Executive Summary
Emerging Markets (EM) activities are closely related to the actions undertaken by the US and foreign investors. EM is generally perceived to be more volatile than the supposedly advanced economies and thus provide considerably higher returns to compensate for any risks that is inherent in the investment. The effect of Fed rate hike mainly affects EM, since previous rate surges by the Fed were associated with a turmoil in EM economies. This report attempts to analyse the relation between Fed interest rates and lower level of capital flows following the Fed’s momentous decision to increase the interest rate through looking at macroeconomic indicators and the drivers behind the direction of the capital flows. Moreover, this report further elucidates the implications of Fed rate hike in EM, followed by the risks that may be incurred by these countries when facing crucial changes such as the introduction of rate hike in the US. The findings suggest that, to a certain extent, the cycles in capital flows to EM economies are correlated to US monetary policies and prevailing global conditions. Moreover, this report also found that the impact of a Fed rate hike was hugely felt by EM economies that bore vast amount of capital flows, allowing their currencies to be highly volatile during the period of Fed rate hike.
Introduction
The US dollar is widely used across international transactions, thus it supports the preconceived notions that any actions taken by the US will clout international finances in a consequential manner. This nation is undoubtedly the most powerful country in the world by virtue of its reputation as the pre-eminent in multiple sectors including technology, finance and business, entertainment and education.
The US’ dominance is highly attributable to its strategic geographic location, being in the midst of the two great oceans puts the US as the global trade centre considering its sizable exports in consumer and technology goods and continuous reliance on the imports of natural resources (The Global State, 2015). The US has a GDP of approximately $18 trillion (bea.gov, 2016), which is almost double to that of China’s $11 trillion (TradingEconomics, 2016), along with a total Foreign Direct Investment (FDI) of approximately $300 billion(FDIUS, 2016). Therefore, the United States is widely regarded as a superpower, whereby, any changes in their policies would result in spillover effects to the rest of the world.
The notion of the US being a global powerhouse is further substantiated by the fact that the dollar is the most demanded currency in the world, whereby 65% of all dollar-denominated bills are held abroad.
The recent decision of the Federal Reserve to increase the interest rate for the first time in nearly a decade signals that US economy is strong enough to bear an increase, with medium term inflation levels rising close to the target level of 2% and an improved labour market (reuters, 2016). In addition, the demand for short-term bonds in the US will rise following a Fed rate hike, such as 2 year, 5 year and 10 year Treasury bonds, further decreasing capital flows in EM.
The potential hike is intended to normalise the US economy, while also acting as a remedy to dampen the impact of a potential financial crisis. However, the rate hike certainly affects the emerging markets, as it may result in the pullback of capital which could be detrimental to potential economic growth.
Macroeconomics Indicators
The relation between Interest Rates and other macroeconomic indicators
Interest rate movements have various economic effects which could lead to a chain reaction in the economy. When interest rates rise, investments, net exports and consumption tend to decline while the opposite is the case when it comes to decreasing interest rates. This can be seen from the GDP equation below:
GDP = G + I + C + (X – M)
where,
G = Government Expenditure
I = Investment
C = Consumption
(X-M) = Net Exports
An interest rate hike would lead to an increase in the cost of borrowing, as interest payments on credit cards and loans are more expensive. Consumers with existing loans will now see a larger portion of their disposable income taken up by interest payments. Hence, making borrowing less favourable and thus leading to a fall in the overall consumption of the economy. The same can be said for investments, as a higher interest rate would mean reduced investments into the financing of equipment and machinery. In other words, when interest rates increase, consumption and investments decrease while savings become more attractive. As the demand for goods drop, so will inflation.
As the interest rate strengthens, so will the country’s currency, as it is more appealing for investors to invest in a country that provides higher returns. This would then result in a capital inflow from foreign countries. In other words, if the country’s interest rates are higher than that of other countries, it would more likely than not, attract foreign capital. Thus, causing an increase in demand for the local currency and subsequently a rise in its value. As the currency appreciates in value, the cost of imports will now decrease which will then result in an increase in overall imports. Exports, on the other hand, will now be less favourable due to the rise in prices. Net exports (ie. exports minus imports) will decline as the total exports reduce while total imports increase. As it is now cheaper to import goods, inflation will also drop as a result.
