Fed rate hike and economic instability in emerging markets Global Economic Outlook, Q1 2016

Emerging markets have been witnessing a rapid increase in capital outflows. Apart from a Fed rate hike, other potential risks are lurking that may trigger paranoia among investors. Will a tighter monetary policy in the United States trigger a domino effect in the global financial world?

DUP1501_SpecialTopic_spotWhen an apple fell on young Isaac Newton’s head, he sought to understand the reason behind the fall and devised the theory of gravity. However, when a falling acorn hit Chicken Little, the chick believed that the world is coming to an end. Both stories started with a similar event, but while the first event led to one of the greatest discoveries, the second event only caused panic.

In today’s financial world, investors’ reactions to any undesirable event often resemble Chicken Little’s. Be it the US Federal Reserve’s (Fed’s) “taper tantrum” in the summer of 2013 or Greece’s bailout drama, the initial market response has been paranoia. Sadly, the capital and currency markets of emerging economies (EMs) face the brunt of such hysteria, although advanced economies don’t remain unscathed either.

Since late 2014, EMs have been witnessing a rapid increase in capital outflows, primarily due to weak economic activity, the global interest rate outlook, and geopolitical factors. According to a report by the Institute of International Finance, in 2015, private capital inflows to EMs are projected to fall to their lowest levels since 2009.1 Data released for August and September confirm that EMs witnessed $40 billion portfolio outflows in Q3 2015, marking it as the worst quarter for capital outflows since the global financial crisis.2 The pace of outflows is expected to accelerate once the Fed tightens its policy rate; if the tightening is aggressive, EMs might need to wait for a long time before they see a rebound in capital flows.

What complicates the matter further is that, although imminent, the rate hike is not the only risk that investors are nervous about. Given that global economic activities are skewed to the downside, a number of short- and long-term risks are lurking ahead. Any of these risks swinging in an undesirable direction may result in a “sky is falling” reaction among investors. The question is whether a tighter monetary policy in the United States will trigger a domino effect in the global financial world.

Before every Federal Market Open Committee (FOMC) meeting held in the last few months, investors’ speculations have caused repeated bouts of volatility in EMs’ financial sectors.

Fed up with tantrums—what to expect

Will it, or will it not? This guessing game over whether US monetary policy tightening will push other global risk events over the edge has been going on for some time now. Before every Federal Market Open Committee (FOMC) meeting held in the last few months, investors’ speculations have caused repeated bouts of volatility in EMs’ financial sectors.

In last quarter’s Global Economic Outlook, we analyzed the economic and financial performance of the five EMs—Brazil, India, Indonesia, Turkey, and South Africa—that have been most affected by the Fed’s taper tantrum in 2013.3 Excluding China, these five economies together accounted for over a third of total nominal GDP of all EMs in 2014. In this article, we try to gauge the possible impact of a Fed rate hike on the financial sectors of these five EMs—first, by simply ignoring that downside risks to global events exist, and then accounting for them along with the Fed rate hike in our analysis.

A simple exercise was carried out to track similar earlier Fed rate hikes and their impact on stock market indices, currencies, and interest rate movements of these five EMs. Our aim was to predict the possible impact if the Fed decides to hike rates after keeping them low for nine years, based on past events. From 1990 on, the Fed raised its policy rates thrice before bringing them down to historically low levels in 2008 (table 1).

However, it is often argued that the post-2008 world is very different from the precrisis one. The depth and the complexity of the 2008 crisis have had a lasting impact on the economic structure and behavior of economic entities across nations. The skeptic behavior of investors and their hysteric response to the slightest hint of bad news are cases in point.

Since there has been no instance of a policy rate hike post the 2008 crisis, our ability to accurately predict investors’ response and the impact on EMs’ financial sectors is limited. That said, on one occasion during 2012–14, the 10-year Fed rate rose for a considerable period. In general, the Fed’s policy rate and the 10-year Fed rate have often moved in tandem, except for this period. We use this period of increasing long-term Fed rates as a proxy for a rising policy rate in order to assess investors’ reaction to a tighter monetary policy post the 2008 crisis.

Table 1. US policy rate hike

Duration of policy rate hike

Rate hike (%)

Feb 4, 1994–Feb 1, 1995


Jun 30, 1999–May 16, 2000


Jun 30, 2004–Jun 29, 2006


Duration of policy rate hike

Rate hike (%)

Q4 2012 to Q1 2014*


*Note: There was no policy rate hike during this period.
Source: FOMC meetings.

More often than not, the stock market indices of these EMs brushed off the initial impact and climbed steadily through the end of the US monetary policy tightening cycle, even during 2012–14.

Reactions of EMs’ stock markets and currencies to a Fed rate rise in the past have been noteworthy. More often than not, the stock market indices of these EMs brushed off the initial impact and climbed steadily through the end of the US monetary policy tightening cycle, even during 2012–14 (figure 1).

