March 16, 2017

On Wednesday, the US Federal Reserve raised the federal funds rate target range to .75%-1%, up from 0.5%. The announcement followed the release of an impressive ADP job report last week, which documented 289,000 jobs added to the US economy in February, 100,000 above the expected level. The report also noted personal consumption expenditure policymakers preferred barometer of inflation to be finally nearing the Feds 2% target, while prospects of a large fiscal stimulus under President Donald Trump is mounting additional pressure on the Fed to begin its series of anticipated hikes to plan accordingly for higher growth (and inflation) in 2018 and 2019.

For the past year, investors have been nervously awaiting a Fed announcement of a rate hike. As such, financial markets have already adjusted to the news that finally arrived Wednesday afternoon: Since the ADP released its job report last week, US futures were trading with a 100% chance that the hike would start today.

The question Wednesday morning was thus not if and when the hike would take effect, but rather, what will be the pace of the rate increase? There were no surprises there either, as the Fed also signaled on Wednesday there will still be a total of three hikes (versus four) over the course of 2017. If the pace of increase is likely not to exceed market expectations, emerging markets should not see their presence slip in global bond portfolios.

So, with the Fed finally relaxing its accommodative stance, along with predictions, what is really at stake for emerging economies?

The consensus among global investors is that not much will change. This assumption is because many countries, like India and Brazil, have taken advantage of the highly favorable external environment of the past few years (in which returns in the US, Europe, and Japan were comparatively low), to also solidify their economic fundamentals. Rising foreign exchange reserves matched rising capital inflows, and policymakers refrained from using new sources of debt to finance fiscal spending sprees, rather than sound investments. To name merely a few policy feats that have increased certain countries attractiveness as a destination for foreign investment: The Central Bank of India has gained impressive credibility, Brazil has signaled a strong commitment to macroeconomic stability, and Malaysia initiated a strong commitment to privatization, free trade, and financial liberalization.

This is not to say that capital will not move, and global economic balances will not shift. What matters most for emerging markets, however, is that capital movements do not balloon into full-blown balance of payments crises, as they did in the 1990s, or wreak political instability. For the most part, emerging markets are in a much better position than they were 20 years ago.

These countries saw a pay-off to their policy reforms in 2016, when they were able to sustain high capital inflows, despite expectations of a Fed rate hike and rising protectionism in advanced economies dimming their external outlook. 2016 was actually one of the best years on record for emerging market bond funds, which saw a USD 37.8 billion in net inflows. saw its year-over-year trading price increase.

Following the Fed announcement on Wednesday, the market began sorting winners and losers as sovereign bond yields spread. While the yield on 10-year Treasury bonds fell to 2.51%, the yield on JP Morgans Emerging Market Bond Index BI yield the largest and most commonly cited benchmarks for emerging market debt also fell from 4.74% to 3.94%. This joint movement affirms expectations that globally integrated bonds and stocks will move together in the wake of the hike.

What is perhaps more important than the Fed hike for emerging markets are outstanding internal challenges, both macroeconomic and political. Countries with a high external financing requirement, high foreign currency debt levels, and low foreign exchange reserves, have the most at stake today. These countries have sizeable external liabilities, so the less available foreign credit becomes for these countries, the more expensive it becomes for them to borrow, the more difficult it is to meet foreign payments, and the greater their borrowing requirement thus becomes. This is why having sources of domestic investment is considered an advantage for emerging markets: Brazils sustained foreign direct investment (FDI) throughout a recession and a political scandal is indeed partially attributable to its sound investment base.

Also a matter of concern will be the extent of a country's reliance on commodity exports. With oil prices expected to remain low for a while, oil-exporters like Russia and Brazil may face difficulties earning foreign exchange and see their trade (and debt) position deteriorate as a result.

In a nutshell, for economies that have evidently learned the least from the 1990s crises and remain heavily dependent upon volatile capital flows, the rate hike poses the greatest threat to their debt sustainability and future economic prospects.

So whos earning a red flag? Turkey and South Africa are in the most vulnerable position today. Turkish and South African debt similarly amount to approximately 50% of their GDP, while their external financing requirement stands at about 25% of their GDP. With such high exposure, a wave of capital outflows is likely to set off a declining spiral of indebtedness. Some estimate Turkeys external debt-to-GDP ratio to surge to 118% by 2020.

Turkeys external debt position is not the only source of its worries, however. The Turkish lira has been sliding since political instability erupted last summer, and it has just trailed ahead of the peso as the worlds worst currency performer in 2017. And as it did in 1999, on the eve of Turkeys last balance of payments crisis, Turkey shows no signs of institutional strength and credibility to help it weather this shock. Central Bank governor Murat etinkaya is seemingly intractable in his commitment to accommodate President Recep Tayyip Erdoans demand for low-interest rates to fight economic contraction, despite a rapidly depreciating lira and rising inflation. Without a diligent and independent Central Bank, the Turkish economy will be even more vulnerable to a rapidly depreciating lira. The Fed hike may aggravate political instability through these institutional weaknesses, though it will likely be overshadowed by Turkeys worsening rift with the EU, the campaign against the Islamic State, and difficulty combating domestic terrorism.

While there is bound to be a lot of noise following the Fed announcement, it is important to bear in mind that financial markets have anticipated a hike for a while, so the real adjustments have likely already occurred. Rather, the hike must be viewed against each country's internal conditions. For India, Prime Minister Narendra Modis recent sweeping victory in state elections signaled widespread approval for his liberalization agenda: the rise in India's stock index following his victory will help mitigate any movement of foreign investment from Indian assets. For Brazil, reinvigorated trade talks between Mercosur, South Korea, Japan, Canada, and India can reduce Brazils already-low dependency on foreign investment, and buoy economic growth even if investment lags. On the other hand, further institutional decay in Turkey and a policy failure to suspend a falling lira may portend another crisis and continued political instability.

By the same logic, the Fed hike may prove less significant than other tax and trade policies currently floating around the Trump administration. The border adjustment tax, for example, which Republican congressmen aim to levy on companies that import goods abroad, would reduce demand for emerging market exports, namely oil. As the fifth leading foreign oil supplier to the US, Mexico would experience a drop in its trading volume.

As seen by the number of variables above, the effects of the Fed hike will be highly local and context-dependent. Better to keep an eye out for the Trump administrations heavily contested trade policy, and the ability of foreign central banks to maintain an air of business as usual.

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