What US interest rate normalisation means for the EBRD region

By Idil Bilgic-Alpaslan, Bojan Markovic, Michel Nies Alexander Plekhanov, Peter Tabak, Emir Zildzovic

What US interest rate normalisation means for the EBRD region

US Federal Reserve’s decision likely to increase market volatility and cost of funding and may have limited effect on growth

On 16 December 2015, the US Federal Reserve raised its federal funds rate by 0.25 per cent to the target range of between 0.25 to 0.5 per cent. The long-expected hike will likely increase market volatility and the cost of funding in EBRD countries.

 This may affect their growth prospects, although the impact is likely to be limited, given that most EBRD countries were not among the major beneficiaries of post-crisis capital inflows. Within this limited effect, EBRD countries will be affected to a varying degree:

  • Countries that are perceived by the markets as having weaker fundamentals or as being exposed to geopolitical uncertainties (for example Turkey, Russia and Ukraine) may be affected more;
  • Countries with larger short-term and portfolio liabilities and those with a larger share of dollar-denominated liabilities (for example  Jordan, Ukraine, and Turkey) may be affected more;
  • Countries with close links to the eurozone (Central Eastern and South Eastern Europe) will continue to benefit from accommodating monetary policy by the European Central Bank (ECB), translating into lower interest rates and better trade prospects.

On balance, among EBRD countries more exposed to market volatility and rising cost of funding is likely to be Turkey which benefited most from post-crisis capital inflows, and where reliance on dollar capital inflows and the share of dollar-denominated debt are higher than in other EBRD countries, although the impact may be limited as some of it has already been priced in by markets.

There may be temporary implications for commodities exporters such as Russia as oil and other commodity prices may fall on the stronger dollar. This is clearly a second-order effect and prices will remain dominated by more fundamental forces.

Countries in Eastern Europe, the Caucasus and Central Asia will be affected indirectly through their exposure to Russia and may see their cost of funding rise slightly, particularly those with a higher share of unhedged dollar-denominated debt.

The Southern and Eastern Mediterranean countries may face higher costs of funding, given that most of their investors are dollar-based, but the overall impact is likely to be limited.

Faced with somewhat lower portfolio inflows, EBRD countries may benefit from alternative sources of funding, such as FDI, private equity, public-private partnerships, and more efficient use of domestic sources of funding through building deeper local capital markets.

Background

The abundant capital inflows  in the past several years provided emerging markets with cheap and longer-maturity funding, although most countries in the EBRD region did not benefit as much as other global regions. Global capital inflows to emerging markets more than doubled from an average of US$ 500 billion a year from 2000 to 2007 to an average of US$ 1.2 trillion during 2009 to 2014 (Chart 1), as investors facing record-low interest rates in advanced economies searched for yields elsewhere.

This gave most emerging market sovereigns, especially in emerging Asia and Latin America, access to cheaper funds at longer maturities, lifting growth and providing additional buffers to soften the impact of the global crisis. Countries that benefited most from capital inflows were large emerging markets, such as India, Indonesia, Brazil, Turkey, Russia and South Africa.

 Nevertheless, most EBRD countries, with the exception of Turkey, have not benefited as much as other global emerging markets (Chart 2), mostly as a consequence of sharply falling net capital flows (including through bank deleveraging in the Central Eastern and South Eastern European region) from advanced European economies that experienced protracted recession.

Capital flows to emerging markets, including the EBRD region, have started to dry up since mid-2013 amid the tapering of the Fed’s quantitative easing and in expectation of the ‘normalisation’ of US interest rates. Net capital inflows in emerging markets fell from a peak of US$ 1.3 trillion in 2013 to an estimated US$ 550 billion in 2015. Large emerging markets, which were the major beneficiaries of the abundance of global liquidity, have been the most affected by these reduced capital inflows.

The lower inflows have further affected the EBRD region too. As capital inflows fell, country risk premia in EBRD countries, as reflected by the Emerging Market Bond Index (EMBI), rose by an average of 50 basis points over the past two years (Chart 3), and EBRD currencies weakened against the dollar by 27 per cent on average in the same period (Chart 4), although other domestic and regional factors also affected these moves. Currency weakening has caused large losses for dollar-based investors, who invested in local currency equity and debt of emerging markets.

