Emerging Markets Aren't Really in Charge of Their Own Interest Rates Anymore
Emerging market central banks are shackled to their U.S. counterparts, with local long-term interest rates held hostage to the Federal Reserve and the monetary policies of other advanced economies.
That's the striking picture painted, in not so many words, by a new Bank for International Settlements (BIS) paper. The research throws into sharp relief how domestic monetary policy in a clutch of emerging markets has been rendered effectively impotent thanks to financial globalization.
"Central banks in small economies have only a very limited ability to influence the long-term interest rate in their own currencies," BIS Economists Peter Hördahl, Jhuvesh Sobrun and Philip Turner write in the paper published last week. "The direct influence of changes in their policy rate relative to that of the Federal Reserve is small."
Drawing on a proprietary model that estimates the world long-term real interest rate, which is principally driven by the U.S., the economists highlight the increasing correlation of emerging market and U.S. yields. They subsequently highlight the challenge emerging markets face in adjusting their long-term interest rates to influence monetary conditions.
"In both advanced and emerging economies, short-term correlations with U.S. long-term yields have increased substantially over the past decade," the economists write. On average over the period 2005 to date, a 100 basis point rise in the U.S. 10-year yield is associated with a 70 to 80bps rise in the yields in other bond markets – swamping the effects of changes in short-term rates."
The paper models changes in long-term interest rates in six advanced and 12 emerging-market economies, with the latter group comprising Brazil, Chile, Colombia, Indonesia, Korea, Malaysia, Mexico, the Philippines, Poland, South Africa, Thailand, and Turkey. The model takes into account 10-year U.S. Treasuries, the local policy rate, a shadow Fed funds rates, and the three-month local money market yield.
The BIS calculates that a 100 basis point rise in the 10-year Treasury note is associated with a 79 basis point rise in the yield in advanced economies, and a 69 basis point rise in emerging market yields. It calls the latter correlation "striking" since the opening of emerging market local bond markets to foreign investors is a relatively recent phenomenon.
Perhaps counterintuitively, the BIS also reckons a 100 basis point rise in the Fed funds rate only directly adds six or seven basis points to long-term rates overseas. In other words, short-term U.S. rates have a relatively modest impact on emerging market yields, and they speculate the sensitivity between the two is higher when the Fed takes global markets by surprise in its hiking cycle, in contrast to the well-flagged lift-off of last year.
In sum, despite the vast macro and financial differences between emerging markets, their long-term yields and, by extension, the shape of their yield curves, move in step with developed market rates. Put simply, while emerging market central banks can chart their own monetary course at the short-end, long-end rates are driven by global forces, according to the BIS research.
Fed chairman Alan Greenspan in the mid-2000s described stubbornly low U.S. long-term rates, even as the U.S. central bank was raising short-term rates, as a policy "conundrum" and cited the flow of global savings into the U.S. from China and the Gulf economies, in particular, as its principal source. The BIS paper doesn't attempt to explain why emerging markets have experienced a similar problem in recent years but previous work has highlighted how the jump in dollar borrowing by emerging market companies, through overseas bond markets and cross-border banking claims, has increased the sensitivity between emerging markets and overseas dollar conditions.
Regardless, the paper's conclusions will no doubt be a source of frustration for emerging market policymakers. Since EM crises from 1997 onwards, they have enacted a slew of reforms — from embracing floating exchange rates, and reducing U.S. dollar debts, to strengthening fiscal positions — all in the name of boosting their external buffers to macro shocks and harnessing control of domestic credit conditions.
The BIS paper, however, highlights the striking correlation of global rate cycles, and thereby, the extent to which growing financial globalization has worsened domestic policy trade-offs — a conclusion consistent with the emerging market boom-and-bust credit cycles in recent years.