How worried should you be when the Federal Reserve (Fed) goes ahead with its first interest rate hike? After all, following years of close-to-zero policy rates and three rounds of quantitative easing, this will be a significant change in policy.
Financial markets do not appear too concerned. One could even say that they are being complacent. Nevertheless, the usual commentators are once again stating that Fed hikes will bring the end of the world and emerging markets.
So who is right, the complacent markets or the doomsayers? We think neither.
In most cases it is a country’s currency that reacts and absorbs the shock rather than the real economy
Using 20 years of data, we modelled the impact of a shock 100bps hike by the Fed on economies and markets in Asia, Africa, the Middle East and Latin America – and found three interesting conclusions:
First, a change in Fed policy will be a significant event for the world. Even if Fed hikes fail to raise long-term market interest rates home, the Fed still matters.
Second, in most cases it is a country’s currency that reacts and absorbs the shock rather than the real economy. This is particularly the case for countries such as Turkey and Indonesia whose currencies tend to weaken following a Fed shock.
Flexible exchange rates help
The fact that the main impact of a Fed shock is felt on currencies is not necessarily a bad thing. With the exception of Hong Kong, the countries we looked at all have flexible exchange rates. And flexible exchange rates following an external shock do what they are meant to be doing by being … well … flexible and moving to absorb some of the shock.
Large currency moves can be problematic for countries that have large foreign currency denominated debt with short-term maturities. Sharp currency moves in Turkey can therefore have some undesirable side effects. But economies in Asia are now in a much stronger position than they were in the 1990s. Net foreign assets (the difference between the value of overseas assets and the value of domestic assets held by foreigners) are now positive and large.
Asian economies are in a better shape today than they were in 2013 when the Fed started talking about tapering
Asian economies are also in a better shape today than they were in 2013 when the Fed started talking about tapering its quantitative easing programme. Current account balances are now healthier and inflation is in check. Even in Indonesia, where the currency reacts the most and foreign currency denominated debt has increased, the maturity profile is much more favourable, with only 12 per cent of the country’s external debt due in less than a year.
Although currencies do move in response to an external shock, we also found that the impact, albeit sizeable, is not permanent. Moves pick up within five to six months after a shock, and then dissipate within a year.
Countries react differently to shocks
Third, it is important to differentiate: grouping all countries under the emerging markets bracket misses the fact that different countries experience very different dynamics.
India seems to be better insulated to external shocks, and this will likely continue to be the case. And Korea seems to do quite well when the Fed shocks. It is important to remember that the Fed is likely to hike when the US economy is doing well, and for Korea the positives from a stronger US economy outweigh the negatives from interest rate hikes.
We need to distinguish between market moves and crises
After years of low interest rates and three rounds of quantitative easing, a rate hike in the US cannot be ignored, but not every country reacts the same, and we need to distinguish between market moves and crises.
Countries in Asia are in a much better position today than they were in the 1990s before the Asian crisis. Never mind the 1990s, they are in a much better position today than they were 2013 when talk of Fed tapering talk caused significant market moves.
So, expect moves. But do not get carried away in the paranoia of doom and gloom.
A version of this article was published in beyondbrics on 27 April 2015