US Fed Rate hike: Impact on Emerging Markets like India

 US Fed Rate hike: Impact on Emerging Markets like India

The Long awaited decision on when will the US Federal Reserve (Fed) increase the interest rates and how will it affect Emerging economies (EM) like India. The Indian economy is a relatively stable economy compared to the rest of the other comparable EM, however it is not isolated and a change in stance by the Fed would result some foreign institutional investors (FII) drawing out of the Indian market and also resulting in change in the demand supply in the real economy.

Emerging markets braced for ripple effect Fears grow that tightening US policy would damage economies across the globe.

For policymakers in emerging markets, the prospect of the US Federal Reserve raising interest rates for the first time since 2006 has been building like a storm cloud on the horizon for much of the past two years.

Officials at the Fed, however, seem determined to play down any suggestion that their actions might contribute to slower growth in EMs and the rest of the world. Yet if they do raise rates, the impact on already fragile emerging economies threatens to bring economic woes to the US and Europe.

The consequences of a US rate rise, would be appropriate by year-end, would be felt across the world, from China to the likes of India, Brazil and Turkey. The countries that grew used to ultra-loose monetary policy in the US and the cheap financing that it spawned. since the recession. EMs have seen growth soar, partly in response to US interest rates being cut to historic lows, then fall back as the Fed moved to tighten even as Chinese growth slackened. Now, against a backdrop in which developed economies account for less than half of world GDP by some measures, the question is whether the US and other industrialised countries will suffer from the fallout from a further EM slowdown caused by a Fed rate rise.

First we had the spill over phase; this was the inability of the west to generate growth and its use of experimental monetary policies, which have undermined growth in EMs.

Stage two is the spillback; the weakness in EMs that disrupts the economies of the west and makes its challenges even harder.

The most profound consequence of higher US rates will be to accelerate capital outflows from China, the source of recent global market turmoil, making the world’s second economic superpower potentially yet more unstable and to an extent from relatively stable EM’s like India.  

That could create another layer of risk for the Chinese economy, the most important, or the least anticipated, consequence for EM, will be the impact on China.

This is because of a big increase in lending to China by foreign banks over the past six years. The funding costs of such banks are affected by the Fed’s short-term interest rates, which are expected to rise by more than long-term rates. As they rise, this source of capital for Chinese borrowers is likely to be cut.

This, in turn, threatens to feed directly back to the US by contributing to a reduction in Chinese buying of US Treasuries. China had to sell more than $100bn of its holdings of US Treasury debt to support the renminbi during the turbulence that followed Beijing’s decision last month to devalue its currency.

If China, which is the largest foreign investor in US Treasuries with $1.27tn, starts to liquidate its holdings regularly, it could create funding shortfalls for the US government and add upward pressure on US interest rates.

China and other EMs have already had a big negative impact on the US economy by contributing to the sharp fall in oil prices, in turn reducing the flow of petrodollars

THE US currency from the dollar-dominated oil trade that is recycled back to US markets.

By cutting the knees from under a critical contributor to the recovery, China and other EMs have flipped the switch from risk on to risk off.

To many investors, the impact on developed markets of slowing growth in China and other EMs is already clear; falling import prices, lower capital goods orders and much weaker profitability of US and European companies, many of which do a lot of business in EMs.

The biggest direct impact from the Fed outside the US is likely to be in those economies that depend on short-term capital flows to finance current account deficits. Worst off are the commodity exporters such as Brazil, Russia and South Africa as they get caught between the strong dollar and a weak China.

Many emerging economies are less vulnerable to a rise in US rates than they were during the EM crises of the 1980s and 1990s as governments have cut back on so-called original sin. The sin consisted of borrowing in US dollars or other foreign currencies and thus exposing themselves to the risk of a devaluation of their own currencies and a consequent explosion in debt servicing costs.

While that is broadly true of governments in the past decade, there has also been an explosion in foreign currency borrowing by corporations in EMs. Many of these have earnings in foreign currencies, saving them from original sin. But the build-up in such debt among other EM corporate borrowers has generated big currency mismatches. This is not the only problem. Sovereign borrowers have committed less original sin but more new sin.  Even though their debts are in local currency, debt levels have gone up, he adds. Most people believe EMs are structurally sound in terms of debt. That is no longer valid.

The idea that EMs have built up enough forex reserves to cover debt payments is misplaced, as the guys holding the assets and the guys holding the liabilities are not the same. This would mean a vast stock of EM debt coming under pressure as rates rise, even if forex reserves stay put.

  

Real economy woes fuel chronic malaise in emerging markets shrinking harvest how developing nations are suffering. Are emerging markets already mired in a crisis? The question of when to apply this description to the unravelling of EM fortunes is more than academic. The word crisis has a way of fixing perceptions among investors, executives and policymakers while displacing nuance from analysis.

The big difference, between the current bout of EM frailty and the Asian crisis in the late 1990s — the last economic meltdown to originate in the developing world is that this episode has evolved over many months, whereas the Asian crisis was an eruptive shock.

EM has a persistent problem that results from two irreversible shocks. One is the end of an era which saw rapid, investment-led growth in China. And, two, the collapse of global trade growth to levels unseen for a generation,

These twin frailties supply a defining characteristic. The current EM malaise has thus far been driven more by real economy debilities than financial market stresses.

Whereas in the aftermath of the 2008-09 financial crises, the dynamism of EM economies helped drag the world back to growth, the vigour is now all but spent. In the first half of this year, emerging markets became a net detractor to global trade growth for the first time since 2009.

In gross domestic product terms, EM growth is likely to fall to 3.6 per cent this year, its lowest level since 2001 — if the 2008/09 crisis, which originated in the US and was therefore an external shock to EM, is excluded. However, the impact on commodity-exporting EM economies is particularly severe, with average GDP growth falling fast towards zero.

This is not a repeat of the ripples that spread across the world’s financial markets in the late 1990s and into systemic banking failures. This is a crisis of growth.

Part of that crisis, is caused by weaker demand: a reversal of capital flows, falling commodity prices and slowing credit growth. Another part is caused by structural problems on the supply side, such as the misallocation of resources in China, persistent low investment in Brazil and Russia, and excessive regulation in India and Mexico.

There is froth in some markets. Like, Turkey looks vulnerable. There is a worry about South Africa’s current account deficit, but economies will not be wiped out in the way Argentina was in 2001 or Brazil was in 1999. We have not seen that real, sudden pain. This is much more of a slow grind.

The bottom line is that there is no EM crisis for as long as debt defaults do not become a big concern.

But the prospect that the US Federal Reserve may raise interest rates for the first time since 2006 is adding uncertainty to the gloomy EM outlook. the potential for tighter US monetary policy has exacerbated significant EM capital outflows even as EM productivity growth slows.

_ Farzan Ghadially