Emerging Markets Get a ‘Fed-ache’

May 10, 2022


Like most emerging markets, Egypt will always target a net inflow of dollars from exports, portfolio investors, and foreign direct investment (FDI). Accordingly, developing countries have always relied on the United States to keep interest rates low. “Markets spent most of 2021 trading on assurances from … the U.S. Federal Reserve [that] monetary policy would continue to be in uber stimulus mode,” wrote Mohamed El-Erian, president of Queen’s College, in a Financial Times blog in January.

However, the Federal Reserve (Fed) plans to reverse that strategy to ease U.S. inflation, which hit a 40-year high in November. “Economic developments and changes in the outlook warrant this evolution of monetary policy, which will continue to provide appropriate support for the economy,” Fed Chairman Jerome Powell said in December.

The change could be problematic for Egypt, which doesn’t peg its currency to the dollar. With tighter monetary policy, “we will see an appreciation in the dollar’s value against other currencies. That will impact banks and cause inflation elsewhere in the world,” said Hisham Ezz El-Arab, Commercial International Bank’s former chairman, to Al Arabiya in December.

That could hamper economic recoveries in Egypt and other developing countries for the next few years. The key to bypassing fallout from the Fed’s tightening policy rests in large part with the Central Bank, which might face tough decisions, at least until inflation in the U.S. cools. “Smart and sensitive policies to maintain economic safety will be essential in 2022,” said Ezz El-Arab.

The greenback’s impact

As the global reserve currency, the dollar’s value affects almost all economic aspects in developing countries that need greenbacks to fuel their GDP and fund imports. “It affects emerging market economies more forcefully than advanced economies,” wrote Ozge Akinci, senior economist at the Federal Reserve Bank of New York’s Research and Statistics Group, in a May blog on Liberty Street Economics.

For example, foreign investors prefer to put their dollars in the United States and other developed, wealthy nations. To attract investors to riskier emerging markets, their governments offer potentially higher profits by issuing higher interest rate treasury debt and raising interbank overnight interest rates.

That premium margin narrows if the dollar appreciates or interest rates increase in safe investment destinations. As a result, foreign investors would seek those safe markets, “sucking out high-interest savings” from emerging markets, said Ezz El-Arab. That results in “higher domestic lending spreads, making credit more expensive … and triggering declines in investment, ultimately slowing economic activity,” noted Akinci.

The dollar’s appreciation against national currencies would also weigh on governments that rely on dollar-denominated treasury debt to finance imports. The value of those foreign currency loans and interest payments in the local currency would increase overnight.

Meanwhile, foreign investors with assets in emerging markets would see the dollar value of their investments decline. That could lead to an exodus, particularly those who primarily invest in government debt or stocks.

That cascade of events would only weaken foreign investors’ demand for national currencies, devaluing them further. That could cripple Egypt, which imports most of its primary and luxury needs, and other import-dependent emerging economies.

Two-prong policy

“Central banks around the world have had loose policies to save their respective economies from collapse due to lockdowns,” said Ezz El Arab. “They had no choice unless they wanted mass loan defaults as businesses go out of business.”

During December’s Fed meeting, Powell said the plan until 2024 is to gradually relax the Fed’s role in stimulating the economy.

Additionally, the Fed is under pressure, with the annual U.S. inflation rate at 6.8% in November, up from 1.4% in January 2021. “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation,” read a Fed statement in December.

The first step is to halt the buyback of treasury debt, known as quantitative easing (QE), starting in late 2021, with the Fed reducing its buyback budget by $15 billion every month. It reached $120 billion in November, dropping to $90 billion in December and $60 billion in January.

However, there is some uncertainty about when QE will stop. El-Erian of Queen’s College noted, “While the [Fed] policy will remain accommodative for a … while the world’s most powerful central bank is set to completely stop its asset purchases by the end of the first quarter” of 2022.

Thomas Costerg, a senior U.S. economist at Pictet Wealth Management, expects easing to end by June. That should open the door for five interest rate hikes through mid-2023, he wrote on the company’s website in December.

Beth Bovino, the U.S. chief economist at S&P Global, expects the Fed to stretch it to September, but “the longer people sit on the sidelines, job market pressure on wages could force the Fed to move faster.”

Interest rate hikes, which ultimately affect the dollar’s value, will not happen until QE ends, Bovino said in November. In December, Jeff Cox, a finance editor at CNBC, said the Fed couldn’t do both simultaneously, “as the two moves work at cross purposes.”

Cox added that the Fed will likely raise interest rates three times this year, twice in 2023 and two times in 2024. Costerg of Pictet Wealth Management believes the Fed will continue to raise rates until inflation drops to 2%.


Stephan Danninger, chief of the International Monetary Fund (IMF) ‘s Macro Policies Division, noted in a January blog that since mid-2021, investors have seen the rise of inflation in the United States as temporary, resulting from “unsteady economic recovery and a slow unraveling of supply bottlenecks.”

However, that “sentiment has shifted,” Danninger said, adding that inflation has yet to cool off and governments’ reactions to the Omicron variant have raised fears.