The change in net exports will significantly affect the balance of payments; which is essentially the ratio between the amount of payments received from abroad and amount of payments going abroad. The balance of payments represents the total foreign trade operations, trade balance and balance between export and import, transfer payments. If capital inflows exceeds payments, the balance of payments will be positive which is a favourable factor for growth.
As a result of lower aggregate demand and reduced financial capability, firms and organisations would have to lay off its employees to cut down costs and improve efficiency. This chain reaction will cause the overall national productivity to decrease, which will then lead to a slowdown in GDP growth.
The US dollar-denominated debt owned by all of EM governments will be relatively more expensive as a result of Fed rate hike, unless it is hedged. Moreover, investment flows from retail and corporate sector will be directed back to the US. Subsequently, EM currencies will depreciate against the US dollar, thus imported goods become more expensive for EM economies. This means that subsidized commodities such as oil that is imported from other countries would now be more expensive. This in turn could lead to EM government issuing more government bonds in the market, further putting downward pressure in EM government budget deficit as the outstanding amount that the government would have to repay the bondholders will increase.
Emerging Markets
According to HSBC, EM such as BRIC (Brazil, Russia, India and China) and MINT (Mexico, Indonesia, Nigeria and Turkey) are often referred to as the transitional phase toward developed market status or industrialized (HSBC, 2016). EM have a significant role in the global economic landscapes and it possess 5 main characteristics; GDP per capita lower than the global average, high volatility, rapid GDP growth, capital markets less mature relative to developed markets and higher than average returns.
The growth of EM will lead to an increase in the number of middle-income earners and a more diverse stream of economic growths when compared to developed markets. With the increasing number of trades of an EM economy with other nations, the forex, debt, liquidity, and equity markets will broaden as a result, thus, enabling the EM economies to facilitate its trading growth. In other words, higher trading activities between countries would imply capital movements to the EM economies.
Collectively, EM economies account for more than 60 per cent of the total GDP (IMF, 2016) and has been the main driver behind the substantial decline in global poverty.
Market Risk
This risk arises as a result of any alterations in the exchange rates, interest rates and other form of risks. Market risk is interrelated with the credit, interest, and foreign exchange risk, in a sense that when there is a surge in these risks, the overall or market risk will be affected. In a broader sense, market risk is synonymous with the term systematic risk, which is a risk that cannot be jettisoned through diversification.
The overall declining performance of EM comes as a result of the US interest rate hike. The stock market of a country, which predominantly accounts for the leading companies in that particular country, can act as a benchmark of where the economy is heading. The detrimental effect of US interest rate hike is reflected in EM’ stock indexes slump, notably in Indonesia and Brazil when the Fed had begun fuelling the world with the possibility of a gradual rate hike earlier in 2015. These particular EMs stock indexes are experiencing lower liquidity as a result of capital outflows from their countries, thus explains a significant plunge in their respective stock market indexes. Despite the evidence suggesting that there is an inverse relationship between the Fed rate hike and the stock market performance, the notion of US interest rate hike having a direct impact on EM’ stocks indexes is only true when all else are equal.
The graph below illustrates the gradual weakening of both Indonesian (shown in blue) and Brazilian (shown in orange) stock market indexes upon receiving news regarding a possibility of fed rate hike at the end of 2015.
Source: Bloomberg
Interest Rate Risk
Interest rates plays a big role in the welfare of an economy. FI’s all over the world are exposed to interest rate risk over time. Interest rate risk is essentially defined as the risk incurred by a Financial Institution when the maturities of its assets and liabilities are mismatched. (Saunders, 2014).
