Home >opinion >The fallout of a Fed rate hike
Photo: Bloomberg
Photo: Bloomberg

The fallout of a Fed rate hike

Will a rate hike by the US Federal Reserve be just a blip in the markets, or could it have more serious consequences?

The spectre of a US Federal Reserve (Fed) rate hike is spooking markets. Money is being pulled out of emerging markets and India is no exception. Long US dollar is the most crowded trade.

Will the rate hike be just a blip in the markets, or could it have more serious consequences? Could its fallout be the latest development in the financial crisis that has been rolling across the globe in the last eight years?

The story of the crisis has so far been one of falling dominoes. It had its humble beginnings in the US sub-prime housing market, acquiring momentum by bringing down banks. Through bank exposures, it spread its wings to Europe. Fiscal expansion to try and limit the impact of the crisis led to burgeoning public debt, which in turn led to strains on the European peripheral economies, bringing about the European sovereign debt crisis. Plummeting growth in the developed countries led to problems for export-oriented economies such as China, which expanded investment to limit the impact. That, in turn, led to massive over-indebtedness and over-investment, the consequences of which are now being felt not only in China, but also in commodities and commodity-producing countries across the globe. Bubbles have been bursting serially around the world since 2007. But the US economy has achieved some measure of stability and it’s time to raise interest rates there.

The question is: could the monetary spillovers from raising rates expose new vulnerabilities and prick some more bubbles? Hyun Song Shin, head of research and economic adviser at the Bank for International Settlements (BIS), seems to think so. He said recently that the dollar surge when the financial crisis first hit was due to the deleveraging of financial market participants outside the US that had used short-term dollar funding to invest in risky long-term dollar assets. Shin says we see a similar over-leveraged scenario in emerging market corporate borrowing today. As interest rates hit rock bottom in the US, emerging market companies went on a dollar-borrowing spree, and they will be hit the most by the rise in the value of the dollar. “The sharp rise in the dollar brings us back full circle to mechanisms at play today. But the protagonists have changed in the meanwhile. The dollar borrowers are not European banks, but emerging market corporates," says Shin. “And the borrowing is done through corporate bonds, rather than wholesale bank funding. Borrowing in US dollars by non-banks outside the United States stands at $9.7 trillion. Of this, dollar borrowing by emerging market borrowers stands at $3.4 trillion, which is more than double what it was before the global financial crisis."

Shin points out that any depreciation against the funding currency—in this case, the dollar—is associated with tighter financial conditions and a dampening of economic activity.

Which are the areas that have the most dollar borrowing by non-financial entities? A BIS working paper on Global Dollar Credit: Links to US Monetary Policy and Leverage by Robert N. McCauley, Patrick McGuire and Vladyslav Sushko has the details. The researchers say: “Dollar credit to Brazilian, Chinese and Indian borrowers has grown rapidly since the global financial crisis...dollar borrowing has reached more than $300 billion in Brazil, $1.1 trillion in China, and $125 billion in India." They say that dollar borrowing is around one-tenth of total credit in Brazil, India and South Korea, lower in China, and higher in Mexico and the Philippines.

Bloomberg reports that, according to the Institute of International Finance, non-financial corporate sector debt in emerging markets has risen $13 trillion since 2009, increasing more than fivefold over the past decade to surpass $23.7 trillion in the first quarter of 2015. The advance has been most concentrated in emerging Asia, where it rose to 125% of gross domestic product.

In short, any rise in US interest rates is likely to roil emerging markets, especially since asset markets have been pricing in very loose monetary conditions. That’s why the financial markets are nervous. The International Monetary Fund, which has been asking the US Fed to go slow on raising rates, is even more so. This is what its staff note prepared for the G-20 summit in Turkey has to say: “The Fed’s lift-off could increase financial market volatility and lead to disruptive asset price shifts, possibly accompanied by capital flow reversals in emerging economies. Long-term interest rate term premiums are historically low in some important advanced economy bond markets, and a sharp decompression of those premiums could disrupt emerging economy bond asset markets, already volatile owing to commodity price declines and uncertainty over China’s growth prospects."

As the taper tantrum and the nervousness last August showed, markets are sensitive to any disruption in currently benign financial conditions. While the US Fed has been extremely wary about upsetting the markets and it has stressed that its monetary tightening will be very measured, the prospect of continuing dollar strength is likely to cast its shadow over emerging markets.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com

Subscribe to newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Click here to read the Mint ePaperLivemint.com is now on Telegram. Join Livemint channel in your Telegram and stay updated

My Reads Logout