If the U.S. Federal Reserve fumbles its long-planned move toward higher interest rates, the sharpest words about Fed Chair Janet Yellen are likely to come from the Turks, Brazilians, Indians, and Chinese, who borrowed in the currency that the American central bank issues. In these once-soaring emerging markets, the U.S. dollar may be their problem.
Even modest increases in U.S. interest rates can redirect the flow of capital across national boundaries as investors seek higher returns in the largest economy in the world and boost the value of the dollar vis-a-vis other currencies. But that hasn’t happened for nearly 10 years as the Fed has kept interest rates low to fight the lingering effects of the Great Recession.
That long stretch of easy money allowed companies all over the world -- from Istanbul to Sao Paulo to Johannesburg -- to fill up on cheap, dollar-denominated credit. And since many of them still earn their profits in lira, reals or rand, they are perilously exposed to any rise in the value of the dollar, which would make paying their debts more and more expensive.
So, companies around the world are watching the Fed, wary of how its turn in policy could ripple across the globe if it ends up coming more quickly than anticipated, or if investors give in to panic.
“There will be shift, there’s no doubt about that, and if the Fed does its work gradually and slowly, people will adjust,” said Lubomir Mitov, the chief economist for central and eastern Europe at UniCredit, a large European bank. “But that’s just not a given since markets are so unpredictable.”
If you are on pins and needles awaiting the Fed, it’s likely you’re in one of the large emerging markets that have done so well over the last decade but where economic growth is now slowing. Stretched budgets mean governments don’t have much room to stimulate their economies with new spending, and political turmoil has unnerved investors. Major companies have borrowed dollars without any clear plan for paying them back.
Since the 2008 financial crisis, dollar credit to non-bank companies -- real estate, construction, utilities and many others -- has exploded from $6 trillion to $9 trillion, according to the Bank of International Settlements. The reason was simple: Fed monetary policy had driven down interest rates on U.S. government bonds, so investors with dollars to sock away put them into dollar-denominated securities issued by companies in fast-growing emerging markets that promised a better return.
The Fed is now making policy in a new era for emerging markets.
This month, Goldman Sachs brought down the curtain on the era that made emerging markets synonymous with explosive growth. Goldman invented the label BRICs -- Brazil, India, Russia and China -- in 2001, but this month dismantled a money-losing investment fund aimed at those previously red-hot markets, reflecting the new reality. The International Monetary Fund, in its latest economic outlook, downgraded growth prospects for emerging markets to 4.2 percent, down from nearly 5 percent in 2014.
It’s a far cry from the situation the Fed faced during previous episodes in which it raised interest rates.
From 2004 to 2006, the Fed notched up interest rates in the United States, but money rushed into the major emerging markets, whose economic growth created appealing enough returns to counteract trends elsewhere. Stocks prices in emerging markets shot up 65 percent, according to a recent study by the Organization for Economic Cooperation and Development.
Big emerging markets have home-grown problems these days.
In Brazil, for example, the slide in energy prices has dented earnings from oil exports at the same time its state-owned oil company, Petrobras, is facing a lengthy corruption investigation that has tarnished the administration of President Dilma Rousseff. Meanwhile, the Brazilian government isn’t in the position to stimulate the economy through new spending.
In China, authorities are trying to cool off a real estate boom without damaging the broader economy and ease the country’s heavy dependence on exports to fire growth. President Xi Jinping has said the country’s growth could sink to 6.5 percent, far off the rates it managed for much of the past 20 years.
“Emerging markets have their own problems these days that are entirely independent of U.S. monetary policy,” said Angel Ubide, a senior fellow at the Peterson Institute for International Economics.
Still, with the world connected by phone, email and financial markets, what the Fed does and says over the next few months will be important.
Turkey, said the economist Mitov, is in a “very precarious situation” because it relies so heavily on money coming into the country. Turks love their credit cards -- notable because emerging-market citizens tend to be savers -- so the country needs $4 billion-$5 billion per month flowing in to keep running.
And Turkish companies need to be able to swap those dollars for lira at reasonable rates, so they can service debts.
Turkey’s current account deficit -- essentially, the money it needs to borrow to hold the economy together -- summarizes the country’s predicament, and its reliance on fickle flows of capital.
That deficit runs at about 5 percent of gross domestic product, a high number for any developing country. Where economic opportunities abound, foreigners are often willing to finance a deficit like that through foreign direct investment in hard-to-move things like factories and industrial machinery. Only a fifth of Turkey’s deficit is financed that way. The rest relies on money that moves at the touch of a button.
“You can only have a deficit like that if somebody is willing to finance it,” Mitov said.
And then there are the politics of Turkey.
President Recep Tayyip Erdogan recently won re-election on the strength of vows to crush Kurdish militants, who renewed a long-simmering guerrilla conflict three years ago. Next door Turkey has to contend with the complicated, grisly war in Syria. And Erdogan’s government has also squeezed press freedom over the past year.
Financial markets have already started voting on Turkey’s prospects, and the results are not good. The Turkish lira has plummeted by nearly a quarter this year alone.
Power-generation conglomerates in Turkey answered the siren call of cheap, dollar denominated debt for the simple reason that Turk’s don’t save much domestically, so they needed to borrow abroad. Since Turkey generates much electricity with imported natural gas, investments in hydropower and solar energy promised a welcome relief from energy import bills, and a shot at fulfilling demand that rose 5.6 percent per year, according a study by the Caspian Strategy Institute, an Istanbul-based research institute.
So, six of the largest publicly listed power companies in Turkey now have about $850 million in exposure to dollar-based debt, according the paper’s author, Fatih Macit. This debt is more than a financial burden, he points out. It “reduces the level of investments” the companies are willing to make, slowing the transition from imported energy.
It can only get worse if the Fed decides it needs to hike rates at an unexpectedly fast clip, said Enestor Dos Santos is principal economist for Brazil and Latin America at BBVA Research. “The baseline scenario is not for the Fed to tighten quickly,” Dos Santos said. “If it comes more speedily than expected, we will see some more serious turbulence.”