For some time, tighter monetary policy by the U.S. Federal Reserve was perceived as the largest external economic threat to emerging countries, especially by those countries themselves.
Judging from discussions with officials from those nations, as well as private-sector participants, this may no longer be the case. Another concern -- the anti-globalization and anti-trade rhetoric of the U.S. presidential election -- has pushed worries about the Fed to the No. 2 slot, for both good and bad reasons.
As the world’s most powerful central bank, the Fed has enormous influence over cross-border capital flows, exchange rates, interest rates and investors’ appetite for risk taking. It impacts the interactions between financial conditions and exchange-rate and interest-rate movements, particularly in emerging economies that lack the tradition of strong institutions, a solid dedicated investor base and sufficient policy responsiveness. For countries with certain rigidities, such as large currency and debt mismatches and/or unrealistic foreign-exchange pegs, the disruptions can be severe.
After an unusual, prolonged period of ultra-loose monetary policy, the Fed has been on a careful path of gradual normalization of its monetary stance. The first indication of this policy transition -- Fed Chairman Ben Bernanke's signal of the possibility of a “tapering” on May 22, 2013 -- caused financial market turmoil. Capital flew out of the emerging world, contributing to disorderly currency depreciation and higher credit risk spreads. Although some measure of financial calm followed as the Fed evolved its communication and skillfully carried out an exceptionally cautious change of policy -- what I call the “loosest policy tightening” in its history, and involving the phasing out of asset purchases and an initial rate hike last December, the first in almost 10 years -- full normalization is far from complete.
In the last two weeks, Fed officials have signaled a higher likelihood of a summer rate increase, which means the threat presented by tighter U.S. monetary conditions to emerging economies is real and imminent. Yet its disruptive impact has lessened for three main reasons:
First, the Fed has credibly shown, through both words and actions, that international conditions are part of its decision-making more than ever before during non-crisis periods. Although the main reason for this shift is U.S.-oriented – that is, the threat of unfavorable spillovers on a domestic economy that has yet to achieve escape velocity and economic takeoff -- the result for the rest of the world is a Fed monetary policy that is more responsive to their economic conditions.
Second, policy makers in emerging economies have already had a few experiences of externally induced disruptions, and some have gotten better at navigating such events. Simultaneously, an important segment of the weakest and least-informed holders of emerging-market assets appears to have been shaken out. As a result, Fed-induced contagion is becoming less traumatic and more differentiated.
Third, there is little probability that Fed policy tightening will be accompanied by similar moves by other systemically influential central banks such as the Bank of Japan, the European Central Bank and the People’s Bank of China. If anything, all three are likely to be loosening their policy stance through liquidity injections in the months to come.
So even though the likelihood of further Fed tightening is high, the emerging world can take comfort that the U.S. central bank isn’t in auto-pilot mode, and is inclined instead to be unusually attentive to international developments, and that part of the adjustment in financial conditions has already taken place.
The concern about the Fed's impact, however, has been overtaken by another worry: Many in the emerging world have been stunned by the sudden increase in U.S. political rhetoric against trade, immigration and foreign direct investment. This is evident not only in the unusually noisy primary contest that precedes the November presidential election – in which the leading candidates have leaned toward or wholeheartedly embraced anti-globalization positions -- but also in the declining prospects that the trade agreements negotiated by the Obama administration will be finalized.