Effects of increasing in feds interest rate on emerging market economies

Crossborder capital flows have been intensified last decades with the greater financial integration. After the global financial crisis in 2008 2009, emerging markets economies (EMEs) have (re)started to be a significant target of global capital flows . “Emergingmarket” assets and currencies became objects of desire on the part of global investors thanks to the global factors (such as US interest rates, risk aversion) and domestic factors ( such as the country’s external financing needs , structural characteristics, the exchange rate regime ). However, emerging markets will suffer a net outflow of capital in th e year of 2015 for the first time since the 1980s as their economic fortunes darken and the US Federal Reserve prepares to lift interest rates. Emerging nations were facing a fifth consecutive yea r of slowing growth, adding that an increase in US interest rates could exacerbate conditions in some leading economies. With the next Federal Open Market Committee ( FOMC) press conference scheduled for December 15, 162015 , only one week away, the effect o f increasing in Fed ’s interest rate on EMEs is one of the biggest concerns all over the world at the end of 2015. This article considers some important factors affecting the Fed ’s decision on lifting the interest rate and analyses how an interest rate hike would influence on EMEs in the perspective on the financial capital outflow from emerging markets.

THE EFFECTS OF INCREASING IN FED’S INTEREST RATE ON THE EMERGING MARKETS

Truong Van Hung - 신천의 December 07, 2015

Abstract

Cross-border capital flows have been intensified last decades with the greater financial integration After the global financial crisis in 2008-2009, emerging mark ets economies (EMEs) have (re)started to be

a significant target of global capital flows “Emerging-mark et” assets and currencies became objects

of desire on the part of global investors thank s to the global factors (such as US interest rates, risk aversion) and domestic factors (such as the country’s external financing needs, structural characteristics, the exchange rate regime) However, emerging mark ets will suffer a net outflow of capital in the year of

2015 for the first time since the 1980s as their economic fortunes dark en and the US Federal Reserve prepares to lift interest rates Emerging nations were facing a fifth consecutive yea r of slowing growth, adding that an increase in US interest rates could exacerbate conditions in some leading economies With the next Federal Open Mark et Committee (FOMC) press conference scheduled for December 15, 16/2015, only one week away, the effect o f increasing in Fed’s interest rate on EMEs is one of the biggest concerns all over the world at the end of 2015 This article considers some important factors affecting the Fed ’s decision on lifting the interest rate and analyses how an interest rate hik e would influence on EMEs in the perspective on the financial capital outflow from emerging mark ets

Keywords: increasing Fed’s interest rate, emerging markets’ response, huge shock to emerging markets, emerging market economies , triggering global debt crisis, capital flight to quality, net outflow of capital from emerging market

1 Introduction

The integration of emerging markets into the global financial system has been characterized by cyclical periods of capital inflows, interrupted by sudden capital outflows and financial crises Probably the most renowned boom-and-bust cycle was the surge of private capital flows to emerging markets during the 90’s that ended with a succession of crises, starting with Mexico in

1995 and then touching East Asian countries in 1997-1998, Russia in 1998, Brazil in 1999, Argentina and Turkey in 2001 The following boom to emerging markets during the 2000’s was again interrupted by a sudden reversal of capital flows during the global financial crisis following the Lehmann Brothers collapse in 2008 Since 2009 capital flows to emerging markets are again at historical heights

According to economic theory, free movement of capital across national borders is beneficial to all countries, as it leads to an efficient allocation of resources that raises productivity and economic growth everywhere Capital inflows to EMEs can help finance domestic economies and contribute to long-run economic growth Foreign portfolio inflows can provide a better opportunity for local capital market development, generally providing increased liquidity and price recovery mechanisms As a result, the economic performance of EMEs has recovered quickly after the financial global crisis in 2008 The stock market of China has gone up steadily until the middle of this year 2015

