August 17, 2015    4 minute read

Is the World Ready for a Fed Rate Hike?

   August 17, 2015    4 minute read

Is the World Ready for a Fed Rate Hike?

Financial market news over the last few months, has been dominated by when the Federal Reserve will finally raise interest rates. Amidst all the speculation, the market agrees that it will come in September or December.

Looking purely at the US picture, it seems the US economy is at least on the right trajectory in terms of dealing with a higher interest rate. As the Fed said in its latest statement, labour market conditions are improving and given that the decline in energy and import prices are temporary, it expects inflation to gradually rise towards 2 percent in the medium term.

However, there is an old economic saying that goes “if the US sneezes, the world catches a cold”. In other words, although not explicitly part of the Fed’s mandate, as the US remains the world’s largest economy, it is worth considering how a US rate hike might affect the rest of the world.

Firstly, it appears that concerns mostly lie with developing economies. In the IMF’s July World Economic Outlook, while advanced economies are still expected to grow at a faster rate than 2014, developing economies are forecast to slowdown for 2015. Looking further into the IMF’s report, three of the four medium-term risks highlighted are very much relevant in respect of a Fed rate hike.

It seems appropriate that the first medium-term risk we should consider is a “sharper than expected slowdown in China” in the week the renminbi was devalued. This action was no doubt taken to boost Chinese exports, after it was reported China’s exports slumped by 8.3 percent in July compared to a year earlier. With the Shanghai Composite falling since June and disappointing Chinese economic data elsewhere suggesting China’s economy is weakening, a US rate hike may be welcome in China. This would weaken the renminbi even further against the dollar, thus helping Chinese exports (as capital moves towards countries with higher interest rates).

Nonetheless, this would of course, not help countries that rely on exporting to China. Even without a weakening yuan, Chinese imports have been weak, having fallen 8.1 percent in July on a year earlier. Therefore, coupling a weakening yuan alongside a Fed rate hike could be toxic in terms of the medium-term risk of

“Lower commodity prices undermining growth in low-income countries”.

Lower commodity prices have no doubt been influenced by the easing of China’s commodity boom. At the extreme end, this has caused countries like Venezuela (where crude oil forms 96 percent of export revenues) facing shortages of basic goods. As most commodities are priced in dollars, a strengthened dollar (via a rate hike), typically depresses commodity prices because it makes these commodities more expensive for holders of other currencies. Therefore, a US rate hike may hurt already squeezed, commodity exporting countries even further.

Lastly, the IMF raised the medium-term risk of “further US dollar appreciation creating balance sheet challenges for dollar debtors” i.e. foreign borrowers who have borrowed in dollars will find their debt servicing costs increasing as the dollar becomes more expensive in terms of their local currency. As Andy Mukerjee reported for Reuters in December 2014, “the prospect of a stronger greenback is now a $10 trillion headache for the global economy.” A looming rate hike may indeed turn this into a migraine.

This is for instance, apparent in Turkey. Turkey’s net foreign liabilities are $430bn. However, the issue is far worse when considering that over the next 12 months, Turkish banks have to repay $95bn in foreign debt and their ratio of foreign liabilities to reserves is 12, making a US rate hike an unwelcome prospect.

The concerns of a US rate hike for the rest of the world (particularly, developing economies) is unlikely to deter the Fed from its much anticipated course of action before the turn of the year, but just highlights why financial markets have been closely following this impending policy decision.

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