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Development Strategy and Policy Analysis Unit w Development Policy and Analysis Division Department of Economic and Social Affairs

Emerging Economies and the Monetary Tightening Path in the United States Development Issues No. 12

25 July 2017

Introduction Summary In tandem with a modest recovery in global commodity prices and international trade, the growth outlook for the emerging In June 2017, the Fed raised its key policy rate for the fourth economies has improved since late 2016. Based on projections time since December 2015, and announced plans to made in the World Economic Situation and Prospects as of gradually reduce the size of its balance sheet. Amid high mid-2017 report (, 2017), emerging economies economic and policy uncertainty, however, rising interest are expected to experience a moderate pick-up in growth in 2017 rates by the Fed may pose considerable challenges for and 2018, marking a reversal of the downward trend seen since the emerging economies. Notably, countries with high 2010 (Figure 1). However, economic growth continues to be borrowing needs, large dollar-denominated debt and below the average for the period between 2000 and 2016, and fragile macroeconomic conditions are at a higher risk of emerging economies remain susceptible to external and domes- experiencing large and potentially destabilising capital tic shocks, amid rising uncertainty in the international policy outflows. In this environment, policymakers will need to environment and structural weaknesses. More specifically, low assess the various policy tools available that will most effectively mitigate the spillover effects of the Fed’s commodity prices have affected investment in large commod- policy transition and enhance the economy’s resilience ity exporters, including , , the Russian Federation to shocks. and , while high political uncertainty is weighing on investor sentiments in , and . In addition, some emerging economies, including , are facing Figure 1 growing financial stability risks, arising from high asset prices GDP Growth in Emerging Economies and elevated debt levels. Percentage Meanwhile, the United States Federal Reserve (Fed) has 10.0 embarked on a monetary policy normalization path, as growth and labour market indicators continue to improve. In June 2017, 8.0 the Fed raised its key policy rate for the fourth time since Decem- Average growth ber 2015, and also announced plans to gradually reduce the size 6.0 2000-2016 of its balance sheet. While the strengthening of US’ growth prospects will benefit the rest of the world through improved 4.0 aggregate demand, rising interest rates and the resultant tighten- ing of financial conditions may pose a significant challenge for 2.0 the emerging economies. This note analyses the current situation of emerging economies in facing the Fed’s ongoing monetary 0.0 policy transition and the underlying policy challenges. 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Are emerging economies at risk? Note: Emerging economies includes , Brazil, Chile, China, , Against a backdrop of excess global liquidity, emerging econo- , , , , , , , , Nigeria, , , the Russian Federation, South Africa, Saudi Arabia, mies experienced a surge in capital inflows in the aftermath of Republic of Korea, , Turkey, , and Bolivarian the global financial crisis (Figure 2). These inflows were driven Republic of . Figures for 2017 and 2018 are forecasts based on World Economic Situation and Prospects as of mid-2017 (United Nations, 2017). The by the widening of interest rates and growth prospects differ- contribution of each country’s real GDP growth to the EM aggregates was entials between the advanced and emerging economies during obtained using PPP weights. that period. However, the slowdown in growth in emerging Source: Authors’ own elaboration.

