Markets will be volatile, but higher US rates alone do not imply stress across EM sovereigns
As a tightening of US monetary policy draws closer, investors are likely to focus again on emerging markets (EMs) with large external funding requirements, said Fitch Ratings. This will be accompanied by greater volatility as markets adjust to the change in EM external financing conditions, as happened in mid-2013 during the taper tantrum, and as is already happening to some degree. But concerns about immediate, broad EM sovereign stresses due solely to higher US policy interest rates are misplaced.Higher US interest rates are widely expected to raise the cost of financing for EMs and contribute to capital outflows, as US investors' search for yield will begin to offer more attractive opportunities at home. High-frequency data suggest funds are already being drawn from EM equity and bond markets, particularly in Asia. The rest of 2015 could therefore be a bumpy ride for investors in the absence of an obvious catalyst to reverse the pullout, but the vulnerability of EMs is qualified in several ways.
No Reversal of a QE-funded "Wall of Money"
Worries about capital outflows from EMs partly rest on the notion that there was a wall of money generated by quantitative easing (QE) that flowed from the US to EMs in search of higher yields. While intuitively appealing, this is not borne out by US balance-of-payments data showing net acquisitions of external financial assets (capital outflows): average quarterly US outflows were USD184bn higher in 2004-2007 than they were during the 2008-2014 QE period.
This is confirmed by the US international investment position (IIP), the asset side of which expanded by USD10.1trn between 2004 and 2007, and by only USD5.3trn from 2008 to 2014. Neither the balance-of-payments flows nor the change in IIP stocks points to EM financial markets experiencing a reversal of significant QE-funded outward US capital flows.
Somewhat Stronger EM Fundamentals
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A key argument that EMs will fare better now than in previous US rate cycles is that their macro and sovereign credit fundamentals have improved. Smaller domestic (fiscal) and external (current account) imbalances, along with more flexible exchange rates and stronger foreign-exchange reserve positions point to a reduction in EM vulnerabilities to changes in market sentiment. This is partly true. On balance, EM fiscal and external fundamentals appear stronger than the early 2000s and about the same as at the start of the last Fed rate rise in 2004. But the potential for higher government and external debt presents risks.
The gross external financing requirement (GXFR) of EMs (current account deficits plus external amortisation payments plus short-term debts) relative to foreign-exchange reserves is lower than in the early 2000s, but not because of smaller current account deficits. The current account improvements in the mid-2000s - although now unwound - contributed to lower amortisation payments, which are keeping overall GXFR from moving higher. This may change if current account deficits persist.
Similarly, the fiscal picture is better than in the early 2000s, although not as favourable as just before the global financial crisis. The median EM general government debt level is 12 percentage points of GDP higher than in 2008, but lower by a similar amount than in the early 2000s. If higher deficits persist, higher government debt will follow.
Median EM External Cost of Funds Not so Volatile
Another concern about rising US interest rates is that the external cost of funds for EMs will rise by even more. In this context it is longer-term market rates that matter more than the US policy rate, so much will depend on the shape of the US yield curve, and whether there is another bond market conundrum, as in 2004 when long-term rates did not respond to higher policy rates.
EM sovereigns that borrow in international capital markets pay a premium relative to US Treasuries, but they also typically have other, less costly sources of external funding. As a result, the median effective external interest rate for EM sovereigns rated 'BB' and 'BBB' (external interest service relative to external debt at the previous year-end) is similar to the 10-year US Treasury yield. In the absence of another conundrum, the external funding costs of EMs that rely more heavily on international capital markets will accelerate more quickly than the median, but overall EM funding costs should increase at a more measured pace if the patterns since the early 2000s remain consistent.
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