Emerging market concerns over aggressive monetary tightening rise

Schroders' David Rees explains the risks to emerging markets from the U.S. Federal Reserve's expected quantitative tightening. Emerging market economies and assets tended to be sensitive to fluctuations in dollar liquidity.

News that the Fed is on track to tighten monetary policy quite aggressively and shrink its balance sheet is equally worrisome for emerging market investors, according to David Rees, senior emerging markets economist at Schroders. The economic consequences of quantitative tightening appear to be manageable, in his view, but it is likely to affect financial market developments.

"In recent weeks, expectations have increased that the Fed will tighten monetary policy", according to the emerging markets expert. This was due to the restrictive tone in the minutes of the December meeting of the Federal Open Market Committee. Voting members would have talked not only about the possibility of raising interest rates sooner than expected, but also about shrinking the Fed balance sheet. The Fed could let short-dated bonds expire or become active as a seller.

Threat of slowdown in economic growth

The prospect of quantitative tightening is likely to have attracted some attention from emerging market investors, according to Rees. After all, "emerging market economies and assets tend to be sensitive to fluctuations in dollar liquidity.", and the last time the Fed reduced its balance sheet in 2018, markets were hit hard, he said.

Economically, the tightening of global dollar liquidity could hurt emerging markets most significantly through the balance of payments, he said. If quantitative tightening reduces dollar liquidity, it could threaten emerging markets that rely on foreign capital inflows to finance their balance of payments deficits. Which would then lead to a reduction in imports and ultimately a slowdown in economic growth.

Keeping an eye on yields on U.S. Treasuries

In fact, there is very little direct correlation between the performance of the Fed's balance sheet and capital flows to emerging markets, he said. Capital flows and the Fed balance sheet – except for the period of the global financial crisis – have often moved in opposite directions, Rees observed (see chart).

This probably reflects the fact that the Fed typically expands its balance sheet in times of crisis and is very cautious about changing course, he said.

Fed balance sheet

Any impact of quantitative tightening on emerging market economic activity is more likely to come through the U.S. government bond market, expert says.

While the Fed balance sheet has little relationship with capital flows to emerging markets, there is a clear link to changes in Treasury yields, he. "If quantitative tightening leads to significantly higher Treasury yields, flows to emerging markets and growth could suffer", Rees said.

Capital flows

Risk to asset prices in emerging markets

A year ago, Rees argued that emerging markets were less vulnerable to a rise in Treasury yields than in the past because inflows into emerging markets were systemically weak and external positions were in relatively good shape. There is a possibility that higher energy costs will lead to a deterioration of the external positions of those emerging economies that are dependent on the import of raw materials. However, apart from a handful of small emerging markets such as Romania, Egypt and Turkey, solid external positions would still provide a buffer against tighter financing conditions.

Balance of payments positions

While the macroeconomic consequences in emerging markets are not particularly worrisome at this point, the same is not necessarily true of asset prices. Because "the last time the Fed shrank its balance sheet in 2018, emerging market financial markets faltered.".

But the relationship between changes in the Fed's balance sheet and emerging markets is not very clear-cut. Although quantitative tightening coincides with a sell-off in emerging market assets, there is no close relationship between the two.

Emerging market investors should pay closer attention to global central bank liquidity

A broader measure of global central bank liquidity, on the other hand, is far better correlated with asset price movements in emerging markets, he said. Here, the global central bank balance sheet is understood to be the sum of the balance sheets of the Fed, the European Central Bank, the Bank of England, the Japanese central bank, the Chinese central bank, the Swiss National Bank and the Swedish Riksbank in U.S. dollars.

Regardless, according to Rees, all signs point to global central bank liquidity starting to shrink in 2023. While not the only driver of market performance, he said, it is likely to be a headwind for emerging market assets. "U.S. dollar-denominated bonds have historically reacted most strongly to quantitative tightening, but equities and currencies will also be vulnerable", concludes the Schroders expert.