As the COVID-19 pandemic enters its third year, emerging market economies (EMEs) will continue to struggle to improve their financial resilience in the face of numerous domestic and global headwinds.
In 2022, these economies will face difficulties managing macroeconomic and financial stability in a highly unsettled global economic environment. This year, EMEs will continue to grapple with higher food and energy prices, persistent inflationary pressures and supply chain disruptions. Even if the global economy performs broadly in line with expectations, EMEs will face new challenges this year in bolstering their growth impulses and overcoming financial vulnerabilities.
This year, three significant external headwinds for these countries are: the tightening of monetary policy in the United States and other advanced economies; China’s slowing growth; and ongoing geopolitical tensions (especially US-China, US-Iran and Ukraine-Russia).
Additionally, major elections will be held in 2022 in several emerging market countries (including Brazil, Colombia, Hungary and the Philippines) amid a polarised political environment, lingering popular discontent and widening economic inequalities. All of these developments could have a significant adverse effect on the outlook of EMEs.
The triple threat of policy tightening
To contain the economic fallout of the COVID-19 pandemic, the Federal Reserve (Fed) took a broad array of actions, including expansionary policy (slashing policy rates to near zero) and ‘quantitative easing’ (large-scale buying of bonds and securities). The Fed has been purchasing $120 billion ($80 billion of treasury securities and $40 billion of mortgage-backed securities) every month since March 18, 2020, to support the US economy.
The Fed’s triple threat of policy tightening – tapering asset purchases, raising the target range for the federal funds rate and shrinking its balance sheet – poses downside risks to a large number of emerging markets and developing economies (EMDE) and low-income countries (LIC).
The tapering of the Fed’s asset-purchase program is the first significant step toward normalising its ultra-loose monetary policy. After completing the tapering process, the Fed would initiate policy rate hikes. After that, the Fed would begin reducing the size of its balance sheet, a process known as quantitative tightening (QT).
The tapering process began in December 2021, with monthly asset purchases reduced from $120 billion to $105 billion. Surprisingly, within two weeks, the Fed decided to double the pace of tapering in response to rising inflation and a stronger economic recovery. On December 15, Fed Chairman Jeremy Powell announced that the Fed would reduce monthly asset purchases by $30 billion. As a result, the Fed’s net new bond purchases will be completely phased out in March 2022, three months ahead of the previous schedule.
Interest rate hike: earlier and faster
The US Fed has committed to maintaining interest rates near zero until inflation averages 2% over time and maximum employment is achieved. Nonetheless, primarily due to inflationary pressures resulting from supply chain disruptions and high commodity prices, the Fed has taken a more hawkish stance in recent weeks and thus could begin raising the federal fund rates even if the other goal of maximum employment has not been achieved fully.
According to the latest inflation data released by the US Bureau of Labor Statistics, the consumer price index increased by 7% in the 12 months ending December, 2021; the highest 12-month increase since 1982. The upcoming employment cost index, which provides data on wage growth, could further add to the Fed’s pressure to usher in higher interest rates in early 2022.
With no signs of inflation abating soon, the Fed may hike rates four times in 2022, beginning in March, and another four times in 2023. The Fed’s December 14-15 meeting minutes indicate that its officials are willing to pursue a much more aggressive policy tightening. The Fed’s so-called “dot plot,” which shows where each member of the Federal Open Market Committee (FOMC) believes interest rates should be in the coming years, revealed that a majority of FOMC members anticipate three rate hikes in 2022. While in September 2021, half of the FOMC members saw only one rate hike in 2022.
As the Fed sets the tone for global monetary policy, other systemically important central banks will follow suit. Except for the European Central Bank (ECB) and the Bank of Japan, all major advanced economies’ central banks have either already raised policy rates or intend to do so in the first quarter of 2022. Since mid-2021, several large emerging market economies (including Brazil, Mexico and Russia) have also raised interest rates, primarily to contain domestic inflationary pressures and avert capital outflows.
Quantitative tightening: fast and furious
Once the US Fed begins raising interest rates, its next move will be to reduce its bloated balance sheet, which currently stands at $8.7 trillion, or roughly 37% of GDP. Before the COVID-19 pandemic, its balance sheet represented approximately 20% of GDP.
There is an increased likelihood that the QT may start shortly after the first rate hike and will be more rapid than the last time. After the Fed began tapering in 2014, there was a two-year lag between the first rate hike and the start of the QT process. This time, the QT process is expected to be swifter as the Fed has already set up a permanent Standing Repo Facility to support the implementation of monetary policy and the smooth functioning of financial markets.
The minutes of the December meeting and comments by FOMC members suggest that the QT process may begin shortly after the rate increase cycle begins. Market analysts predict that the upcoming reduction in asset holdings will be more aggressive, likely totalling $750 billion per year.
