Impact of Interest Rates on Emerging Markets
Interest rates in advanced economies have increased at the fastest pace in 20 years, and that has made some emerging market economies especially vulnerable. Let’s look at why.
To start with, higher global interest rates increased borrowing costs and many emerging markets rely on external financing for public spending. So when interest rates go up, it becomes more expensive for countries to pay back their existing debt. It also becomes harder for countries to access new financing and could even increase the risk of default.
Rising interest rates also make emerging markets more vulnerable to capital outflows. Since high interest rates in advanced economies mean higher returns there, investors typically move capital away from emerging markets, and that often entails buying advanced economies’ currencies, which reduces demand for currencies in emerging markets, creating depreciation and ultimately inflation pressure.
Now, in the face of these pressures, how can emerging markets respond?
The standard short-term policy response is to increase domestic interest rates, to incentivize investors to keep their money in emerging markets. But this isn’t always optimal because it could lead to unnecessary economic contraction or even create financial stability risks, especially if the increase is rapid.
That’s why at the IMF, through our Integrated Policy Framework, we advise countries on how to use a set of tools rather than just interest rates, depending on each country’s economic characteristics and the type of external pressures it is facing. For example, in some emerging markets, foreign exchange markets are relatively shallow, so the exchange rate tends to be more sensitive to large transactions. If these countries experience sudden, large capital outflows due to the loss of investor appetite, they can sell foreign exchange domestically to offset the negative impact on the exchange rate. And when a crisis is imminent, restricting capital outflows can be an option, too.
These policies, however, cannot substitute for a promising and stable growth model and prudent fiscal policy. So, given the recent rise in interest rates all over the world, what has been the effect on emerging markets?
Countries with stronger growth prospects for inflation, larger reserves have weathered the rapid rise in global interest rates relatively well. And because markets don’t expect interest rates to rise much further, emerging economies are already becoming more attractive for international investors. At the end of the day, though, it will depend on actual monetary policy in advanced economies. And that’s why clear guidance from their central bank is key to avoiding financial disruption to emerging markets.