Lift-off, finally.

Lift off finally

Commencing countdown, engines on, check ignition, and may God’s love be with you…

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KPMG in the UK

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As Janet Yellen prepares us for a lift-off in US Fed rate, albeit one with a more gradual path than your average spaceship, the option of not raising rates following the next FOMC meeting on 16th December seems to be off the table. With so much ink already poured in anticipation, and with many commentators arguing that the rise has already been well discounted by the markets, you’d be forgiven to think nothing more of it. But after nearly seven years at the effective lower bound, a first increase in the Fed rate may hold a special significance. 

 

For a start, markets are not always rational, and are likely to be more volatile around the time of the announcement than fundamentals would suggest, just as we saw recently in September when stock markets across the world reacted to a correction in the Shanghai stock market. But nevertheless, volatility is likely to prove largely short-lived. 

 

More sustained impacts could be experienced by emerging markets, in particular those naughty economies that took advantage of record low global interest rates to binge on foreign debt, and are now looking particularly vulnerable. Ever since the Taper Tantrum days of 2013, many emerging countries had their currencies weaken against the US dollar (see chart below). Consensus forecasts see the exchange rate of most of them stabilise around the current level, but is this realistic? 

 

This comes at an unfortunate time when growth prospects for many emerging economies are on the decline, as a result of lower commodity prices and problems emanating from poor domestic policies, heightening the chances of international investors withdrawing from those markets. The risk that a Fed rate rise would trigger large outflows of capital from emerging economies into dollar-denominated assets is therefore real, and will cause currencies and capital markets in those countries to weaken further.

 

Businesses in emerging markets are particularly vulnerable to further weakening of their local currencies. In its recent Financial Stability report1, the IMF estimated that the proportion of Latin American firms with positive foreign exchange exposure rose from 40% in 2001-07 to 60% in 2010- 14. The rise in EMEA was more muted, while Asian firms saw a decline over the same period but their proportion remains at over 50%.

 

Among non-Asian emerging economies, the largest rise in the proportion of firms with positive foreign exchange exposure since 2010 was in the mining sector, a sector suffering from the recent falls in commodity prices.

 

Many companies that borrowed cheaply in the good days, predominately in US dollar, generate most of their earnings in local currency, making them imprudently exposed to further rises in the dollar. Risks are not confined to the emerging markets, however, currencies in developed economies are also likely to be affected, although to a smaller extent.

 

One concern that could affect companies and economies globally is the possibility that the lift-off is premature. There are many arguments in favour of raising the Fed rate, but lower employment levels and persistently weak inflation may prove that the US economy is still not ready for a rise. A deterioration in the US economy as rates rise would leave the Fed with little if any ammunition to perk up the economy.

 

A weaker US economy will add significant drag to the already fragile growth experienced by many other developed economies, and put pressure on emerging markets’ exports earning through lower demand. This is perhaps the risk that could have the largest impact on the global economy as we approach a new era in monetary policy.

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