Trouble in Emerging Markets
Now that the Federal Reserve is raising rates, money is flowing back into the U.S. and making it more difficult for heavily-indebted emerging economies to service and repay their debts.
The U.S. Federal Reserve and other central banks around the world are attempting to return to “normal” interest rate levels following a period of healthy growth and years of near-zero rates. While some economists are concerned about the rising interest rate environment and its impact on U.S. economic growth, it is the emerging markets that may face the greatest threat. Countries such as Argentina, Venezuela, Turkey, and Brazil have already been hit hard by weakening currencies and economic strife. And, after a decade of heavy borrowing, these countries and many others may have trouble repaying their debts. Large-scale defaults in emerging economies could spread and potentially derail the U.S. economy and hamper international growth.
During the Great Recession, the Federal Reserve lowered the federal funds rate to near zero in an effort to stimulate the economy. The Bank of England, European Central Bank and Bank of Japan followed suit and lowered their policy rates as well (Figure 1). With interest rates in the advanced economies at record lows, many investors flocked to emerging markets seeking higher returns. This allowed the governments and companies of emerging economies to issue debt and borrow heavily on the international markets almost unabated for the last ten years (Figure 2). Now that the U.S. has entered into a period of rising rates, investor money is flowing back into U.S-based assets and putting upward pressure on the dollar. This is making it more difficult for emerging markets to finance their growth and repay their debt – especially dollar-denominated debt. Investor caution can already be seen in the lagging performance of emerging market investment funds vs U.S. equities since the start of 2018 (Figure 3). If the Federal Reserve is forced to raise rates faster than anticipated, emerging markets will likely bear the brunt of the pain. The Fed will need to be very cautious not only to preserve growth at home, but abroad as well.