The impact of the Fed's policy on emerging markets

Federal Reserve Chairman Jerome Powell. Photo: AFP

President of the US Federal Reserve, Jerome Powell, said at a press conference after climbing 25 basis points the US federal funds rate that he was aware that the action of the Fed could put a strain on emerging markets at the Fed, but all countries would benefit from healthy growth in the United States.

This is the big question for emerging markets: will capital flows to them diminish as the United States raises rates and reduces their balance sheets, or will US growth earnings offset this effect? ?

Recall that during the period 2004-07, the Fed slowly and gradually raised its key rate, but the flow of funds to emerging markets remained intact.

But we are in a very different environment now. There was no trade war in the 2000s and no one questioned globalization. The United States was far from being protectionist and China was growing by leaps and bounds.

Consider what the Asian Development Bank said in its updated Asia Development Outlook released on Wednesday. According to the report, "either to reduce the holdings of the Fed's portfolio, or further increase the key rate would raise interest rates in the United States, as well as the two actions simultaneously. This implies a stronger US dollar, which has mixed effects, and the potential for capital drainage in Asia. Rising US interest rates could impact emerging markets in Asia by raising interest rates in the region, posing a challenge to financial stability. The region would face higher financing costs for investments and higher discount rates, which would reduce asset valuations and weaken the balance sheets of businesses in the region. "

The AfDB has said that emerging markets have benefited greatly from quantitative easing by the Fed and other central banks in developed countries, and that now that liquidity is tightening, this could lead to market outflows. capital. He added that "normalizing the Fed's strong balance sheet since November 2017 would affect global capital flows. Total Fed assets have declined steadily since then, albeit slowly. Due to its direct impact on the US money supply, balance sheet normalization has a greater impact on global liquidity than the Fed's key rate hikes. "

Emerging markets are already experiencing the impact of this normalization of the Fed's balance sheet and the repatriation of funds to the United States. A Bank of America Merrill Lynch survey of global fund managers this month was called "Splendid Isolation," a reference to the unique position of US equity markets, which have reached new heights with other regions. Long US equities, the long US dollar and emerging markets in the near term are overcrowded.

Emerging markets with current account deficits, such as India, have seen their currencies depreciate sharply. The Bank for International Settlements has also recently highlighted growing market divergences, with favorable financial conditions in the United States and tighter conditions in emerging markets.

The last meeting of the Federal Open Market Committee reinforced the prevailing sentiment. He raised the US policy rate by 25 basis points, but this was widely expected. It also revised its median GDP estimates for the United States, both for the current year and for 2019. It left the median forecast for the Fed Funds rate unchanged, marking a further rise this year and three for 2019. that he would continue to raise rates to avoid overheating, even beyond the "neutral rate", even though inflation was not progressing.

Does this mean the party is over for the emerging markets? There may be a pause in the carnage – the US dollar may have reached the limits of its strength at the moment and it seems that fund managers fear that the US recovery is a bit long. Chris Williamson, chief economist at IHSMarkit, commented on the flash index of purchasing managers for the US economy in September: "The escalation of trade wars and the ensuing price hike for the US economy. year to come sharply down during the month. While activity could rebound after the storms, the decline in optimism suggests that the long-term outlook has deteriorated, at least in the sense that growth may have peaked.

What about the future? Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, believes the volatility of emerging economies should not be a surprise. He thinks the current turbulence is "similar to a patient's withdrawal symptoms" as he is withdrawing from the narcotics of extremely low interest rates. Borio's prognosis is that "policy makers and market players should prepare for a long and hectic recovery".