However, emerging markets will suffer a net outflow of capital in the year of 2015 for the first time since the 1980s as their economic fortunes darken and the US Federal Reserve prepares to lift interest rates Emerging nations were facing a fifth consecutive year of slowing growth, adding that an increase in US interest rates could exacerbate conditions in some leading economies The projection will heighten concerns about the prospects for leading emerging economies including China and Brazil

The FED announced to withdraw the QE (quantitative easing) in Oct 29th, 2014 what meat that the United States already have enough ability and confidence to recovery their own economic The US economy created a lot more jobs in October than economists had forecasted This suggests that the US economy is getting stronger and, combined with upbeat comments made by the Fed after its September meeting, is causing more people to believe that there will be a rate rise in December With the next Federal Open Market Committee (FOMC) press conference scheduled for December 15, 16/2015 - only one week away, the effect of increasing in Fed’s interest rate on EMEs is one of the biggest concerns of the central banks and governments all over the world at the end of 2015 This article considers some important factors affecting the Fed’s decision on lifting the interest rate and analyses how an interest rate hike would influence

on EMEs in the perspective on the financial capital outflow from emerging market

The Fed’s interest rate policy will also largely impact the stock market, bond market, emerging market currencies, the euro/yen trading, gold and crude oil markets Nevertheless, the moving of hiking interest rate on the above markets is out of range of our topic

This paper is divided into six sections as follows: The second section will mention the recent economic performance of EMEs, especially in five emerging markets Brazil, Russia, India China and South Africa (BRICS) The third section will observe the recent improvement of US economy and outline some important factors affecting the Fed’s decision on whether rising the interest rate or not The fourth section will provide how the global market factors outside US influence on the Fed’s decision The fifth section, also the main purpose of this article, is to analyze how an interest rate hike would afflict the EMEs The final section will summarize the paper

2 The recent economic performance in EMEs

First of all, we are going to overview the emerging markets and analyze their recent economic performance The BRICS will be the most important EMEs of our article Based on the recent economic performance in EMEs, we can predict the effects of increasing in Fed’s interest rate

on emerging markets

It was not too long ago that the emerging markets were regularly eulogized as the permanent powerhouses of the world economy During the 2000s, with excitable neologisms like BRICS coined in their honors, the big emerging economies drove a boom in global output and trade

And when the rich world suffered a dislocating shock during the financial crisis in 2008, many middle-income nations, with relatively resilient banking systems and large foreign exchange reserves rode out the turbulence and rapidly resumed growing

2.1 Overview of EMEs

In this section, we will examine the five largest economies in EMEs – BRICS In 2015, BRICS represents over 3 billion people or 42% of the world population; as all five members are in the top 25 of the world by population, and four are in the top 10 The five nations have a combined nominal GDP of US$16.039 trillion, equivalent to approximately 20% of the gross world product, and an estimated US$4 trillion in combined foreign reserves The BRICS have received both praise and criticism from numerous commentators Bilateral relations among BRICS nations have mainly been conducted on the basis of non-interference, equality, and mutual benefit (win-win) It is estimated that the combined GDP (PPP) of BRICS would reach US$50 trillion mark by 2020

But as we know not all BRICS nations are doing well, China's economy is in constant decline from 2013 with its stock market reaches a new low in this September troubling global stock

grow at rate of 3% this year Although India's GDP is 7.5% this year it was expected more

before, but as of BRICS only India is growing as expected for BRICS countries

2.2 Recent performance in BRICS in detail

 China GDP Growth Weakest Since 2009

 China GDP annual growth rate

China is one of the biggest economies of the world, the Chinese economy was witnessing

growth even in the wake of a weakened world economic scenario, but it has been slowing down

gradually year after year since 2010 to 7.4% in 2014

The Chinese economy grew an annual 6.9 percent in the third quarter of 2015, slightly down

from 7.0 percent expansion in the previous quarter, but narrowly above market expectations It

is the slowest growth since the first quarter of 2009, mainly due to a slowdown in industrial

output, sluggish property investment and a contraction in exports

 China Capital Flows

China recorded a capital and

financial account deficit of 63.40

USD HML in the third quarter of

2015 Capital Flows in China

averaged 199.43 USD HML from

1998 until 2015, reaching an all

time high of 1320.80 USD HML

in the fourth quarter of 2010 and a

record low of -945 USD HML in

the first quarter of 2015

GDP growth of China (YoY)

