Will interest rate hikes restore confidence in emerging markets?

A wave of interest rate hikes is hitting  emerging markets right now.

It started with India, which raised its policy rate by 25 basis points to 8% early this week, and was followed by Turkey and South Africa. (100 basis points make one percentage point.)

Turkey lifted its key benchmark rate by a hefty 4.25 percentage points to 12% after an emergency midnight meeting on Tuesday, while South Africa raised rates by 50 basis points to 5.5%.

As global investors flee emerging economies, currencies are tumbling, forcing central banks to use one of their most traditional tools — the interest rate — to prop up these currencies.

So, who’s next in line to raise rates? Brazil, Indonesia and Thailand seem most likely to tighten monetary policy soon, according to a report by The Guardian newspaper.

Just to clarify, a country raises interest rates to make investments in the country more alluring because these investments will offer higher returns compared with other countries.

That, it is hoped, will prevent investors from selling a currency like the Turkish lira or Argentine peso, or assets invested in such currencies, and buying a safe-haven currency such as the US dollar, or dollar-denominated assets.

So, will the current wave of higher interest rates be enough to persuade global investors to stay invested in emerging market assets?

Unlikely. It’s the oldest trick in the central banker’s book — and investors know how it’s played. Turkey’s lira rose after its central bank shock-and-awe rate hike, but soon surrendered its gains. The South African rand has also  slipped after the central bank raised the interest rate. However, the Indian rupee is holding strong – for now.

Higher interest rates may temporarily calm jittery investors but the effect is unlikely to last, mainly because high rates will also choke economic growth, which makes investments in emerging market assets more unappealing.

Especially when growth in developed markets, such as the US, seems to be on an uptrend, there seems to be even less reason to justify putting too much money in trouble-prone markets.

And several emerging economies are facing a host of problems, ranging from political to social and economic, as this blog post of mine argues.

Interest rates have also been too loose too long in emerging markets (barring some exceptions), which have enjoyed the benefits of easy money from the US Federal Reserve’s quantitative easing (QE) programme.

As an Economist blog notes, “That broad point—that policy is too lax—is true across much of the emerging world. Until it raised rates from 5% to 5.5% on January 29, South Africa’s policy rate was below inflation. Indonesia is in the same boat, although its inflation jumped after a welcome cut in fuel subsidies.”

Now, with the Fed tapering QE gradually, investors will start becoming more discerning about where they put their money. Economies with too many troublesome warts are going to experience some bouts of sell-offs.

No, don’t blame the Fed for what’s happening.  It’s not the Fed’s fault. As I’ve highlighted before, the Fed’s taper just brought the problems simmering in emerging markets to the fore.

Given that most emerging nations have a lot of repair  work  to do on their economies, this bout of currency turmoil is unlikely to go away quickly.

[Image Credit] 

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