With the prospect of monetary policy normalization in the U.S., the dollar is expected to strengthen and interest rates are expected to rise.
In recent weeks, this concern has fanned volatility in the emerging markets where many economies rely heavily on external financing to fuel growth. Indeed, higher rates and weaker local currencies mean financing costs will quickly get much more onerous.
Of course, some emerging market economies are more vulnerable than others. For instance, Morgan Stanley has dubbed the weakest group as the “Fragile Five”: India, Indonesia, Turkey, Brazil, and South Africa.
Generally speaking, economists have looked at two measures to assess these economies’ exposure to normalizing U.S. monetary policy.
First is current account balances as a percentage of GDP.
“Countries with large current account deficits (such as Turkey, South Africa, Indonesia, India and Brazil) have been particularly hard hit by currency depreciation,” said Societe Generale’s Patrick Legland. “With their economies slowing, several large EM countries must now address growing structural imbalances just when they are facing tighter financial conditions. In January 2014, the World Bank thus warned that in developing markets “…growth prospects remain vulnerable to headwinds from rising global interest rates and potential volatility in capital flows”. With the Fed taper, a new dilemma has appeared for India’s, Turkey’s and Brazil’s central banks, as local currency depreciation add to domestic inflationary pressures at a time of slowing growth momentum.”
Second is foreign reserves as a percentage of GDP.
“Overall, since the crisis of the late 1990s, emerging markets have on average achieved greater exchange rate flexibility and financial integration (capital account openness) while retaining some monetary independence,” said Legland. “EMs with larger stocks of international reserves compared to their short-term debt have become more resilient to external shocks. Foreign reserves have become a hedging tool to monitor the currency, both against unwanted appreciation or depreciation of the currency.”
None of these problems developed overnight. And they won’t be fixed overnight either.