US Rates, Policy Divergence, Keep Pressure on Emerging Markets


Tuesday, June 19, 2018 09:57 AM /Fitch Rating


US monetary tightening, divergent global monetary policies, and potential market volatility remain key challenges for emerging markets heading into 2H18, Fitch Ratings says. Recent pressure on EM currencies shows that markets are less forgiving of policy mistakes and inconsistencies, and EM policymakers' responses can have growth implications. 

Central bank meetings last week highlight the divergence of monetary policy. The Fed firmed its language on normalisation and is tightening policy through balance-sheet adjustments and rate rises, while the ECB remains more accommodative. Although the ECB will wind down quantitative easing into end-2018, this implies a slower start to policy rate normalisation. 

We now expect one rather than two ECB rate rises in 2019, while our forecast for a total of four Fed increases in 2018 and three next year is unchanged (see 'Global Economic Outlook - June 2018'). The BoJ affirmed its accommodative stance, with a cap on 10-year bond yields at around zero, in contrast to the Fed and ECB's gradual approaches to withdraw stimulus, although in practice BoJ purchases have slowed since its shift to yield-curve control from a target for the volume of asset purchases in 2016.

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The ECB's pre-commitment that policy rates will not change "at least through the summer of next year" appears designed to avoid a 2013-style 'taper tantrum'. But the different pace of monetary normalisation in the US and eurozone and divergence in underlying growth and inflation dynamics puts upside pressure on the US dollar. Along with rising US bond yields, this is leading to tightening global financial conditions and is making bond and currency markets and capital flows more volatile. 

Recent pressures on EM currencies likely reflect a combination of idiosyncratic risks and the shifting global liquidity backdrop. EM vulnerabilities vary and no EM sovereign ratings will be affected by an increase in the Fed Funds rate alone. But knock-on effects as international capital flows are redirected could pressure sovereigns that rely heavily on portfolio debt flows to finance current account deficits, raise the cost of refinancing external debt, or prompt pro-cyclical monetary tightening. 

Fitch cross-sector analysis published in May highlighted Argentina (B/Stable), Turkey (BB+/Stable), and Ukraine (B-/Stable) as being among the most exposed of the larger EMs (see 'From QE to QT: Emerging Market Cross-Sector Risks'). All three have large external funding needs, while banks in Ukraine and Turkey have significant foreign-currency lending. Our analysis also highlights pockets of risk in some higher-rated countries. 

Argentina and Turkey remain at the forefront of the EM FX sell-off, and in both cases, the responses highlight the policy challenges and trade-offs that this presents. Argentina's large IMF programme mitigates sovereign financing risks, but may test the government's capacity to accelerate fiscal consolidation and improve the credibility of monetary and exchange-rate policies. The likely impacts of peso depreciation and monetary and fiscal tightening have caused Fitch to cut its 2018 growth forecast to 1.3% from 2.6%. 

In Turkey, rate rises totalling 500bp since late April and an announced simplification of the interest-rate framework may help reduce immediate risks to macroeconomic and financial stability. But higher domestic and external financing costs and a weaker currency will dent growth, although this will be felt more keenly in 2019 with the withdrawal of election-related stimulus. We have reduced our 2019 growth forecast to 3.6% from 4.7% in our latest Global Economic Outlook. 

Other sovereigns have been proactive in their responses to EM currency weakness. For example, central banks in Indonesia (BBB/Stable), the Philippines (BBB/Stable), and India (BBB-/Stable) all raised rates in May, somewhat earlier than we had forecast. The growth impact is far less dramatic - we have shaved 0.2pp off both our 2018 and 2019 growth forecasts for Indonesia, but have increased our India forecast for FY2018-2019 slightly, to 7.4% following better-than-expected 1Q18 GDP. Nevertheless, higher financing costs from monetary tightening and higher market premiums and a rising oil price limit the upside to Indian growth.

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