 Russia Falls Deep into Recession

Russia is the largest country in the world and the fifth largest economy The Russian economy is commodity-driven Russia is the world’s largest producer of oil (12 percent of world output), natural gas (18 percent) and nickel (20 percent) The energy sector is the most important, it contributes 20-25 percent of GDP, 65 percent of total exports and 30 percent of government budget revenue In 2014, following Russia's military intervention in Ukraine, prospects for economic growth declined further With its over reliance on energy and oil exports, Russia faces

an 8.2 percent drop in output in 2015 and 6.4 percent in 2016, as a significant collapse in oil prices and western sanctions sent the economy into a sharp contraction

The Russian economy shrank 2 percent on quarter in the three months to June of 2015, the worst performance since the 2009 crisis The GDP shrank 2 percent, the fourth straight quarter of contraction, following an upwardly revised 1.57 percent drop in the first three months of the year, revised data from the statistical office showed Year-on-year, the economy shrank 4.6 percent

At the beginning of November 2015, The Russian Central Bank has abandoned its defense of the ruble and declared that it will make no further interventions to prop up the weakening currency The regulator’s decision resulted in a rapid slide by the ruble after that

GDP growth of Russia (YoY)

USDRUB Exchange Rate

 Brazilian Economy Falls into Deep Recession

Brazil is the seventh largest economy in the world and the largest in Latin America In recent years, the country has been one of the fastest-growing economies in the world primarily due to its export potential The country’s trade is driven by its extensive natural resources and diverse agricultural and manufacturing production Also, rising domestic demand, increasingly skilled workforce along with scientific and technological development, have attracted foreign direct investment However, bureaucracy, corruption and weak infrastructure remain the biggest obstacles to economic development

The Brazilian economy shrank 4.5 percent year-on-year in the third quarter of 2015, sixth consecutive contraction and the worse since modern records began in 1996 The GDP in Brazil shrank 1.7 percent on quarter in the three months to September of 2015, worse than market expectations Considering the first nine months of the year, the economy shrank 3.2 percent, the biggest fall ever

 South Africa Annual GDP Growth Slows to 1%

The South African economy advanced 1 percent year-on-year in the third quarter of 2015, easing from an upwardly revised 1.3 percent expansion in the previous period and lower than market expectations of a 1.3 percent rise It is the lowest growth rate since the 2009 recession

due to a slowdown in manufacturing and finance, real estate and business services while agriculture and utilities contracted for the third straight quarter Year-on-year, the economy expanded 1 percent, slowing from a 1.3 percent increase in the second quarter of the year and the lowest since the 2009 recession

GDP growth of Brazil (YoY)

GDP growth of Brazil (YoY)

GDP growth of South Africa (YoY)

 India GDP Growth Beats Expectations

The Indian economy expanded 7.4 percent year-on-year in the three months to September of

2015, following an upwardly revised 7.1 percent expansion in the second quarter Figures came

better than market expectations of a 7.3 percent increase, boosted by financial, real estate and

insurance activities and manufacturing

In summary, most of the large EMEs are in a difficult economic situation Russian and Brazilian

economies are falling into deep recession Chinese and South African economies have been

contracting Although Indian economy is slightly expanding but Indian economy is presently

operating in a very challenging environment partly because of worldwide economic weakness

and partly due to some home grown factors

3 Why is the Fed considering rising interest rates now?

3.1 The current performance of US economy

Since the US economy is improving, it is widely expected that US Fed will raise the interest

rates soon The US economy is showing some positive signs of the recovery such as GDP,

unemployment rate, consumer price index in the third quarter of 2015

 US economy has been improving

The US economy is rebounding The Real GDP growth (based on 2009 dollars) grew by 3.7%

during the second quarter and by 2.1% in 3nd quarter 2015

GDP growth of India (YoY)

