INVESTORS’ expectations for interest-rate hikes in the United States next year have grown rapidly in recent weeks as inflation in the world’s biggest economy keeps surging.
Most traders are currently pricing in between two and three interest-rate increases of 25 basis points (bps) each by the United States Federal Reserve (Fed) for the second half of 2022.
But if the Fed turns out to be more hawkish than expected, it could cast problems for emerging-market (EM) economies, of which Malaysia is a part.
As Nomura Global Research puts it, a major surprise to the financial markets could trigger a capital flight, and thus huge currency depreciation in some EM economies.
According to the financial services group, the Fed’s dogmatic forward guidance leaves the US central bank – almost by design – behind the curve if it is wrong about transitory inflation.
“On some monetary policy rules, the Fed may need to quickly raise rates by as much as 300-400 bps to catch up and avoid a wage-price spiral,” Nomura says.
“This would be a major surprise to markets, and may be the trigger for investors to reprice risk, resulting in capital flight and sharp currency depreciation in the more vulnerable EM economies,” it notes.
A sharp currency depreciation may have amplifier effects by adding to inflation and increasing the cost of foreign currency debt repayment, Nomura says in its report titled “The Covid-19 Endgame”, adding that a more hawkish Fed at a time when China is in an economic slump is a poor combination for EM.
Unprecedented easing
Last week, the Fed indicated it would complete tapering its bond-buying programme by mid-2022; thereafter it would begin to gradually raise interest rates.
The US interest rates have been hovering between 0% and 0.25% since March 15, 2020.
This is part of the massive stimulus measures unleashed in the US at the onset of the Covid-19 pandemic to contain the economic fallout.
Other governments and major central banks have similarly implemented sizeable stimulus measures to mitigate the economic damage from the global health crisis.
According to Nomura, the unprecedented scale of policy easing by the major central banks is the core reason behind the lack of EM currency crises during Covid-19, and it has masked new EM risks.
EM currency crises have probably just been delayed, the group argues, noting that it expects more frequent EM crises in the coming years and greater investor discrimination.
“If we define an exchange rate crisis as a depreciation of the local currency of more than 10% against US dollar on a month-on-month, three-month moving average basis, there were 10 EM currency blow-ups during the 1997/98 Asian crisis and another 10 during the 2007/08 global financial crisis, but remarkably none so far during the 2020/21 pandemic,” Nomura notes.
“This has led some to argue that EM economies have become more resilient, citing more flexible exchange rates, current account surpluses (or smaller deficits), larger foreign-exchange reserves and less hot money inflows in recent years.
“These are positive factors, but in our view, it is the unprecedented scale of policy easing by the major central banks that is the core reason behind the lack of EM currency crises, and it has masked new EM vulnerabilities,” it explains.
Besides the risk of a more hawkish Fed, Nomura says, other factors that could result in more frequent EM crises in the years ahead include middle-income trap; negative real rates; twin-deficit risk; and crypto challenges.
Middle-income trap
Even before the pandemic, EM economies were already struggling with slowing trend growth and rising debt ratios. Nomura points out Covid-19 has only amplified these negative elements.
“The crisis is likely to have long-lasting negative impacts, as advanced economies accelerate automation and rely less on global value chains, putting at risk the EM development growth model of exporting cheap labour,” it says.
Lost education from Covid-19 has also been a major setback for EM in up-skilling its workforce.
“Against this backdrop, it is more important than ever for EM to invest in infrastructure, education and research and development to escape the middle-income trap, yet fiscal finances are already strained by the pandemic, especially in low-income developing countries,” Nomura says.
“There is a higher risk that more EM economies will remain stuck in the middle-income trap with below-potential growth than would have been the case without the pandemic,” it adds.
With inflation rising, real interest rates have turned negative for most economies.
And many EM economies are still looking at deeply negative real rates, although some have started raising interest rates.
Nomura notes this leave many EM economies exposed to a sudden repricing of risk in markets should investors reassess the full extent of EM vulnerabilities related to chronically weak growth, high inflation, large budget deficits and high public debt.
“The pandemic has resulted in an abnormally large excess of private saving over investment in EM, but as economies reopen and the dark clouds of uncertainty start to lift, households are likely to run down precautionary savings and firms step up new investments, causing the saving-investment surplus to decrease,” it says.
Yet the large fiscal deficits are unlikely to decrease much in countries run by populist governments that, amid rising income inequality, have struggled to maintain popularity during the pandemic and will likely opt for continued expansionary fiscal policies, Nomura points out.
“If the private saving-investment surplus shrinks, the still-large fiscal deficits will ‘leak’ into current account deficits.
“If supply bottlenecks ease and commodity prices slump, it would be doubly bad for EM commodity exporters,” it explains.
The larger the portfolio capital inflows, the greater the scope for abrupt outflows when bad times arrive, as seen for many EM economies, including Malaysia, during the 2013 Taper Tantrum incident.
Weak inflows
It appears the risk of hot money outflows is low for now, as portfolio inflows have not been strong in recent years, Nomura says.
However, it notes, while portfolio inflow data are timely, they provide an incomplete picture, one that understates the potential for large hot money outflows.
“A more encompassing measure is portfolio liabilities – the accumulation of all past portfolio inflows plus any changes in market value – which have swelled in many EMs, driven by asset price revaluations and a decade of quantitative easing in developed-market economies driving the hunt for yield in EM,” Nomura argues. It adds the official reserve assets in some EM are not sufficient to cover total portfolio liabilities.
Despite the various risks and uncertainties, Nomura acknowledges there will be some EM economies that will be fairly resilient.
There are 10, however, that will be more vulnerable, and these include Brazil, Colombia, Chile, Peru, Hungary, Romania, Turkey, South Africa, Indonesia and the Philippines.