External headwinds continue to mount for emerging markets (EM) at a time when many are still in the process of recovering from the economic damage inflicted by the pandemic. As the Federal Reserve (Fed) tightens monetary policy to attempt to return inflation to its 2% objective, EMs could see trade and financial conditions deteriorate. In our view, an incomplete recovery from the pandemic, more challenging fiscal and political dynamics, and an increase in nonresident portfolio flows in recent years increase the vulnerability of several major EMs to an abrupt deterioration in the U.S. economy.

We forecast U.S. GDP growth to slow to 2.4% this year and 1.6% in 2023 from 5.7% in 2021. That said, factoring in the much weaker than anticipated first-half of 2022 and assuming the second half of this year holds to our June forecast, 2022 annual average GDP growth would be just 1.8%, much lower than our June estimate of 2.4% and closer to S&P Global Ratings' downside estimate of 1.7% (see more in "U.S. Recession--Are We There Yet?", Aug. 2, 2022). While our baseline incorporates below-trend growth, especially into next year, the chance of a recession within the next 12 months is rising. We assess the risk of a recession in the U.S. in the next 12 months at 45% (see "U.S. Business Cycle Barometer: The Party’s Over," July 27, 2022). We now expect the Fed to push rates to 3.00% by year-end and reach 3.50%-3.75% by mid-2023.

In our baseline forecast, the Fed will keep monetary policy tight until inflation decelerates and nears its target in second-quarter 2024. We expect the Fed will start to cut rates in third-quarter 2024. The highly unpredictable nature of the unfolding pandemic and the Russia-Ukraine conflict means that the probability of policy mistakes have risen and the level of uncertainty around our GDP projections is unusually high. While there are reasons to believe the U.S. economy's strong buffers (high household savings and robust labor market dynamics, for example) could help weather these cross-currents, the longer they prevail, the higher the risk of a sharper slowdown in economic activity. If business confidence continues to weaken more than in our baseline, investment and hiring will naturally follow, and unemployment will rise. In such scenario, the U.S. economy could go from a "soft-landing" (our baseline scenario) to a "hard-landing".

How A Downside Scenario Would Affect EMs

It is clear that in periods of U.S. economic weakness, most major EMs see a material deterioration in their own economies. There have been three U.S. recessions in the last 30 years or so (excluding the pandemic-induced downturn): the 1990-1991 recession sparked by an oil price shock and the subsequent response by the Fed to tighten policy, the 2001 dot-com bubble, and the 2008-2009 Global Financial Crisis (GFC). EMs throughout each of those periods experienced significant structural changes to their economies, which means that the impact of a U.S. economic downturn on EMs also has differed over time.

Table 1

In the early 1990s many EMs had fixed exchange rates, and in most cases their economies were less open to trade than today. During that period, EMs faced several economic crises mostly related to their structural rigidities (pegged exchange rates) and less directly tied to the evolution of the U.S. economy. In the early 2000s, most major EMs had fully embraced flexible exchange rates and started rapidly integrating into the global economy both through trade and financial markets. This came with clear benefits, such as reaping gains from trade and access to capital markets, as well as monetary policy flexibility. During this period, China's share of global trade increased rapidly, which had a parallel effect to EMs that were developing trade ties with China, most of them in Asia. During this period, what happened in the U.S. started to matter more to EMs. By the 2008-2009 GFC, most EMs were highly integrated with the global economy. As a result, during the GFC, every major EM either fell into an outright recession or suffered from well-below-average growth (see table 2).

Table 2

In other post-GFC periods in which the U.S. economy grew below trend--for instance, in 2016 when GDP expanded 1.7% (from 2.7% in 2015)--EMs also saw weaker economic growth. During that period, a sharp drop in oil prices in late 2014 and early 2015 drove a sharp decline in investment in the energy sector in the U.S., which spilled over to other sectors, leading to a corporate earnings recession. At the same time, China was being rocked by instability in its stock market, further dampening business confidence. As activity recovered from that slump, inflation rebounded and the Fed started increasing interest rates by the end of 2015. This, eventually, brought down inflation expectations in the U.S. but also dampened domestic demand. Consequently, during that period most EMs also experienced below-trend growth. On average, major EMs excluding China grew 3.5% in 2016, compared with 4.2% on average in the previous five years.

The channels of transmission of a sharp deterioration in the U.S. economy to EMs would likely be the same as in past such episodes: trade and financial conditions. Knock-on effects would also be important. This is especially the case in regard to what a weaker U.S. economy would mean for growth in China, given that several EMs are more vulnerable to what happens in China than in the U.S.

