Effects of increasing in feds interest rate on emerging market economies

THE EFFECTS OF INCREASING IN FED’S
INTEREST RATE ON THE EMERGING MARKETS

Truong Van Hung - 신천의
December 07, 2015

Abstract

Cross-border capital flows have been intensified last decades with the greater financial integration.
After the global financial crisis in 2008-2009, emerging markets economies (EMEs) have (re)started to be
a significant target of global capital flows. “Emerging-market” assets and currencies became objects
of desire on the part of global investors thanks to the global factors (such as US interest rates, risk
aversion) and domestic factors (such as the country’s external financing needs, structural characteristics,
the exchange rate regime). However, emerging markets will suffer a net outflow of capital in the year of
2015 for the first time since the 1980s as their economic fortunes darken and the US Federal Reserve
prepares to lift interest rates. Emerging nations were facing a fifth consecutive yea r of slowing growth,
adding that an increase in US interest rates could exacerbate conditions in some leading economies. With
the next Federal Open Market Committee (FOMC) press conference scheduled for December 15, 16/2015,
only one week away, the effect o f increasing in Fed’s interest rate on EMEs is one of the biggest concerns
all over the world at the end of 2015. This article considers some important factors affecting the Fed ’s
decision on lifting the interest rate and analyses how an interest rate hike would influence on EMEs in the
perspective on the financial capital outflow from emerging markets.

Keywords: increasing Fed’s interest rate, emerging markets’ response, huge shock to emerging markets,
emerging market economies, triggering global debt crisis, capital flight to quality, net outflow of capital
from emerging market

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1. Introduction

The integration of emerging markets into the global financial system has been characterized by
cyclical periods of capital inflows, interrupted by sudden capital outflows and financial crises.
Probably the most renowned boom-and-bust cycle was the surge of private capital flows to
emerging markets during the 90’s that ended with a succession of crises, starting with Mexico in
1995 and then touching East Asian countries in 1997-1998, Russia in 1998, Brazil in 1999,
Argentina and Turkey in 2001. The following boom to emerging markets during the 2000’s was
again interrupted by a sudden reversal of capital flows during the global financial crisis
following the Lehmann Brothers collapse in 2008. Since 2009 capital flows to emerging
markets are again at historical heights.
According to economic theory, free movement of capital across national borders is beneficial to
all countries, as it leads to an efficient allocation of resources that raises productivity and
economic growth everywhere. Capital inflows to EMEs can help finance domestic economies
and contribute to long-run economic growth. Foreign portfolio inflows can provide a better
opportunity for local capital market development, generally providing increased liquidity and
price recovery mechanisms. As a result, the economic performance of EMEs has recovered
quickly after the financial global crisis in 2008. The stock market of China has gone up steadily
until the middle of this year 2015.
However, emerging markets will suffer a net outflow of capital in the year of 2015 for the first
time since the 1980s as their economic fortunes darken and the US Federal Reserve prepares to
lift interest rates. Emerging nations were facing a fifth consecutive year of slowing growth,
adding that an increase in US interest rates could exacerbate conditions in some leading
economies. The projection will heighten concerns about the prospects for leading emerging
economies including China and Brazil.
The FED announced to withdraw the QE (quantitative easing) in Oct 29th, 2014 what meat that
the United States already have enough ability and confidence to recovery their own economic.
The US economy created a lot more jobs in October than economists had forecasted. This
suggests that the US economy is getting stronger and, combined with upbeat comments made by
the Fed after its September meeting, is causing more people to believe that there will be a rate
rise in December. With the next Federal Open Market Committee (FOMC) press conference
scheduled for December 15, 16/2015 - only one week away, the effect of increasing in Fed’s

interest rate on EMEs is one of the biggest concerns of the central banks and governments all
over the world at the end of 2015. This article considers some important factors affecting the
Fed’s decision on lifting the interest rate and analyses how an interest rate hike would influence
on EMEs in the perspective on the financial capital outflow from emerging market.
The Fed’s interest rate policy will also largely impact the stock market, bond market, emerging
market currencies, the euro/yen trading, gold and crude oil markets. Nevertheless, the moving of
hiking interest rate on the above markets is out of range of our topic.

