How will US interest rates affect emerging markets?

– In May the US Federal Reserve implemented its largest interest rate increase in two decades

– The move is likely to affect emerging market currencies and increase debt payments

– Emerging markets are better positioned to combat higher interest rates than in the past

– Many central banks anticipated the rate hike and implemented their own fiscal measures

Following the US Federal Reserve’s decision to raise benchmark interest rates in recent months, analysts are closely tracking the impact this will have on emerging markets and their economies.

On May 4 the Federal Reserve raised its benchmark interest rate by 0.5 percentage points to a target range of 0.75-1%, the largest increase since 2000. This followed a 0.25-percentage-point rise in March, the first since December 2018.

The decision to lift interest rates comes amid attempts to control inflation in the US, which hit a 40-year high of 8.5% in March.

After rates reached historic lows during the pandemic, the Federal Reserve signalled that it will continue to raise them gradually over the coming months in small increments to provide a so-called soft landing for the US economy.

Impact on emerging markets

While the rate hikes were initiated to help the US domestic economy, higher interest rates are nevertheless likely to impact emerging markets.

Past experiences, most recently in 2013, have shown that interest rate rises often increase the cost of servicing US dollar-denominated debt for emerging markets, lead to a depreciation of their currencies, weaker demand for exports in the US and potential outflows of capital from lower-income economies.

Higher interest rates were cited as a contributing factor, along with Russia’s invasion of Ukraine, when the IMF in April downgraded its full-year growth outlook for developing and emerging market countries from 4.8% to 3.8%.

The primary challenge of higher interest rates is that they weaken the value of other currencies against the dollar, making it more expensive to service existing debt payments and often triggering an outflow of capital investment from emerging markets.

To shore up foreign exchange rates, curtail inflation in their own economies and pay down dollar-denominated debt, emerging market central banks have already started raising interest rates.

On the same day that the US Federal Reserve hiked its rate in May Brazil’s central bank increased its rate by one percentage point to 12.75%. This was the 10th consecutive rate hike for Brazil, with another expected in June. Nigeria similarly responded to the move by raising its lending rate by 150 basis points, its first interest rate hike in six years.

The impact of the rate hikes is not expected to be felt universally, however.

Countries that run consistent trade deficits financed with dollar-denominated debt are likely to be more exposed to the potential flow-on effects. Examples include Argentina, Brazil, Colombia and Turkey, which have seen the largest increases in their bond yields among emerging markets since the end of 2020.

One week after the Federal Reserve’s hike Argentina’s central bank raised its interest rate by another two percentage points to 49%. In contrast, Turkey has held its rate steady at 14% this year, despite the official inflation rate reaching a two-decade high of 70% in April and the Turkish lira continuing to weaken.

Emerging markets have learned from past crises

While pressure on exchange rates and bond yields is likely to persist over the coming 12 to 18 months, there is some evidence to suggest that many emerging markets are better positioned to handle the fiscal challenges than in the past.

For one, several central banks anticipated the Federal Reserve’s move and started raising their own rates last year.

Mexico raised its interest rate for the eighth consecutive time in mid-May. The currency has been on a broadly upward trajectory against the dollar since December, and the economy posted stronger-than-expected growth in the first quarter of the year.

In Colombia – where the central bank has increased interest rates six times since September, from 1.75% to 6% – the peso also rallied against the dollar in May after experiencing a drop in late April.

In general, emerging markets also hold larger foreign currency reserves, rely less on dollar-denominated debt and run smaller current account deficits than in the past. According to a paper from the Brookings Institution, a US think tank, in 2013 the world’s most fragile countries had an average current account deficit of 4.4% of GDP, but this figure stood at 0.4% in mid-2021.

More diversified economies and trade relationships are also serving to insulate emerging markets today. In the past, a US economic slowdown was devastating for the export potential of many emerging markets; however, today most are more resilient and able to export goods to many other countries, including but not limited to China.

Although China is facing its own economic headwinds due to dollar appreciation and its “zero-Covid” strategy, many emerging markets have more diversified, non-commodity export sectors, making them better able to withstand the potential fallout of rate hikes and a slowing global economy.

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