 Consumer Price Index

The primary concern of the US Fed is to achieve 2%

inflation rate to achieve the sustainable GDP

growth rate, otherwise the US can again slip into

deflation For July 2015, the core inflation grew by

1.8% YoY, which is near the targeted inflation

Even the last 12 months’ average core inflation is

around 1.7%, which is also not so far from the

targeted inflation Thus, core CPI inflation can

reach the targeted 2% inflation rate in near

term

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers increased 0.2 percent in October after decreasing 0.2 percent in September

 Unemployment rate is within the target range

The second most important goal for US Fed is to keep unemployment rate between 5.2% - 5.5%

in long-run In August 2015, the unemployment rate fell to 5.1% below the targeted long-run normal rate of unemployment of 5.2% - 5.5% of US fed In October and November 2015, the unemployment rate fell again to 5.0% as the table below

In addition to that, the trailing 12 months

unemployment rate is 5.5%, which is still

satisfactory It is evident from the chart that the

unemployment rate is falling after the 2008 financial

crisis continuously and it’s near the 2008 levels

before crisis

3.2 Current level of US interest rate

The US was hit by the crash in its housing market

and banking sector between 2007 and 2009 The Fed

felt it needed to pull out all of the stops to prevent

the economy from collapsing into a new Great

Depression One way of keeping things afloat was

by cutting the cost of borrowing to rock-bottom

levels

It's been nearly 10 years since the Federal Reserve

3.3 Why is the Fed considering rising interest rates now?

With interest rates so low for so long, fed chair Janet Yellen, wary of acting too late and allowing inflation to spiral out of control, has been indicating that the Fed would move to raise rates sometime this year 2015

America has seen its longest private sector hiring spurt on record, and unemployment has halved since its peak The US economy created a lot more jobs in October than economists had forecasted This suggests that the US economy is getting stronger The Fed thinks the hot jobs market could spur a pickup in inflation and wages Given it is tasked with keeping inflation low,

it is considering raising the cost of borrowing to keep the economy on an even keel

4 How does the global market affect the Fed’s decision

In theory, the Fed makes its decision on raising rates based on its appraisals of domestic economic issues However, with emerging markets accounting for 39 per cent of global GDP in nominal terms and 52 per cent in purchasing power parity terms, a US monetary policy that enfeebles emerging markets risks depressing global demand and therefore impacting US growth further down the line As a result, the turmoil in the global market and EMEs has puzzled the market whether the US Fed will increase interest rate this December or not The US Fed is also concerned about the slowing Chinese economy since it can drag the world into another recession

 The slowdown in Chinese economy

A number of global economic events, most notably in China and emerging market as well, have given the Fed recent cause to worry that U.S growth could be hampered Chinese economy is slowing down Its domestic demand is reducing and exports are falling, along with the stock market turmoil in China In August, China devalued Yuan against US Dollar by 2% to boost its exports This devaluation has made US goods more expensive in global market, which could adversely impact US economy Fed has therefore worried that China’s growth slowdown will be worse than expected and will have negative impact on the recovery of US market

In a specific sense, a Fed rate hike runs the risk of increasing the attractiveness of US-dollar assets relative to those denominated in Yuan, thus accelerating capital outflows from China and leaving Beijing with fewer resources to invest in US Treasury debt and this would create potential funding shortfalls for the US government

China’s economy, however, is not the only one having a rough go of it Other developing economies have been slowing for a number of years with the International Monetary Fund (IMF) predicting that such emerging market economies will slow for the fifth consecutive year These weak global economic conditions that depress global demand may have spillover effects

on the U.S economy