Inflation hawks are about to get what they want from the Federal Reserve — which means emerging markets are about to get what they’ve traditionally feared.
The prospect of higher US interest rates, which the Fed is promising to deliver this year and next, has typically been a recipe for trouble in developing economies, especially when it results in a stronger dollar. The so-called taper tantrum of 2013 and Mexico’s 1990s crash stand out in the history books.
The good news for 2022 is there are reasons to think the fallout may be less severe this time.
Emerging markets look better-placed to weather any storm. Many have built up foreign-exchange reserves in the past decade. Those that produce commodities can sell their output at surging prices. And the underlying cause of rate-hikes in the developed world -– booming economies that have set off inflation -– are helpful for developing countries because they ensure a strong market for exports.
The opposite scenario, of a feeble post-Covid recovery in rich countries, would be worse, according to Maurice Obstfeld, a former chief economist at the International Monetary Fund. “It would be cold comfort for emerging markets if monetary tightening by the advanced central banks is abandoned in the face of advanced economy recessions,” he says.
‘Bear the brunt’
That doesn’t mean there’s nothing to worry about.
As hard as the pandemic has been in rich countries, it’s been tougher on poor ones that lag in vaccination rates and lack the resources needed to carry their economies through Covid. Many have borrowed heavily.
Tighter policy at the Fed and other major central banks can make that bad situation worse. Unless emerging markets raise rates as well, putting the brakes on their own recoveries, there’s a risk of capital flight that weakens currencies and makes debt-servicing harder.
The International Monetary Fund and the World Bank have warned of that scenario. So has China’s President Xi Jinping, in an unusually blunt January 17 video address to the World Economic Forum.
“If major economies slam on the brakes or take a U-turn in their monetary policies, there would be serious negative spillovers,” he said. “They would present challenges to global economic and financial stability, and developing countries would bear the brunt of it.”
For the Fed and its peers the chief task is to keep their own economies out of trouble. That means containing inflation. But they typically keep a close eye on the global impact of their monetary plans, too — not least because they can boomerang.
“Their primary mandate is a domestic one,” says Carmen Reinhart, chief economist at the World Bank. “But it’s not unprecedented either for international conditions to weigh in.”
One need only look back six years to find one precedent, when the Fed was forced to shift course because of international blowback from its own policy.
In December 2015, the US central bank raised rates for the first time since the global financial crisis, and flagged four more hikes for the following year. Concern about the impact of a strengthening dollar on China was dismissed.
Yet China’s worsening growth outlook triggered a sharp depreciation of the yuan and a sell-off in local equity markets that spread around the world. The Fed backed off, and didn’t hike again until December 2016.
Much is different this time. The Fed and other big central banks are reacting to a serious bout of actual inflation, not to the possibility that one might arrive. Their tightening has more urgency and momentum.
Also, while emerging markets are clearly in for a rough ride — and a handful risk default — debt woes may be less likely to accumulate to the point where they imperil global growth or trigger broad market turmoil.
Interest rates are low in both advanced and developing countries, meaning there’s room for them to rise before credit gets severely pinched. And Reinhart points to the commodity boom under way since 2020, which contrasts with the slump in the middle of last decade.
“For emerging markets, there are not two shoes, there’s three,” she says. “There’s international interest rates, international capital, and commodity prices. Higher commodity prices help a great deal.”
How Xi’s China, a massive importer of commodities, navigates the Fed tightening cycle will be crucial. Seeking to fend off crisis in an over-leveraged property market, the People’s Bank of China has begun an easing cycle — moving in the opposite direction to the Fed.
So far, the yuan has remained resilient, helped by surging exports and foreign-investor inflows — and that offers support for other emerging currencies.
Elsewhere in the Asia-Pacific region, many investors remain relatively bullish despite the current jitters –- partly because countries have built up their defenses since the 2013 tantrum: accumulating reserves, shrinking current-account deficits and holding on to monetary-policy firepower.
While Fed tightening has historically been bad for emerging markets, “we expect growth to prove more sustainable in Asia,” says Damian Sassower, chief EM credit strategist for Bloomberg Intelligence. He points to Indonesia, Malaysia, Thailand and the Philippines as standout prospects.
Beware the BEASTs
There are potential flashpoints. Latin America is among the regions hardest-hit by the pandemic and has already seen a slew of debt defaults. Brazil, the region’s largest economy, is mired in recession and beset by fiscal and political tensions.
Perhaps even more worrying is Turkey, whose President Recep Tayyip Erdogan has bullied the central bank into lowering interest rates even as prices soared. Some Wall Street banks see Turkish inflation peaking above 50% this year — a dangerous pace for a country whose business sector carries a heavy load of dollar-denominated debt.
Bloomberg Economics research puts Argentina, Egypt and South Africa alongside those two nations — a configuration labeled the “BEASTs” — near the top of its most-vulnerable list.,
Mark Sobel, a former Treasury official and now US chairman of the think-tank OMFIF, acknowledges that Fed tightening will impact emerging markets, and that there are plenty of countries with “idiosyncratic problems.” He just doesn’t think those cases will add up to one big risk.
“Maybe I’m being Pollyannish,” he says. “But I don’t see that creating systemic problems for the global economy right now.”