Asset transformations are one of the key functions of FIs; this generally involves FI’s buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchases. (Saunders, 2014) However, the primary and secondary securities may be subject to a mismatch as they often have different maturity and liquidity characteristics (Saunders, 2014)
In theory, a Fed interest rate hike should not be followed with an upsurge in EM interest rates, as it would be appropriate for emerging markets to exploit this opportunity to encourage expenditure through maintaining or cutting their respective interest rates.
Reinvestment Risk
With an increase in rates from the US, investors investing in EM bonds would be potentially exposed to reinvestment risk. In view of the fact that EM rates would be relatively lower than the US, FI’s of EM would be potentially exposed to risk by holding shorter-term assets than its liabilities. Under these circumstances, FIs in EM will face greater uncertainty about the interest rate movements in which they could reinvest funds borrowed for a longer period. (Saunders, 2014).
FI would face a loss or negative spread in the second year as the positive spread earned in the previous year by holding maturities assets shorter than liabilities will be offset by the negative spread in the second year (Saunders, 2014).
Sovereign Risk
Sovereign risk is defined as the risk of a foreign central bank altering its exchange regulations, to significantly reduce or nullify the value of its foreign exchange contracts. It also includes the possibility of a foreign nation being unable to meet its debt obligations. (Investopedia, 2016) Sovereign risk can affect investors and MNCs’ should the foreign central bank decide to alter its monetary policies. This is highly likely in the event of a fed rate hike, as foreign central banks will look to adjust their monetary policies to accommodate the changes made by the Feds. For example, the central bank in China may decide to switch its policy from a fixed to a floating rate. (Investopedia, 2016). This is in turn would could alter the benefits to currency traders.
Foreign Exchange Risk
Forex risk refers to the risk whereby exchange rate fluctuations may adversely affect the value of financial institutions’ (FIs) assets and liabilities that are denominated in foreign currencies. In a broader context, Forex risk can be defined as the risk of an alteration in the investment value as a result of any changes in exchange rates of the currency.
In country such as Mexico where foreign banks are predominant in their financial industry, the country may be relatively more exposed to risk than any other EM economies. This is evident, since Fed raise the interest rates from 0.25% to 0.5% have resulted in a strengthened US dollar. When the US dollar appreciates against Mexican Peso, internationally active financial institutions based in Mexico would experience a significant fall in its revenue following a depreciated value of the domestic currency. Therefore, Mexico will experience a slowdown in growth, as FI’s are the key driver behind Mexico’s economy.
However, the strengthening of the US dollar could also signal a proliferation of trading activities in the EM. This notion could be further explained as an appreciation of the US dollar allows for increased trading competitiveness in the EM following weaker currencies of EM. The depreciation of a nation’s currency against others implies that the nation’s goods are relatively cheaper for foreign buyers and that foreign goods are relatively more expensive for foreign sellers (assuming all else are equal). Furthermore, the depreciated currencies of EM against the US dollar means that the domestic demand for the goods increase as it is now cheaper and foreign producers will find it hard to sell their goods to the EM, stimulating the domestic economy. This can be seen in countries such as Indonesia, where Rupiah depreciated significantly as a result of tapering by the Fed (that eventually triggers an interest rate hike in the US) in early 2015.
Liquidity Risk
Liquidity risk refers to the sudden increase in withdrawals of liability holders that leave FIs in a position of having to liquidate assets in a short period of time. Even modest increase in the U.S. interest rates can redirect the flow of capital across national boundaries as investors seek higher returns in the largest economy in the world. As a result of that, there would be less investors seeking returns from corporate bonds in EM, leaving their markets to be more illiquid. In other words, corporate bonds become harder to be traded in EM.
Credit/Default risk
With the long period of low interest rate in US after the Credit Crunch 2008, many government and big companies around the world took advantage of the cheap source of borrowing. However, an interest rate hike, would impact some EM, especially those who have borrowed from US.
