By Karen Stroecker and Giorgina de Rosario
LONDON (Reuters) – The prospect of US interest rates rising to levels last seen in the run-up to the global financial crisis has cast a shadow over emerging economies struggling to recover from the coronavirus, grappling with rampant inflation and grappling with capital flight. .
Several previous emerging market crises have been linked to a stronger dollar and higher US interest rates, forcing developing countries to adopt tighter monetary policy to support their currencies and fend off inflationary pressures, leading to higher dollar debt servicing costs.
This time around, there are some differences: Emerging central banks have been leading rather than lagging in the tightening cycle, as policymakers in several regions started raising interest rates as early as the summer of 2021.
However, with major central banks now joining the inflation battle, markets expect the US Federal Reserve to raise interest rates to 4.6% by March 2023 – a move that will heighten tensions, especially in smaller, riskier developing economies.
This is a sharp and rapid change from what it was just 12 months ago, when Fed forecasters predicted no rate hikes in 2023.
“This year has been a perfect storm,” said Damien Bouquet, CIO at Finisterre Capital.
“The Federal Reserve and the European Central Bank (ECB) are behind the curve we need to move toward tighter financial conditions.”
Some of the world’s poorest countries expect debt service payments to rise to $69 billion by 2024 – the highest level in the current decade, according to a recent report.
It’s been a tough year for financial markets as countries grapple with a potential recession and energy shock in the wake of the war in Ukraine, but some emerging nations’ assets have taken a disproportionate hit.
Shares from developing countries are down about 28% this year, underperforming key benchmarks developed in Europe and the United States which are down about 20%. Both fixed income and local currency returns are very low, while currencies – with a few exceptions mainly in Latin America – have also fallen.
According to the Institute of International Finance’s Capital Flows Institute, emerging market assets suffered a record-breaking outflow due to Russia’s invasion of Ukraine on February 24. The Institute of International Finance said in September that capital outflows from emerging markets excluding China that ended only in August were similar to those during the 2013 tantrum.
“The fortunes of emerging markets continue to depend heavily on what the Fed does,” said Manik Narain, head of emerging markets strategy at UBS.
Reuters calculations showed that central banks in major emerging markets provided nearly 6,000 basis points in interest rate increases in 2022 through the end of August in their fight against inflation.
But monetary tightening is also dampening economic growth. The Fed’s actions, along with those of other major central banks, led to early warnings from international officials and analysts that rising currencies such as the dollar and the euro could tighten global financial conditions to the point of triggering a global recession.
Claudia Kalish, head of emerging market debt at M&G Investments, said developing central banks are finding themselves in different stages of the tightening cycle.
“If you look ahead and the implied curves of some countries in Latin America like Chile and Brazil, those markets are already starting to cut rates for the second half of next year,” Kalish told Reuters.
Kalisz added that central and eastern European central banks still have to offer more rate increases even though the cycle is coming to a close.
In general, many of the largest emerging market economies have enjoyed better fundamentals, with countries such as Brazil, Mexico or South Africa raising interest rates, building reserves and enjoying healthy trade balances due to the commodity price boom.
The presence of deeper liquidity markets in major emerging economies meant that they could focus on increasing debt domestically. However, there is a bit of a slowdown in dealing with smaller and riskier emerging markets.
14 of these so-called frontier markets that have issued international debt see their bonds trading at a premium of more than 1,000 basis points over safe-haven US Treasuries. Many others such as Egypt or Kenya are far from these levels.
Such wide spreads in bond yields mean that these countries are effectively excluded from the markets and unable to refinance at this point. Many – like Egypt and Ghana – are knocking on the doors of the International Monetary Fund (IMF) to help support their financing.
Raphael Cassin, head of hard currency debt in emerging markets at Itau Asset Management, said investors need some clarity about how long interest rates will remain high.
“If it’s temporary, it will be fine. The majority of countries don’t have significant financial needs this year or next. What really matters is what happens in the long run.”