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Historically, emerging markets have enjoyed rising US interest rates about as much as mice like meeting my cat Pickle. But as the Federal Reserve has tightened monetary policy over the past couple of years, overall they have not fared too badly. With a handful of exceptions, foreign investors have not fled. Exchange rates have not gyrated. Growth has not tanked. Why?
Explanations for this resilience can be split into two categories: good policy and good luck. The former would bode well, since sense is easier to sustain.
Optimistically, then, a recent blog from the IMF points towards enhanced central bank independence and improved policy framework, “closely aligned with IMF advice”, as perhaps the most important contributor.
The IMF thinking its own recommendations are brilliant is not exactly toast-dropping stuff. But a recent working paper by Şebnem Kalemli-Özcan of the University of Maryland and Filiz Unsal of the OECD also argues that recent resilience is due to climbing central bank credibility, along with a declining exposure to dollar-denominated debt.
Consider the old, unhealthy financial dynamic: the Fed raising interest rates pulls investors towards juicier US returns, driving down the value of emerging markets’ currencies. That creates problems for anyone borrowing in dollars. But it also generates imported inflation. Anticipating that inflation, investors ditch the local currency, making the problem worse. Efforts to stop the dynamic by raising interest rates risk cratering the economy.
Compared with crises in the 1980s, today’s investors are far more willing to lend to EM borrowers in their local currency. Paul McNamara, an investment director at GAM, calls that “a colossal deal”, as currency moves can absorb shocks rather than making them worse. More recently, sovereigns have also been locking in low interest rates for longer periods, and cultivating a base of relatively stable domestic investors.
There are caveats to these broad trends. Debt levels have soared over the past decade, faster than the pace of (rising) foreign debt holdings. A study from the Bank for International Settlements found that while 15 of the 25 economies they study have seen the share grow significantly since 2000, from around 2013, broad progress slowed.
Important exceptions include Argentina and Turkey, whose reliance on hard currency bonds rose in the 2010s. One could argue, though, that their lack of institutional strength shows how much policy matters.
Emerging market central banks deserve credit for their robust response to the recent bout of inflation. Between the start of 2021 and the start of the Fed raising rates, Latin American central banks had already tightened monetary policy by an average of 4 percentage points. Elina Ribakova of the Peterson Institute for International Economics praises them for adopting hawkish rhetoric even before the Fed.
Arguably, this aggressive response from the likes of the Brazilian and Mexican central banks reflects a lack of credibility when it comes to defeating inflation. If they had been more confident in their ability to sustain inflation at their target after what seemed like a transitory shock, they could have been more relaxed.
Celebrating hard work is important. But some of EM’s recent success was probably due to factors beyond their control. Relative to earlier episodes of Fed contagion, the change in global financial conditions was gentler.
Added to that, past examples of contagion from the Fed involved EMs unwillingly playing catch-up. This time, there was a common inflation shock, which gave EM central banks a clear reason to raise interest rates. As many did so, they blunted the incentive of investors to flee. That enabled looser fiscal policy, which helped support growth.
There are also dangers lurking in the background. A recent working paper highlights the risks associated with the switch towards long-term borrowing, namely that interest rate changes have much bigger effects on the value of those loans. Elijah Oliveros-Rosen of S&P Global Ratings points out that a lot of the debt issued in 2020 will come due between 2025 and 2027. If the Fed keeps policy tight, some borrowers could find themselves in trouble when they go to refinance.
For now, a certain amount of backslapping is probably permissible. But not so much that it devolves into complacency. And when more shocks come along, we’ll get a better idea of who really can escape the Fed’s claws.
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