Will Fed Tightening Choke Emerging Markets?

CAMBRIDGE – As the Federal Reserve moves closer to initiating one of the most long-awaited and widely predicted periods of rising short-term interest rates in the United States, many are asking how emerging markets will be affected. Indeed, the question has been asked at least since May 2013, when then-Fed Chairman Ben Bernanke famously announced that quantitative easing would be “tapered” later that year, causing long-term US interest rates to rise and prompting a reversal of capital flows to emerging markets.

The fear, as IMF Managing Director Christine Lagarde has reminded us, is of a repeat of previous episodes, notably in 1982 and 1994, when the Fed’s policy tightening helped precipitate financial crises in developing countries. If the Fed decides to raise interest rates this year, which emerging markets are most vulnerable to a capital-flow reversal?

There is no question that emerging markets are highly sensitive to global market conditions, including not only changes in short-term US interest rates, but also other financial risks, as measured, for example, by the volatility index VIX. Capital-flow bonanzas, often spurred by low US interest rates and calm global financial markets, end abruptly when these conditions reverse.

By the end of the currency crises in East Asia and elsewhere in the late 1990s, emerging-market governments had learned some important lessons. Five reforms were particularly effective: more flexible exchange rates, larger foreign-currency holdings, less pro-cyclical fiscal policy, stronger current accounts, and less debt denominated in dollars or other foreign currencies.