Emerging market outlook - effects of a US interest rate hike
20/Nov/2014 • Currency Updates•
We expect the Dollar to gain against all other major G10 and emerging market currencies throughout 2015 on the back of the relatively strong US economic performance. This momentum should prompt the Federal Reserve to hike interest rates in the spring of next year. This hike will be well ahead of any other major central bank currently engaged in a zero-interest rate policy and may have dramatic effects on emerging market currencies.
We can expect that the interest rate hike in the US to cause a partial reversal in portfolio investment flows to these emerging markets, the effects of which will vary according to the status of each nation. However, there are certain emerging market currencies which will be particularly vulnerable to such reversals due to four primary factors:
- High and persistent current account deficit. The current account deficit measures a country’s net financing need and can reveal the extent to which the country is dependent on the kindness of foreign investors to maintain financial stability. The highest and more persistent the current account deficit, the harder the country would be hit by a reversal in portfolio investment flows.
- Dependence on fickle portfolio flows. A country whose capital account is dependent on foreigners’ purchase of publicly traded stocks and bonds is in a much more vulnerable position than one that relies mostly on FDI (Foreign direct investment), which is more stable over time. Most real investment projects require constant expenditures over time, whereas financial portfolio preference can and will shift very quickly.
- Size of FX reserves. These will determine the ultimate limit in the ability of a country to support its currency in a selloff. If a country does not have the necessary reserves in place at the time of the US interest rate hike, they will not be able to defend their position in the FX markets and thereby may be exposed to heightened volatility.
- Banking system stability. Countries where banks are weakly capitalised, or whose balance sheets are exposed to currency depreciation, will find themselves particularly exposed.
The above factors can be better understood by taking one emerging market currency as an example. The South Korean Won (KRW) is relatively well positioned according to the above criteria. It enjoys a massive structural current account surplus that has actually risen lately, currently around 5.8% of GDP. It also enjoys sizable FX reserves, at above nine times its imports. Its banking system is stable and does not depend on foreign financing. According to our framework, therefore, we would expect KRW to be one of the top emerging market performers next year. The South Korean central bank seems to agree, and has signalled that its easing cycle is over with rates bottoming out at 2%.
We have put together a report on the 16 main emerging market currencies, divided by continent. This covers their economic stance, outlook and our exchange rate forecasts up until the end of 2015. You can download this report or contact us on 0845 510 1009 for more information on a specific currency.