How Rising Interest Rates Could Affect Emerging Markets

IMF Blog, April 5, 2021

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How Rising Interest Rates Could Affect Emerging Markets

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Bibliographic details

• Authors: Philipp Engler, Roberto Piazza, Galen Sher
• Published: April 5, 2021

Summary

• Rapid vaccine rollout in the United States and passage of its $1.9 trillion fiscal stimulus package have boosted the expected US recovery, contributing to a rapid rise in longer-term US interest rates.
• The rate on 10-year Treasury securities went from under 1 percent at the start of the year to over 1.75 percent in mid-March.
• For emerging markets, the critical factor is the reason behind the rise in US interest rates.

Cause and effect

• Good news about US jobs or COVID-19 vaccines:
  • Tends to produce stronger portfolio inflows to most emerging markets and lower spreads on US dollar-denominated debt.
  • Can lead to export growth for emerging markets and lift their domestic interest rates; overall impact is benign on average.
  • Countries that export less to the United States but rely more on external borrowing could still experience financial market stress.
• Higher US inflation news:
  • Tends to be benign for emerging markets; their interest rates, exchange rates and capital flows tend to be unaffected.
  • Past inflation surprises have reflected a mix of good economic news and bad news.
• Monetary policy surprises (expectations of hawkish central bank actions):
  • Captured by increases in interest rates on days of regular Federal Open Market Committee or European Central Bank Governing Council announcements.
  • Each percentage point rise in US interest rates due to a “monetary policy surprise” tends immediately to:
  • Lift long-term interest rates by a third of a percentage point in the average emerging market.
  • Lift long-term interest rates by two-thirds of a percentage point in an emerging market with a lower, speculative grade credit rating.
  • Causes immediate portfolio capital outflows and currency depreciations against the US dollar.
  • Raises the US “term-premium,” increasing spreads on dollar-denominated emerging market debt.

Empirical observations and recent developments

• A mix of reasons has driven up US interest rates so far, with “good news” on economic prospects being the main factor to date.
• Expectations of economic activity in some emerging markets picked up between January and March, possibly contributing to higher interest rates and a surge in capital flows in January.
• The subsequent rise in US interest rates has generally been orderly; markets have been functioning well:
  • Short-term US interest rates have remained near zero even as long-term rates rose.
  • Stock prices remain high.
  • Interest rates on corporate bonds and dollar-denominated emerging market bonds have not diverged from those on US Treasury securities.
• Market inflation expectations appear contained near the Federal Reserve’s long-term target of 2 percent a year.
• Much of the increase in US interest rates is due to a rising term premium, which could reflect rising investor uncertainty about inflation, future debt issuance, and central bank bond purchases.
• Capital flows were volatile: outflows in February and early March turned to inflows in the third week of March, but volatility persisted.
• Uncertainty exists about whether large quantities of US Treasury securities expected to be issued this year could crowd out borrowing by some emerging markets.

Policy implications and recommendations

• Advanced economy central banks should provide clear, transparent communications about future monetary policy under different scenarios. The Federal Reserve’s guidance about preconditions for a rise in policy rates is cited as a good example.
• Further guidance on possible future scenarios would be useful given the Federal Reserve’s new monetary policy framework is untested and market participants are uncertain about the pace of future asset purchases.
• Emerging markets should ensure domestic inflation is expected to be stable to continue providing policy support:
  • Examples: central banks in Turkey, Russia and Brazil raised interest rates in March to control inflation, while those in Mexico, the Philippines and Thailand kept interest rates on hold.
• To offset higher global interest rates, emerging and developing economies should seek more accommodative monetary policy at home and aim for some autonomy from global financial conditions.
• Strengthen financial resilience by:
  • Lengthening debt maturities.
  • Limiting currency mismatches on balance sheets.
  • Taking additional steps to boost overall financial resilience.
• Strengthen the global financial safety net:
  • Enhance arrangements like swap lines and multilateral lenders to provide foreign currency to countries in need.
  • The IMF’s precautionary financial facilities can boost member countries’ buffers against financial volatility.
  • A new allocation of IMF special drawing rights would also help.
• The international community should be prepared to help countries in extreme scenarios.

Institutional and structural findings

• During the pandemic, many emerging market central banks were able to ease monetary policy even amid capital flight.
• Economies with:
  • More transparent central banks,
  • More rules-based fiscal decision-making, and
  • Higher credit ratings

were able to cut their policy rates by more during the crisis.

This blog draws on research by Ananta Dua, Philipp Engler, Chanpheng Fizzarotti and Galen Sher, led by Roberto Piazza and supervised by Oya Celasun.

References

• Our research
• seem contained
• boost financial resilience
• special drawing rights