How a Strong U.S. Dollar Can Hurt Emerging Markets

Since the U.S. Federal Reserve Bank ended its bond-buying program last year, market pundits have been spending a lot of time trying to predict when the Fed will begin to normalize interest rates. Whenever this happens, the impact of such a decision will be felt outside of America as well. Of particular concern is the likely impact on emerging markets, especially if capital outflows accelerate and money rapidly returns to the U.S.

Additionally, higher interest rates could make it more expensive for overseas borrowers to service their debt commitments. This has prompted officials like Christine Lagarde, the Managing Director of the International Monetary Fund (IMF), to warn of the “spillover” effect the Fed’s decision is likely to have on volatility in financial markets, especially emerging markets.

There are two key factors that make higher U.S. interest rates difficult for emerging markets. The first is a reversal of capital flows. This is important because some emerging markets are heavily reliant on foreign inflows to fund fiscal or current account deficits. The IMF says that between 2009 and 2013, emerging markets received about $4.5 trillion in gross capital inflows, representing roughly half of all global capital flows in that period.

If investment returns in the rise in the U.S., international capital flows away from emerging markets could accelerate and make funding the “twin deficits” more difficult. This may already be happening, even before the Fed hikes rates. The International Institute of Finance says private capital flows to emerging markets fell by $250 billion in 2014.

The second factor is the less visible threat of U.S. dollar-denominated debt. Emerging market governments, corporations and banks took advantage of low-cost dollar finance to shore up their finances. Data from the Bank of International Settlements supports similar figures reported by the IMF that emerging market borrowing has doubled in the past five years to $4.5 trillion. This is problematic because local currency devaluation caused by a reversal of capital flows can make servicing this dollar debt more difficult. Furthermore, corporations and banks that borrowed in dollars could be facing additional pressure if they don’t have matching revenues or assets.

Estimates of exactly which countries are most exposed vary widely, but some countries seem to consistently appear on the lists of the U.S. Fed, international banks and rating agencies. The table below shows the countries that seem to have the largest external financing challenges. Despite a somewhat varied list, Brazil, Turkey and South Africa appear most consistently, both across sources and across time. The Fed issued its vulnerable list in February 2014, and Moody’s just published its list at the end of March 2015.

Economies Viewed As Being Vulnerable to Rising US Interest Rates

Source: Federal Reserve, Estado, Moody’s

Another way to measure which countries are experiencing credit stress is to look at the Credit Default Swap (CDS) market. Current CDS spreads supplied by Deutsche Bank seem to suggest Brazil is most worrying, with a higher overall market implied default probability that is also rising.

Fitch Ratings, another credit rating agency, publishes a Fitch CDS Map, an interactive tool designed to identify and expose month-over-month changes in credit default swap spreads. Positive changes in CDS spreads signal markets' perception of increased risk while negative changes indicate credit strengthening. Here too, Brazil seems particularly problematic, with spreads widening 15.74% in March 2015, compared with 8.09% for Turkey and 4.59% for South Africa, according to Fitch.

Before the most recent Federal Open Market Committee (FOMC) press release on March 18, many market participants seemed convinced of a June rate hike. In fact, the CME Group's FedWatch tool had the probability of a June hike at 50%. Following the statement, the probability fell marginally to 48.9%. Despite this small decrease, market expectations still seem focused on a June lift-off with just a 40.9% chance of rates remaining unchanged, down from a 46.9% probability when measured in February. 

The CME tool uses 30-Day Federal Funds futures contracts to calculate the probability of where the spot target Fed Funds rate may be by the end of the month, during which an FOMC meeting is scheduled to occur. The tool represents a direct reflection of collective marketplace insight regarding the future course of Fed monetary policy.

Strangely, market expectations for the timing of the Fed’s interest rate normalization differ from the Fed’s own expectations. The BBC reported that the Fed's median estimate currently shows rates at 1% by January 2016 and 2.5% by January 2017. Meanwhile, the futures market discussed previously expects the U.S. to be rated around 0.5% by January 2016 and just 1.5% by January 2017.

Rising U.S. rates are likely to present specific challenges to emerging markets, especially those with external financing vulnerabilities such as Brazil, Turkey and South Africa or governments, companies and banks with large amounts of dollar-denominated debt that could become more expensive to service.