Keep your powder dry
Emerging markets have coped with the rate shock surprisingly well
But the real test is yet to come
The prospect of rising interest rates in America has long stoked anxiety as far away as Mexico City, Delhi and Jakarta—with good reason.
When Paul Volcker, then the chairman of the Federal Reserve, tightened monetary policy to tame inflation in the early 1980s, Latin American countries were plunged into crisis as they fell behind on their dollar debts.
A decade later American rate rises precipitated Mexico’s tequila crisis.
And in 2013 the Fed’s attempt to scale back its bond-buying led to a “taper tantrum”, in which panicking foreign investors fled fragile economies including Brazil, India and Indonesia.
By comparison, this time seems curiously calm.
Although the Fed is raising rates at its most furious pace since the Volcker era, much of the market drama has centred on rich countries rather than emerging ones.
It is the central bank in Britain, not Brazil, that is scrambling to avert a bond-market crisis, triggered by the government’s reckless budget.
In part this resilience is testimony to the fact that emerging markets are in better health today.
But it would also be a mistake for countries to lower their guard.
The real test is yet to come.
As the Fed has raised rates this year, the dollar has rocketed.
The dxy, a measure of the greenback against half a dozen major currencies, has risen by 18% in 2022 and is at its mightiest level in nearly two decades.
Underlying the headline surge, however, is a complex picture.
During the taper tantrum emerging-market currencies suffered most.
Between May and December 2013 the Brazilian real and the Indian rupee fell by 10-13% against the dollar, and the Indonesian rupiah by 20%, even as the euro and sterling rose.
This year the real has gone up against the greenback, while the rupee and rupiah have depreciated by 7-10%.
If you earn in euros or pounds, though, your wages are now worth a staggering 15-18% less in dollar terms.
Why have emerging markets got off relatively lightly?
Part of the answer lies in the reason for the dollar’s strength.
Rather than being fuelled by an aversion to risk and a flight towards safe American assets, much of it reflects differences in economic fundamentals and anticipated interest rates.
And the fundamentals for emerging markets have vastly improved, with decent growth, bigger reserves and deeper local capital markets that can help absorb shocks.
Rather than letting inflation spiral, central banks in emerging markets were also quick off the mark, raising rates well before their peers in the rich world.
Annual inflation averaged 10% across emerging countries in the second quarter of this year, barely higher than in energy-crisis-stricken Europe and overheating America.
Today it is the European Central Bank and the Riksbank, not the Reserve Bank of India or the Banco Central do Brasil, that are vying to prove their inflation-fighting credentials as they race to keep up with the Fed.
Emerging economies have also so far intervened in currency markets only modestly.
Their aim has been to prevent depreciation and to reduce the inflationary effects of a stronger dollar.
Those outside China have spent around $200bn this year, reckons JPMorgan Chase.
That is a small fraction of their total reserve pile of nearly $4trn.
The trouble is that much of the adjustment is yet to come.
The Fed is intent on raising rates until it sees “compelling evidence” that inflation is moving down; investors expect them to rise by roughly one and a half percentage points by the spring.
The economic pain from higher rates has yet to hit home.
In forecasts published on October 11th the imf predicted that a third of the world economy would experience recession this year or next, with growth in America, Europe and China stalling.
That will translate into less demand for Apple handsets made in Vietnam and for Indian it services.
Energy and metals producers reaped a bonanza after Russia invaded Ukraine, but they are unlikely to be spared if demand slows.
And as the global financial system adjusts from cheap money to higher borrowing costs and a slowing economy, it could yet suffer the kind of dysfunction and investor panic that hurts financial markets in the rich world and emerging markets alike.
Speaking on October 10th, Jamie Dimon, the boss of JPMorgan, America’s biggest lender, warned that the next percentage point of rate rises would be more painful than the first.
Special fx
It is this risk that emerging markets need to keep in mind.
They may be tempted to use their foreign-reserve ammunition more quickly in order to defend their currencies and avoid raising interest rates at home.
But they must resist that urge, so that they can save their reserves of firepower for the moment when emergency truly strikes.
Better instead to let the market set the exchange rate, and keep using interest rates to tame inflation.
Sounder fundamentals have helped emerging markets defy history, but vigilance is still required.
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