The spill-over effects of policy tightening on emerging markets
Given the dominant role of the US dollar in the international monetary system, the Fed’s aggressive stance towards monetary policy tightening could spell trouble for EMEs that are inextricably linked to global financial markets. Policy tightening would have direct negative ramifications for EMEs and LICs with open capital accounts, sizeable current account deficits and high levels of external debt.
A more hawkish policy stance by the Fed could be highly disruptive to emerging markets for several reasons. Firstly, an aggressive financial tightening would raise US yields and strengthen the US dollar against EM currencies. As a result, portfolio flows would abruptly reverse. The US-based global investors would pull money out of emerging markets and invest in “safe-haven” US assets, a la the infamous 2013 “taper tantrum.”
According to the Institute of International Finance’s Capital Flows Tracker, foreign investment in emerging market stocks and bonds (excluding China) has declined since December 2020, owing to concerns about fragile economic recovery.
The sudden stops and reversal of capital flows will lead to depreciation pressures on EM currencies. When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. If the EM currency depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds.
When foreign investors dump EM financial assets en masse in panic and move their capital to safe-haven assets (for example, US treasury bonds), it creates more depreciation pressures on the EM currencies. A rapidly depreciating EM currency will likely prompt even more foreign investors to withdraw their money, as they fear the domestic currency will fall further. This could eventually result in a run on the domestic currency, perpetuating a currency crisis.
A depreciated currency would undoubtedly help boost exports, benefiting countries like Saudi Arabia and Iran that export energy, but would hurt countries like India, Indonesia and Turkey that import oil and gas.
Secondly, EMDEs and LICs with a large stock of foreign currency debt and low forex reserves will be particularly vulnerable to tightening global financial conditions. This group of countries includes Argentina, Colombia, Indonesia, Turkey and Sri Lanka.
In 2020, six countries – Argentina, Ecuador, Belize, Lebanon, Suriname and Zambia – defaulted on their sovereign debt. Sri Lanka is next in the queue. Despite concluding currency swap agreements with China and India, Sri Lanka’s external liquidity is precarious due to annual foreign-currency obligations of $5-6 billion until 2025, and the country’s forex reserves (currently $1.5 billion) are dwindling to cover only a month’s imports.
Thirdly, a rising US dollar would increase the debt-servicing costs (in local currencies) of EM non-financial corporates (NFC) with unhedged currency exposure, thereby exacerbating liquidity and solvency concerns. Even if EM NFCs use derivatives to hedge foreign exchange risks, they may still be exposed to significant liquidity risk due to maturity mismatches. Because of tighter global financial conditions, NFCs from China, Brazil, India and Mexico having significant refinancing needs during 2022-23 would face prohibitive costs while raising new dollar debt or rolling over their existing dollar debt.
Fourthly, in response to faster rate hikes by the Fed, EME central banks would have to raise interest rates to maintain interest rate differentials, prevent capital outflows and domestic currency depreciation, despite sluggish recovery and growth risks.
Indeed, tighter monetary policy by the US and other advanced economies presents dilemmas for policymakers in EMEs. If EM central banks continue the current loose monetary policy with low-interest rates, it will lead to capital outflows and domestic currency depreciation. On the other hand, if EM central banks pursue tighter monetary policy by increasing interest rates too early, it would derail a fragile domestic economic recovery. Hence, both options risk undermining the economic recovery process. Only those EMEs that actively manage capital accounts can pursue some degree of monetary autonomy.
Are India’s forex reserves adequate to cushion against external shocks?
It is important to note that the impact of capital reversals could be pronounced in India with a limited capital account liberalisation. The Indian rupee is not fully convertible on capital account. In India, portfolio flows into equity markets are unrestricted, but are subject to sectoral caps and macroprudential restrictions in debt markets.
The fast accumulation of forex reserves in recent years has made India the fourth-largest forex reserve holder in the world after China, Japan, and Switzerland. India’s forex reserves currently stand at $632 billion, with an import cover for 15 months. Many analysts believe that India’s huge forex reserves would be sufficient to address capital flight and currency depreciation in response to tighter monetary policy by the Fed. That may not be the case if we assess forex reserves in relation to external liabilities.
To better gauge India’s external vulnerabilities, let’s begin with short-term external debt liabilities. India’s external debt worth $256 billion will mature over the next 12 months, according to the September 2021 data released by the Ministry of Finance. NFCs alone account for $128 billion, according to the data. To put this in context, India’s total external debt maturing until September 2022 accounts for 40% of the country’s forex reserves.
Second, India’s negative net international investment position (the difference between foreign assets and liabilities) of $331 billion as of September 2021 is a cause for concern if sudden stop events materialise.
Third, according to the foreign portfolio investments (FPI) data by National Securities Depository Limited, US-domiciled funds own as much as 38.5% of Indian equities, accounting for $246 billion of the $640 billion total equity portfolio of FPIs in November, 2021. Rapid selloffs by US-based funds would put downward pressure on the rupee, as foreign investors would convert their equity investments in the rupee to the US dollar. The rupee depreciation would also result in imported inflation as India relies heavily on oil imports to meet domestic demand.
