On December 16, 2015 the Federal Reserve Open Market Committee will decide on whether to raise the short term nominal interest rate. What effect will this announcement have on global investors? Will it affect emerging market debt flows? Are hard currency debt flows more sensitive to this announcement than local currency debt flows? Are some emerging market debt investors and some regions more sensitive to this announcement than others?
Volatility in foreign investor debt flows have caused financial crises in emerging markets during the 1990s and 2000s when they had fixed exchange rates and issued hard currency debt in dollars. When U.S. interest rates rose, countries like Mexico and Indonesia had to break their pegs, making their dollar debt unsustainable and thus leading to defaults. As a result, the International Monetary Fund and the U.S. Department of the Treasury encouraged emerging economies to develop domestic financial markets and issue local currency debt. Local currency debt now accounts for the majority of emerging market debt issuances. Since the global financial crisis, interest rates in the United States have been zero, and foreign capital flows have moved to hard currency, local currency, and mixed currency debt in emerging markets.
My paper “U.S. Monetary Expectations and Emerging Market Debt Flows” examines the effect of 54 Federal Reserve announcements on emerging market debt flows since the Global Financial Crisis (GFC). I do this analysis in two parts. First, I take all the Federal Reserve announcements since the GFC and categorize them as easing (unexpected), tightening (unexpected), easing (expected), and tightening (expected) using two year expectations of the short term nominal interest derived from federal fund futures and a shadow rate term structure model of expectations. For the purpose of categorizing announcements during this time period, I find that the shadow rate term structure model is a better measure than federal fund futures.
Second, I use the announcements categorized by the shadow rate term structure model to examine the effect on debt flows by currency (all currencies, hard currency, local currency, mixed currency), investor (all investors, active investors, passive investors), and regions (all, Asia excluding Japan, Latin America, EMEA, and Global EM). I use an event study approach to examine daily debt flows seven days before and after Federal Reserve announcements. I find that the 1) tightening (unexpected) announcements lead to outflows by emerging market debt investors, 2) local currency debt flows are less sensitive to announcements than hard currency debt flows, 3) passive investors are more responsive than active investors, and 4) in comparison to other regions, debt flows to Latin America are the most sensitive to Federal Reserve announcements.
What will happen to emerging market debt flows on December 16? It appears that most market participants expect the Federal Reserve to raise rates at the next meeting. However, what is not certain is where markets expect the short term interest rate to be in two years. This measure could change at the December meeting. According to my paper, if the change in expectations is tightening (unexpected) then this will have a significant effect on emerging market debt flows. It will be interesting to see how things play out.
Eric Fischer. “U.S. Monetary Expectations and Emerging Market Debt Flows” 2015.
Aizenman, Joshua and Mahir Binici, Michael M. Hutchison. “The Transmission of Federal Reserve Tapering News to Emerging Financial Markets” NBER Working Paper 19980, 2014.
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Eichengreen, Barry and Ricardo Hausmann. “Exchange Rates and Financial Fragility” Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming, 1999.
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Miyajima, Ken and M.S. Mohanty, Tracy Chan. “Emerging Market Local Bonds: Diversification and Stability” BIS Working Paper 391, 2012.
Puy, Damien. “Mutual funds flows and the geography of contagion.” Journal of International Money and finance Vol 60, 73-93, 2016.
Tett, Gillian. Emerging markets repent of ‘original sin’. April 18, 2014. Financial Times.
This post written by Eric Fischer.