Why rising interest rates are bad news for emerging markets

14 January by Ola Sholarin

CC - Flickr - Day Donaldson - Emerging markets aren’t in Janet Yellen’s economic club

All eyes are on the US Federal Reserve FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank : http://www.federalreserve.gov/
which is expected to raise interest rates for the first time in nearly a decade. Since the financial crisis in 2008, the US, along with the eurozone, UK and Japan have held their interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
close to zero and used quantitative easing to flood financial institutions with capital.

This two-pronged approach to reviving economic growth has led to a colossal amount of money being injected into the global financial system, offered at next to nothing. While the aim has been to revitalise the consumer spending needed to boost the economies of advanced economies, developing countries are poised to be the victims of these policies.

More than US$12 trillion has been injected into the global financial system since 2008 all in the name of stabilising the global economy. The injection of hot money at this pace and quantity is nothing more than a false economy, and could sooner rather than later trigger massive economic challenges in emerging economies.

Investors have been able to borrow significant sums for very little and direct the proceeds into high-yielding assets in developing countries. A fire hose of cash has poured into investments, financing infrastructure and other projects. But the massive surge in the supply of cheap credit has created unstable bubbles.

As the following graph shows, key emerging economies such as Ghana, Nigeria, Argentina, Brazil, Thailand and Vietnam have seen dramatic increases in their debt stock Debt stock The total amount of debt . And they are not alone. World Bank World Bank
WB
The World Bank was founded as part of the new international monetary system set up at Bretton Woods in 1944. Its capital is provided by member states’ contributions and loans on the international money markets. It financed public and private projects in Third World and East European countries.

It consists of several closely associated institutions, among which :

1. The International Bank for Reconstruction and Development (IBRD, 180 members in 1997), which provides loans in productive sectors such as farming or energy ;

2. The International Development Association (IDA, 159 members in 1997), which provides less advanced countries with long-term loans (35-40 years) at very low interest (1%) ;

3. The International Finance Corporation (IFC), which provides both loan and equity finance for business ventures in developing countries.

As Third World Debt gets worse, the World Bank (along with the IMF) tends to adopt a macro-economic perspective. For instance, it enforces adjustment policies that are intended to balance heavily indebted countries’ payments. The World Bank advises those countries that have to undergo the IMF’s therapy on such matters as how to reduce budget deficits, round up savings, enduce foreign investors to settle within their borders, or free prices and exchange rates.

http://worldbank.org
data shows they are among 80 emerging markets whose debt has increased significantly since the financial crisis.

A number of others such as Mongolia, Mauritius and Papua New Guinea saw their debt stock increase by close to 1,000% in the five years following the 2008 financial crisis. These are all low income economies and so their ability to absorb economic shocks is minimal. If (and when) foreign investment is pulled out, they will suffer.


Bubble bursting

If investment is withdrawn – as is likely when interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
rise – this will leave a gaping hole in the financial system of the recipient countries. Investment in everything from infrastructure to health, education and manufacturing in these countries would be left chronically underfunded, as a colossal amount of money would need to be channelled towards debt-servicing for many years to come.

Not only this, an increase in interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rates could trigger a massive capital outflow from developing countries to where the return on investments has suddenly increased. This is likely to cause a massive shortfall in market capitalisation and burble-busting in the developing countries affected.

To fill the sudden shortfall in capital, the developing countries affected could turn to public or private lenders for urgent financial assistance. But this will increase their debt burden even further.

Most of the debt stocks owed by these developing countries are denominated in foreign currencies, with approximately 80% in US dollars. As the US raises interest rates, the US dollar will strengthen, which will significantly heighten the debt-servicing cost for countries paying back their debts in that currency. Given the nature of their fragile economies, developing countries including Nigeria, Vietnam, Ethiopia and Ghana are most likely to be vulnerable and may have to resort to further borrowing and a fire sale of valuable assets in order to meet their debt obligations.

Exchange rate uncertainty could also trigger a series of credit events, which are capable of hurting the countries’ credit rating. This could lead to margin calls and a review of the existing terms and conditions of lending. And this will only exacerbate the debt burden of the countries concerned even further.

Even a small percentage increase in interest rates is likely to cause shock waves across developing countries. It is a challenging time for emerging markets right now, with commodities Commodities The goods exchanged on the commodities market, traditionally raw materials such as metals and fuels, and cereals. in a prolonged slump, and with both China and the eurozone (other key investors) facing economic slowdown.

With an interest rate hike marking the end of cheap credit, this will cause a gaping hole in developing economies’ capital markets. The outflow of capital from their markets will in turn cause their currencies to depreciate further, while the US dollar will strengthen as money flows in. This could lead to even more serious and prolonged debt-servicing problems.


Author

Ola Sholarin

Senior Lecturer, Quantitative and Financial Economics, University of Westminster


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