Healthier but still exposed
17 October 2017
The simultaneous normalisation of both the Fed’s balance sheet and policy rates has raised fears of a repeat of the 2013 “taper tantrum” or the Latin American debt crisis in the 1980s; however, on average EM fundamentals are relatively healthier than at the outset of previous episodes of Fed tightening. In 2013, many EMs had large fiscal deficits, real wage growth above productivity growth and pockets of rapid leverage growth. This policy mix resulted in high inflation, large current account deficits and low real rates. In addition, EM currencies rallied substantially in the run-up to 2013. As US rates increased, EM central banks were forced to also raise policy rates. Higher domestic rates (in combination with weaker commodity prices) forced EMs into an adjustment that weakened GDP growth. Currently, EMs possess much-improved fundamentals after four years of adjustment, albeit with some exceptions, and benefit from stronger global growth. EM policymakers have reversed previously loose fiscal and credit policies, as a result current accounts have improved to 0.2% of GDP from a deficit of 1.7% in the second-quarter of 2013, and real rates are currently nearly 3% compared with 0.6% in May 2013. Higher real rates in EM leave the rate differential with the US at approximately 300 basis points (bps), well above the 70bps observed in 2013. This leaves most EMs with a policy buffer to absorb Fed rate hikes without having to raise domestic policy rates and derail their growth trend. Indeed, the growth-inflation mix has allowed many EMs to ease amid higher Fed policy rates (see Chart 10).
Nevertheless there are risks to this outlook. A meaningful, and unexpected, rise in US inflation that causes a sharp rise in longer-term Treasury yields is one risk. Indeed, with the market pricing in a shallow tightening path, anything other than a predictable and gradual tightening could cause stress. Even with high real rates providing a buffer for EM central banks, the policy rate is only one determinant of a country’s financial conditions. EMs are still exposed to broader global financial conditions, including longer-term interest rates, credit growth and capital flows that are driven by global conditions beyond the control of local EM central banks. Thus, even with flexible currencies and policy space there could still be pockets of vulnerability across different regions and countries. Credit spreads, currency volatility, credit growth and trade flows can all provide insight into the impact of DM tightening on EM financial conditions. A key metric to watch will be portfolio flows. Non-resident portfolio flows are on track to reach $300 billion for 2017, more than twice the total observed during 2015-16 (see Chart 11). According to the IMF, these inflows have helped to improve policy buffers by boosting FX reserves. They have also helped to lower yields and spreads for sovereigns and corporates, boosting asset valuations and external bond issuance. While US monetary policy matters, especially if the moves are large and unexpected, the other key dynamics affecting capital flows are commodity prices and, especially, China. Since the end of last year, China has limited the impact of Fed tightening in two ways – first, its domestic stimulus delivered a large positive shock to EM that bolstered EM’s current account even as the Fed was tightening. Secondly, China’s efforts to control outflows and its currency have limited the damage Fed tightening can have on EM risk sentiment. If the Fed moves gradually and China remains stable, EM can weather the storm. If US policy or China surprise, then EM could see some setbacks.