Development Issues are intended to clarify concepts used in the analytical work of the Division, provide references and analysis of current development issues and offer a common background for development policy discussions. This note was prepared by Poh Lynn Ng and Sebastian Vergara in the Development Policy and Analysis Division of UN/DESA, in the context of the World Economic Situation and Prospects as of Mid-2017(United Nations, 2017). The authors thank Diana Alarcón and Ingo Pitterle for comments and suggestions. The views expressed here are those of the authors and do not necessarily reflect those of the United Nations. For more information contact: [email protected] or [email protected]. The full archive is available at: http://bit.ly/DevIssues. economies, coupled with the sharp decline in commodity prices, and reducing monetary policy space. weaker global trade and high political turbulences in some The current monetary tightening process in the United States countries, significantly reduced capital inflows in recent years. could have large spillovers on the emerging economies for several In 2015 and 2016, emerging economies experienced a significant reasons. For one, the rapid rise in corporate debt post-crisis is net outflow of capital (Figure 2), and portfolio flows declined vis- a growing source of vulnerability for the emerging economies. ibly in most emerging regions with respect to the flows observed Driven by cheap funds, the outstanding corporate debt of non- in 2010-2014 (Figure 3). financial corporates has increased from 61 per cent of GDP in While the US’ monetary normalization process is expected to 2008 to 102 per cent of GDP in 2016 (Figure 4). In particular, proceed on a gradual path, a significant pick-up in inflationary China has seen the sharpest rise in corporate debt, with debt levels pressures could force the Fed to raise interest rates at a faster-than- standing at over 160 per cent of GDP in 2016, while debt levels expected pace. This will in turn trigger heightened risk aversion in Turkey, Chile and the Russian Federation have also increased and global financial volatility. A sudden surge in capital outflows visibly (Figure 5). High corporate leverage not only constrains from emerging economies will adversely impact equity prices and capital expenditure, but also poses a risk to financial stability. As the Fed raises rates, there is a risk of an abrupt tightening of global currencies, while significantly raising external borrowing costs financing conditions, forcing corporates to deleverage sharply. Figure 2 The debt service-to-income ratio of the private non-financial Capital flows in emerging economies sector has also increased in several economies, amid weak export Billions of dollars earnings and declining commodity-related revenues. Lower 2000 earnings have also affected corporate profitability, especially in Capital Inflows commodity-sectors, leading to higher debt service-to-income 1500 Capital Outflows ratios (UNCTAD, 2016). Net Capital Inflows The fragility of corporate balance sheets in emerging economies 1000 has also been exacerbated by the rise in dollar-denominated debt (Figure 6)1. In particular, offshore borrowing by large emerging 500 market firms through subsidiaries abroad has visibly increased in Brazil, China, the Russian Federation and Turkey. Notably, 0 corporate debt in foreign currency has risen not only in the trad-

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 able sector, but also in non-tradable sectors, such as construction -500 and real estate, where currency mismatches are more prominent

-1000 Note: Figures for 2016 are preliminary data, while figures for 2017 are projections. Figure 4 Source: Authors’ own elaboration based on data from the Institute for International Emerging economies: outstanding credit to non-financial corporates Finance (IIF, 2017). Percentage of GDP 110 Figure 3 Portfolio capital inflows in emerging economies 100 Annual average, billions of dollars 140 90 2002–07 120 2010–14 80 2015 70 100 2016 60 80 50 60 40 40

20 2008-Q1 2008-Q3 2009-Q1 2009-Q3 2010-Q1 2010-Q3 2011-Q1 2011-Q3 2012-Q1 2012-Q3 2013-Q1 2013-Q3 2014-Q1 2014-Q3 2015-Q1 2015-Q3 2016-Q1 2016-Q3

Note: The BIS’ definition of emerging markets includes Argentina, Brazil, Chile, 0 China, Colombia, the Czech Republic, SAR, Hungary, India, Indonesia, , Korea, Malaysia, Mexico, Poland, , Saudi Arabia, , South Africa, -20 Thailand and Turkey. Emerging Asia Latin America Emerging Europe Africa and the Middle East Source: Authors’ own elaboration based on BIS Total Credit Statistics. Note: Figures for 2016 are estimated. Source: Authors’ own elaboration based on data from the Institute for International 1 See the World Economic Situation and Prospects Monthly Briefing No. 96 Finance (IIF, 2017). (November 2016).

2 July 2017 Figure 5 Figure 6 Emerging economies: outstanding credit to non-financial corporates Outstanding dollar-denominated debt securities in Percentage of GDP developing regions 180 Billions of US dollars 2007 160 600 2016 Developing Europe 140 Developing Asia and Pacific 500 120 Developing Africa and Middle East Developing Latin America and Caribbean 100 400 80 60 300 40

20 200 0 India Chile 100 Brazil China Turkey Poland Mexico Malaysia Republic of Korea Indonesia Federation The Russian 2005-Q1 2006-Q1 2007-Q1 2008-Q1 2009-Q1 2010-Q1 2011-Q1 2012-Q1 2013-Q1 2014-Q1 2015-Q1 2016-Q1 2017-Q1 South Africa 0 Source: Authors’ own elaboration based on BIS Total Credit Statistics.

