How emerging markets react to Fed rate hikes

In its recent meeting, the Federal Open Market Committee (FOMC) announced its target policy rate at 2-2.25 per cent. In the backdrop of a strengthening labour market, improving economic activity, and inflation within its 2 per cent target, the US Fed reaffirmed its plans to continue to raise rates gradually.

Such upward movement of the US policy rate can have an acute impact on emerging markets (EMs). The rising rate differential between the US and other mature markets pulls global capital towards the US, at the expense of relatively riskier EM assets. The EMs saw portfolio equity outflows of over $17 billion in October 2018 alone, marking the worst month since the 2013 taper tantrum.

A recent report of the US-based International Institute of Finance, predicts a $10 billion cumulative fall in inflows to EMs during the last quarter of 2018. Also, it shows that inflows are expected to fall by another $36 billion in 2019, bringing the cumulative fall in inflows from the fourth quarter of 2017 to a huge $88.6 billion. The ongoing contraction in global financial conditions and unpredictability around trade and foreign policy are likely to continue, prompting volatility in EM portfolio flows.

Contagion effect

The contagion effect of the US rate hike and the consequent outflows from the EMs also saw relentless ascent of the dollar vis-à-vis the EM currencies.

While the Turkish lira faced bloodbath depreciating by 34 per cent, the Brazilian real emerged as the worst currency in Latin America with 19 per cent loss in value. Coincidentally, both Turkey and Brazil had their domestic economic settings also to blame for this downfall. The rouble and peso fell 14 per cent and 10 per cent, respectively.

In Asia, the rupee was the worst performer, depreciating by around 10 per cent in the last 12 months, with Indonesian rupiah closely following at 7 per cent. China, as a result of its trade war with US, saw the yuan fall by 5 per cent.

Any further tightening of liquidity by the Fed is likely to push bond yields up in US and hence result in more money flowing out of most of the EMs to developed markets.

In the last 12 months, the US Fed has raised rates four times, triggering the outflow of capital from EMs. However, the central banks of these economies have been cautious and not raised their own policy rates in haste.

In December 2017 and March 2018, the US Fed increased rates by 25 basis points (bps) each time. While Mexico and China reacted by increasing their respective policy rates by 25 bps and 5 bps, some of the other EMs like Indonesia, India, and Turkey kept their policy rates unchanged for a significant long time.

On the contrary, Russia and Brazil, showed an accommodative policy regime — having reduced their policy rates by 100 bps during this period.

However in the last six months the EM economies witnessed some upward movement in policy rates. This, however, is not necessarily because of the apprehension of further Fed hikes, but more so because of local factors.

Indonesia, for example, raised rates five times in the last few months as the rupiah was witnessing a nearly 20-year low against the dollar. On the other hand, Turkey, which has been embroiled in multiple issues with US, saw a dramatic rise in interest rates to 24 per cent in a bid to control inflation and prevent a currency crisis.

India, too, had its local factors such as a five-year high current account deficit, rising inflation and fiscal slippages, which were all becoming a concern for the RBI, resulting in a hike of the repo rate. Going by this trend, the EMs are likely to continue to focus more on their domestic concerns than on Fed actions while deciding on their policy rates.

RBI’s stance

At the RBI’s Monetary Policy Committee (MPC) meeting on December 5, a similar approach is expected. The latest data show retail inflation having eased to 3.31 per cent in October, thanks to a fall in food prices. Besides, global crude prices have now plunged. Though the respite in oil prices may be temporary given the sudden increase in US supplies, it will help to keep inflation benign for the time being.

The softening of crude oil prices, which was a huge drain on India’s current account balance, will enable the rupee to recover further. The rupee has strengthened by almost 5 per cent in November, luring back FIIs into India. Export revenues showed double digit growth in October. In this situation, the RBI may keep the policy rates unchanged. This, however, hinges on the MPC not turning dovish, following the 7.1 per cent moderate growth in second quarter GDP.

The author is an Economist with Exim Bank. The views are personal.