The rapid distribution of vaccines in the United States and the approval of a $ 1.9 trillion fiscal stimulus package boosted the expected recovery of the US economy. As these developments anticipated, long-term interest rates in the US rose rapidly, and the price of the 10-year Treasury fell from less than 1% at the start of the year to more than 1.75% in mid-March. A similar increase occurred in the United Kingdom. In January and February, interest rates also rose slightly in the Eurozone and Japan, before concerned central banks adopted a more favorable monetary policy.
Emerging and developing market economies are watching interest rates rise with some concern. Most of them are facing a slower economic recovery than advanced economies due to longer waiting times and limited space to apply their financial incentives. Now, there are signs of a contraction in capital entry into emerging markets. The fear is a repeat of the so-called tapering tantrum of 2013, when signs of a faster-than-expected decline in US bond purchases caused a sudden influx of capital from emerging markets.
Is this fear justified? Our analysis In the new release of the WEO, it appears that in the case of emerging markets, what matters is the reason for the rise in interest rates in the United States.
When the cause is good news about jobs in the US or vaccines against Covid-19, most emerging markets tend to see a greater influx of portfolio investments and a decline in dollar-denominated debt margins. Good economic news in advanced economies may lead to growth in exports from emerging markets, and it is natural for resumption of economic activity to raise domestic interest rates. The overall effect is benign for a typical emerging market economy. However, countries that export less amounts to the US, but are still more dependent on foreign loans, could feel the pressure on financial markets.
When news of rising inflation in the US pressures US interest rates, it also tends to be benign for emerging markets. The trend is that interest rates, exchange rates and capital flows in these markets will not be affected, perhaps because previous inflation surprises reflected a mixture of good news about the economy, such as increased appetite for spending, and bad news, such as higher output. Costs.
However, when the increase in interest rates in advanced economies is driven by the expectation of more restrictive measures by central banks, it could hurt emerging market economies. Our study captures these “monetary policy surprises” in the form of interest rate hikes on days of regular announcements by the Federal Open Market Committee (Fomc) or the European Central Bank Board. We find that every percentage point increase in the US interest rate due to the “monetary policy surprise” tends to immediately raise long-term interest rates by one-third of a percentage point in a typical emerging market economy, or two-thirds of a percentage point in a low-rated speculative economy. If the other conditions are maintained, emerging markets suffer from an immediate outflow of portfolio investment and the devaluation of their currencies compared to the dollar. An important difference in the rise in interest rates motivated by good news from the economy is that term premiums – which offset the risk of holding long-term debt – are rising in the US with surprises in the form of more restrictive monetary policy and as a result, profit margins rise on denominated emerging market debt In dollars.
Indeed, a combination of these reasons is the US interest rate hike. So far, the “good news” on the economic outlook has been the main factor. The outlook for economic activity in some emerging markets improved between January and March, which may partially raise interest rates in these economies and may help explain the sudden increase in capital inflows in January. The subsequent hike in US interest rates has been an overall thing, with the markets doing well. Even as long-term interest rates increased, short-term interest rates in the United States remained close to zero. Equity prices remain high, and interest on US dollar-denominated bonds and emerging markets is the same as on US Treasuries.
In addition, market expectations for inflation It appears to be contained Close to the Federal Reserve’s long-term target of 2% per annum; If they remain at this level, it may help contain the increase in US interest rates. Part of the increase in this interest is due to the normalization of investor expectations regarding US inflation.
However, other factors appear to be at play. Much of the increase in US interest rates is due to the increase in term premiums, which may reflect investor uncertainty about inflation, the pace of future debt issuance and the central bank’s purchase of securities. Capital outflows from emerging markets in February and early March turned into inflows in the third week of March, but movements have been volatile since then. It is also unclear whether the sheer volume of Treasury bills that the US is expected to issue this year would harm borrowing by some emerging markets.
Therefore, the situation is fragile. Interest rates in advanced economies are still low and could rise further. Investor sentiment may deteriorate regarding emerging market economies. To avoid this outcome, central banks in advanced economies can help by issuing clear and transparent communications about future monetary policy in various scenarios. A good example of this is Federal Reserve directive on preconditions for raising benchmark interest rates . As the recovery continues, it will be useful to provide more guidance on potential future scenarios, given that the Fed’s new monetary policy framework has not been tested and market participants are unsure of the pace of future asset purchases.
Emerging markets will only be able to continue implementing supportive policies if domestic inflation is stable. For example, central banks in Turkey, Russia and Brazil raised interest rates in March to control inflation, while central banks in Mexico, the Philippines and Thailand kept interest rates unchanged.
Ideally, emerging and developing market economies should seek to offset the rise in some global interest rates by adopting a more appropriate monetary policy. Therefore, they need some independence regarding global financial conditions. The good news is that many central banks in emerging markets have managed to loosen monetary policy during the pandemic, even in the face of capital flight. Our analysis suggests that economies with more transparent central banks, more rule-based tax decisions and better credit ratings have managed to lower benchmark interest rates during the crisis.
Given the still high risk tolerance in global financial markets and the potential for greater differentiation between markets in the future, now is a good time for emerging market economies to extend debt maturities, reduce currency mismatches on balance sheets, and more generally, take the necessary steps. Increase financial flexibility.
It is also time to strengthen the global financial protection network – the system of mechanisms such as swap lines and multilateral funders that can offer foreign currency to countries in need. The international community must be ready to assist countries in extreme scenarios. The IMF’s Safeguard Lines could increase member states’ defenses against fiscal volatility and new allocations Special Drawing Rights From the International Monetary Fund would also be helpful.
This blog is based on the studies of Ananta Dua, Philip Engler, Chanfeng Vesarroti and Galen Sher, led by Roberto Piazza and led by Oia Silason.
Philip Engler He is an economist in the Department of Multilateral Supervision in the Studies Department of the International Monetary Fund. Previously, he worked at the German Institute for Economic Research (DIW Berlin) and at the Free University of Berlin (FU Berlin). His studies focus on fiscal policy and macroeconomics in open economies.
Roberto Piazza He is an economist in the International Monetary Fund’s Fiscal Department, where he works in the Fiscal Policy and Supervision Division. Prior to that, he worked in the Studies Department of the International Monetary Fund and the Bank of Italy. He holds a Ph.D. in economics from the University of Minnesota. His studies focus on growth theory, monetary policy, and international macroeconomics.
Galen Sher He is an economist in the Department of Multilateral Supervision in the Studies Department of the International Monetary Fund. Previously, he worked in the Western Hemisphere, managing the monetary and capital markets at the International Monetary Fund, and was a studies economist at the Bank of England. His research focuses on applied econometrics and risk measurement.
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