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Fed Rate Hike and its Effect on Emerging Economies

By Prajesh Gupta, NMIMS Mumbai, Batch 2015-17

The recent announcement by Janet Yellen and the Federal Open Market Commission (FOMC)
regarding the U.S. central bank's policy-setting committee, which had raised the range of its
benchmark interest rate by a quarter of a percentage point was an expected one. The interest rates
have been hiked to between 0.25 percent and 0.50 percent. Though the rate hike was expected by
many, the assumptions of its effects are varying. While some experts state that it might cause
another slowdown in the U.S, other say that the hike will harm emerging economies.
Current Performance of Emerging Economies
China accounts for nearly 30% of the economic activity of emerging economies and it is the
largest buyer of commodities. The Chinese slowdown has led to decline in the rates of
commodities. The private sector debt has risen to extreme levels, especially in China, Thailand
and Turkey. On the other hand countries like Chile, Mexico, Hungary and Indonesia have high
foreign currency borrowing. India has been able to sail through this period due to oil price
decline and focusing on domestic demand. Corruption scandals in Brazil have rocked their
vulnerable economy. Brazils Real has lost half its value to the US dollar this year and the
Russian Ruble is at its lowest compared to the US currency. It is the emerging economies that are
displacing the developed nations as the most troubling cloud on the economic horizon.

Figure 1: Percentage Unemployment in the US

Source: Bloomberg

Reasons for Rate Hike

There are a few indicators which state that US economy is resurging, consumers are spending at
the fastest pace since recession. Sales of new and previously owned homes are rising. The U.S.
has generated 12.1 million new jobs in the past five years. The unemployment rate is down to an
eight-year low of 5%. It is half of what it was in 2009. This has helped increase spending of the
average American. A stronger labor market and cheap gas are fueling consumer spending.
The earlier rates which were quite low, provided an advantage to hedge funds and high frequency
traders who used to practice algorithm based trading. With Feds decision, the volatility will
reduce. We can expect retail investors to have more confidence in the markets and hopefully the
market fundamentals will gain prominence.

Effect of Rate Hike on other Emerging Economies

The world economy is fragile and any kind of fed action is bound to have effects. Low
commodity prices, rising debt and slowing economies have already taken a toll on most nations.
The knock-on effects of the hike on emerging markets will be currency devaluation and capital
outflows. Before the hike, a major advantage for institutions of emerging markets was the low
interest rates in the US. Emerging market governments, corporations and banks took advantage
of low cost dollar finance to shore up their finances. Data from the Bank of International
Settlements show similar figures reported by the IMF that emerging market borrowing have
doubled in the past 5 years to $4.5 trillion. The vulnerable list issued by the Fed and by Moodys
in 2015 show that Brazil, Turkey and South Africa appear most consistently and have the largest
external borrowing challenges. Credit Default Swap (CDS) market also helps describe the credit
stress in emerging markets. The figure below shows Brazil and Turkey are under deep credit
stress and any actions by the US Federal Reserve can have dire consequences on their economy.

Figure 2: Annual Default Probability from 5 Year Credit Default Swap Spread

Source: Deutsche Bank Research

The period of economic recovery had seen a rise in capital inflow of US $4.5 Trillion till 2014 in
these markets. The rate hikes could also lead to reversal of capital flow from emerging
economies. Political turmoil and high inflation of about 9% are already plaguing Turkey.
Withdrawal of capital due to rate hike can further harm the economy. South Korea has the benefit
of one of the largest current account surpluses in the region but its economy is vulnerable to
foreign shocks. Its majority of exports are to China, which has been facing a slowdown and
hence a rate hike by the Federal Reserve can amplify its losses.
Corruption is plaguing Brazil, while the oil price crash has already affected Russia. On the other
hand, Chinas private sector is ridden with debt. Even though it's foreign exchange reserves have
declined but the country still has the largest foreign exchange reserves and possesses ample
buffers to repay overseas creditors and honor import commitments compared to others. Actions
of US Federal Reserve will strengthen the dollar against the emerging market currencies.
Evidence from the past rate hikes shows that stock markets reacted positively, at least on eight
out of 10 occasions, for almost all the emerging economies. It should also be noted that the
equity markets saw a bullish phase. Increasing risk appetite among global investors made them
flock to emerging markets. It was only on two occasions that the stock markets reacted
negatively. Foreign investors who had already invested in these markets will fear that the
depreciation will wipe out their profits and hence capital outflow can be accelerated.

Effect on Indian Economy

Nearly $3 billion worth of investment had been withdrawn by foreign investors before the rate
hike. Most of the money withdrawn has been termed as short-term money, there is still enough
residing in the markets and can leave, depending on future hikes. According to experts, the
Indian economy has a positive outlook. The external balances have significantly improved since
2013. Foreign exchange reserves rising by a margin of $65 billion as of November 2015 and the
current account deficit (CAD) is narrowing. Sinking oil prices have been a boon in this regard
and have helped in reducing the CAD. Unlike other emerging powers, India is less dependent on
commodity exports, and thus has not been negatively affected by the global rout in commodity
prices. Only a small part of Indias sovereign debt is denominated in foreign currencies. Indias
favorable economic growth outlook in the range of 7-8% makes it a relatively attractive option
for foreign investors. The bond rates and currency will gain. Bond yields are likely to soften and
the rupee is estimated to stabilize between 66.3-66.8 to the US dollar.
The rate hike brings a suspense attached to it, especially for the emerging economies. The growth
rate of the MSCI Emerging Markets Index, which captures growth trends in large and mid-cap
companies in emerging markets, has increased over the years, exhibiting better prospects for
these countries. However, the exit from zero policy rates will cause serious problems for those
nations which have large borrowing needs, large stocks of debt most of which are in US dollars,
and monetary and fiscal policy shortcomings. Such nations would only hope that the interest
payments do not continue to be a problem. Chinas economic slowdown, along with a nosedive

in commodity prices, will create additional headaches for emerging economies, most of whom
have not implemented the structural reforms to their economic policies.