficit. A silver lining, however, is that its central bank reserve adequacy remains one of the healthiest among EMs. In Turkey, domestic demand and imports recovered strongly in third-quarter 2020, powered by a large credit stimulus, while revenues from tourism slumped. This led to a significant widening of the current account deficit in 2020; however, it improved in 2021, helped by strong goods exports and a partial recovery in tourism revenues. Turkey's external financing needs remain significant, however, due to a large level of external debt.

Chart 9

While Brazil's external position has actually improved over the last two years, the magnitude of its fiscal deterioration also makes it among the EMs most vulnerable to shifting Fed expectations. Brazil is an example of how idiosyncratic factors (politically related, for Brazil) will play a key role in exacerbating (or improving) vulnerabilities to higher U.S. interest rates. Brazil is approaching what could likely be a divisive general election in October, which has increased pressure to extend spending on temporary government assistance programs for the incumbent party to regain popularity ahead of the election. Fiscal slippage in the face of still-fragile economic recoveries, challenging social and political dynamics in many cases, and high inflation, could amplify further adjustments in EMs to the normalization in U.S. monetary policy.

What Happens After 2022 As Real Interest Rates Rise And The Fed Continues Tightening?

If we assume that EMs will deliver the interest rate hikes priced in the market, by the end of 2022 they will be higher than before the pandemic in several countries, mainly in Latin America (see chart 10). However, in most cases they are still below their peaks of the previous Fed tightening cycle. A big question will be what will EM central banks do in 2023, when the Fed will likely still be in the midst of tightening monetary policy, and what will this mean for EM real rates? Because EMs started hiking before the Fed, will they stop before the Fed, too? If we judge by what happened in the previous Fed hiking cycle, the median EM continued hiking until the Fed stopped. If this is the case, it is likely that several EMs will see real interest rates continue to rise in 2023, in some cases even surpassing the levels of the previous tightening cycle.

Chart 10

If that is the case, the next question is are higher real interest rates warranted in EMs? While you could argue that before the pandemic, neutral real interest rates in EMs were declining in line with what was happening in advanced economies as population growth slowed and aged, it is less clear that will continue to be the case after the pandemic. Higher debt ratios in EMs could warrant higher neutral real interest rates to compensate for the increase in fiscal risk premia, in the absence of faster economic growth. One of the scars left by the pandemic in some major EMs could in fact be higher neutral real interest rates--especially in those with higher debt and lower growth in their new post-pandemic normal.

Endnotes

(1) While offshore investors in local sovereign bonds sold off, particularly in 2020, the marginal buyers in some of these economies were central banks, who are much more "stable" investors.

(2) J. Scott Davis, Dan Crowley, and Michael Morris (2018), "Reserve Adequacy Explains Emerging-Market Sensitivity to U.S. Monetary Policy," Federal Reserve Bank of Dallas Economic Letters.

(3) Among them, only Turkey was among the economies (the "Fragile Five"--Brazil, India, Indonesia, Turkey, and South Africa) that got particularly volatile during the taper tantrum episode of 2013.

(4) The rise in fiscal deficits and debt burden is likely even higher in advanced countries since they could do it more easily.

(5) Lower share of FX-denominated debt is definitely good from a balance sheet perspective. But the presence of nonresidents in local debt matters as well.

(6) For Turkey, 2019 (prepandemic) is not a good comparison because it was a year of adjustment after the 2018 currency crisis, with sharply lower imports, and the CA in surplus.

Appendix

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