/ 30 October 2014

Imminent rise in US interest rate spells trouble for emerging markets

Imminent Rise In Us Interest Rate Spells Trouble For Emerging Markets
To survive one needs a diversified portfolio with a balance between domestic and international investments and financial planning that takes a long-term view.

Despite a possible fallout, emerging markets have found little room to manoeuvre as they are boxed in by a myriad other challenges.

On Wednesday, Federal Reserve chair Janet Yellen announced the end of bond buying and indicated that rates will likely rise in the United States in mid-2015. Emerging markets have been enjoying capital inflows as interest rates in advanced economies have remained at historic lows in the wake of the 2008 financial crisis of which the impacts continue to linger. But once rates rise in the US, massive outflows are expected for the developing economies. 

According to Vivek Arora deputy director at the International Monetary Fund who addressed a conference at the South Africa Reserve Bank in Pretoria on Thursday afternoon: “We have seen a substantial increase in capital inflows to emerging markets and rise in assets prices – and it’s not justified by stronger fundamentals.”

Jitters in the market of late is likely a sign of that, Arora added. “What is a little troubling, this generally robust picture does not match growth prospects. Growth has serially failed to meet forecasts which, themselves, have been revised downward constantly,” he said. “There is a decline in growth expectations, at the same time capital flows are going up. There is a disconnect.”

Preparation for the fallout
But emerging economies are certainly not blissfully ignorant of this fact. Instead, moves are afoot to protect themselves for the come down – particularly through rebuilding reserves, which aim to act as buffers in times of stress. Even those inflation-targeting economies, such as South Africa, have started to rebuild these rainy-day reserves.

In most cases however, these fiscal buffers are smaller than before as public debt in emerging markets has gone up and there are contingent liabilities to consider if growth were to slow.

“So the scope for supportive policy from the fiscal side is not very high,” he said.

While their recovery is being observed in the US and the United Kingdom, quite opposite is true for other major economies like the eurozone and Japan. This asynchronous cycle, Arora warned, poses a risk for emerging markets.

Indeed, like South Africa, most of its peers have negative output gaps and, despite this, most have inflation elevates at some distance above the mid-point of target band, if not outside of the target band. “We are seeing elevated fiscal and current account deficits in most of the emerging world,” Arora said.

In response to inflationary pressure, some developing economies opted to raise interest rates, South Africa being one of them. Where inflation was contained these central banks were able to cut rates.

The ease monetary policy would boost growth, to tighten it presents an elevated inflation risk.

Several emerging market economies face a policy dilemma where the output gap is negative, but inflation is high, said Arora. “There is little room in these economies to ease monetary policy in order to remain consistent with their inflation objectives … The scope for easing monetary policy is limited where inflation expectations are high, and they are in fact high in most emerging markets.”

Effects for SA
Arora observes that out of the emerging economies, South Africa comes out worst when looking at the critical twin deficits – that is the current account deficit paired with the budget deficit – which together see an economy in worse shape than any other of its peers. The elevated deficits restrict the flexibility of monetary and fiscal policy.

In any emerging market, structural factors (those more long term and not necessarily related to the recession) contribute to current account deficits and changes in the exchange rate may not have an effect on the current count if there are structural reasons for it. Worsening of terms of trade may also have contributed.

While emerging markets have their own domestic and structural issues, external downside risks are a threat to them all, Arora said. Surprises in monetary policy normalisation in advanced economies is one. Geopolitical risks, and their impact on energy prices, trade and capital flows, is another.

The possibility of sharp slowdown in growth is another, which could particularly impact commodity prices which many emerging economies are heavily reliant on.

“The policy challenges are complex for emerging economies are complex, they need to support growth, and strengthen resilience … the trade-offs are difficult and really depend on country circumstance.”