Chart 1 Capital flows to emerging markets             Chart 2 Non-FDI net capital inflows

Source:Institutte of International Finance              Source: IMF and authors' calculation

The US Fed rate hike and its implications

This week’s rise in the Fed funds rate by 25 basis points to between 0.25 and 0.5 per cent, has further affected financial markets over the past week. Despite being a long expected move, the hike had not been fully priced in by the markets, resulting in elevated market volatility over the past week, as reflected in the VIX index, a measure of global stock market volatility (Chart 5), although there was not much volatility after the announcement itself. EBRD currencies, particularly those of larger countries, came under renewed pressure recently, and equity markets also took a hit (Chart 6).

While the rise in the US interest rate indicates better growth expectations in the US, in the short term, it is likely to increase market volatility and the cost of funding in EBRD countries. This may affect their growth prospects, although the impact is likely to be limited, given that most EBRD countries were not among the major beneficiaries of capital inflows in the first instance. The Fed’s decision indicates that the US economy is getting in better shape, which should boost export demand in the long term for products from emerging markets.

Nevertheless, for most EBRD countries the upside potential is very small, given that exports to the US make up around 2.4 per cent of their total exports (Chart 7). In the short term, most EBRD countries are likely to suffer from somewhat lower capital inflows and rising cost of funding, as well as higher interest payments for unhedged dollar-denominated debt, which may weaken growth.

 Exchange rates may come under further pressure in some countries. But this impact is likely to be limited, given that most countries in the EBRD region did not benefit from large post-crisis capital inflows in the first place. In addition, a stronger dollar tends to soften oil and commodity prices, benefiting oil-importers, although the impact, if it happens, would probably be mild and short-term, as the hike has been expected for some time.

Chart 3: Country risk premia                                  Chart 4: Exchange rate against the dollar

Source: JP Morgan                                               Source: Macrobond

Chart 5: VIX index                                              Chart 6: Equity markets in selected countries

Source: Macrobond                                                 Source: Macrobond            

The EBRD region will be affected by the US rate rise in a differentiated way for three main reasons: (i) policy and fundamentals; (ii) source and character of capital inflows; and (iii) links to the Eurozone where the monetary stance remains loose.  Among EBRD countries, those that markets perceive as having weaker fundamentals and that are exposed to ongoing regional geopolitical uncertainties, such as Turkey, Russia, and Ukraine, may be affected more.

Countries with larger short-term loans or portfolio inflows as well as those with a larger share of dollar-based investors (for example Jordan, Ukraine, and Turkey – Charts 8 and 9) may be more exposed to the US rate hike than those where foreign direct investments (FDI) or non-dollar inflows in general dominate.

EBRD countries with tighter links to the eurozone currently benefit from the recently expanded and extended quantitative easing programme of the ECB through better trade prospects and by ‘importing’ lower interest rates with access to cheaper funding from Eurozone parents for banks operating in these countries. Nevertheless, servicing their dollar-denominated debt (Chart 10), where such debt is not hedged, will present an increased burden for these countries, too.

Chart 7: Share of US in total exports                   Chart 8: Short-term loans and portfolio liabilities

Source: UN Comtrade                                    Source: IMF Balance of Payments Statistics

Among EBRD countries more exposed to market volatility and rising cost of funding is likely to be Turkey, since it benefited most from post-crisis capital inflows, although some of the adjustment has already been priced into the markets. In Turkey the combination of: a reliance on dollar capital inflows; a still large (albeit falling) current account deficit; a higher share of dollar-denominated debt; the open foreign currency positions of Turkish corporates; and regional political uncertainty, have already put the lira and country risk premium under pressure over the past year.

The current account deficit stood at 5.1 per cent of rolling GDP as of October 2015, while external financing needs amounted to an estimated US$ 200 billion in 2015. The open currency position of the corporate sector, albeit partly hedged, is around US$ 180 billion (Chart 11). That said, any further impact on the lira may be moderate, since to date it has already weakened by around 27 per cent against the dollar in 2015. Public finances and the banking sector remain stable, with public debt of around 36 per cent of rolling GDP, a non-performing loan ratio of 3 per cent, and banks’ capital adequacy ratio of nearly 15 per cent as of October 2015.

The rising cost of funding and market volatility in the aftermath of the Fed rate lift-off is likely to have only a limited negative impact on GDP in 2016, and this may be partly offset by weak oil prices, given that Turkey is a major oil importer.

