The Malaysian Reserve

Fed raises rates, emerging markets roil — it’s déjà vu

The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S., on Friday, Nov. 18, 2016. Federal Reserve Chair Janet Yellen told lawmakers on Thursday that she intends to stay in the job until her term expires in January 2018 while extolling the virtues of the Fed's independence from political interference. Photographer: Andrew Harrer/Bloomberg

For the second time this year, the US Federal Reserve (Fed) has raised interest rates. With the recent 25 basis-point hike, the Fed funds rate is now near 2%.

Though still low from a historical perspective, the rate has nearly doubled from 18 months ago.

The signal from the Fed is that even with this second hike, the tightening is not quite done.

This tightening stance by the Fed appears to be causing dislocations, particularly among emerging markets (EMs).

As US rates rise, the global riskreturn trade-off gets altered. Higher US dollar returns increase its relative attraction, causing a reversal of capital flows from the emerging world to the US.

Developed world surpluses that had once sought higher returns in EMs are now reversing.

Just as the inflows had pushed financial and asset markets of the developing world higher, the current reversal has caused sharp falls in equities, rising bond yields and a deflation in asset prices.

In addition to the resulting wealth transfer, EMs are now faced with sharply higher funding costs.

What is worrying now, is that the weaker spots within the emerging world appear ripe for full blown crises. Argentina and Turkey appear highly vulnerable, but so too are other Muslim nations like Jordan, Pakistan, Egypt, Indonesia and Malaysia.

The common denominator for their vulnerability appears to be foreign currency-denominated obligations, ie some form of debt.

With the exception of Malaysia, all the other countries have huge current account deficits. Such deficits require financing through capital account inflows, failing which, reserves would fall.

The typical capital account financing would be in the form of portfolio inflows — essentially short-term foreign debt. In Malaysia’s case, it is a case of foreign debt cloaked as foreign direct investment by the previous government.

Policy Options

In terms of policy options, these emerging economies may have worked themselves into a corner.

The capital outflows have pressured their currencies, causing sharp depreciations. These sharp depreciations invariably raise the spectre of domestic inflation as import prices rise.

For importers of US dollar-denominated oil — Turkey, Jordan, Pakistan, Egypt and the like — the inflationary pressures are likely to be more acute.

The standard prescription to check currency depreciation would be to raise domestic interest rates, but this may not be an option as raising rates will kill off domestic growth and endanger the already leveraged private sector.

If monetary policy options are closed, the debt overhang implies little, if any, fiscal space.

Alas, all this is not new. Several previous studies have shown that financial crises in EMs are often triggered by rising interest rates in the developed world, in particular the US.

So, this is not the first time rising US rates is causing problems in the developing world.

What is surprising is the recurring nature of this phenomenon. Every time the Fed raises rates or threatens to — remember the taper tantrum of 2015 — EMs wallow in agony. The repeated recurrence points to three key factors.

First, EM nations appear to have nothing other than a debt-financed growth model. Despite the repeated vulnerabilities that debt-funded growth causes, there seems to be no new thinking in alternative growth models.

This is sad, since Islamic finance offers risk-sharing alternatives that the Muslim nations in particular ought to know.

A second observation that emerges is that despite abundant labour and various cost advantages, many of these nations, such as Jordan, Egypt and Pakistan, have not been able to build trade competitiveness.

As such, they are perennially plagued by current account deficits, and need constant handouts and foreign aid to sustain. Their inability to wean themselves off even after decades is testimony to poor leadership and incompetent policy formulation.

The third and perhaps most obvious factor that comes out of this phenomenon is the US’ hegemony of the global financial system. Despite its erosion as an industrial power and in its manufacturing prowess, the US continues to be the centre of the financial universe.

Global financial markets dance mainly to one tune, that of the Fed’s. The tune having been set at Bretton Woods in 1944 and hard coded since then.

For example, while the Fed has been tightening, the European Central Bank (ECB) and the People’s Bank of China (PBoC), the two other central banks of significance, have been loosening.

The ECB has been particularly dovish, having postponed its bond repurchase. The PBoC has just announced a reduction in liquidity reserve ratios for Chinese banks.

Yet, even though the latter two central banks are doing the opposite, it is the Fed’s actions that matter to emerging and global markets.

Transparency, Soft Power

Why is this so? It probably has to do with the fact that while Germany, Japan, Korea and China have challenged the US in industrial power and technology, none have been able to, nor challenged the US in financial hegemony.

While the basic building blocks for this dominance were undoubtedly laid at Bretton Woods, the openness and transparency of US financial markets and the clever use of soft power have perpetuated the hegemony.

For Muslim nations of the developing world, there is a clear need for introspection and alternative financing models.

Going down the same path of debt-financed growth has not, and will not, get them out of boom-bust cycles.

Islamic finance offers alternatives, policymakers need to merely change their line of sight.