Brazil has the second biggest dollar-denominated debt in the world after China (Money.CNN, 2015), according to the Bank for International Settlements. Brazilian companies have borrowed billions of dollars over the last decade, and might find themselves unable to repay those debts if the dollar gains more ground against the Real (Brazilian currency), increasing their vulnerability and the probability of default. Furthermore, many Dollar denominated debts could become unsustainable, resulting in credit risk (ibtimes, 2015). In this case, foreign governments and companies not paying back their loans. However, the strong dollar relative to the other currencies is beneficial for exporters as their sale could potentially grow.
Global Repercussions of Fed Rate Hike
EM as a whole are now experiencing a slowdown in the growth rates and reverse capital flows. According to IMF, EM economies are facing a negative net capital flows, indicating that net capital outflows are considerably larger relative to its net capital inflows. In 2015, IMF estimated that there were USD$531 billion of capital outflows and USD$48 billion, suggesting a huge discrepancy between the inflows and the outflows of capital in EM. One of the contributing factors would be the US asynchronous monetary policy that is increasing the rate of interest following an accelerating economic growth in the US (at Q2 2015 and Q3 2015 of 4.6% and 4.3% respectively). This rate hike resulted in an appreciation of the US dollar, further putting pressures on EM corporations that undertook a significant amount of US dollar denominated debt. As a consequence, systematic risk will prevail when such companies are defaulting, resulting banks or governments that are exposed to these companies to incur hefty losses.
The dollar is regarded as the world’s de facto reserve currency, so changes in the U.S. monetary policies can impact the global economy in various ways.
Firstly, a rise in the US interest rate will simultaneously trigger the strengthening of the dollar, which will then cause US exports to be more expensive abroad. This will lead to a decline in demand for US goods and could further weaken US manufacturing. With lower demand for US goods, imports from foreign countries will increase and could cause inflation to drop in the US.
Secondly, rising interest rates from the Feds will eventually lead to an increase in the cost of borrowing, which in turn will lead to slowdown in manufacturing and production in the US. Thus, an increase in US imports. This as a result, will boost exports in foreign countries which will help boost their respective economies despite weakening their currencies.
Thirdly, when the dollar strengthens, its position relative to the other currencies strengthens as well. Although it may weaken other currencies and push up import prices, this would be beneficial as it would help increase inflation in countries, especially in the Eurozone, where inflation has been below the target level of 2%.
Seeing as commodities such as gold and oil are priced in dollars, a stronger US currency will increase the prices of these commodities. However, economies that rely heavily on commodity exports may be at a disadvantage as demand for these commodities drops due to increased prices.
Furthermore, with oil prices remaining low, a strong dollar position could also prompt investors to dump oil futures to invest in US dollars, which may provide higher returns. This could be especially true for oil-producing countries such as Saudi Arabia, Venezuela, Nigeria and Malaysia.
An interest rate hike could also cause adverse effects to the UK economy. For example, should the Bank of England increase interest rates to 2%, approximately one-third of households would have to cut spending or borrow more, assuming wages fail to increase in tandem.
Conclusion
Based on the research conducted, higher US interest rates are closely linked to lower levels of capital flows to EM economies.
Series of capital inflows, however, is mostly associated with the prevailing domestic macroeconomic conditions when disregarding foreign influence. Furthermore, political risk also plays a role in the movement of capital flows across borders. In other words, EM economies with lower level of capital inflows are often identified with weak domestic fundamentals and are more susceptible to risk.
However, most EM nowadays are more stable than they used to be.It is imperative to note that the ubiquitous impact of a Fed rate hike on EM is only true to a certain extent, assuming all else are equal. Investors have built up expectations regarding the Fed rate hike leading up to the Federal Open Market Meeting. Hence, the potential risk of a sudden shift in market sentiment is unlikely to happen. However, EM that rely heavily on commodities and hold a large amount of dollar-denominated debts would be prone to insolvency.
As said above, the interest rate hike does indeed have an impact on the global market, especially to the EM, although the impact is insignificant. It can however, be seen through the chain reaction with spillover effects to global trade i.e. their imports and exports business, as the strengthened dollar is used worldwide in trading. Furthermore, the strengthened US currency adversely impacts the dollar-denominated consumers with repayment burden.