Emerging Markets Look Ready for Janet Yellen

  • Developing economies have strengthened their defenses
  • Fed is forecast to raise benchmark interest rate in December

Are Emerging Markets Ready for a Fed Hike?

Emerging-market economies appear ready for Janet Yellen.

Cushioned by a rally in stocks, currencies and commodities, a brightening growth outlook and fatter foreign-exchange reserves, governments from Jakarta to Warsaw have sandbagged defenses in anticipation the Federal Reserve chair will raise interest rates by year-end.

It’s a far cry from 2013, when the prospect of the Fed slowing bond purchases sent markets into a tailspin. Though the Fed telegraphed its last interest-rate increase in December 2015, the move may have compounded investor anxiety when concerns over China’s outlook surfaced the following month. Traders have priced in about a 16 percent chance of a rate hike when the Fed meets this week, with 73 percent odds of an increase at or before the December meeting.

“The prospect of a resumption of tightening by the U.S. Fed will be a concern for a handful of emerging markets,” said Krystal Tan, Singapore-based economist at Capital Economics. “But these are the exceptions rather than the rule.”

The International Monetary Fund in October nudged higher its forecast for emerging-market growth this year to 4.2 percent. Capital Economics estimates developing economies are growing by their fastest in 18 months, spurred by higher commodity prices and signs that China’s economy has stabilized.

Higher U.S. interest rates help strengthen the greenback, drive up borrowing costs and tend to weigh on commodity prices. That can hurt those companies and governments in the developing world that rely on commodity exports and borrow in dollars.

Their growth matters. Emerging markets account for 45 percent of global trade, according to the Bank for International Settlements, up from just above 30 percent in 2000.

Demand for emerging-market assets has been buoyed by expectations that growth will continue to outpace that of advanced economies, amid a global hunt for better returns in an environment where trillions of dollars of debt worldwide offer negative yields.

In much of Latin America, concerns about a Fed hike have eased. Growing international monetary reserves have been complemented by more fairly valued currencies. More market-friendly governments in countries like Brazil and Argentina have actually brought down the cost of borrowing for sovereigns and corporates this year.

The Brazilian real is the world’s best-performing major currency this year with a 24 percent gain against the dollar.

“Investors and these economies are now less fearful of rate hikes in the U.S.,” said Alberto Ramos, chief Latin America economist at Goldman Sachs Group Inc. “Part of the adjustment has already been absorbed. These economies have already decelerated and absorbed the commodities shock through the terms of trade. And currencies have moved a lot over the last two years.”

Asia Fortified

Things look better in Asia too. According to BlackRock Inc., $71 billion worth of investment fled Asian stocks and bonds, excluding Japan, after the 2013 taper tantrum when then-Fed Chairman Ben S. Bernanke signaled an end to quantitative easing was in sight.

“We don’t expect a tantrum replay, as we see the Fed raising rates gradually,” BlackRock Global Chief Investment Strategist Richard Turnill wrote in a note Monday. Emerging markets in Asia appear to be in “better shape now than in 2013,” he said.

Standard Chartered Plc estimates Asia will drive the world economy next year, accounting for 58 percent of global growth, with little prospect that scenario will be unwound by one or two hikes by the Fed.  

“On balance, I think emerging markets can cope with a hike in December and a few hikes next year, provided these are against a background of solid U.S. and global economic growth,” said Shane Oliver, Sydney-based head of investment strategy at AMP Capital Investors Ltd., which oversees about $121 billion.

Yet risks remain. Non-financial debt in major emerging-market economies grew from 60 percent of gross domestic product in 2006 to 110 percent at the end of 2015, according to the BIS, which said in an August report that the increase “rings alarm bells.” U.S. dollar obligations could get a bit tougher to repay if the greenback rallies significantly on the back of higher interest rates.

For a QuickTake on what a strong U.S. dollar means for the world economy, click here

Vulnerable regions include Southeast Asia, which is at risk of being caught with dollar debt that’s serviced by a weakening local currency, an old trap dubbed the “original sin.” China, Brazil and Russia are also among those flagged for foreign-currency exposure.

Still, there are buffers. Governments have restocked depleted foreign-exchange reserves -- Brazil’s are up by 2.3 percent from a year ago and Thailand’s are up by 16 percent, according to data compiled by Bloomberg. Flexible currencies and stronger balance sheets will also help. Overall foreign-currency debt as a percentage of GDP is smaller than it was before the last financial crisis, according to the BIS.

Improving fundamentals and a gradual adjustment to China’s slower growth mean developing economies should be able to cope if and when the Fed raises interest rates, said Kevin Loane, an economist at London-based Fathom Consulting. 

“Our view is that emerging markets can handle it,” said Loane. “Emerging-market policy makers would probably welcome the certainty at this point.”

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