The Impact of Rising Interest Rates on Emerging Markets

The United States Federal Reserve’s recent rate hike after a decade has prompted fears of financial turmoil in emerging markets. This rate hike is significant to global markets because the strengthening of the U.S. dollar could cause trouble in countries where firms have borrowed heavily with American currency, and the weaker domestic currencies could make it more difficult to pay back the dollar debt. In 2015, investors have withdrawn $500 billion from emerging markets, and this new development could prompt a larger outflow in the coming months from emerging markets.

The Federal Reserve has stated that it will be raising rates slowly; however, a more aggressive rate raise can cause more uncertainty in markets. Many emerging-market currencies are already under pressure due to decreasing prospects for growth, low commodity prices, declining productivity, and a stronger dollar. The International Monetary Fund estimates that the emerging markets have borrowed trillions of dollars more than the commodity prices and global demand have warranted. Although most of the debt was borrowed by companies, similar problems in the corporate sector can seep into the financial markets. A large part of the reason why the IMF urged the Federal Reserve to delay a rate rise was due to the spillover effects, and developing nations can account for nearly 40 % of global output.   

Many governments and companies in emerging markets have borrowed heavily in U.S. dollars due to low rates over the last decade, and investors were benefiting due to the possibility of higher returns. After the rate hike, money has been withdrawn from emerging markets due to a stronger dollar, low commodity prices, and lower productivity. A few emerging markets that stand to be negatively impacted are Brazil, Turkey, and South Africa.

Turkey has benefited from near zero interest rates and has had a large influx of foreign direct investment, causing its economy to rapidly grow in recent years. Turkey stands to face difficulties if the dollar further strengthens because it imports more than it exports and a stronger dollar can make Turkey’s imports more expensive. South Africa borrowed heavily in dollars when the interest rates were low, and has one of the highest external financing requirements, which means that its currency reserves are smaller than the amount needed to service its foreign debt and pay for imports. In addition, South Africa’s economy is dependent on mining, which has been negatively impacted by low commodity prices. Brazil has been facing economic difficulties due to a shrinking economy, high inflation, and a weak currency. Brazil has the second largest dollar-denominated debt, and Brazilian companies have borrowed billions of dollars and may face difficulties in repaying the loans if the dollar becomes stronger.