New York 2018

Manhattan, New York, United States (Unsplash, 2018)

This article is brought to you thanks to the strategic cooperation of The European Sting with the World Economic Forum.

Author: Marco Magnani, Senior Research Fellow, Harvard Kennedy School of Government & Olivier Clavet, The Institute for Advanced International Studies at Laval University


The US economy is thriving. Its GDP growth rate is above 3% – the first three quarters of 2018 saw 2.2%, 4.2% and 3.5% respectively. Unemployment is below 4%, and October’s 3.7% is the lowest since 1969. This positive trend is expected to continue.

However, emerging market economies are experiencing the opposite situation, with low investor confidence, a drastic slowdown in foreign direct investments, severe devaluations of local currencies, high levels of indebtedness for both governments and corporations, and increasing risks of default.

Are the two radically different scenarios connected? While the problems in emerging economies have multiple sources, including past economic mistakes and current political uncertainty, the Federal Reserve’s current monetary policy is undoubtedly exacerbating these challenges.

With three interest rate increases so far in 2018, and eight altogether since the end of quantitative easing (QE), the target range for the federal funds rate is now 2-2.25%, the highest in ten years. The Fed’s restrictive monetary policy is the logical consequence of a healthy US economy, and is aimed to maintain price stability, preventing inflation. However, the status of the dollar as reserve currency and the size of the US economy make the Fed’s moves very relevant to the rest of the world. They may have negative implications on emerging markets, causing disruptive global spillovers.

Quantitative easing and capital flows to emerging markets

In the aftermath of the 2008 financial crisis, and the consequent expansionary monetary policy implemented by the Fed, emerging market economies benefited from considerable capital inflows. The Fed’s massive QE, which injected about $4.5 trillion of liquidity into the economy in nearly six years, kept interest rates and portfolio returns extremely low in the US and pushed capital towards emerging markets to achieve a significant yield.

Specifically, the period between 2009 and 2011 was marked by a surge in capital flows towards emerging market economies, particularly towards those with relatively strong fundamentals, such as Brazil, Russia, India, China and South Africa. As a result, they experienced extraordinary growth in their GDP and stock markets.

Cheap money and a weak dollar also encouraged governments and corporations in emerging countries to borrow money, often denominated in US dollars. This increased both sovereign and private debt.

Fed rate increases and capital flight from emerging economies

Today, regained confidence in US economic conditions and rising interest rates, in addition to fear of trade wars and increasing political uncertainty in many emerging countries, are generating the opposite trend. Capital is quickly returning to the US, interrupting growth in many emerging economies.

Capital outflows mean sharp reductions in foreign direct investments and drops in local stock markets. Turkey is a good example. After growing very fast in the past five years, the country shows the classic signs of overheating: a large trade deficit, a construction boom and soaring debt. Erdoğan’s decision to appoint his inexperienced son-in-law as Minister of Finance and to undercut the Central Bank’s independence have made things worse. Argentina, Russia and other emerging countries are also losing investors’ confidence and experiencing capital flight, leading to serious consequences for foreign direct investment and their stock markets.

Pressure on local currencies and risk of instability

One consequence of capital outflow is huge pressure on local currencies. The Turkish Lira sank in August to a historical dip, losing about 40% of its value vis-à-vis the dollar. Argentina is coping with a currency in freefall, and has had to raise interest rates to 60%. Brazil faces the same economic turmoil, with an unsteady Real losing about 20% against the dollar over the summer. Significant devaluations have also characterized the South African Rand, Russian Ruble and Indonesian Rupiah. Countries such as Egypt, Pakistan, Sri Lanka and Ukraine are also at risk due to political instability. The risk of contagion is serious.

A strong dollar and increasing stress on emerging economies’ debt

Another reason for concern is the strengthening value of the dollar, as its fluctuations can have a destabilizing effect. In the recent past, several emerging countries’ governments and corporations have raised debt denominated in US dollars. Rising interest rates and a stronger dollar mean larger debts, more expensive interest payments and higher risk for sovereign and corporate debt defaults.

Currently Turkey, Argentina, Chile, Hungary and Poland have more than 50% of their total debt – sovereign and private – denominated in foreign currencies. By the end of 2019, $2.7 trillion of emerging markets’ debt is expiring, a third of which is in US dollars. In the case of Argentina, Colombia, Egypt and Nigeria, 75% of short-term debt is in dollars. This is while most of these countries are experiencing significant growth slowdowns. Argentina is a particularly serious case. The IMF has granted a $57 billion bailout package but its 2018 estimates are a 65% debt/GDP ratio and negative GDP growth of 2.6%.

A similar situation is hitting the private sector in emerging countries. Multinationals such as Gazprom, Cnooc, Petrobras, Vale and Tata are heavily indebted in US dollars.

The impact on commodity markets

A strong dollar creates instability in the commodity market, as most commodities are traded in US dollars. This puts enormous pressure on countries where growth largely depends on the export of commodities.

A weak dollar had increased proceeds coming from exports, as more dollars were needed to purchase the same value of raw materials. With the increase of interest rates and a stronger dollar, these dynamics are inverted and the drop of revenues in real terms means slower growth rates.

This is the case in Venezuela, Brazil and Russia for oil and gas. Nearly 80% of Venezuelan exports are related to oil products. Oil or gas account for a third of Russian exports, representing half of the state’s revenues. Chile is in a similar situation regarding copper, Peru and South Africa for other mineral products, and several Latin American countries for agricultural products. In Argentina, corn, wheat, soybean meal and soybean oil encompass more than a third of total exports.

Is this time different?

The Fed is doing what is right for the US economy. However, history has shown how monetary policy decisions taken in Washington may trigger unintended consequences in emerging economies, sometimes also with social and political implications. So it was with the Southeast Asian financial crisis in the late 1990s. Low interest rates contributed to forming a bubble that eventually burst. Since then, central banks, including the Fed, have become more transparent, and emerging economies more resilient.

It is hard to say if things will be different this time. What is certain is that in a global world with increasingly interdependent economies and interconnected financial markets, high currency volatility and fast movements of capital may be a source of instability, both in emerging and advanced economies. And a local problem can rapidly become a global risk.