Don’t Blame the Fed for the Emerging-Markets Meltdown

(Bloomberg Opinion) -- There’s no shortage of explanations for the growing carnage in emerging markets, including trade wars, current-account imbalances and flat commodity prices. 

But some commentators blame the Federal Reserve’s rate hikes for fueling the capital flight from the world’s riskier economies, and drawing investors chasing yield to the U.S.

The meltdown may be far from over, though the Fed probably won’t have much to do with it. The historical record shows that the relationship between emerging-market economies and U.S. monetary policy has never been a straightforward matter of cause and effect. It’s far more complicated.

Mexico in the 1980s is the textbook case of the Fed kicking an emerging economy over a cliff. Between 1979 and 1981, the central bank raised rates from 10.25 percent to 20 percent. Mexico had plenty of short-term dollar liabilities that couldn’t be rolled over because of the soaring U.S. rates, triggering a crisis.

What’s often forgotten is that factors other than the Fed, such as declining oil prices that hit Mexico hard, played a significant role. But even if Fed Chair Paul Volcker contributed to the crisis, this episode was an anomaly. Annual net capital flows to emerging markets actually increased after Volcker initiated his rate-raising campaign — and they continued increasing until late 1981.

Only then did capital flows begin a slow decline that lasted the remainder of the decade. But this trend did not coincide with further tightening from the Fed because the central bank had begun reducing rates. Simply put, this earlier era provides little evidence in support of the idea that Fed policy drives capital to emerging economies when interest rates are low and draws it out when rates are high.

The ensuing years present a similarly complicated picture. Beginning around 1987, private inflows of capital to emerging markets turned positive, increasing at a steady pace for more than eight years. This happened as the Fed both increased rates and then cut them. It’s hard to see an obvious correlation. 

More recent history is equally ambiguous. The global financial crisis that hit in 2008 prompted an unprecedented response from the Fed, as it slashed rates to near zero and instituted quantitative easing. In the popular imagination, these unorthodox policies drove huge amounts of capital to emerging markets in search of higher yields.

But that’s not what happened. Before 2008, the Fed had gradually hiked rates, eventually hitting a high of 5.25 percent in 2006. Yet during that same period, the flow of private capital into emerging economies actually increased. One study observed that capital flows to emerging economies “peaked before the loosening of advanced economy monetary policies” instituted in the wake of the crash.

The flows did plummet after the crash, but the Fed had no role. They rose again, peaked in 2010, and then began falling, well before the U.S. central bank took its first steps toward raising rates.

But if the Fed isn’t to blame, what does cause capital to flow out of emerging markets? A recent statistical analysis that evaluated a number of possible culprits concluded that the fluctuation in capital flows to emerging-market economies is largely driven by two factors: commodity prices and the so-called “growth differential.”

High commodity prices are good for emerging markets, attracting capital. But when prices decline, investors withdraw money and put it elsewhere. The same holds for the “growth differential,” the gap between growth rates in advanced versus emerging markets. When the gap narrows, emerging markets lose their appeal, and capital flows out. These forces account for two-thirds of the changes in capital flows. And they’re likely driving much of the recent shift out of emerging markets.

Yet none of this means the Fed has minimal power over emerging markets? Although the aggregate flow of capital in and out has been largely unaffected by central bank policy, individual countries may have problems that heighten their vulnerability when interest rates rise.

For example, a study that analyzed data from 1987 to 2014 found that the likelihood that any given emerging market would sustain a crisis — banking, currency or sovereign debt — jumped from 6.4 percent in years when the Fed wasn’t tightening versus 17.3 percent when it is raising interest rates.

Even if that sounds dramatic, not all rate hikes are equal. It matters whether the Fed is keeping above or below the “natural rate of interest” — the interest rate that neither fuels economic growth nor undercuts it. According to this study, only when rate hikes are above the natural rate and unexpected does the likelihood of a crisis significantly increase.

But for now, the Fed’s rate increases have shadowed the natural rate. They’ve been modest and predictable, with the Fed offering plenty of forward guidance. Absent a sudden uptick in the inflation rate, the Fed is unlikely to shock the world with a surprise rate hike. In other words, the Fed isn’t doing much to significantly increase the risk of a crisis in any given country.

Which is not to say that there won’t be problems: emerging-market economies will continue to experience crises. But just remember: It’s not the Fed’s fault.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to Bloomberg Opinion.

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