Post-U.S. Rate Hike Outlook: Emerging Market Economies Challenged by Strong Dollar

ITO Hiroyuki
Visiting Fellow, RIETI

The United States Federal Reserve Board (the FRB or “the Fed”) raised its policy rate by 0.25% on March 16, 2022. With that, the zero-interest rate policy, which had been in place since March 2020 in response to the Covid-19 pandemic, came to an end.

The latest monetary tightening is meant to contain the ongoing high inflation that marked the highest level in the last four decades. The U.S. economy has been on a solid recovery path since the spring of 2020, and the demand for goods and services has been strong. Especially once mass vaccination started rolling out in 2021, aggregate demand increased and economic recovery became more solid.

However, on the supply side, there has been a severe shortage of labor, causing delays in production and logistics. The supply chain is not functioning at full capacity, affecting the retail industry. Supply is not keeping up with strong demand in the service sector either, affecting healthcare, food services, and lodging. The situation became severe around the second half of 2021, causing inflation to reach the highest level since the early 1980s.

Furthermore, Russia's invasion of Ukraine in February 2022 led the prices of crude oil, natural gas, wheat, and other commodities to soar since both countries are major exporters of these natural resources and commodities. This situation has negatively affected the global economy.

The Russian economy has been hit by a wide range of economic sanctions, including the exclusion of some Russian banks from the SWIFT (Society for Worldwide Interbank Financial Telecommunications) network, restrictions on trading of the Bank of Russia’s foreign exchange reserves, the removal of the country’s Most Favored Nation (MFN) status in international trade, and the withdrawal of foreign companies from the country’s markets. The ruble exchange rate has temporarily plunged and there is widespread concern that, along with the default of some Russian government’s foreign-currency-denominated bonds and the state-owned Russian Railways, high inflation will put further pressure on the economy.


It is a common practice to raise policy rates to control high inflation. Raising policy interest rates is most effective when high inflation is caused by an overheated economy on the demand side. However, the current high inflation is caused by supply-side problems such as supply chain disruptions, labor shortage, and surging prices of natural resources and commodities. Unless these problems are solved, it will be difficult to contain inflation only through monetary policy. Hence, the current situation of high inflation is likely to persist for a long time.

The greatest risk to the U.S. economy is stagflation, which entails both high inflation and economic stagnation. Higher costs of financing due to higher policy rates and the growing uncertainty associated with the Ukraine crisis could dampen consumer and investment sentiment, leading to a recession.

Tighter U.S. monetary policy could also have a significant impact on emerging market economies, especially those with large external debt.

Many emerging market economies have high external debts, about 60% of which are denominated in U.S. dollars. These economies are vulnerable to changes in the Fed's monetary policy. A monetary tightening by the Fed could cause the dollar to appreciate, increasing the demand for dollar-denominated assets and causing capital to flow out of emerging markets into advanced economies, especially the U.S.

The U.S. dollar has been the most dominant reserve currency in the post-WWII international monetary system. Dollar-denominated financial assets are widely available in the world. The dollar’s share as a settlement currency is high in international trade, and the same is true for cross-country bank loans. Therefore, other countries, especially those which cannot issue debt in their own currencies, such as emerging market and developing countries, are vulnerable to U.S. macroeconomic conditions and monetary policy through fluctuations in the exchange rate against the dollar. Thus, shocks emanating from the key country, i.e., the U.S., determine other peripheral countries’ asset markets, credit growth, and cross-country capital flows.

Even before the pandemic, many emerging market economies had been heavily indebted. After the Global Financial Crisis of 2008, the U.S. and other advanced economies implemented lax monetary policy, which led to depreciation of the dollar and other major currencies, lowering the cost of financing in hard currencies and resulting in an increase in the external debt among emerging market economies.

The figure shows that private capital inflows to emerging market economies increased around 2008, when the value of the dollar (measured by the real effective exchange rate) declined. The rise in capital inflows increased the appetite for domestic investment as well, which raised the overall debt of these economies. Between 2010 and 2019, the ratio of gross debt to GDP among emerging market economies expanded from 60% to over 170%. In 2006, foreign investors' holdings of emerging market government debt reached 43% of GDP, and the ratio of foreign currency-denominated corporate bonds to GDP increased from 19% in 2010 to 26% in 2018.

Private Sector Capital Inflows and the Real Effective Exchange Rate of the Dollar in Emerging Markets
Private Sector Capital Inflows and the Real Effective Exchange Rate of the Dollar in Emerging Markets
Note: Real effective exchange rates are indexed to 2010 = 100.
Source: IMF and BIS.

Many countries tried to prevent the pandemic from damaging their economies by aggressively mobilizing public finances. Government expenditures were aimed to contain the spread of the infection, protect health care systems, and supplement the incomes of individuals and businesses. However, combined with a decline in tax revenues due to the slowing of the economies, aggressive fiscal policy led to an increase in budget deficits, and countries that had already been overburdened with high levels of debt found themselves with even larger debts as a result of the pandemic.

A rise in U.S. interest rates under such circumstances could, as noted above, lead to an increase in the burden of repaying external debt.


The Ukraine crisis has also increased the demand for U.S. dollars as a safe-haven asset. In addition, investors may see a possible grand-scale Russian default as a sign of rising risk premia among emerging market economies, all of which implies that there is a good chance of the dollar remaining strong for the time being.

If this trend continues, emerging market economies are expected to face depreciation of their currencies, and thereby experience higher prices, especially for imported goods. Global inflation would reduce the purchasing power of consumers in emerging market economies, making their lives worse-off.

Facing the possibility of global inflation, central banks in emerging market economies may consider raising policy rates. While this could help alleviate the depreciation pressure of their currencies and thereby subdue inflation, higher policy rates could increase financing costs and slow business investment and consumer spending.

In Europe and the U.S., where third-dose vaccination rates are high, infection conditions tend to have improved and that has led to strong demand. In contrast, in emerging market and developing countries, the recovery in aggregate demand has not been as strong because vaccination has been delayed and income supplementation policies have not been implemented on a large scale. Given these circumstances, raising interest rates can be risky for emerging market economies.

Thus, irrespective of their own interest rate policies, emerging market economies are in a difficult situation. On the one hand, if the U.S. tightens monetary policy, but if these economies decided not to respond, inflation would rise and their currencies would depreciate. In other words, they would end up importing inflation from abroad.

On the other hand, if emerging market economies raised their interest rates, they might be able to curb inflation, but higher domestic interest rates might lead to higher interest payments on outstanding debt, which would increase country risks, especially for countries with large debt.

In a highly globalized world, U.S. economic conditions and policies are deeply intertwined with those of emerging market economies. Shocks emanating from the U.S. travel through the global financial markets. To ensure as much stability as possible, financial authorities need to communicate well with market participants and enhance market and policy transparency. Fiscal authorities and central banks can promote active information exchange through transnational organizations such as the G7 and G20.

The best course of action is to focus on increasing the predictability of the economic outlook and monetary and fiscal policies. That would enhance stability in financial markets and international trade. Individual countries’ efforts should benefit the world as a whole.

>> Original text in Japanese

* Translated by RIETI.

April 14, 2022 Nihon Keizai Shimbun

April 17, 2019