For example, Mexico's GDP elasticity with the U.S.--remained essentially equally high pre- and post-GFC and equally low with China (see tables 3-4). This shows strong economic linkages with the U.S. that have structurally endured over the last two decades, even as China's role in the global economy grew. By contrast, GDP elasticities in countries such as India have increased both with respect to the U.S. and China, potentially showing a broader integration into global trade and financial markets. In those cases, vulnerability to external factors have arguably increased over the last couple of decades. In other cases, such as Brazil and Chile, GDP elasticities with the U.S. have fallen but have increased with respect to China's GDP, potentially reflecting the growing influence of China in commodity markets (which are key exports of Brazil and Chile).

Trade: Mexico Is The Most Vulnerable, But Knock-On Effects Matter More For Asia

From a trade perspective among the major EMs, unsurprisingly, Mexico is by far the most vulnerable to weaker U.S. demand. Mexico's goods exports to the U.S. account for nearly 28% of its GDP. In 2009, when Mexico's GDP contracted 5.1% during the U.S.-centered GFC, over half of the GDP drop (2.9 percentage points) was explained by the collapse in exports (most of those destined for the U.S.). Since the GFC, Mexico's trade exposure with the U.S. has actually increased (it was 20% of GDP in 2007). A 5% drop in real goods exports to the U.S., for example, which is half the size of the drop during 2009, would now alone subtract 1.4 percentage points to Mexico's GDP growth. One important caveat to point out regarding Mexico is the behavior of remittances from the U.S., which could offset some of the negative impact from trade. In past periods of U.S. economic weakness, remittances to Mexico fell--in 2009, for example they fell by nearly $4 billion. During the pandemic-downturn however, remittances actually increased, by just over $4 billion in 2020 (which is about 1% of GDP higher than the previous year).

However, there are other major EMs outside of Mexico with significant U.S. trade exposure (see table 5). Two in Asia stand out for having a large share of exports to the U.S. in relation to their GDP, Malaysia (9.2% of GDP) and Thailand (6.9%), mostly encompassing consumer and capital goods. Similar to Mexico, after the GFC, real exports in Malaysia and Thailand's fell more than 10% in 2009. However, both countries also have a high exposure to China (11% of GDP in the case of Malaysia, 6% in the case of Thailand), explaining a large part of export weakness that year. In those cases, the secondary trade impact would be particularly important for overall export performance--in other words, what weaker U.S. demand would mean for China's own demand for exports sourced from places such as Malaysia and Thailand. A large share of the exports from Malaysia and Thailand directed to China are intermediate goods, which then become final goods purchased in the U.S., among other main economies, generating an extra supply-chain related vulnerability to weaker U.S. demand.

One important thing to consider is the evolution of U.S. import sensitivity to GDP, which has been declining in recent decades (see chart 1). EMs that have been importantly dependent on the U.S. market for growth of their own exports may find that sales to the U.S. market have steadily been smaller as a share of U.S. overall growth.

Chart 1

And we can see in the corresponding table (table 6) that in fact implied elasticity of imports from many of major EMs have declined even more in the last decade before the pandemic hit. Even when the US recovers from a probable recession, the EM exporters to the US may be disappointed. Also, those EMs that had expected to eat into China's share of the production of consumer goods may not experience such a robust environment for their products in the U.S., as was the case over the 90's and 00's.

Table 6

Financial Conditions: Ultra Loose Policies During The Pandemic Increased Risk Of Reversal Of Capital Flows From EMs

Beyond the obvious direct trade linkages, another important channel of transmission is the typical tightening in financial conditions during a sudden and unexpected deterioration in the U.S. economy. A tightening in U.S. financial conditions first tends to act by reversing foreign capital flows that went into EMs, especially if it's driven by higher U.S. interest rates because the associated increase in risk aversion redirects capital back to safer assets. In turn, capital outflow pressures increase depreciation in EM currencies, which--when abrupt and sustained--can influence inflation expectations. This can prompt EM central banks to increase domestic interest rates to curb capital outflows and stabilize exchange rates at the cost of tightening domestic financial conditions. This was the case for, example, in 2015-2016 when U.S. financial conditions tightened as the Fed was increasing interest rates and several major EMs also increased their own benchmark interest rates (see chart 2).

Chart 2

Therefore, in EMs that have a high share of nonresident capital flows, the pass-through of a deterioration in U.S. financial conditions to weaker domestic financial conditions tends to be higher. In several EMs, this channel of transmission may be more important than the trade channel during episodes of a weak U.S. economy.

Chart 3

A key question is whether EMs' vulnerability to a reversal in capital flows has increased in recent years compared with previous episodes in which U.S. financial conditions tightened abruptly. Starting by taking a look at the share of GDP of nonresident portfolio flows, this has increased throughout the pandemic-downturn recovery in several EMs to levels higher than before the pandemic (see table 6). This is not entirely surprising because the rapid loosening in monetary policy in advanced economies during the onset of the pandemic downturn attracted a rapid inflow of foreign portfolio capital into EMs where risk-adjusted returns can be higher. Part of those inflows started to reverse in the second half of last year as financial conditions started to tighten (see chart 4), but a further decline in confidence would likely intensify that trend.

