Pundits and analyst reports are rife: Federal Reserve monetary normalisation may cause disruptive portfolio outflows from emerging markets, significant exchange rate depreciations and undermine these countries’ economic stability.
Urjit Patel, governor of the Reserve Bank of India, has warned of a possible hit to dollar funding. Others contend that the Fed is indifferent to the decline in the emerging market outlook and should slow its course.
However, the Fed is right not to be unduly worried about the emerging market impact from continued gradual monetary tightening. Fed Chair Jay Powell correctly argues that while US monetary policy plays an important role in influencing emerging market domestic financial conditions, that role is often exaggerated. Further, based on his Congressional testimony, Powell stressed that continued robust US economic developments will drive rates, though concerns about the trade conflict with China could impact the US outlook and thus give the Fed pause over the slightly longer term.
Anxiety about potential emerging market fallout has focused on Argentina, Turkey, Brazil and South Africa. Yet, while invariably affected by general dollar movements, these countries’ financial markets reflect idiosyncratic conditions.
Markets are differentiating – at least so far – between disparate countries according to individual political and economic conditions. The dollar is up only around 5% against the Fed’s ‘other important trading partner index’ (grouping mainly emerging markets) this year. Furthermore, emerging markets have macroeconomic policy tools at their disposal to maintain resilience, if needed, in the face of dollar appreciation.
The Fed should clearly continue to pay considerable attention to global financial and economic developments. China and Italy loom large, as do emerging market developments. But the global economy is doing well. US growth is robust, while inflation remains contained. The Fed has well communicated its monetary policy course. The Vix volatility index is well down from its highs earlier this year and only slightly elevated compared with before the stock market’s early 2018 turbulence. Despite normalisation, US monetary policy and financial conditions are still accommodative.
Legitimate concerns over lamentable US trade protectionism will weaken confidence and growth, but should not alter the solid near-term US outlook. Delaying normalisation could trigger the very disruption that markets and policy-makers wish to avoid. As noted by Powell in a speech earlier this year, some studies show that rarely more than 25% of emerging market capital flows can be ascribed to global conditions generated by major advanced economies and that only roughly 10% of the variation in global risk (Vix) can be attributed to Fed monetary policy.
But even these observations need to be further qualified. A 2014 International Monetary Fund ‘Spillover Report’ notes that there is an important difference between the impact of an unexpected US monetary policy tightening, and an interest rate increase linked to stronger growth. It found that unlike the 2013 ‘taper tantrum’ unrest over Fed tightening fears, higher US growth is beneficial for emerging markets, even factoring in higher interest rates.
Fed communication following the 2013 upset has been well telegraphed and non-disruptive. If current differences between market pricing of the Fed funds rate path v. the Federal Open Market Committee’s ‘dot plot’ projections, or an unanticipated spike in inflation, gave rise to a general repricing of risk and volatility, the picture might change.
We also need to look at the context of exchange rate movements. If most emerging market currencies were falling in line with the dollar’s rise in response to firming interest rates amid orderly and liquid trading, eyebrows would not be raised. If, on the other hand all, currencies were falling rapidly in response to disorderly and volatile US financial developments characterised by market contagion, that would be cause for concern.
Individual countries must also be examined. In Argentina, questions about high inflation and large borrowing associated with the gradual pace of fiscal adjustment heightened the risk that the government would face difficulties in rolling over maturing debt, forcing it to seek an IMF programme. In Turkey, unorthodox monetary policies and high credit expansion, as well as political uncertainty, have given rise to a large current account deficit, and exacerbated longstanding concerns about policy credibility. In Brazil, markets are encumbered by unresolved questions over high debt and its sustainability on top of political uncertainties. South Africa has been hit by slow growth and political turmoil earlier this year.
In contrast, Asian and central European emerging market currencies and interest rates generally have performed far better. So have Mexican markets, despite the uncertainties associated with US trade policies and North American Free Trade Agreement negotiations. These countries generally have better than average fiscal positions, as well as current account positions largely covered by FDI inflows, and often ample reserve buffers.
Markets are following a differentiated approach over emerging markets. Foreign developments, including in emerging markets, will clearly impact the US outlook and global and US financial stability. The Fed needs to take these firmly into account. But in weighing up the solid US recovery, financial markets, and its next interest rate moves, the Fed should stick to its current course.
Mark Sobel is a former Deputy Assistant Secretary for International Monetary and Financial Policy at the US Treasury and until earlier this year US representative at the International Monetary Fund.