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US rate hike poses risk to emerging economies

Interest rates in the United States have been held close to zero since December 2008 as a way to stimulate economic growth by encouraging borrowing and consumption. It seemingly looks like this strategy has worked. Core inflation rose 1,3% year-on-year in October. However, it has been below the target of 2% over the past 42 months.

Nesbert Ruwo and Jotham Makarudze

The unemployment rate fell to 5%, the lowest level since April 2008, from 5,1% in September. The jobless rate is now at a level many Federal Reserve System— the central bank of the US (Fed) officials could see as consistent with full employment. The economy registered a 2,1% economic growth in the third quarter of this year. It is expected that the economy will grow by 2,5% in 2015 compared to 2,4% in 2014.

The Fed had set a precondition that it would be “appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its 2% objective over the medium term”. These conditions could have been met as the Fed is likely to conclude that the economy is strong enough to handle the first hike in interest rates in nearly a decade.

But this picture is not the same elsewhere. While the Eurozone clawed back out of deflation in October, with consumer prices registering a 0,1% growth against a target inflation rate of 2%, the zone is still experiencing anemic economic growth. Unemployment is still high at 10,8%, with Germany registering the bloc’s lowest rate at 4,5% and the highest unemployed Europeans being the Greeks at 25%. The zone’s economy grew by 0,3% in the third quarter, and this could reinforce expectations that the European Central Bank (ECB) will expand its current €1,1 trillion stimulus programme at its meeting this week. This could mean an extension of bond buying beyond September 2016, or increasing monthly bond purchases from the current amount of €60 billion.

South Africa has this year increased its repo rate twice by a total of 50 basis points (bps) but against a background of weak economic growth and high unemployment. Kenya held its rate steady at 11,5% in November after 300 bps increase in two meetings earlier this year. Ghana raised its rates for the fourth time this year by 100 bps to 26%. In Mozambique, the benchmark rate was raised by 50 bps to 8,25%. With inflation slowing down, Nigeria could have some room to ease its monetary policy this week, which could ease government borrowing costs in the wake of dropping oil revenues. Brazil held its rate steady at 14,25% but there is increasing pressure for a hike to tame inflation. China is in a monetary expansionary mode, and Russia pledged to cut rates in coming months to trim borrowing costs and prop-up its economy. India’s central bank has already cut interest rates four times this year and is expected to hold rates steady in this week’s meeting.

When US embarked on its quantitative easing programme, capital increasingly moved away from the US towards riskier emerging markets in search of higher yields, in typical carry-trades. But this is reversing as US gears for an interest rate hike cycle. It doesn’t seem like the expanded Eurozone’s stimulus programme could reverse the flight back to the dollar denominated assets and the weakening in emerging currencies like the South African rand, and the Brazilian real.

The world’s two biggest central banks will most likely move in opposing directions next month — the ECB is expected to move towards easing on Thursday, while the US is expected to move towards a tightening in the Federal Open Market Committee at the December 15-16 meeting. For most emerging economies that wanted to pre-empt the Fed move, they could be found in a conundrum on the backdrop of their weaker economic growth prospects in addition to weakening currencies.

The 2016 national budget statement notes that Zimbabwe’s interest rates are “consistent with rates of interests on the Euro-bonds raised by some of the regional countries”. As such, the Fed rate hike could mean a re-rating of local borrowing rates. This could come at a time when the economy is in a deflationary mode. The budget statement projects consumer prices coming down by 1,6% in 2016. Real GDP growth is projected at 2,7% up from this year’s estimated 1,5%. IMF projects that sub-Saharan economies will grow by an average of 4,3% in 2016.

The disconnected monetary policies, in addition to commodity price slump, and slowdown in China pose a risk to the global economic prospects. IMF warned that global growth is still fragile and “could be derailed if transitions are not successfully navigated” as the hiking cycle could elevate the downside risks. ECB’s Benoît Cœuré puts it that central banks’ responses should not only be tied to domestic economics alone but also to cross border markets and this calls for an understanding of what he calls “the international macroeconomic adjustment process”.

Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on media@opportunvest.co.za

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