Federal funds rate or fed rate and emerging economies are always strongly correlated in a world where capital inflows and outflows are not regulated. After all, US monetary policy has strong binding on the liquidity in global money markets as well equity markets. It is a textbook economics to say that a hike in Federal funds rate will hurt emerging economies. This has been observed previously several times. In this article we shall check this interdependence in the perspective of the recent development. Let us go back a decade earlier.
August 2007, US financial market witnessed a massive burst in the subprime mortgage-backed security market. Quality of mortgages already touched the bottom. High delinquency rates pushed the situation to its brink. Significant financial distress was experienced across the board, in public as well as private financial institutes. Many global financial giants collapsed for their exposure to subprime mortgages. The crisis trickled down to other sectors too. Federal Reserve responded quickly and tried to improve short term liquidity into the system by extending term loans to banks and cutting down fed rate.
Quantitative easing (QE) in monetary policy was continued further to stabilize the economy as all the major economic indicators were going southward. It was the worst financial crisis since the Great Depression of 1930s and impacted all the major global economies and their emerging counterparts. By end-2008, fed rate went down to as low as 0.25%, which is effectively zero, and stayed there till end-2015.
How does the fed rate work?
It is now time to understand how the fed rates work within US and outside:
- Federal funds rate is a target rate at which inter-bank short term borrowing happens; that means the Federal Reserve cannot force banks to lend and borrow at that rate; instead it uses open market operations to push borrowing rate to its targeted rate. This is supervised by Federal Open Market Committee (FOMC).
- When Federal Reserve wants to push the borrowing rate down FOMC simply buy securities from member banks and infuse cash in the system. Extra cash lowers the lending-borrowing rate for the banks. Another way of looking at it is through the extra credit in banks’ balance sheet. By purchasing securities from banks, Federal Reserve increases credit in banks’ balance sheet. More credit means more reserve and more liquidity to lend in the market. In both the ways, banks are compelled to accept lower federal funds rate. On the other hand, when FOMC wants to push the fed rate up they suck liquidity from the market by selling securities. Banks, with no excess reserve in the books, are left with no other option but to increase the lending rates.
- The objectives of tweaking fed rate are, mostly, to control inflation and to maintain economic growth. During 2007, the primary objective of cutting down fed rate and the continued easing was to counter recessionary tendency in the US economy.
- Low fed rate and increased liquidity pushed down rates on all types of loans, starting from credit cards and home loans to business loans. Consumption increased and cost of borrowing for businesses went down. Expansionary monetary policy slowly started reviving confidence in the US economy.
Impact outside US
Due to liquidity easing in US, American economy slowly started bouncing back. After economic contraction in 2008, 2009 and 2010, it witnessed growth in 2011 and the trend continued (Exhibit 1). Low borrowing cost freed up excess funds to be invested in equity and debt markets within US and across the world. A considerable share of that “new found” liquidity got channelled into emerging economies as portfolio investments.
These were short to medium terms investments in nature and was trying to take advantage of the gap in interest rates between US and the emerging economies. For an example, during this period rate of interest in India was around 7% on secured securities and in sovereign bonds. This was a considerable gap to lure foreign portfolio investments. Same was the scenario in other emerging economies.
- From 2009 to 2013, emerging economies witnessed net portfolio investment inflow of over US$ 580 billion. Majority of that went to China, Brazil and India.
- Backed by this fund inflow, emerging equity markets also rallied steadily from the record lows of 2008.
- Nifty 50, a benchmark equity market index in India, soared up to 8360 in June 2015 from the lows of 3000 in December, 2008. It was roughly 17% rate of return annually.
- During same period, the Chinese benchmark index, SSE Composite, ascended to 4,277.22 from the low of 1,976.82, giving a 12% rate of return on annualised basis.
Things started to change
By the end of 2015, Federal Reserve decided to put an end to its accommodative monetary policy by increasing the federal funds rate for the first time since 2008. There were several reasons behind this decision.
- Inflation was getting back to normal track, employment data started showing positivity and consumption data was also on steady trend.
- Low interest rate for consecutive 6 years started contributing to housing boom and household debt level in US increased.
- Low cost of borrowing also started overheating equity markets posing risk of another asset bubble.
To nip the chance of another financial crisis in the bud, Federal Reserve considered tightening money market slowly by increasing fed rate. Improving health of the economy gave Fed confidence. In 2015, federal funds rate was increased by a 25 basis points and in 2017 alone fed rate was revised upward 3 times; each time by 25 basis points. As per the Federal Reserve long term forecast, fed rate will be maintained upward with a long term target of 2.9% by 2020. As of December 2017, target fed rate is 1.25-1.5%. Federal Reserve is expected to raise the target rate more rapidly in coming days is the economy supports.
QE tapering by Fed and Emerging Economies
An end to quantitative easing in federal monetary policy was directly a bad news for all the emerging markets which enjoyed from the inflows of portfolio investments.
For evidence, just following the announcement of the end to monetary easing in US, emerging markets reacted sharply in December 2015. Nifty 50 in India suffered a decline of 8.27% within a month; similarly Jakarta, Brazil and Turkish benchmark indices suffered losses of, respectively, 17.6%, 18.54% and 24.19%.
It is important to understand what could be the implication on emerging economies in medium to long run if Fed continues raising it federal funds rate as per its declared policy.
- Economic growth- growth in emerging economies is significantly dependent of foreign direct investments as well as portfolio investments. The latter is more important for tackling current account deficits. Significant import bills and energy import costs put lot of pressure on current accounts balance. India is surely a good example. Sudden outflow of portfolio investments can put huge strain on emerging markets’ exchange rates as well as on currency reserves.
- Domestic bond and equity market- shortage in liquidity due to outflow of portfolio investments can create shortage of fund and push the borrowing rate upward. This can be noted, especially in countries with less structured and illiquid debt and equity markets. In stock market, it can result in sudden crash in the prices of stocks and other assets.
- Effects on exchange rates– sudden outflow of capital put huge pressure on countries exchange rates. Majority of emerging economies do not enjoy depth in their currency exchange market. So, significant capital outflow always creates volatility in exchange rate and end up increasing exchange rates. This further puts pressure on current accounts via increasing import bills.
- Effect on privately owned companies– companies raising dollar-denominated debts from foreign investors would feel the burnt as cost of borrowing will increase significantly. Rate of interest will increase following higher fed rate and extra cost will be incurred for weakened domestic exchange rates.
However, in economics we often could not get straight answer to many situations. Recent QE tapering by Federal Reserve is more like that.
Recent performance in emerging equity markets shows not much downward tendency as it was expected, following the hike in fed rate. Both India and China performed well despite 3 straight hikes in fed rate in 2017. Many experts are commenting that major emerging economies have already decoupled their markets to a certain extent from the impact of hike in fed rate in coming years. Asset prices in these markets have also discounted upcoming and obvious fed rate hikes.
It is worthwhile to note that emerging countries, excluding China, witnessed a slippage of 1 percentage point in their aggregate annual credit-to-GDP ratio in 2016-17. The gap between aggregate credit to GDP ratio and its long term trend is also going down from its peak of 6.6% in 2015. It shows that these economies are confident[Business or investment?] to survive further hike in fed rate. So, we cannot simply deduce that monetary contraction in US will drain out capital from emerging economies and leave them gasping.
Besides, all emerging markets are not of similar type. They have different dynamics. For example, India and China are more sensitive to internal forces; while Mexico, Taiwan and South Korea is more susceptible to changes in developed markets. So, even if Fed continues with its targeted rates in coming years it will not be correct to ring the alarm unequivocally.