For several months now, global markets and policymakers have waited for the FOMC’s periodic meetings nervously. The central bank of the world’s largest economy is preparing to raise interest rates from historical lows.
What will be the effects of higher interest rates on emerging economies? To answer this question, it is necessary to put the clock back a few years.
What Happened When Interest Rates Were Lowered?
In the aftermath of the subprime crisis, the Fed and central banks of other developed countries aggressively cut interest rates to stimulate economic growth. In theory, lower interest rates should encourage banks to increase lending to individuals and companies. Traditional economic theory suggest that this should lead to a virtuous circle of growth. When interest rates are lowered, it becomes less expensive for people to borrow money. This in turn encourages them to spend more, which leads firms to produce more goods and services. To produce more, firms need to hire new workers.
The more easily accessible money did not stay at home, however. Low interest rates led investors in developed countries to “chase yields” by investing in emerging economies where interest rates were higher. This led to a flow of portfolio investment from the US and other developed economies to emerging economies.
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Furthermore, central bank stimulus programs (quantitative easing, QE) significantly lowered borrowing costs in developed markets. This encouraged corporates in emerging markets to borrow from developed countries rather than from their own countries. This has resulted in a significant build-up of corporate debt as shown in this chart:
Emerging Market Corporate Debt (Percent of GDP)
Source: IMF
Past emerging market crises have been marked by similar rises in leverage – the most notable example is the 1997 Asian Financial Crisis. This time around, the accumulated debt may also create problems for emerging markets when interest rates rise.
What Is Likely to Happen When Interest Rates Rise?
When the Fed starts to raise interest rates, some of the capital that was invested in emerging economies is likely to head to the US, as the interest rate differential between the US and emerging markets will shrink. The dollar is likely to appreciate against other currencies, although this may have been priced in by markets to some extent already.
This means that companies in emerging markets, who borrowed in dollars when interest rates were low, will be liable for more debt if their home currencies decline in value against the dollar.
Simultaneously, emerging markets that experience large capital outflows may also see their currencies weakening against the dollar. This may lead to higher import-led inflation in some economies.
To counter this, central banks in these countries may hike rates, which may lead to slower growth in the emerging world. A slowdown will make it harder for indebted corporates in these countries to earn enough to pay down debts, even if these are denominated in local currencies.
Furthermore, according to Paul Krugman, there is a risk that rate hikes in emerging markets may have negative spillover effects onto developed economies.
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The possibility of spillovers suggests that perhaps central banks need to consider the effects of their actions on other economies than their own. This may be difficult in practice as the mandate of most central banks only covers domestic economic stability, but clear communication from central banks can play an important role, according to the IMF.
Fed officials are trying to reassure markets through this approach and have stressed that the pace of rate hikes will be more gradual than in previous cycles. Moreover, a few months ago, emerging market central bankers wanted the Fed to raise rates to end the uncertainty.
Yet, when the Fed does put the brakes on, the actual event may trigger less anxiety from the markets than the anticipation of the event. This is what occurred when the Fed tapered QE – markets were turbulent in the run-up to the first cut in bond purchases in December 2013, but reacted less when the tapering actually started.
Moreover, some of the gains in the dollar may already have been priced in – which lowers the probability of a sharp depreciation in emerging market currencies. This chart in the Financial Times suggests that in previous rate hike cycles, the dollar has appreciated before the first increase, but these gains have generally not been sustained after the hikes.
Dollar Index Before and After First Fed Rate Rise of a Cycle
A delay in an appreciation may give emerging markets a brief respite. Policymakers in these countries should use this to strengthen balance of payment accounts and to clean up non-performing loans in the banking system.
Meanwhile, policymakers in advanced economies should take the possibility of spillovers into account when raising rates. These measures may help buy some time for over-leveraged emerging markets companies to cope the move away from near-zero rates.