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This paper is divided into six sections as follows: The second section will mention the recent
economic performance of EMEs, especially in five emerging markets Brazil, Russia, India
China and South Africa (BRICS). The third section will observe the recent improvement of US
economy and outline some important factors affecting the Fed’s decision on whether rising the
interest rate or not. The fourth section will provide how the global market factors outside US
influence on the Fed’s decision. The fifth section, also the main purpose of this article, is to
analyze how an interest rate hike would afflict the EMEs. The final section will summarize the
paper.

2. The recent economic performance in EMEs
First of all, we are going to overview the emerging markets and analyze their recent economic
performance. The BRICS will be the most important EMEs of our article. Based on the recent
economic performance in EMEs, we can predict the effects of increasing in Fed’s interest rate
on emerging markets.
It was not too long ago that the emerging markets were regularly eulogized as the permanent
powerhouses of the world economy. During the 2000s, with excitable neologisms like BRICS
coined in their honors, the big emerging economies drove a boom in global output and trade.
And when the rich world suffered a dislocating shock during the financial crisis in 2008, many
middle-income nations, with relatively resilient banking systems and large foreign exchange

reserves rode out the turbulence and rapidly resumed growing.
2.1. Overview of EMEs
In this section, we will examine the five largest economies in EMEs – BRICS. In 2015, BRICS
represents over 3 billion people or 42% of the world population; as all five members are in the
top 25 of the world by population, and four are in the top 10. The five nations have a combined
nominal GDP of US$16.039 trillion, equivalent to approximately 20% of the gross world
product, and an estimated US$4 trillion in combined foreign reserves. The BRICS have received
both praise and criticism from numerous commentators. Bilateral relations among BRICS
nations have mainly been conducted on the basis of non-interference, equality, and mutual
benefit (win-win). It is estimated that the combined GDP (PPP) of BRICS would reach US$50
trillion mark by 2020.
But as we know not all BRICS nations are doing well, China's economy is in constant decline
from 2013 with its stock market reaches a new low in this September troubling global stock
exchanges, this year China is expected to grow with 6.5% GDP which is way less than previous
decade average GDP. Slow in China's GDP is also troubling Brazil which was very much
depended on China's trade. This year, Brazil is expected to grow at -2.7% which is certainly not
good for economy. Similarly, Russia which is currently under numerous sanctions against it due
annexation of Crimea, make it grow by -3.7%. Same goes for South Africa which is expected to

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grow at rate of 3% this year. Although India's GDP is 7.5% this year it was expected more
before, but as of BRICS only India is growing as expected for BRICS countries.
2.2. Recent performance in BRICS in detail


China GDP Growth Weakest Since 2009
 China GDP annual growth rate

China is one of the biggest economies of the world, the Chinese economy was witnessing
growth even in the wake of a weakened world economic scenario, but it has been slowing down
gradually year after year since 2010 to 7.4% in 2014.
The Chinese economy grew an annual 6.9 percent in the third quarter of 2015, slightly down
from 7.0 percent expansion in the previous quarter, but narrowly above market expectations. It
is the slowest growth since the first quarter of 2009, mainly due to a slowdown in industrial
output, sluggish property investment and a contraction in exports.

GDP growth of China (YoY)

 China Capital Flows
China recorded a capital and
financial account deficit of 63.40
USD HML in the third quarter of
2015. Capital Flows in China
averaged 199.43 USD HML from
1998 until 2015, reaching an all
time high of 1320.80 USD HML
in the fourth quarter of 2010 and a
record low of -945 USD HML in
the first quarter of 2015.

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

Russia Falls Deep into Recession

Russia is the largest country in the world and the fifth largest economy. The Russian economy is

commodity-driven. Russia is the world’s largest producer of oil (12 percent of world output),
natural gas (18 percent) and nickel (20 percent). The energy sector is the most important, it
contributes 20-25 percent of GDP, 65 percent of total exports and 30 percent of government
budget revenue. In 2014, following Russia's military intervention in Ukraine, prospects for
economic growth declined further. With its over reliance on energy and oil exports, Russia faces
an 8.2 percent drop in output in 2015 and 6.4 percent in 2016, as a significant collapse in oil
prices and western sanctions sent the economy into a sharp contraction.
The Russian economy shrank 2 percent on quarter in the three months to June of 2015, the worst
performance since the 2009 crisis. The GDP shrank 2 percent, the fourth straight quarter of
contraction, following an upwardly revised 1.57 percent drop in the first three months of the
year, revised data from the statistical office showed. Year-on-year, the economy shrank 4.6
percent.
GDP growth of Russia (YoY)

At the beginning of November 2015, The Russian Central Bank has abandoned its defense of
the ruble and declared that it will make no further interventions to prop up the weakening
currency. The regulator’s decision resulted in a rapid slide by the ruble after that.

