Emerging Markets Have Become More Resilient

For decades, the threat of raising US interest rates sent a shiver down the spine of investors with exposure to so called ‘emerging markets’. However, despite the most aggressive US rate hikes in four decades, emerging markets have come through largely unscathed.

Structural reforms have made developing countries more resilient and in the long run many could come to be perceived as less risky than some of their developed market counterparts.

The term 'emerging market' arose in the 1980s, serving as a more politically correct alternative to the former and rather more disparaging 'third world' label. Over time, the term has evolved to encompass a diverse range of countries from different geographical regions that are perceived as promising investment destinations albeit with higher risk compared to wealthier countries. Indeed, for many investors, the phrase 'emerging market' is synonymous with risk and the series of crises that rocked developing nations during the 1980s and 1990s helped cement this view.

Vulnerability to external shocks justified this perception, with rising US rates often triggering a chain reaction with devastating consequences for the poorest and most indebted countries. Countries inundated with capital inflows and hefty dollar-denominated debt may have enjoyed an initial economic boom, but as interest rates rise and the cost of servicing debt becomes more expensive, the tide goes out and doubts about the growth trajectories of these nations typically begins to worry investors, triggering capital flight.

Simultaneously, higher US interest rates incentivize the repatriation of capital to developed markets. This exodus weakens the local currency, exacerbating challenges associated with servicing dollar-denominated debt and increasing investor anxiety. Additionally, central bank interventions to stabilize emerging market currencies often deplete foreign exchange reserves, worsening these crises further.

This cycle has played out many times in recent decades. The Latin American debt crisis of the 1980s, catalysed by Paul Volcker's aggressive interest rate hikes, sent shockwaves through the region. Then again, when the Federal Funds Rate increased from 3% to 6% in less than a year in 1994, this resulted in a financial crisis in Mexico. The pattern continued with rates hikes in 1999-2000 sparking crises in Turkey and Argentina in addition to popping the dot.com bubble.

The 2008 global financial meltdown, however, signalled a turning point, as advanced economies seemed to have become just as dependant on low interest rates as emerging markets, and were equally devastated by the effects of the crisis. Furthermore, the increase in interest rates in the lead up to the crash could not be absorbed without extraordinary interventions like quantitative easing, which has led to an unprecedented increase in the debt levels of developed nations.

Structural Reforms Make EMs More Resilient

Emerging markets have become much more resilient than in previous decades. This is largely due to structural reforms and a reduced reliance on volatile foreign capital flows. Most of the countries devastated by the 1997 crisis in Asia are now running current-account surpluses, a notable departure from the deficits that characterized the pre-1997 era, while the composition of public debt has shifted, with a smaller proportion being denominated in foreign currencies, mitigating currency depreciation risks for countries who have borrowed heavily to fund growth.

Unlike in the previous eras, where nearly all debt was denominated in foreign currencies, now only around 60% of debt is issued in foreign currency and efforts by organizations like BRICS to further reduce foreign currency denominated debt have also contributed to this shift. The New Development Bank, founded by the BRICS, has the stated aim of denominating 30% of its loans in local currency by 2026 to further insulate borrowers from fluctuations in exchange rates. 

However, perhaps the most pivotal development has been the widespread adoption of inflation-targeting regimes by central banks in emerging markets. This shift reflects a greater emphasis on controlling inflation and adjusting interest rates accordingly. Price stability is now the primary objective of monetary policy, with most emerging markets abandoning currency pegs and opting for more flexible exchange rate regimes.

Contrasting this increased fiscal prudence among emerging market central banks, the Bank of England and the US Federal Reserve have both been forced to intervene in their respective bond markets to maintain financial stability. In 2022, the BOE bailed out the gilt market when pension funds struggled to absorb the shock of rising interest rates while the Fed was forced to create a facility to swop bonds for their face value in cash following the collapse of Silicon Valley Bank.   

This intervention by the Fed was not the first, after $800 billion of quantitative easing during the 2008 crash, which was followed by additional stimulus during the coronavirus pandemic. Today, the Fed’s balance sheet exceeds $7 trillion due to these extraordinary liquidity measures.

Nevertheless, as the Fed embarked on a series of eleven consecutive rate hikes starting in early 2022, it was emerging markets that received the financial media’s scrutiny. However, contrary to the historical pattern, the outcome was not as catastrophic as many predicted. Although there were isolated defaults in Sri Lanka, Ghana, and Argentina, the widespread breakdown typical of previous crises was notably absent despite the fastest tightening cycles in four decades.

Consider a country like India. Once deemed a member of the ‘fragile five’, India has enacted financial reforms that have led to a huge improvement in market sentiment, with the price of insuring against a default on Indian government debt via credit default swaps declining over 80% in the last ten years. Furthermore, during the recent tightening cycle, several emerging markets, including Brazil, Mexico, Chile, and South Africa, pre-emptively raised interest rates, where in the past these central banks would have been more likely to lag the Fed.

Through financial market reforms and more assertive central banking policies, formerly ‘third world’ countries have enhanced their resilience to external shocks. At the same time, advanced economies have resorted to unorthodox monetary policy interventions in the face of increased economic instability. Combined with efforts by the BRICS to increase the use of local currencies, this could further increase financial stability in developing countries and eventually help reverse the difference in risk perception between advanced economies and emerging markets.