5 Ways a Fed Rate Hike Could Impact Emerging Markets

A Look at How the Federal Reserve Could Impact Investors

Federal Reserve Chairman Janet Yellen could have a big impact on emerging markets if she chooses to raise interest rates. Chip Somodevilla / Getty Images

The Federal Reserve has a tremendous impact on the U.S. stock market through its various monetary policy tools. But few investors realize its impact on the global financial markets through the valuation of the U.S. dollar. Since the dollar is a global reserve currency, changes in its valuation can have a tremendous impact on everything from foreign reserves at global central banks to corporate balance sheets containing dollar-denominated debt.

Here are five ways the Federal Reserve could impact emerging markets and what it means for investors in these markets.

1. Rise in Corporate Defaults

Many emerging market companies have benefited from low U.S. interest rates by borrowing in dollars and repaying debt with stronger local currencies. According to the Bank for International Settlements, there was about $1.1 trillion in dollar-denominated bonds issued by non-bank emerging market companies outstanding in Q3 2015 compared to just $509 billion at the end of 2008 – a significant increase during a period of low-interest rates.

Higher U.S. interest rates could make these debts more difficult to service. For example, Brazil’s currency fell to record lows against the dollar in 2015, which made it difficult for companies generating revenue to repay debt in U.S. dollars. These increased costs could lead to a wave of corporate defaults that could hurt the emerging market corporate bond market and ETFs like the iShares Emerging Markets Corporate Bond ETF (CEMB).

2. Lower Foreign Investment

Many emerging markets have seen significant foreign direct investment since the 2008 global financial crisis. With U.S. and European bond yields at record lows, investors flocked into higher yielding emerging market stocks and bonds to bolster their portfolios yields. These emerging market economies became reliant on this steady increase in foreign investment to drive economic growth and witnessed significant expansion over the past several years.

Higher interest rates could draw more investors back to the U.S. and spark an outflow of capital from emerging markets. This lower foreign investment could put the brakes on economic growth in many economies that rely on such investments. The so-called Fragile Five economies have been deemed the most vulnerable to this kind of downturn – Turkey, Brazil, India, South Africa, and Indonesia – and warrant particularly close attention.

3. Falling Currency Values

Many emerging markets have experienced a significant appreciation in their currencies. For example, the USD/ZAR currency pair rose from less than 10.00 in 2012 to a high of 17.00 in January 2016 as the U.S. dollar depreciated against the South African rand. South Africa was able to leverage this increase in its currency valuation to borrow more U.S. dollars to finance various growth initiatives and increase government spending.

The bad news is that the rand – and other emerging market currencies – have already started to fall amid expectations that the Federal Reserve will increase interest rates. These dynamics could make it more difficult for countries like South Africa to repay their dollar-denominated debts – the same issue faced by many private companies.

The only solution may be to let its currency fall in value, which could help exports but hurt investment.

4. Sovereign Rating Pressure

Many emerging market governments took advantage of low U.S. interest rates to borrow in U.S. dollars. For example, South Africa borrowed heavily when the dollar was low and used the proceeds to help finance its growth and budgetary needs. These dynamics helped many emerging markets outperform over the past several years, but the strategy could come back to haunt them when the dollar rises in value and these debts become more expensive.

South Africa has one of the largest external financing requirements in the world, which means that its currency reserves are smaller than the amount needed to service its foreign debt and pay for imports. These dynamics could lead to a lower credit rating and higher borrowing cost moving forward if the U.S. dollar appreciates in value.

A higher borrowing cost could make it more difficult to obtain the funding needed to invest in growth.

5. Lower Dollar Commodities

Many emerging market economies are reliant on commodities to drive their economic growth. For instance, Brazil and Russia depend heavily on crude oil and natural gas prices, while Chile and Peru rely extensively on copper and other hard commodities. Commodity prices have risen over the past several years since they are priced in U.S. dollars and more dollars were required to purchase the same ‘value’ of commodities, putting a higher dollar value on them.

If the dollar rises in value, these dynamics could reverse and commodities could see further downward pressure. This is bad news for emerging markets because most commodities are sold in U.S. dollars, which means that they will generate less revenue in real terms. Less revenue could translate to slower growth and lower valuations for commodity-focused companies operating in these key emerging market economies.

The Bottom Line

The Federal Reserve has a significant impact on domestic markets, but many investors fail to realize it's equally important impact on foreign markets. Emerging markets are particularly vulnerable to these changes in interest rates and the dollar’s valuation relative to local currencies. The upshot is that the Federal Reserve has acknowledged this and does incorporate global concerns into its monetary policy decisions – but that doesn’t mean it won’t have an impact.