USDRUB Exchange Rate

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

Brazilian Economy Falls into Deep Recession

Brazil is the seventh largest economy in the world and the largest in Latin America. In recent
years, the country has been one of the fastest-growing economies in the world primarily due to
its export potential. The country’s trade is driven by its extensive natural resources and diverse

agricultural and manufacturing production. Also, rising domestic demand, increasingly skilled
workforce along with scientific and technological development, have attracted foreign direct
investment. However, bureaucracy, corruption and weak infrastructure remain the biggest
obstacles to economic development.
The Brazilian economy shrank 4.5 percent year-on-year in the third quarter of 2015, sixth
consecutive contraction and the worse since modern records began in 1996. The GDP in Brazil
shrank 1.7 percent on quarter in the three months to September of 2015, worse than market
expectations. Considering the first nine months of the year, the economy shrank 3.2 percent, the
biggest fall ever.
GDP growth of Brazil (YoY)

GDP growth of Brazil (YoY)



South Africa Annual GDP Growth Slows to 1%

The South African economy advanced 1 percent year-on-year in the third quarter of 2015,
easing from an upwardly revised 1.3 percent expansion in the previous period and lower than
market expectations of a 1.3 percent rise. It is the lowest growth rate since the 2009 recession
due to a slowdown in manufacturing and finance, real estate and business services while
agriculture and utilities contracted for the third straight quarter. Year-on-year, the economy
expanded 1 percent, slowing from a 1.3 percent increase in the second quarter of the year and
the lowest since the 2009 recession.

GDP growth of South Africa (YoY)

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

India GDP Growth Beats Expectations

The Indian economy expanded 7.4 percent year-on-year in the three months to September of
2015, following an upwardly revised 7.1 percent expansion in the second quarter. Figures came
better than market expectations of a 7.3 percent increase, boosted by financial, real estate and
insurance activities and manufacturing.

GDP growth of India (YoY)

In summary, most of the large EMEs are in a difficult economic situation. Russian and Brazilian
economies are falling into deep recession. Chinese and South African economies have been
contracting. Although Indian economy is slightly expanding but Indian economy is presently
operating in a very challenging environment partly because of worldwide economic weakness
and partly due to some home grown factors.
3. Why is the Fed considering rising interest rates now?
3.1. The current performance of US economy
Since the US economy is improving, it is widely expected that US Fed will raise the interest
rates soon. The US economy is showing some positive signs of the recovery such as GDP,
unemployment rate, consumer price index in the third quarter of 2015.


US economy has been improving

The US economy is rebounding. The Real GDP growth (based on 2009 dollars) grew by 3.7%
during the second quarter and by 2.1% in 3nd quarter 2015.

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

Consumer Price Index

The primary concern of the US Fed is to achieve 2%
inflation rate to achieve the sustainable GDP
growth rate, otherwise the US can again slip into
deflation. For July 2015, the core inflation grew by
1.8% YoY, which is near the targeted inflation.
Even the last 12 months’ average core inflation is
around 1.7%, which is also not so far from the
targeted inflation. Thus, core CPI inflation can
reach the targeted 2% inflation rate in near
term.
On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers increased
0.2 percent in October after decreasing 0.2 percent in September.

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

Unemployment rate is within the target range

The second most important goal for US Fed is to keep unemployment rate between 5.2% - 5.5%
in long-run. In August 2015, the unemployment rate fell to 5.1% below the targeted long-run
normal rate of unemployment of 5.2% - 5.5% of US fed. In October and November 2015, the
unemployment rate fell again to 5.0% as the table below.

In addition to that, the trailing 12 months
unemployment rate is 5.5%, which is still
satisfactory. It is evident from the chart that the
unemployment rate is falling after the 2008 financial
crisis continuously and it’s near the 2008 levels
before crisis.
3.2. Current level of US interest rate
The US was hit by the crash in its housing market
and banking sector between 2007 and 2009. The Fed
felt it needed to pull out all of the stops to prevent
the economy from collapsing into a new Great
Depression. One way of keeping things afloat was
by cutting the cost of borrowing to rock-bottom
levels.
It's been nearly 10 years since the Federal Reserve
raised its benchmark interest rate, and since
December of 2008, the organization has kept the fed
funds rate within a range of zero and a quarter
percent.