Special Topic Figure 1

The impact on the domestic currencies, however, varied across these five EMs. The real exchange rate appreciated in India every time the Fed raised its policy rate, while Indonesia’s domestic currency remained more or less stable. When a hike in the Fed’s policy rate coincided with stress in the external sectors of Brazil and South Africa, their currencies depreciated. Lately, Turkey’s domestic currency has been vulnerable to tighter US monetary policy because of high external financing requirements and high dollar-denominated debt (figure 1).

While a US rate hike often led to a narrowing of the long-term interest rate spread in the EMs (relative to the US long-term rate) prior to the global financial crisis, this trend reversed when yields for 10-year bonds rose in the United States during 2012–14.4 Except for India, the interest rate spread widened for the other four EMs. In other words, investors were demanding a premium to hold bonds of those EMs whose economic fundamentals were relatively weak (figure 1).5

If the past could be any indication of the future, figure 2 summarizes what one may expect if the Fed decides to raise its policy rate.

Special Topic Figure 2

But that’s not the whole story

If only investment decisions were simple with known challenges. While the biggest imminent risk that markets may be facing is the Fed’s interest rate hike, that’s not the entire story. The decision to hold EM assets is often influenced by several other global events (figure 3); most risks associated with these are currently skewed to the downside.

Special Topic Figure 3

Such events include:

  • China slowdown: Disappointing economic data and volatility in China’s stock markets continue to worry investors. Credit and property markets are showing signs of a bubble. The government has intervened on occasion to stymie volatility in the financial market. China has been easing its monetary policy as well as its lending standards since a year, and in August it devalued its currency in order to spur the economy.
  • Oil price volatility: Geopolitical tensions in Russia, the deal between Iran and six powerful economies, the economic slowdown in the Eurozone, increased US domestic production of crude oil, and uncertainties regarding capital investments by major energy companies all have helped increase volatility in oil prices. A fall in global oil prices by approximately 50 percent in the last year has been a welcome relief for oil-importing economies such as India. At the same time, the price drop has severely hit revenues of oil-exporting economies such as Brazil and has aggravated risks of deflation in the United States and Eurozone.
  • Eurozone crisis: Risks of a financial contagion due to the Greece crisis may have receded for now, but the issue is far from being over. Leaders of the Eurozone agreed to bail out Greece on the condition that the present Greek government implements serious reforms, which are likely to push Greece into a deeper recession in the next few years. Whether the present government will continue to implement austerity measures and reforms amid economic crisis and social unrest is anyone’s guess, but uncertainty over Greece’s exit from the Eurozone still exists.
  • US dollar appreciation: The recent strengthening of the US economy, poor global growth, and expectations about a policy rate hike have led to a sharp appreciation of the US dollar. An appreciating dollar has created balance-sheet challenges for countries whose debts are dollar denominated.
  • Excess global liquidity: Ultimately, only central banks can create official liquidity. The massive quantitative easing programs by the United States, Japan, and the Eurozone since the crisis have resulted in the balance sheets of these nations’ central banks ballooning. On average, advanced nations’ central-bank balance sheets have grown from 10 percent to 20 percent of the world GDP since 2007.6 Abundant global liquidity has encouraged global investors to flock to emerging markets to seek higher returns, making it easier for the latter to access skittish foreign investments to finance their growth sans any structural reforms.

Risks associated with each these events, along with a hike in the Fed’s policy rate, have impacted the financial sectors of the five EMs. However, the significance of each event and the extent of the resulting volatility in their financial sectors differed substantially across these EMs. Here we analyzed two questions:

  1. How have global risk events impacted the stock prices and currencies of the five EMs during 2007–15? Which event has had a profound impact on the EMs?
  2. How vulnerable are the five EMs to the downside shocks of each of these global risk events?

Our findings are summarized in figures 4 and 5.

Special Topic Figure 4See endnote 7.


Special Topic Figure 5See endnote 8.

Lurking threat

While the conclusions derived from the above analysis are not infallible, they provide insight into EMs’ vulnerability to different global episodes. The Fed rate hike has been hogging the headlines, probably because, unlike other events, investors associate this event with a probable date (subsequent FOMC meetings). More than the fact that US monetary policy is tightening after nine years, it is the possible domino effect that worries investors. Consequently, around every impending meeting, curiosity and speculation on possible outcomes keep investors busy. In comparison, all the other events are less perceptible. However, that does not take the edge off the fact that the EMs are equally, or probably more, susceptible to events such as China’s economic slowdown and oil price volatility.

Our analysis suggests that in the medium term, India may have less to worry about, while Brazil might be in the red zone if global risk events go south. That said, none of these economies are prepared to counter long-term risks. When it comes to implementing structural and meaningful economic reforms, which is key to building resilience, the governments in all these five economies have somewhat failed to impress investors. These nations have hesitated to implement reforms over the last few years. For now, they can only hope that no potential crisis halts their growth path.