How Do U.S. Interest Rate Hikes Affect Emerging Markets?

While all eyes were on the American economy Thursday ahead of the Federal Reserve’s much-anticipated interest rate decision, emerging markets were also anxious, fearful over the effects of a surging dollar and capital outflows. And some emerging countries have enough troubles as it is.

“Panic and turmoil” face such economies when the Fed raises interest rates, said World Bank Chief Economist Kaushik Basu this month in a Financial Times interview. “It will cause some immediate turbulence.”

But emerging markets dodged a bullet -- the Fed chose to leave rates unchanged Thursday, citing in its statement "global economic and financial developments."

The year had already been a painful one for many emerging economies. The slowdown in China has raised fears over flagging demand from the world’s second-largest economy. Meanwhile, tanking commodity prices are weighing heavily on countries from Malaysia to Brazil.

The MSCI Index of emerging markets was down nearly 15 percent over the past three months, which were marked by increasing volatility.

Two factors make a rate hike in the U.S. particularly unwelcome to countries like South Africa and Turkey, whose currencies buckled in anticipation of Thursday’s much-awaited decision.

First, higher interest rates strengthen the dollar against other global currencies and attract capital away from emerging markets, which saw about $4.5 trillion in gross inflows between 2009 and 2013. If that tide begins to ebb, governments will struggle to fund their liabilities and businesses could starve for investment.

Second is the gargantuan pile of credit denominated in dollars that weighs on government and corporate accounts the world over. Ultra-low interest rates have led borrowers to take trillions of dollars in debt tied to the dollar. When interest rates rise, many of those debts could become unsustainable.

That glut of dollar-denominated credit has even led some to ponder a global debt crisis spurred by ripple effects of a rate hike. Credit market volatility in advance of the Fed’s decision was not “isolated tremors,” Bank for International Settlements official Claudio Borio said recently, “but the release of pressure that has gradually accumulated over the years along major fault lines.”

But as New York University economist Nouriel Roubini has argued, many emerging market countries’ own domestic woes far outweigh any impact felt from the U.S. Federal Reserve. “Some will suffer more than others,” Roubini wrote in an op-ed, “but, with a few exceptions lacking systemic importance, widespread distress and crises need not occur.”

In fact, it was the uncertainty over a rate hike more than the hike itself that bothered some emerging nations' central bankers in the leadup to the Fed’s decision. Officials in Peru, Indonesia and Mexico all indicated that when it comes to a Fed rate hike, the sooner the better.

In part, that’s because raising interest rates sends a signal to the rest of the world that the U.S. economy is in good spirits. And greater demand from the U.S. would be a welcome tonic for countries smarting from China’s recent stumbles.