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3.3. Why is the Fed considering rising interest rates now?
With interest rates so low for so long, fed chair Janet Yellen, wary of acting too late and
allowing inflation to spiral out of control, has been indicating that the Fed would move to raise
rates sometime this year 2015.
America has seen its longest private sector hiring spurt on record, and unemployment has
halved since its peak. The US economy created a lot more jobs in October than economists had
forecasted. This suggests that the US economy is getting stronger. The Fed thinks the hot jobs

market could spur a pickup in inflation and wages. Given it is tasked with keeping inflation low,
it is considering raising the cost of borrowing to keep the economy on an even keel.
4. How does the global market affect the Fed’s decision
In theory, the Fed makes its decision on raising rates based on its appraisals of domestic
economic issues. However, with emerging markets accounting for 39 per cent of global GDP in
nominal terms and 52 per cent in purchasing power parity terms, a US monetary policy that
enfeebles emerging markets risks depressing global demand and therefore impacting US growth
further down the line. As a result, the turmoil in the global market and EMEs has puzzled the
market whether the US Fed will increase interest rate this December or not. The US Fed is also
concerned about the slowing Chinese economy since it can drag the world into another
recession.


The slowdown in Chinese economy

A number of global economic events, most notably in China and emerging market as well, have
given the Fed recent cause to worry that U.S. growth could be hampered. Chinese economy is
slowing down. Its domestic demand is reducing and exports are falling, along with the stock
market turmoil in China. In August, China devalued Yuan against US Dollar by 2% to boost its
exports. This devaluation has made US goods more expensive in global market, which could
adversely impact US economy. Fed has therefore worried that China’s growth slowdown will be
worse than expected and will have negative impact on the recovery of US market.
In a specific sense, a Fed rate hike runs the risk of increasing the attractiveness of US-dollar
assets relative to those denominated in Yuan, thus accelerating capital outflows from China and
leaving Beijing with fewer resources to invest in US Treasury debt and this would create
potential funding shortfalls for the US government.
China’s economy, however, is not the only one having a rough go of it. Other developing
economies have been slowing for a number of years with the International Monetary Fund
(IMF) predicting that such emerging market economies will slow for the fifth consecutive year.
These weak global economic conditions that depress global demand may have spillover effects

on the U.S. economy.

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

Falling Commodity Prices

The commodity price has been falling because of slowing
Chinese demand for commodity. The fall in commodity prices,
especially in crude oil, can hamper the US Fed from
achieving 2% targeted inflation rate. In addition, falling
commodity prices will drag down the investments in
commodity business. Thus, hinder new jobs.


Slowing Global Demand

The commodity driven economies like Australia, Brazil and
Venezuela has already been severely impact by the falling commodity prices. Thus demand in
these economies will decline and eventually lead to slow down is global demand. In
addition, Euro Zone is still struggling to get out of deflation. US Fed will closely watch the
developments before hiking interest rates.
Pessimist’s thinks that the FED will severely suppressed the emerging markets and optimists
believe the effects are exaggerated. If that does happen, it will be the first US rate rise since
2006. It will bring a huge shock and impact to emerging markets. Our subject is to analysis and
predicts the effects of FED’s next move on the emerging markets.

5. How an interest rate hike would affect emerging market

There are primarily two ways in which a Fed interest rate hike would affect the economies of
emerging markets.
5.1 Capital flight to quality
Flight to quality is the action of investors moving their capital away from riskier investments to
the safest possible investment vehicles. This flight is usually caused by uncertainty in the
financial or international markets. And in this case, rising Fed’s interest rates would encourage
further capital outflows from emerging markets and frontier-emerging market as investors turn
to the safety of U.S. markets with the promise of higher returns than has been experienced over
the last number of years. Emerging market governments and companies will feel the pinch as
funds previously used for investment begin to dry up.
The Bank for International Settlements (BIS) said cross-border loans fell by $52bn in the first
quarter, chiefly due to deleveraging by Chinese companies. It estimated that capital outflows
from China reached $109bn in the first quarter, a foretaste of what may have happened in
August after the dollar-peg was broken.

