The fragility of emerging markets continues to dominate financial news. Several currencies have registered double-digit losses over the past few months, equity valuations have been dropping, and the rate of economic growth has decelerated. Even the Chinese government capitulated to a slowing economy and devalued its currency, a decision that should provide support to its exporting sector.These events are encouraging market commentators and investment strategists to predict further economic struggles in emerging countries and continuing weakness in their stock and foreign exchange markets. There appears to be a fairly broad consensus among market participants: The outlook for emerging market countries, companies, and currencies is inauspicious.
According to a popular story, the strength of the U.S. dollar and the expected interest rate hikes by the Fed could trigger a new wave of troubles for emerging economies. “If history is any guide,” writes Xie (2015), “emerging markets are headed for trouble as the dollar strengthens.” Because of currency mismatches on their balance sheets, weak commodity prices, and deteriorating market sentiment, emerging market economies should be at risk of reenacting the Asian and Russian crises, perhaps on a larger scale.
But is this actually a probable outcome? Like so many other stories economists tell, this one intuitively makes sense. It’s credible. But it rests on three commonly accepted propositions that are not supported by the data. In other words, the plot—a strengthening U.S. dollar threatens emerging market economies—owes its plausibility to three myths. Let’s examine them.
Higher U.S. yields will only cause more economic troubles to emerging economies
The existing level of U.S. interest rates and the potential actions of the Federal Reserve are seen as a cause for great concern in emerging markets. In the global competition for investors, an increase in the yield on U.S. assets could drive the borrowing costs of many non-U.S. companies and governments higher (both in local currency and dollar terms). Does this mean that higher interest rates in the United States are always bad news for emerging markets? Not quite.
The key is to recognize that not all interest rate increases are the same. Investors should always seek to identify the underlying factors driving the markets. For instance, Buitron, Vesperoni, and Loungani (2015) suggest three different types of shocks that can lead to an interest rate increase: money shocks (unanticipated central bank actions implementing tighter monetary policies); real shocks (good news about the economy); and risk shocks (heightened risk aversion on the part of market participants).
A money shock is exemplified by the measures taken by the Federal Reserve, under the direction of Paul Volcker, to fight persistent inflation in the early 1980s. That abrupt policy change pushed the U.S. economy into a recession and sent shockwaves through the international financial markets, emerging as well as developed. We do not seem to be in a comparable situation nowadays.
Yet higher interest rates can be good news if they signal stronger economic performance. Solid growth rates tend to be associated with higher interest rates—this is the meaning of a real shock—and the rest of the world can benefit from strong U.S. growth. Indeed, the United States is still the world’s largest economy, and an improvement in U.S. economic performance should pave the way for expansion at the global level.
Moreover, economic growth can also influence investors’ attitudes toward risk. Good times lead to increasing risk appetites and may encourage investors to diversify away from the expensive U.S. market. The desire to reallocate assets tends, in turn, to stimulate a rally in foreign financial markets. And the empirical evidence supports this narrative.
Buitron and her colleagues analyzed the effects higher U.S. and European yields have on smaller and emerging economies.1 The authors’ findings are remarkable. They documented that, when yields increase because of better economic performance, emerging market economies experience higher capital inflows and faster growth in industrial production during the subsequent year.
Hence, what is good for the United States and other developed economies is also good for the emerging world. These conclusions are particularly significant in light of the Federal Reserve’s current posture. Indeed, the FOMC has been fairly cautious, and the expected policy rate increase is entirely justified by a tightening of the labor market and a core inflation rate closer to the target.
Because there are several moving parts, it might be helpful to visualize the dynamic relationships between annual changes in the 10-year Treasury yield, changes in risk appetites (proxied by annual percentage changes in the VIX Index), and annual emerging market currency returns against the dollar. The findings displayed in Figure 1, based on a 20-year measurement period,are consistent with Buitron and her coauthors’ evidence: higher interest rates in the United States have been positively correlated with returns on emerging market currencies and with rising risk appetites.