Chart 4

Among the major EMs in which nonresident flows as a share of GDP have increased the most in recent years are Chile, Colombia, and Malaysia (see table 7). To the extent that those portfolio flows are cyclical (not driven by a structural deepening in capital markets), the risk of a more abrupt reversal in capital flows if financial conditions in the U.S. weaken further is higher now than before the pandemic.

The tightening in financial conditions in 2008 was triggered by the onset of the GFC. In 2011 it was driven by concerns of sluggish post-GFC recovery in the U.S. and concerns over the eurozone debt crisis. Finally, in 2015, tighter financial conditions were associated with an abrupt dive in oil prices, and the start of a Fed tightening cycle. One key period that we do not include, in which several EMs experienced capital outflow pressures is the taper tantrum episode in 2013. We exclude this period because U.S. financial conditions did not tighten significantly through that episode.

Chart 5

However, in all of those periods, most EMs experienced net outflows of nonresident capital that year (see table 8). Clearly there are a lot of idiosyncrasies at play, which lead to differentiation in terms of the direction and magnitude of capital flows in EMs during those events. However, in the most recent of those periods (2015), which is arguably the one with the highest similarities to what is taking place this year because the Fed's rate hiking cycle was a main reason for tightening in financial conditions, most EMs suffered from large nonresident capital outflows. Among the highest were South Africa and several Latin American economies (see table 7). In all of those economies, central banks increased domestic interest rates, tightening domestic financial conditions, partly in an attempt to cushion capital outflows to prevent abrupt exchange-rate depreciations and thus anchoring inflation expectations.

Tightening domestic financial conditions (combined with lower business confidence as risk-adjusted growth expectations were reassessed) led to a weakening in actual fixed investment the following year (2016) across all of the EMs that saw net nonresidential capital outflows in 2015 (see chart 6).

Chart 6

One factor that is different this year than in previous periods of rapid tightening in U.S. financial conditions is that in several EMs interest rate differentials with the U.S. are higher. This is particularly the case in most Latin American economies, which started increasing interest rates in 2021 as inflation started to pick up in those countries before most other major EMs (see chart 7). As a result, Latin America's higher interest rate differentials may help cushion capital outflow pressures if U.S. financial conditions tighten further, lessening further upward pressure on domestic interest rates. In other EMs, the likelihood of an increase in interest rates to curb capital outflows is higher.

Chart 7

The Fed's Response Can Influence The Intensity And Duration Of Capital Outflows

The Fed's response to a weaker-than-anticipated U.S. economy would be important to fully assessing the impact on EMs. A likely response to such an event would be for the Fed to at least pause its current monetary tightening cycle. This would likely encourage capital flows back into EMs thanks to the associated improvement in global financial conditions and more favorable interest rate differentials in EMs. In the event the Fed's response to such a scenario is to stick with its tightening plan--if inflation expectations, for example, do not fall substantially in a scenario of weaker U.S. economic growth--capital outflow pressures would likely stay in place for longer, amplifying pressure on central banks to increase domestic interest rates.

Incomplete Recoveries, Challenging Fiscal Dynamics, And Political Uncertainty Could Amplify The Impact Of A Hard Landing In The U.S.

Preexisting economic weakness in a given EM would likely amplify the impact of an external shock driven by a deteriorating U.S. economy. Most major EMs are still well short of full recovery to their pre-pandemic trend growth--the median EM is still over 4% short of that level (see "Emerging Markets: Where Is The Growth Shortfall From Pre-Pandemic Trend?," published July 7, 2022). Among the weakest recoveries from the pandemic, according to this metric, are Mexico (nearly 10% below its pre-pandemic trend growth), Thailand, and the Philippines (see chart 8). A disruption to the ongoing recovery from the COVID-19 downturn could increase the possibility of economic scarring (output lost in economic downturns that is not recovered).

Chart 8

More challenging fiscal dynamics across most EMs, after in many cases sizeable stimulus measures throughout the pandemic downturn, may mean that either fiscal space would be more limited in the event of another downturn or the risk of fiscal slippage is high. Fiscal challenges are particularly acute in places such as Brazil, India, and South Africa, where government debt-to-GDP ratios have risen quite sharply, and growth dynamics remain weak.

Chart 9

Furthermore, one of the aftermaths of the pandemic in several EMs, especially in Latin America, has been higher levels of political polarization, which has resulted in lower levels of policy predictability (see "Economic Outlook Latin America Q2 2022: Conflict Abroad Amplifies Domestic Risks," published March 28, 2022). This means that the policy response to the next economic downturn is likely to be more uncertain, which, in turn could amplify capital outflows that could come from tighter financial conditions as investors take a more cautious approach until they have greater policy visibility.

Related Research

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