Emerging markets are the first to feel the impact of the Fed’s expected policies. “These changes have made the outlook for emerging markets more uncertain,” wrote Danninger. “In recent months, emerging markets with high public and private debt, foreign exchange exposures and lower current-account balances [already have seen] larger movements of their currencies relative to the U.S. dollar.”

At the World Economic Forum’s Davos Agenda, Chinese President Xi Jinping warned, “If major economies slam on the brakes or make major U-turns in their monetary policies, there will be serious negative spillovers. They would present challenges to global and economic financial stability, and developing countries would bear the brunt.”

Central banks in several emerging markets are already taking pre-emptive actions. For example, Brazil raised interest rates from 2% in February 2021 to 9.25% by January 2022, while Russia raised rates from 4.25% to 8.5% during the same time. Danninger said their dollar borrowing costs were still low, yet their priorities were stabilizing foreign funding and limiting the likelihood of increasing inflation rates.

Egypt’s CBE, on the other hand, has maintained interest rates at 8.25% since December 2020, the lowest it’s been since 2014. Beltone Financial’s December report explained that the current rate ensures loans are not too expensive for companies, keeps inflation between 5% and 6% according to CAPMAS, and is attractive for foreign treasury and stock investors. Others follow the same strategy, including Morocco, Taiwan and Malaysia.

Policy keyholder

Danninger stressed that the fate of monetary policies and foreign currency inflows in emerging markets would be dictated by the success of the Fed’s policies to lower inflation. “Should policy rates rise and inflation moderate as expected, history shows that the effects for emerging markets are likely benign if tightening is gradual, well telegraphed and in response to a strengthening recovery.” he wrote.

Confirming that scenario, economists expect a boom in GDP growth fueled by the approval of a $1 trillion infrastructure bill that should attract massive FDI to America. “We estimate that $1 trillion in infrastructure investment will add $1.4 trillion to the economy,” said Bovino.

Accordingly, emerging markets’ central banks would have to contend only with possible currency depreciation, “but foreign demand would offset the impact from rising financing costs,” said Danninger. That is because the Fed would likely drop interest to historical averages once inflation has reached its 2% historical average. “We think the Fed will not want to move interest rates above its 2% inflation target — in essence, inflation-adjusted Fed rates will stay native,” wrote Costerg of Pictet Wealth Management.

On the flip side, emerging market central banks might have to contend with a less benign fallout if the Fed’s policy shift doesn’t yield the desired results. “Broad-based U.S. wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation,” noted Danninger.

As a result, the Fed might accelerate rate increases. “That could rattle financial markets and tighten financial conditions globally,” said Danninger, and that would mean slower U.S. demand and trade activity that may lead to dollar outflows from emerging markets and sustained decline in the value of the foreign currencies.

Danninger stressed the importance of allowing emerging market currencies to devalue against the dollar and rising interest rates, even if they put the brakes on GDP growth. “If faced with disorderly conditions in foreign exchange markets, central banks with sufficient reserves can intervene, provided this intervention does not substitute for warranted macroeconomic adjustment.”

Way forward

Egypt’s GDP growth has proved resilient despite the pandemic and lower-than-planned vaccination rates. It was the only country in the MENA region to grow in 2020, at 3.5%. And last year, it was the fourth-fastest, at 2.8%, according to data aggregator Statistica.

The government in January said it projected GDP growth to reach 5.7% in both 2022 and 2023. However, experts are wary of such projections, given the Fed’s U-turn on longstanding monetary policies.

Ezz El-Arab stressed that central banks in emerging markets would have to be careful to balance policies in light of inflation, economic activity, and the reaction of other markets. “Central banks must put forth several plans for several scenarios, given how the United States and, subsequently, other nations, particularly China … behave in 2022.”

Danninger noted such pressure goes beyond making interest rate decisions at the right moment. “Clear and consistent communication of policy plans can enhance the public’s understanding of the need to pursue price stability,” he noted. Those plans should look at the next three to five years. “Such a strategy could include announcing a comprehensive plan to gradually increase tax revenues, improve spending efficiency or implement structural fiscal reforms, such as pension and subsidy overhauls.”

Additionally, Egypt and emerging economies should reduce spending and revenue mismatches and hedge their exposures, said Danninger. According to the CBE’s latest data, Egypt’s external debt increased by 11.6% during the fiscal year 2020/2021, compared with a year earlier. As a result, external debt-to-GDP crept up to 34.2%, up from 34.1% in the reporting period.

Danninger also said continuing support for businesses that propped up several emerging market economies during the pandemic’s early days could prove risky in an environment where U.S. interest rates are high and rising. “It should be calibrated carefully to the outlook and to preserve financial stability,” he said.

However, that might not prove enough in the face of a continuous Fed tightening if rising inflation persists. “Some [emerging] countries may need to rely on the global financial safety net,” Danninger said, such as financing agreements with the IMF and other international institutions. “Given the risk that [COVID-19 poses, coinciding] with faster Fed tightening, emerging economies should prepare for potential bouts of economic turbulence.”