Several emerging-market leaders are urging the Fed to get on with raising rates. They’re walking a dangerous path
Capital is fleeing emerging markets at a faster pace than you can say SOS. Figures released today by the Institute of International Finance (IIF) show that foreign investor flows to growth economies fell to just $548bn this year, lower than levels recorded at the peak of the financial crisis. Outward-bound flows from residents have meanwhile accelerated, meaning net capital flows to emerging markets will turn negative this year – for the first time since 1988.
IIF largely attribute this to slowing growth within the category’s largest members, as well as to persistent uncertainty about China’s economic outlook and policies. But another key factor is also at play: the prospect of a looming rise in US interest rates, which if materialised would draw further capital out of emerging markets, weaken their currencies and make dollar-denominated debt harder to repay.
And yet we’re only speaking of a prospect here. The mooted hike has yet to happen, and nobody knows when it will (investors reckon there is a 40 percent chance it will happen before Christmas). But the mere thought that it is in the cards is enough to reverse investment flows – in a way not seen for nearly 30 years. So surely things will get far worse when the Fed eventually pushes the button?
Well, not everybody thinks so. Taking note of the Fed’s inaction last month, central bankers from India, Indonesia, Mexico and Peru have called on their US counterparts to start raising rates. Since everybody is anticipating a hike by the end of the year, they say, better to get it over and done as early as possible (they’re hoping for October).
Their request is a curious one. All of the above states, apart from India, are in the top eight emerging markets deemed most sensitive to more expensive imports, private sector credit and foreign debt by The Economist’s capital-freeze index. The IMF this week reported a fourfold increase in corporate debt over the last decade, a growing portion of which – now traded in the bond markets – would become harder to serve should the dollar become dearer.
But one can guess a multiple rationale behind their call. Uncertainty about the timing of a rise in US rates and their eventual levels has been a chief driver of volatility in stock and currency markets across the emerging world. It has also made it hard for developing countries to issue new bonds on capital markets – due to wild fluctuations in the pricing of debt – at a time when some of them are at risk of a liquidity crunch.
India, Indonesia, Mexico and Peru have hopes that a stronger dollar will help their exporters, too (or at least those who haven’t borrowed too much in greenback). With commodity pricing sagging, some could indeed benefit from a boost to their manufacturing sector.
Rate rises also have value for the signal they send about the broader health of the global economy: Janet Yellen, the Fed’s chief, postponed a hike last month because of the institution’s concerns about China and emerging markets. Pulling the trigger next time round, even through a modest rise, would show her greater confidence about the developing world’s economic prospects. Emerging markets would like to see that.
But their impatience is misguided. While a Fed move would put an end to speculations as to when the first hike happens, uncertainty will likely resurface before each of the institution’s meetings. Yellen has made it clear an initial raise shouldn’t be read as the start of a series, or even as indicative of a hike the following month. So volatility will probably linger.
Neither will weaker currencies be a net bonus for emerging markets. The corresponding unattractiveness of their assets, relative to US ones, mean outflows will accelerate. This will make developing countries poorer overall, especially if that forces them to spend vast amount of hard-currency reserves.
And the signalling effect has merit only if it indicates real improvements in emerging market prospects, which should anyway become visible before the Fed decides to act. The sheer announcement of a rate rise won’t improve the world’s economic outlook just like that.
The one exception here is probably Peru. The country has already started raising rates to dampen rapidly rising prices; it will probably be forced to continue no matter what the Fed decides. Unless a US rate rise buoys the dollar, its currency will strengthen as a result. This will further hurt its exporters. But Mexico, India and Indonesia are in no rush to see US rate rise, which would likely force them to follow suit. They’d be better off keeping their monetary policy lax in order to stimulate investment and spending.
At a time when they keep on being showered by a monsoon of bad news, it is understandable that emerging markets believe anything is better than the status-quo. But it not always is: no matter how hard it falls, rain can easily be followed by a storm. Our gang of four should be careful what it wishes for.