US rate hike poses challenges for emerging economies – BIS

MANILA, Philippines - The prospects for higher US rates posed challenges for a number of emerging market economies (EMEs), including currency weakness, higher bond yields, and possible capital outflows.

•    According to the Bank for International Settlement (BIS) in its quarterly review, a slowdown is expected in international financial flows.

•    Cross-border banking contracted in the second quarter, for the first time since mid-2013. International debt securities issuance slowed in the third quarter, particularly for EMEs.

•    Currency movements may have affected banking flows, as the weakening of the euro coincided with increased euro-denominated borrowing outside the euro area.

The interplay between the shifting prospects for policy normalization in the United States, emerging market weaknesses and accommodation in other major advanced economies, drove market developments in the fourth quarter of 2015, the quarterly review said.

Markets stabilized in October following the August-September rout. Fears of a crisis centered on emerging markets faded as Chinese equity and currency markets – the rout’s epicenter – stabilized.

Policy interventions in EMEs and expectations for continuing monetary accommodation in advanced economies, supported sentiment. Asset markets rebounded strongly worldwide and volatilities fell.

“Sentiment changed following the Federal Open Market Committee’s October meeting and early November’s strong US labor market report. Both events raised the odds for a US interest rate hike this year,” the report said.

US bond yields rose and the dollar re-asserted its strength, reflecting market expectations that the gap between the US policy rate and those of other advanced economies would widen.

Although EME markets suffered a particularly sharp re-pricing, market reactions were short-lived. In the first five days following the US payroll data, equity, bond and foreign exchange markets seemed to replay the mid-2013 “taper tantrum.”

But in contrast to the earlier episode, markets across the different emerging market asset classes had largely recouped these losses by mid-November.

The market’s recovery might suggest that EMEs could ride out the prospect of US monetary tightening.

However, less favorable financial market conditions, combined with a weaker macroeconomic outlook and increased sensitivity to US rates, heighten the risk of negative spillovers to EMEs once US rates do start to rise.

Tighter financial conditions could also accentuate rising financial stability risks.