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Given what followed, emerging markets fear Fed redux in 1994: McGeever

By on April 23, 2022 0

(Views expressed here are those of the author, columnist for Reuters.)

ORLANDO, Fla. — If the Federal Reserve is using 1994 as a template for its likely aggressive monetary tightening, then emerging market investors can be forgiven for feeling nervous given what followed in the world at the time.

Refinancing needs in developing economies are at record levels. Inflation is high and rising despite the fact that many emerging central banks have discounted Fed rate hikes over the past year, as has government debt as a share of gross domestic product.

To be sure, the external position of emerging markets is much stronger today than it was in the mid-1990s – debts are mostly denominated in local currencies, far fewer exchange rates are pegged to rigidly to the dollar and many central banks are sitting on huge piles of foreign liquidity reserves.

But the sharp rise in US bond yields and the surge in the dollar are weighing on growth in emerging economies and overall debt sustainability. Emerging market assets have been under pressure for some time.

The surge in US real, or inflation-adjusted, yields is particularly noteworthy. As real U.S. bond yields turn positive again, Western investors fearful of currency risk, capital loss and inflation feel more comfortable placing themselves in the relative safety of Treasuries, and capital are sucked in by high-octane emerging markets.

The US 10-year real yield has jumped towards zero, falling from around -1.10% over the past six weeks. Patrick Curran, senior economist at Tellimer, says markets may still be underestimating the upside potential they may still have.

“Gone are the days when you could just pencil in a 2% inflation forecast and estimate your actual rates from there,” Curran says, noting that headline inflation in the United States is the highest in 40 years, 10-year inflation expectations are the highest in 25 years, and emerging market inflation rates are also rising.


U.S. money markets now expect the Fed to raise interest rates by 50 basis points at each of its next three meetings for a total of 275 basis points this year, culminating in a “terminal” rate l next summer which could exceed 3.5%.

It would be similar to 1994-95, where the Fed’s 300 basis point tightening cycle over 12 months included several 50 basis point moves and even a 75 basis point increase.

This rapid and destructive bond tightening under then-Fed Chairman Alan Greenspan achieved the rare twin feat of stifling inflation while avoiding recession.

But what was a soft landing for the US economy turned out to be much bumpier for emerging markets. A stronger dollar and higher U.S. yields helped spark the 1994-95 “tequila” crisis in Mexico, which later morphed into the 1997 Asian crisis, which later fueled the 1998 Russian crises and Brazilian of 1999.

Nobody is suggesting an exact repetition. But the pressure comes now as the International Monetary Fund this week noted “lingering scars” from the pandemic, meaning emerging economies will fail to return to their pre-COVID growth path for several years.

The IMF also warned that emerging markets remain vulnerable to a tightening in global financial conditions. A “sharp and rapid” increase in U.S. interest rates could cause “significant spillovers” to some emerging economies, especially smaller and weaker “frontier” markets.


According to Goldman Sachs, financial conditions in the United States are the tightest since November 2020, and emerging market conditions are close to being the tightest since 2008. This year’s tightening has been driven almost exclusively by higher prices. bond yields and widening credit spreads.

Funding needs are high. Total public debt in emerging markets stands at around 66% of GDP, according to the IMF, nearly doubling since 2008. This debt explosion could only be paid off because global rates crashed to virtually zero after the 2008 crisis.

But with growth expected to remain subdued, the IMF expects the debt-to-GDP ratio of emerging economies to continue to rise steadily to reach 75% of GDP by 2027.

Analysts at the Washington-based Institute of International Finance note that emerging market bonds and loans across all sectors maturing by the end of next year total around $9 trillion. Even though about 85% of this sum is in local currency, well over $1 trillion is exposed to rising US rates.

Emre Tiftik, director of sustainability research at the IIF, points out that countries that rely more on foreign currency borrowing will be hit hard. Middle- and low-income economies are particularly at risk.

“Furthermore, many emerging market sovereigns have started to borrow short-term, increasingly using bonds. This short-term debt needs to be repaid in a rising interest rate environment, which weighs heavily on budget balances.

(Views expressed here are those of the author, columnist for Reuters.)