(Chui et al, 2016). Also, given that the increase in US interest 2005-Q1 2006-Q1 2007-Q1 2008-Q1 2009-Q1 2010-Q1 2011-Q1 2012-Q1 2013-Q1 2014-Q1 2015-Q1 2016-Q1 2017-Q1 rates might support a further strengthening of the dollar, the cur- Source: Authors’ own elaboration based on BIS Debt Securities Statistics. rency mismatch risks can raise as well as debt servicing costs. In addition, the “financialization” of the corporate sector in order sheets are in general less levered than during the build-up to the to exploit carry trade opportunities has contributed to a rapid Asian Financial Crisis, corporates in emerging economies remain expansion of credit and a build-up of financial vulnerabilities in highly vulnerable to financial shocks, particularly sharp exchange some countries. Moreover, a significant part of corporate debt rate devaluations. Also, further protectionist policies could was neither channelled to productive investments nor to high- increase pressures on the balance of payments through capital productivity sectors in recent years (Bruno and Song, 2015). This outflows and a worsening trade balance in some economies. resource misallocation not only adversely impact medium-term Overall, while there is limited risk of a widespread emerging growth, but also raises concerns over debt sustainability (Pitterle market debt crisis, the feedback loops between tightening global et al, 2015). financial conditions and the real economy could significantly The spillover effects from the US’ monetary tightening path undermine the growth outlook in emerging economies. Given on emerging economies could be considerably amplified depend- the strength in macroeconomic fundamentals, the prospects ing on the evolution of commodity prices, the value of the dollar across emerging economies vary significantly. Notably, however, and the potential implementation of trade protectionism policies. emerging economies with high borrowing needs, large dollar- Renewed weakness in commodity prices would weigh on the denominated debt and fragile macroeconomic conditions will terms of trade of commodity exporting countries, further under- likely be the most susceptible to large and potentially destabilis- mining profitability and credit worthiness of the corporate sector. While global commodity prices have recovered modestly from the ing capital outflows. Against this backdrop, the implementation record-lows seen in early 2016, prices have remained well below of an appropriate policy mix in emerging economies encompasses pre-crisis levels. This has left many commodity-dependent econo- significant challenges. mies in Africa, Latin America and Western Asia with subdued growth, fragile export earnings and relatively weak fiscal posi- Policy Challenges tions. Meanwhile, a significant appreciation of the dollar could Recent decades have shown that global financial cycles and exacerbate the difficulties in rolling over dollar-denominated capital flows amplify business cycles in emerging economies, 2 corporate debt . The Federal Reserve Economic Data (FRED) encompassing significant policy challenges. In turn, empirical Broad Trade Weighed US Dollar Index has appreciated by almost evidence suggests that strong macroeconomic fundamentals tend 20 per cent since early 2014, and a further appreciation could to provide little insulation to sudden changes in global financing significantly increase the risks of corporate distress and default. conditions, and that “sudden stops” episodes continue to have Noticeably, Alfaro et al (2017) shows that while corporate balance real economy effects in emerging economies (Eichengreen and 2 Given that commodity prices tend to exhibit an inverse relationship with the Gupta, 2016). In recent years, however, emerging economies dollar, a further strengthening of the dollar would also prolong the weakness in receipts of commodity-related revenue, exacerbating vulnerabilities in these have also become more prepared to utilise a wider, and more countries. heterodox, policy toolkit in facing external shocks through the

