(Bloomberg) -- Emerging markets with the weakest financial metrics, especially those with high inflation, tend to be the worst affected by U.S. interest-rate shocks, according to a study by Federal Reserve Board economists.
“Both the bright and the dark side of foreign responses to U.S. interest rate increases” are highlighted by the discussion paper, wrote the authors, Matteo Iacoviello and Gaston Navarro. “On the dark side, these responses seem to be large, to the point that they suggest that foreign economies -- especially vulnerable, emerging economies -- may react to U.S. monetary shocks more so than the U.S. economy itself.”
The duo constructed a “vulnerability index” to measure how financial fragility might explain differing negative impacts across countries’ gross domestic products in the wake of Fed rate-hike shocks. Included in the index:
- Inflation, measured by consumer-price changes
- Current-account balance as a share of GDP
- Foreign-exchange reserves as a share of GDP
- External debt, net of reserves, as a share of GDP
“In emerging economies all four indicators -- inflation in particular -- have explanatory power in enhancing the response of GDP to a U.S. shock,” Iacoviello and Navarro wrote in the April 23 paper.
While the Fed economists didn’t address this year’s market volatility as the U.S. continues with its monetary tightening, the two worst-performing emerging market currencies in 2018 so far are Argentina’s peso and Turkey’s lira. Both countries have double-digit inflation rates.
Using data from 1965 to 2016, the study found a 1 percentage-point “policy-induced” rise in U.S. rates lowers emerging-nations’ GDP by about 0.8 percent, a little more than the 0.7 percent reduction seen in the U.S. For emerging nations with high vulnerability-index readings, the impact is more than double, the economists said.
“High inflation may indicate structural problems in a government’s finances, or could generate political instability which in turn acts as an amplifier of the effects of higher U.S. interest rates,” Iacoviello and Navarro wrote. “High inflation may also increase the sensitivity of a country’s borrowing costs to changing interest rates.”
And as for the “bright side” of the findings?
"Countries that succeed in keeping their financial house in order can weather foreign shocks relatively better than their vulnerable counterparts," the economists said.
©2018 Bloomberg L.P.