Are emerging markets prepared for the Fed rate hike storm? Global Economic Outlook, Q4 2015
Are emerging economies ready for the US Federal Reserve’s impending rate hike? Five countries—Brazil, India, Indonesia, South Africa, and Turkey—show different levels of preparedness.
It has been two years since the US Federal Reserve (Fed) first signaled its intention to taper its massive quantitative easing program (QE3). The unexpected announcement in May 2013 panicked investors, and markets went into a frenzy of selling risky assets of emerging markets (EMs), with five in particular—Brazil, India, Indonesia, South Africa, and Turkey—among the worst affected. Poor economic fundamentals resulted in extreme volatility in their currency, bonds, and stock markets.1
With the Fed setting the stage to announce a policy rate hike in its December Federal Open Market Committee (FOMC) meeting, the fear of more financial market turbulence is back. This time the scene is different, though: The Fed has been extremely cautious in communicating its intention to tighten US monetary policy and has given enough hints of raising rates in its last few FOMC meetings.2
However, risks to global economic activities are skewed to the downside. Oil prices are at levels last seen during the 2008 global financial crisis, with a high likelihood of being pushed down further, owing to sluggish global demand and higher production in the near term. In addition, recent data indicate that China’s economy is probably slowing faster than expected, with concerns sparking severe global financial market turbulence in late August: In a span of two weeks, about $5 trillion of equity market capitalization was wiped out globally; China alone lost $1 trillion in just one day. The Chinese government’s inability to reduce its equity market volatility through interventions, including prompt action in August to devalue its currency, suggests that investors are worried about economic headwinds, and that there might be more asset price corrections coming.
We found that India has fared relatively better with respect to economic and financial sector performances since 2013, while conditions in Brazil and Indonesia appear worrisome.
Recently, some of the EMs’ bankers expressed their confidence in their preparedness to face the outcomes of an impending Fed policy rate hike in the Jackson Hole meet.3 The question is: Are they really prepared?
To help answer this question, we analyzed the EMs’ readiness by tracking their financial and economic performances since 2013, when the Fed first hinted at tapering QE3, as well as examining their near-term economic outlook. Since it is impossible to cover every emerging economy for our analysis, we focused on five EMs—Brazil, India, Indonesia, South Africa, and Turkey—that were the most affected by the Fed’s 2013 “taper tantrum.” These five economies together accounted for over a third of total nominal GDP of all EMs (excluding China) in 2014.
We found that India has fared relatively better with respect to economic and financial sector performances since 2013, while conditions in Brazil and Indonesia appear worrisome. In addition, India’s near-term outlook is relatively favorable when compared with the other four economies.
In other words, India may be better prepared than the other four EMs in the event of a crisis. On the other hand, Brazil may limp toward a longer recovery. Indonesia, Turkey, and South Africa, too, may experience severe financial turmoil, with economic consequences lingering for years.
Did they learn their lessons from the Fed tantrums?
These five EMs held general elections fairly recently. Although there is less likelihood of political instability in the medium term, political risks and policy uncertainty vary significantly across these five economies. Elections in India led to the formation of a government with an absolute majority in the parliament’s lower house; the elected party won by promising economic reforms and is perceived to be investor-friendly. On the other hand, elections in Brazil and Turkey weakened their respective governments’ position. Support for Brazil’s president has collapsed, and a minority government in Turkey has increased political risks. One thing is common among these economies: Despite promises, the newly elected governments have thus far failed to implement structural reforms.
Financial sector performance
The four panels in figure 1 compare the experiences in the currency, bond, and stock markets of these five EMs, along with the inflow of portfolio investments. The variables are indexed to Q1 2013 in order to capture their movements prior to, during, and after the Fed’s taper tantrum in summer 2013.
Panel 1: The stock price indices steadily improved in India and South Africa after the turmoil of 2013, with growth momentum remaining robust after their respective general elections as well. These two economies’ indices outperformed the aggregate EM equity index by a significant margin throughout this period. Equity indices in the other three nations took a longer time to bounce back. Turkey’s and Brazil’s indices still haven’t recovered to their levels prior to summer 2013. The index in Indonesia regained some of its lost ground in 2014 but has fared poorly since the election.
Panel 2: Strong and steady growth in portfolio investment inflows in India and South Africa since 2014 aided their strong stock market performances. Portfolio investment inflows remained highly volatile in Indonesia throughout the period, though they improved marginally post the election. In contrast, elections in Brazil and Turkey failed to improve capital flows into their economy—a reflection of low investor confidence in the current governments.
