The first hike in US interest rates in nearly 10 years is not expected to trigger a large-scale crisis in emerging markets. However, as reported by Atradius, some risks remain. The rise comes at a historic moment in which emerging markets are struggling with China's slowdown, reduced commodity prices and growing geopolitical challenges. The risk of a sudden change in market sentiment is therefore present. In this scenario, the most vulnerable countries are Turkey, Indonesia, South Africa and Malaysia: they have high external financial needs and a relatively low buffer, so restructuring and bankruptcy measures cannot be ruled out. In fact, the most vulnerable are precisely those markets with a strong need for financing, high debt in foreign currency, questionable monetary policy.
The interest rate hike is part of a process of normalization of US monetary policy after dampening the effects of the financial crisis that began in 2007 in the domestic real estate market. The Central Bank (Fed) lowered interest rates in December 2008 and bought bonds and other securities on a large scale (so-called Quantitative Easing). As the US economy has strengthened, the need for ultra-expansionary monetary policy has diminished. The Fed gradually bought fewer bonds and eventually officially ended this program in October 2014. Early that same year, the Fed has also begun to prepare market expectations for the future increase in interest rates by announcing the conditions for normalisation: The pace and extent of normalization would depend on the strength of the US economy, especially with regards to employment and inflation. Ultra-expansive monetary policy has driven many yield-seeking investors to emerging markets, causing upward pressure on local currencies and rising equity, bond prices and interest rates. Lower interest rates, both external and internal, they have in turn stimulated local employment growth, particularly in the energy and construction sectors, which have increased their leverage thanks to cheap cash flows. Most of the loans were made domestically in local currency, but also by foreign banks with increasingly elaborate operations in the international capital market.
Such a capital outflow process makes external debt financing more difficult and costly, and that's because of depreciation and interest rates. Thus leading to a decline in the solvency of borrowers in emerging countries. Particularly disruptive in this context are “sudden stops” in capital flows, which in the past have often been associated with sharp rises in the US interest rate. These sudden stops are often followed by balance of payments crises: it is for this reason that the Fed improved its communication strategy, while emerging markets improved their macroeconomic policies at the same time, moving to floating exchange rate systems, building solid foreign reserves and improved debt structure and composition. As a result, according to analysts emerging countries are now better equipped to resist a Fed rate appreciation, using official reserves and the exchange rate as a shock absorber. The measure depends greatly on the need for gross external financing and the timing of repayment of external debt. The greater this requirement, the worse the impact of amortization on debtors' solvency and the greater the vulnerability to a change in capital flows associated with a normalization of US monetary policy.
The general expectation is that the Fed's own rate hike will have a moderately negative impact on capital flows to emerging markets and, consequently, on the solvency of the debtors themselves. After all, this take-off will not come as a shock, but as an adjustment process already in full swing and according to many analysts largely completed. Furthermore, based on the Fed's communications, market expectations generally speak of a gradual adjustment of tariffs accompanied by a strengthening of the US economy. Large-scale crises such as in the decade 1980-1990 are therefore not foreseen. However, a further slowdown in economic growth is expected in emerging markets. In countries that trade most with the US, such as Mexico and Central America, the negative impact will be partially offset by an increase in exports.
In any case, there is still uncertainty about the growth estimates of the US economy in the medium to long term e the rate hike comes at a time when the economic environment is already challenging for emerging markets due to the slowdown in China, the decline in the amount of trade flows globally, reduced prices of raw materials and growing geopolitical risks. The risk of a sudden change in market sentiment is therefore present. Here then is that the most vulnerable are those countries (and those companies) with high external financing needs and insufficient foreign exchange reserves. This especially applies in Turkey and, to a lesser extent, Indonesia, South Africa and Malaysia.