Chart 9: Dollar-based portfolio liabilities           Chart 10: Corporate external debt in US$

*Source (Chart 9): IMF Coordinated Portfolio Investment Survey, EBRD calculations.

**Source (Chart 10): National authorities via CEIC.

Chart 11: Net corporate FX exposure in Turkey     Chart 12: Net oil imports

Source: Central Bank of Turkey.                         Source: IMF World Economic Outlook.

Russia is somewhat exposed to the US rate hike through the indirect impact of oil prices. Due to its current account surplus, low external sovereign debt, deleveraging corporate sector, and mostly non-interest-sensitive FDI flows, Russia is less directly exposed than Turkey to US interest rates. Nevertheless, insofar as a stronger dollar further softens commodity prices in the short term, the rouble and economic growth may weaken. In the longer term, however, stronger US growth will support global growth, and reduce the downside risk for commodities and their prices.

In Ukraine the present IMF programme reduces vulnerabilities to some extent. At the same time, growth prospects remain fragile and options for market refinancing of large external debt with relatively short maturities will depend on global risk appetite, as well as domestic policy factors.

In the short-term, countries in Central and South-Eastern Europe (CSEE) are likely to be less exposed to the US rate hike due to their closer ties with the Eurozone. While high portfolio debt stocks in CSEE countries renders them vulnerable to rising international funding cost, a large share of Eurozone-based investors, surpluses or ongoing adjustment in current accounts, as well as in some cases existing IMF programmes, will help to offset the detrimental impact of the US rate increase on their growth.

The ECB quantitative easing seems to have already contributed to improved financial conditions. Eurozone lending surveys and credit growth turned markedly more positive in September. At the same time, bank data from the CESEE Deleveraging and Credit Monitor, published by the Vienna Initiative showed a marginal uptick in exposures for the first time in four years in the CSEE economies. Falling commodity prices in the short term will support growth in the region.

Countries in Eastern Europe and Caucasus (EEC), the Central Asia (CA) and the Southern and Eastern Mediterranean (SEMED) regions may be affected indirectly by the Fed rate hike. EEC and CA economies, in particular, are exposed to Russia through trade, investment, remittances and financial sector linkages. These countries may see a rising cost of funding following the Fed rate increase, particularly those with a higher share of dollar-denominated debt. Commodity exporters in the CA region (Chart 12), similarly to Russia, may be adversely affected by lower commodity prices. SEMED economies may face a higher cost of funding, given that most of their investors (including those from the Gulf) are dollar-based. These economies are also in a weaker competitive position vis-à-vis economies where currencies weaken in response to the normalisation of US monetary policy. But the effect is likely to be limited as these countries were not among the major beneficiaries of capital inflows in the first instance.

Lower portfolio inflows will require EBRD countries to find alternative sources of funding in order to maintain and improve growth in the future. A revival of FDI would be the most desirable substitute for deteriorating portfolio inflows, but this would depend on economic developments in the main investor countries as well as improvements in the business environment and revival of stalled structural reforms in recipient countries.

Deepening domestic capital markets would allow a more efficient use of available domestic sources of funding.  However, this would require stimulating domestic savings and developing a long-term domestic investor base, such as pension or insurance funds.

To counter reduced access to cheap sovereign funding in the future, countries would also be well advised to develop alternative ways to fund large-scale long-term projects, such as infrastructure or energy. These may include attracting private capital into public-private partnership (PPP) structures, provided that strong institutional frameworks and project management capacity are in place to ensure the success of PPPs.

With an overleveraged corporate sector in many parts of the EBRD region and a rising cost of debt due to tighter US monetary policy, corporates may have to rely more on private equity funding in the future.

Attracting alternative sources of funding and thus ensuring sustainable growth in EBRD countries will depend on their ability to revive structural reforms and improve institutional capacity. As discussed in the EBRD Transition Report 2013, entitled ‘Stuck in Transition?’, structural reforms have stalled across the EBRD region since the mid-2000s.

Reviving structural reforms and further improving institutional capacity is vital for growth to return to pre-crisis levels. The Report estimated that in the absence of structural reforms, potential growth in the EBRD region would be around 0.7 percentage points a year lower than in the reform scenario.

The necessity of structural reforms is becoming even more pertinent now that sources of cheap and abundant funding will be in decline.