Development Issues No. 12 3 use of monetary, fiscal, exchange rate, macro-prudential policies policy in supporting growth in emerging economies will be con- and capital controls (Gosh et al, 2017). strained by the tightening cycle in the United States. Also, the However, the implementation of policies often entails sig- potential effects on growth from further easing are likely to be nificant trade-offs. In addition, despite the availability of a wider limited, given that loose monetary policies have been relatively policy toolkit, it appears that emerging markets have become ineffective in boosting domestic demand in recent years. Nota- more sensitive to global financial conditions after the global bly, private investment has remained largely subdued in many financial crisis of 2007/08, as a result of larger financial shocks emerging economies. Also, recent empirical evidence has shown and stronger interconnectedness with global financial markets. that global financial conditions tend to generate large spillovers For instance, Ahmed and Zlate (2014) and Brandão-Marques et into local financial markets and to disrupt domestic monetary al (2015) show that, after the financial crisis, portfolio flows to policy efforts to manage financial conditions. For instance, Rey emerging economies have become more sensitive to interest rate (2015) highlights the existence of a global financial cycle in differentials and to global financial conditions. Given the per- capital flows, asset prices and credit growth that co-moves with sistently challenging external environment, emerging economies volatility, uncertainty and risk aversion, which is not aligned with need to carefully calibrate the policy mix to strengthen growth countries’ specific macroeconomic conditions. As a result of this prospects and create an enabling macroeconomic environment in global cycle, monetary policies, especially in highly integrated order to make significant progress towards achieving the Sustain- capital markets, become independent “if and only if the capital able Development Goals. account is managed”. In the near term emerging economies need to deploy a more Looking ahead, emerging economies need to strengthen the effective use of fiscal policy and progress further on structural design, implementation and evaluation of macro-prudential reforms to promote investment demand, lift potential growth and policies to limit the excessive credit growth, avoid risky currency encourage a sustained and inclusive growth. As highlighted in the mismatches and promote an analogous increase in productive World Economic Situation and Prospects 2017 (United Nations, investments. The implementation of prudential measures consti- 2017), a balanced policy mix is required to achieve stronger and tutes a major policy tool to contain financial fragilities (Hanson more sustainable growth. In particular, fiscal policy should play a et al, 2011, Hahm et al, 2012). However, each country needs to key role in managing domestic demand by altering the level and composition of public expenditures and implementing income evaluate and assess the policy tools available in order to imple- policies. Fiscal policy should also act as a catalyser for private ment a policy mix that most effectively addresses its priorities. investment through public-private partnerships and other policy For example, broad-based capital tools, including counter-cycli- instruments to boost the private engagement in innovation, cal capital buffers and dynamic provisioning requirements, can infrastructure, renewables and green energies, among others. In alter credit growth, while the implementation of sectoral tools, addition, policymakers should prioritize reforms that address such as loan-to-value and debt-to-income ratios and capital structural bottlenecks which are constraining investment and requirements can target vulnerabilities in specific sectors, such as productivity growth. The revival of investment is a key challenge corporates and households. Meanwhile, liquidity and structural going forward, even in emerging economies with a relatively solid tools can also increase the strength of the financial sector through outlook. A sustained recovery of private investment is necessary reserve requirements, funding ratios or capital surcharges to large to boost productivity growth, which is a long-term determinant banks. The activation and duration of these measures should be of income and living standards. calibrated to country specific circumstances and coordinated Monetary policy has played a key role in promoting macro- with the monetary policy stance. Moreover, understanding the economic stability in recent years, as emerging economies coped complementarities of these measures with other macroeconomic with domestic turbulences and external headwinds, including policies and capital controls constitute a major area for future high financial volatility and the collapse in commodity prices. In research, especially in emerging economies where financial mar- the short to medium-term outlook, however, the role of monetary kets are developing rapidly.

4 July 2017 References Alfaro, Laura, Asis, Gonzalo, Chari, Anusha and Ugo Panizza (2017). “Lessons Hahm, Joon-Ho, Mishkin, Frederic S., Shin, Hyun Song and Kwanho Shin Unlearnt? Corporate Debt in Emerging Markets”, NBER Working Paper (2012). “Macroprudential Policies in Open Emerging Economies”, 23407, May. NBER Working Paper No. 17780, January. Ahmed Shaghil and Andrei Zlate (2014). “Capital flows to Hanson, Samuel G., Kashyap, Anil K. and Jeremy C. Stein (2011). “A economies: A brave new world?”, Journal of International Money Macroprudential Approach to ”, Journal of and Finance, Vol. 48 (PB), pp. 221-248. Economic Perspectives, Vol. 25, No. 1, pp. 3-28. Brandão-Marques, Luis, Gelos, Gaston, Ichiue, Hibiki and Hiroko Oura (2015). Institute of International Finance (2017). “Capital Flows to Emerging Markets “Changes in the Global Investor Base and the Stability of Portfolio Eye of the Trumpstorm”, February 8. Flows to Emerging Markets”, IMF Working Paper, WP/15/277, April. Pitterle, Ingo, Haufler, Fabio and Pingfan Hong (2015). “Assessing emerging Bruno, Valentina and Hyun Song Shin (2015). “Global dollar credit and carry markets’ vulnerability to financial crisis”, Journal of Policy Modeling trades: A firm-level analysis”, BIS Working Papers No. 510, Bank for 37, pp. 484–500 International Settlements, Basel. Rey Hélène (2015). “Dilemma Not trilemma: The global financial Cycle and Chui, Michael, Kuruc, Emese and Philip Turner (2016). “A new dimension the Monetary Policy Independence”, NBER Working Paper 21162, May. to currency mismatches in the emerging markets: nonfinancial United Nations (2017). World Economic Situation and Prospects 2017. companies”, BIS Working Papers No 550, March. Sales No. E17. II.C.2. Eichengreen, Barry and Poonam Gupta (2016). “Managing Sudden Stops”, United Nations Conference on (UNCTAD) (2016). Policy Research Working Paper 7639, , April. Trade and Development Report, Sales No. E.16.II.D.5. Ghosh, Atish R., Ostry, Jonathan D. and Mahvash S. Qureshi (2017), “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?”, IMF Working Paper WP/17/69, March.

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