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5.2 Triggering global debt crisis


Debt ratios reaching extreme levels across all major regions

The majority of emerging market debt is in U.S. dollars, which has been attractive over the last
number of years due to ultra-low interest rates. If U.S. rates rise, it could make many of these
debts unsustainable. Furthermore, that could cause borrowing costs to surge as investors worry
about the ability of governments to pay their debts. Governments could be forced to take on
the debt of failing corporations that have bulked up on corporate bonds in the low-rate
environment, especially as exchange rate values fall against the dollar.
In the immediate aftermath of the global financial

crisis,
emerging-market
economies
used
government coffers to spend their way out of their
problems. Their efforts–coordinated with major
government and central bank stimulus in advanced
economies–helped juice the global recovery.
Strong growth in the lead up to the crisis meant
many emerging markets had government budget
surpluses.
But growth has been slowing in many emerging-market nations as they strain their ability to
expand without major overhauls to their economies. Now emerging-market balance sheets are
largely in the red, with budget deficits expanding to levels not seen for a decade.
Debt ratios have reached extreme levels across all major regions of the global economy, leaving
the financial system acutely vulnerable to monetary tightening by the US Federal Reserve, the

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world's top financial watchdog has warned. And BIS said total debt ratios are now significantly
higher than they were at the peak of the last credit cycle in 2007, just before the onset of global
financial crisis.
Combined public and private debt has jumped by 36 percentage points since then to 265
percentage points of GDP in the developed economies. This time emerging markets have been
drawn into the credit spree as well. Total debt has spiked 50 points to 167 percentage points,
and even higher to 235 percentage points in China, a pace of credit growth that has almost
always preceded major financial crises in the past.
Adding to the toxic
mix,

off-shore
borrowing in US
dollars has reached a
record $9.6 trillion,
chiefly due to leakage
effects
of
zero
interest rates and
quantitative easing in
the US. Dollar loans
to
EMEs
have
doubled since the
Lehman crisis to $3
trillion, and much of
it has been borrowed
at abnormally low
real interest rates of
1%. Roughly 80% of
the dollar debt in
China is on shortterm maturities.
These countries are
now being forced to
repay money, though
they do not yet face
the sort of 'sudden
stop' in funding that
typically leads to a

violent crisis.
The BIS report said: “the rich countries have failed to right the ship over the last seven years or
bring leverage back down to manageable levels. Aggregate private debt has barely stabilized, let

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alone started to correct downwards, even in the corporate sector. And government debt
continues to rise steadily, in a manner reminiscent of Japan’s trend deterioration in the 1990s".
Britain, Spain, and the US have cut household debt ratios but this is still not enough to offset the
massive jump in public debt since the Lehman crisis. France has suffered the worst deterioration
of any major country in the developed world, with total non-financial debt levels spiraling
upwards by 75 percentage points to 291 percentage points, overtaking Britain at 269 percentage
points for the first time in decades.

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

What will happen if the Fed raises interest rates for the first time since 2006?

A study on financial spillovers in the BIS report found that much of the global financial system
remains anchored to US borrowing rates, whether or not countries have fixed exchanged rates or
floating currencies, and regardless of normal theory on trade links and business cycles. On
average, a 100 point move in US rates leads to a 43 point move for emerging markets and open
developed economies, with powerful knock-on effects on longer-term bond rates. "We find
economically and statistically significant spillovers," it said.
The grim implication is that emerging economies may face a monetary shock as rates ratchet
higher, even if the liabilities are in their own currencies.

Enthusiasts for the 'BRICS' and mini-BRICS insist that today's EM squall is entirely different to
the crises in the early 1980s and mid-1990s since the governments of these countries no longer
borrow in dollars or hard-currencies - though their companies clearly do, and on a very large
scale.
The BIS data suggests that this assumption may be complacent. Emerging markets may just as
vulnerable this time, and perhaps more so given the much greater stock of debt. If the Fed raises
interest rates in December 2015, the global debt crisis may be happening since then.

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6. Summary
In conclusion, we have already seen the antecedents of the main impact: a stronger US dollar,
backed by higher US interest rates, tends to depress the values of emerging market currencies at
a time when many EM economies are already weakening and their currencies have already
slumped against the greenback. The Fed’s rate rise could exacerbate the EM currency turmoil,
and even help precipitate a full-blown crisis.
A rate rise could yield a “shock” and a new crisis in emerging market. Capital flight from
emerging market to US market will be happened. Thanks to the dangerously high debt ratio in
US dollar associated with the strong devaluation of the emerging market’s currencies, an
increase in Fed’s interest rate can trigger a global debt crisis in the near future.

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