What Developed World Interest Rates Mean for EMDEs
Global interest rate trends, especially those from developed economies like the United States, can hold significant influence over emerging markets and developing economies (EMDEs). Primarily, this is due to the interconnectedness of financial markets and the reliance of many EMDEs on external capital flows. Recently, with the Federal Reserve lowering interest rates in the second half of 2024, emerging markets are once again facing both opportunities and challenges.
Interest Rate Hikes: A Double-Edged Sword for Emerging Markets
When developed countries raise interest rates, the impact on emerging markets is profound, especially in terms of currency valuation, capital flows and debt servicing. Historically, rising interest rates in the U.S. have led to capital outflows from EMDEs, higher borrowing costs and depreciated local currencies.
Higher interest rates in developed economies attract global investors towards the relatively safer and now higher-yielding assets in these regions. This results in capital outflows from EMDEs as investors seek better returns in markets such as the U.S. For instance, during the 2013 taper tantrum, the Fed’s announcement to reduce asset purchases triggered a sell-off in EMDE assets, as investors pulled funds back to the U.S. This scenario is not unique, as interest rate hikes often cause depreciation of local currencies in emerging markets, escalating the cost of servicing debt denominated in foreign currencies.
Countries like Argentina, heavily reliant on dollar-denominated debt, often face severe fiscal strain during such periods. The increased cost of servicing debt depletes foreign reserves, pressuring local governments to cut spending, which can lead to economic slowdowns and even fiscal crises.
The capital outflows resulting in depreciated local currencies can also trigger inflation as imported goods become more expensive, further straining the budgets of consumers and businesses alike. In nations like Turkey, where inflationary pressures are persistent, a weakened currency translates directly into higher costs for imports, driving up the cost of living and lowering purchasing power.
Interest Rate Decreases: A Mixed Bag of Relief and Risk
While increases in interest rates generally exert adverse effects, rate cuts in developed economies present a different mix of opportunities and challenges for EMDEs. The Fed’s recent decision to cut rates, for instance, opens the door to potential capital inflows as investors seek returns in emerging markets, which typically offer higher yields.
Interest rate cuts in advanced economies reduce the appeal of low-risk assets, prompting investors to seek better returns in EMDEs. With lower rates in the U.S., many emerging markets could see an influx of foreign investments, as evidenced by recent trends in Latin America and Asia following the Fed’s rate cuts. Sectors like technology and consumer goods in markets such as India and Brazil stand to gain as capital becomes more accessible and affordable.
Additionally, businesses in emerging economies can benefit from lower borrowing costs if central banks in these regions follow suit and cut their rates in tandem. For example, in response to the Fed’s recent cuts, several central banks in Asia are expected to lower their rates, potentially enhancing local credit conditions and encouraging business investments.
However, while interest rate cuts can boost capital inflows, there’s an associated risk if EMDEs become too reliant on such funds. External funding can be fickle, as investors may rapidly withdraw capital in response to unexpected rate hikes in developed economies. This happened recently with Argentina, where an influx of foreign capital was swiftly followed by a wave of outflows when U.S. rates began rising, leaving the country’s economy vulnerable and further worsening its debt burden.
Business-Level Implications: Winners and Losers
When interest rates in developed countries decrease, businesses in EMDEs that benefit from foreign investments see opportunities for expansion. The technology and finance sectors, especially in countries like India, Brazil and Mexico, stand to gain as international capital becomes more affordable and accessible. These sectors often rely on both equity and debt financing, and with lower global rates, they can leverage capital inflows to fuel growth and innovation.
Banks and financial institutions, too, experience positive effects, as lower rates in developed markets often lead to higher growth prospects and an expansion of the domestic credit market. For instance, following the Fed’s recent rate cuts, many Latin American banks anticipate increased demand for loans, with sectors like retail and manufacturing expected to expand as businesses seek to take advantage of improved financial conditions.
On the other hand, rate hikes in developed countries can spell trouble for export-oriented industries. A stronger dollar, as often seen when U.S. rates rise, makes exports from EMDEs more expensive, potentially reducing demand from international buyers. The agricultural sector in Brazil, for example, has often struggled during periods of U.S. rate hikes due to a stronger dollar, which drives up the price of commodities on the global market.
Industries with substantial foreign-denominated debt, like infrastructure, face additional pressure during rate hikes as borrowing costs increase. In Turkey, for instance, the construction industry has been heavily impacted by U.S. rate hikes, leading to rising costs of materials and higher debt servicing obligations. This has contributed to a slow-down in new projects and an overall decline in the sector’s profitability.
The Path Forward: Strategies for Emerging Markets
For EMDEs, managing the spillovers from global interest rate changes requires a proactive and resilient approach. Building foreign currency reserves, improving regulatory frameworks and fostering a balanced economic environment are key to mitigating the adverse effects of these external shocks.
Countries like India have taken steps to build significant foreign currency reserves, which provide a buffer against exchange rate volatility and help maintain stability in times of financial turbulence. Such strategies can protect emerging economies from the more severe consequences of developed market rate hikes, such as sudden capital outflows and currency depreciation.
Moreover, maintaining prudent fiscal policies is critical. Countries with high levels of debt need to be especially cautious, as the burden of servicing foreign-denominated debt can become unsustainable during periods of rate hikes. Mexico’s central bank, for example, has pursued a conservative monetary policy, allowing it to maintain stability even when U.S. rates have risen sharply.
To navigate the uncertain terrain of global interest rate fluctuations, some EMDEs are increasingly embracing currency flexibility. Moving away from fixed exchange rates can allow these economies to adjust more effectively to external shocks, as seen with nations like Indonesia, which has opted for a more flexible currency regime. This flexibility provides a cushion, as it allows the currency to adjust naturally without requiring interventions that deplete reserves.
Additionally, diversifying debt sources and relying more on local currency financing reduces vulnerability to interest rate hikes in developed countries. Brazil has been a leader in this area, successfully increasing the proportion of debt denominated in its local currency, the real, to avoid exchange rate risks.