Panel 3: We tracked these economies’ real effective exchange rate instead of the valuation of their currencies relative to the US dollar. This helped in avoiding the effect of the appreciation of the dollar itself due to the Fed’s QE3 tapering during this period and the strengthening of the US economy. Broad-based currencies in all, except in India, depreciated in real terms after 2013. Elections failed to contain the momentum of currency depreciation in Brazil, Turkey, and Indonesia—again evidence of low investor confidence in their governments. Brazil’s domestic currency depreciated the most.
Panel 4: In order to counter plunging currencies and stop capital outflows during the economic turmoil of 2013, all the five economies began drawing on their reserves and hiked their policy rates in Q3 2013. Elevated policy rates, in addition to investors’ high risk perception, pushed up their long-term bond yields. At the same time, high demand for US Treasuries drove down long-term bond yields in the United States. While India managed to check its 10-year bond yield spread with respect to the Fed rate of similar maturity, the yield spread widened considerably for all the other four economies after summer 2013. Policy rate cuts in Turkey succeeded in narrowing the interest rate spread in the interim period, though increasing political risks and weakening economic prospects have reversed the trend lately.
Elections failed to contain the momentum of currency depreciation in Brazil, Turkey, and Indonesia—again evidence of low investor confidence in their governments.
Economic performance and outlook
Financial sector performance often reflects a country’s economic performance and outlook. Since 2013, investors have, unsurprisingly, favored economies with improving economic fundamentals. The four panels of figure 2 compare the five EMs’ economic performance and outlook.
Panel 1: India’s economic growth outperformed growth in the other economies; the economy is forecast to grow at a strong and steady pace in the next two years.4 Indonesia was the second-best performer in terms of economic activities. Brazil, in contrast, has been in a recession for some time, with economic activity expected to contract in the next two years.
Panel 2: India has had more success in taming inflation, managing to reduce its consumer price inflation from double digits to levels that are currently the lowest of the five economies. Brazil has failed to control inflation, although declining economic activity may ease pressure on prices in the next two years.
Panel 3: India stands out in its efforts to control its current account deficit, lowering it to 2 percent of GDP from 4 percent in the past two years. Turkey, too, has had some success, containing its deficit from double to single digits. That said, volatility in current account imbalances remains a challenge for all the five EMs, as their trade balances have remained vulnerable to global risks.
Panel 4: Brazil has had serious trouble managing its fiscal deficit. In contrast, Turkey managed a sustainable fiscal account during this period. Volatility in the fiscal deficit concerned India, although it stayed within the government’s target range post elections.
How have they fared overall?
Although two years is hardly enough for an economy to develop maturity to deal with severe crises, the direction of improvements in these economies since May 2013 suggests their vulnerability to global shocks.
By that measure, India unambiguously emerges as the winner: Its economic and financial sector performances distinctly outperformed those of the other four EMs since the Fed’s first hint of tapering. Falling international oil prices, easing domestic credit conditions, and the government’s efforts to improve India’s infrastructure are expected to boost growth in the near term. In other words, India may have less to worry about any crisis arising due to a Fed rate hike, and it remains a preferred destination for investment among EMs.
Brazil, in contrast, was the worst performer, based on the measures we analyzed—and, due to both internal and external factors, appears to be in the most worrisome situation among the five EMs. The ongoing political crisis, falling commodity prices, and China’s economic slowdown are taking a toll on economic growth. In addition, the government’s recent decision to cut back on austerity measures has frazzled investors; most credit agencies recently downgraded the country to junk status. The economy runs a significant risk of a forthcoming US rate hike causing severe financial turbulence, with a deeper recession possible if global risks go south. One saving grace is Brazil’s reserve position, which may provide some cushion to financial volatility.
Since 2013, the performances of Indonesia, Turkey, and South Africa have closely followed that of Brazil. High dependence on commodity exports and the Chinese economy makes them vulnerable to falling commodity prices and economic weakness in China. In addition to the above risks, Turkey’s domestic currency is highly exposed to the Fed interest rate hike because of its high external financing requirements. These economies’ dwindling reserve positions make them highly vulnerable to global shocks.
Overall, investor sentiments toward these EMs have soured. The MSCI emerging market index has fallen close to 11 percent in the last three months, making it the worst quarter since 2011. Signs of distress in EMs have persuaded investors to remain vigilant of EM’s asset market. Unsurprisingly, the Fed decided to postpone its decision to raise its policy rates in September, citing concerns about EMs. But for how long will the Fed postpone what is inevitable?