Will the Fed sink emerging markets (again)?

This is the fifth column in a Heard on the Street series on the end of zero interest rates.

When the U.S. central bank begins to raise interest rates, emerging markets often begin to plunge again: their borrowing costs rise, their currencies fall, and to top it off, slowing U.S. growth lowers demand for their products. Will it be the same time as the end of the zero interest rate era?

Much remains uncertain, including the trajectory of oil prices and the war in Ukraine, but it is possible to make some initial observations. First, several of the big emerging markets under pressure from previous Fed hike cycles – South Korea in the late 1990s and China in late 2015 – look much better insulated now. Large oil or gas importers with high foreign debt are likely places to avoid. But some of the worst offenders in this regard, including Turkey and Argentina, are already well blacklisted by foreign investors.

While it’s still unclear if, or where, problems might arise this time around, understanding how past crises have unfolded can help investors know what to look for. Emerging market debt and currency crises typically arise after a combination of the following: financial liberalization, large-scale capital inflows during periods of low global interest rates, deterioration of the trade balance, and domestic investment boom , especially in relatively unproductive assets such as housing.

The Asian financial crisis, which arrived in 1997 after the low interest rate years of the early 1990s, was a textbook case: yield-hungry global investors poured money into growing Asian economies fast like Thailand and South Korea, helping to finance huge housing and investment booms. Partly for this reason, these countries found themselves with highly valued currencies, domestic resources locked in asset bubbles, and reduced export competitiveness. This made them vulnerable to capital flight after the change in the global rate environment. Further back, a similar story unfolded in Latin America in the late 70s and early 80s.

More recently, China’s mini-debt and currency crisis in 2015 and 2016 was basically the result of national deleveraging efforts, but it came on the heels of a huge boom in housing investment. , and it was exacerbated by the previous stages of opening up capital. account and the Fed’s own rate hike cycle.

An inversion in the US Treasury yield curve has been seen for decades as a harbinger of recession, and it looks like it’s about to reignite. The WSJ’s Dion Rabouin explains why an inverted yield curve can be so reliable in predicting recession and why market watchers are talking about it now. Illustration: Ryan Trefes

These days, two of the biggest and most important emerging markets – China and South Korea – seem quite isolated. China has tightened controls on money leaving the country following the 2015 crisis and both countries have huge war chests of foreign exchange reserves. Korea is a crucial exporter of something the rest of the world can’t live without: advanced semiconductors. China could increasingly benefit from conducting its oil trade in its own currency with partners like Russia and Saudi Arabia and, to some extent, demand for its currency and public debt. other autocratic states.

One potential trouble spot is India, the world’s third largest importer of crude oil after China and the US ratings agency Fitch, which noted in November that its public debt burden, which accounts for around 90% of product gross domestic, is the highest among its emerging market counterparts. BBB rating range. Its total debt of 173% of GDP last September, according to the Bank for International Settlements, is also high.

But India’s foreign exchange reserves of around $620 billion are substantial relative to its economic weight, and its foreign debt is relatively small – around 20% of the size of the economy last June. according to the Reserve Bank of India. That compares to around 29% for all low- and middle-income countries in 2020, according to the World Bank. Turkey and Argentina, two countries that have recently experienced debt problems, both exceeded 60%. However, if oil prices rise further, India will be forced to make difficult policy choices. If not, it might be able to weather the current storm without a massive fiscal blowout or a sharp series of growth-damaging interest rate hikes.

Rising rates in the US usually mean trouble overseas. It will probably be the case this time too, but several of the larger whales that washed up from the last tidal wave are now swimming much more comfortably. The problem will probably appear somewhere again.

Write to Nathaniel Taplin at nathaniel.taplin@wsj.com

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