Suppose large capital outflows from equity markets occur due to the Fed’s tighter monetary policy stance, combined with significant debt repayments and rising international crude oil prices. In that scenario, India’s massive forex reserves may be insufficient to contain downward pressures on the rupee and protect the domestic economy from large outflows.
In such a scenario, Indian NFCs with substantial US dollar debt must also watch out, as their share of the country’s total external debt is a whopping 36.9%. Indian corporates that have not hedged their foreign currency borrowings may face higher foreign currency funding costs, as well as liquidity and solvency risks.
Whither international cooperation?
In an ideal world, swift international policy coordination would manage the spill-over effects of the monetary policy normalisation in the US and other advanced economies. Policy coordination among emerging and advanced economies would also help avoid spillbacks to advanced economies. Despite repeated calls by several emerging market central banks for some form of rules-based international monetary policy coordination in a financially interconnected world, the US Fed and other advanced central banks have overlooked such demands.
The second option is close collaboration between the US Fed and EMDE central banks in providing foreign currency swap lines to address potential dollar funding risks. The Fed has remained evasive in this regard as well. Even if not used, such dollar liquidity arrangements would enhance EM central banks’ credibility and financial market stability.
During the COVID-19 crisis, the US Fed offered temporary currency swap lines to only two EM central banks (of Brazil and Mexico). In 2021, the Fed established a new foreign and international monetary authorities (FIMA) repo facility, which provides dollar liquidity to other foreign central banks (that do not have access to swap lines with the Fed) in exchange for US Treasury securities as collateral.
Hence, EMEs have extremely limited access to both dollar funding mechanisms. Until now, the Fed has shown no willingness to extend these mechanisms to EMEs and LICs that do not have access to swap lines or a sufficient quantity of US Treasury securities to use the FIMA repo facility effectively.
Primarily due to the Fed’s selective approach, bilateral currency swap arrangements between EMEs have proliferated in recent years. In particular, the People’s Bank of China (the country’s central bank) has renewed or signed yuan-denominated currency swap agreements exceeding $500 billion with 35 EMEs and low-income countries (including Argentina, Turkey, Thailand, Pakistan and Sri Lanka); more than any other country in the world.
Intriguingly, Pakistan in 2013 and Argentina in 2014 used yuan-denominated swap agreements to obtain renminbi and convert it to US dollars in offshore markets during times of financial distress. No wonder, such flexible currency swap agreements also bolster China’s global economic influence, much to the displeasure of the US.
Following the Asian financial crisis of 1997, many EMDEs have been accumulating large foreign exchange reserves to self-insure against volatile capital flows and other external shocks. While it is undeniable that large forex reserves bolster EM central banks’ ability to intervene in currency markets, holding large reserves entails fiscal costs. Additionally, central bank interventions are considered most effective when conducted for a brief period (less than a month). Otherwise, central banks risk depleting substantial forex reserves without significant impact, as seen in China (2015) and Turkey (2019-20).
The need for swift domestic policy action
The EMEs and low-income countries should initiate swift domestic policy responses to minimise the adverse effects of cross-border spill-overs caused by the tightening US monetary policy. Given that the US and other advanced economies have already begun the process of policy normalisation, the next three months are critical for emerging market policymakers to take proactive measures to cushion the impact on domestic growth sources and insulate their economies from volatile capital flows.
While EMEs and LICs should tailor their responses to their particular circumstances and vulnerabilities, macroprudential tools, capital controls and currency-based measures are all examples of time-tested measures that can help prevent and mitigate external financial shocks. The challenge lies in designing an appropriate policy mix depending on the potential macroeconomic and financial risks.
It is high time that EM policymakers rethink the costs and benefits of an open capital account and adopt a cautious approach towards capital account liberalisation. A significant number of studies have found no causal relationships between capital account liberalisation and economic growth, while the costs are increasingly evident in the form of recurrent financial crises in emerging markets.
In addition, EMDEs need to strengthen regulation and supervision of their financial sectors to identify potential systemic risks and risk build-up in specific sectors. Their central banks should regularly monitor banks and NFCs to assess their foreign currency exposures and derivatives positions to limit system-wide financial risks.
To sum up, monetary policy normalisation is happening in the US. Recent developments indicate that the Fed is adopting an aggressive stance toward its monetary policy and is eyeing interest rate hikes early this year. An earlier and faster normalisation of monetary policy by the US Fed increases the risks to macroeconomic and financial stability in emerging markets and low-income countries. In the absence of international policy coordination, EM policymakers must make full use of the available policy levers to strengthen macroeconomic fundamentals and policy frameworks.
Kavaljit Singh works with Madhyam, a policy research think-tank, based in New Delhi.