The impact of US Fed policy on emerging markets

That is the big question for emerging markets—will fund flows to them wane as the US raises rates and winds down its balance sheet, or will the benefit they gain from higher US growth offset that effect?

Recall that during 2004-07 the US Fed slowly and steadily raised its policy rate, but fund flows to emerging markets remained intact.

But we’re in a very different environment now. There were no trade wars back in the noughties, nor was anyone questioning globalization. The US was far from protectionist and China was growing by leaps and bounds.

Consider what the Asian Development Bank said in its Asian Development Outlook Update released on Wednesday. It said, ‘either reducing Fed portfolio holdings or further hiking the policy rate would push up interest rates in the US, as would both actions simultaneously. This implies a stronger US dollar, which has mixed effects, and the potential for capital to drain from Asia. Higher US interest rates could spill over into emerging Asia by raising interest rates in the region, thereby posing a challenge to financial stability. The region would face higher financing costs for investment and higher effective discount rates, which would lower asset valuations and weaken the region’s corporate balance sheets.’

The ADB said that emerging markets had benefited hugely from the quantitative easing done by the Fed and other central banks in the developed countries and now that liquidity is being tightened, it could lead to capital outflows. It added, ‘the normalization of the Fed’s burgeoning balance sheet since November 2017 would affect global capital flows. Total Fed assets have declined steadily since that time, albeit slowly. Because of its direct impact on the US money supply, balance sheet normalization has a greater impact on global liquidity than do the Fed’s policy rate hikes.’

Emerging markets are already reeling under the impact of this normalisation of the Fed’s balance sheet and the repatriation of funds to the US. A survey of global fund managers by Bank of America Merrill Lynch this month was titled ‘Splendid Isolation’, a reference to the unique position of the US stock markets, which have been making new highs as funds rotate into it from other regions. Long US stocks, long US dollar and short emerging markets are crowded trades.

Emerging markets that run current account deficits, such as India, have seen their currencies depreciate sharply. The Bank for International Settlements too has recently underlined the widening divergences in markets, with benign financial conditions in the US and tightening conditions in emerging markets.

The latest meeting of the Federal Open Markets Committee has reinforced the prevailing sentiment. It hiked the US policy rate by 25 basis points, but that was widely expected. It also revised its median GDP estimates for the US up, for both the current year and for 2019. It left the median projections for the Fed Funds rate unchanged, pencilling in one more rate hike this year and three for 2019. Fed chairman Powell said that he would continue to raise rates to prevent overheating, even beyond the ‘neutral rate’, that is even if inflation did not move up.

Does that mean the party is well and truly over for emerging markets? There may well be a pause in the carnage—the US dollar may have reached the limits of its strength for now and there are signs that fund managers are worried the US recovery is a bit long in the tooth. Commenting on the flash Purchasing Managers Index for the US economy for September, Chris Williamson, chief business economist at IHSMarkit said, ‘“The escalation of trade wars, and the accompanying rise in prices, contributed to a darkening of the outlook, with business expectations for the year ahead dropping sharply during the month. While business activity may rebound after the storms, the drop in optimism suggests the longer term outlook has deteriorated, at least in the sense that growth may have peaked."

What of the future? Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements, says that the volatility engulfing emerging market economies should not come as a surprise. He believes the current turbulence is ‘akin to a patient’s withdrawal symptoms,’ as he is being weaned away from the narcotic of ultra-low interest rates. Borio’s prognosis is that ‘policymakers and market participants should brace themselves for a lengthy and eventful convalescence.’