Impacts of US Monetary Policy Transition on Emerging Economies

QUESTIONS & ANSWERS 1
QUESTIONS AND ANSWERS
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Question 1
Introduction
Following the current recovery observed in both the global community and international
trade, emerging economies have registered some degree of improvement as compared to their
state before 2016. In support of this opinion, the 2017 report by the World Economic Situation
and Prospects indicated that emerging economies would experience moderate pick-up growth in
2017 and 2018 to reverse the downward trend experienced since 2010 (Rugman and Verbeke,

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2017). The economic growth has however remained below the average between rendering
emerging economies susceptible to both domestic and external shocks amidst the rising
uncertainties in the global policy environment and structural changes.
For instance, the Federal Reserve (Fed) of the United States has embarked on
normalizing its monetary policy as the country’s economy expands and labor market indicators
improve. Recently, Fed raised its key policy rates for the fourth time since 2015 and announced
its plans to gradually reduce its balance sheet size (Lake, 2018). While this approach will
strengthen its growth prospects and benefit some few world economies by improving aggregate
demand and raising interest rates, significant challenges will be posed to most of the world
economies which are mainly emerging economies. This paper analyses the impacts of the Fed’s
ongoing monetary policy transition on both the US economy as well as the rest of the world
economies.
Against the backdrop of the excessive global liquidity, the emerging economies are
expected to experience a surge in their capital inflow just the same way they experienced after
the global financial crisis. The inflow will be driven by the widening interest rates and growth
prospects differentials between them and the already established economies (Schuknecht, 2017).
The stagnant economic growth coupled with a sharp decline in the prices of commodities and
weak global trade in some emerging economies has significantly reduced their capital inflow in
recent years.
Although the US’ monetary normalization is expected to take a gradual path, inflationary
pressures will likely force Fed to increase interest rates at faster rates than expected and that will,
in turn, increase the risks of global financial and aversion. An abrupt surge of capital outflows

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from the world emerging economies is therefore expected to adversely affect both the equity
currencies and prices while reducing monetary policy space and raising the costs of borrowing
externally (Brack, 2017).
The tight monetary policy in the United States is also expected to have large spillovers on
the world’s emerging economies because of several other reasons. First of all, the rapid increase
in corporate debt after the global economic crisis of 2007-2008 has been a potential vulnerability
for most of the emerging economies. Also, geared by cheap funds and outstanding corporate
debts from non-financial organizations, corporate debt has increased from 61% of GDP to 102%
of the GDP between 2008 and 2016 (Tietenberg and Lewis, 2016). In particular, China alone has
seen her corporate debt rise sharply at a rate of more than 160% of the GDP closely followed by
Turkey, Chile, and Russian. The high corporate debt has not only constrained capital expenditure
but has also led to high risks as far as financial stability is concerned.
There is also a risk of abrupt tightening of the global financing conditions which will
force corporates to deleverage sharply as Fed raises the rates. As a result, debt service-to-income
ratio in private and non-financial sectors will increase in several economies because of the
decline in commodity revenues and weak export earnings. The low earnings will, in turn, affect
corporate profitability commodity-sectors hence leading to high debt service-to-income ratios
(Mastel, 2016).
The fragility of company balance sheets in the emerging economies will also be
exacerbated by the increasing dollar-denominated debts particularly in the offshore borrowing
carried out by the large emerging markets through subsidiaries abroad in countries like Brazil,
Turkey, China, and Russian Federation (Wallace, 2017). Notably, corporate debt in form of

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foreign currency will rise not only in the tradable sector of the economy but also in other non-
tradable sectors like the construction sector and real estate sectors where currency mismatch is
common. Also, considering the fact that the increasing interest rates may end up strengthening
the dollar, the risk of currency mismatch will increase debt servicing costs further.
In addition, “financialization” in the corporate sector to utilize trade opportunities will
build up financial vulnerabilities and rapidly increase credit in some states. Moreover, a large
part of the corporate debt will neither be channeled to viable investments nor high-productivity
sectors implying that there will be resource misallocation which will not only impact the
medium-term growth of the other world economies but also raise concerns over debt
sustainability (Beghin and Bureau, 2017).
The spillover impacts of the US’s tight monetary policies on the emerging economies is
expected to be amplified by the value of the dollar, the evolution of commodity prices and the
implementation of several other protectionist policies. Renewed commodity price weaknesses
will weigh on the terms of trade in exporting countries which will further contribute to
undermining creditworthiness and profitability in the corporate sector. And although commodity
prices will recover modestly from the low records, they will still remain below the expected
levels (Moyer and Josling, 2017). This will leave economies which are commodity-dependent
like Africa, Western Asia and Latin America with subdued growth, weak fiscal positions, and
fragile export earnings (Bayne, 2017, p.97). Meanwhile, the significant dollar appreciation may
as well as exacerbate difficulties when rolling over corporate debts in dollar-denominated
economies. According to the current statistics as released by the Federal Reserve Economic
Data, the US Dollar Index has been appreciating by approximately 20% since early 2014 and the
trend is expected to significantly increase the risks of corporate default and distress. Noticeably,