Robust Institutions Act as a Buffer for Emerging Economies Against US Monetary Policy Shifts

The influence of US monetary actions on a global scale is profound, particularly in terms of capital movements and credit expansion within emerging economies. This underscores the significance of sound macroeconomic policies and robust institutions in the ability of these markets to withstand fluctuations during varying monetary phases.

The US dollar remains the dominant currency in international trade and finance, as well as in the reserves held by central banks worldwide.

Consequently, US monetary policy continues to steer global financial trends, influencing the flow of capital and the growth of credit globally. The dominance of the dollar ultimately restricts the monetary policy options for emerging markets that are deeply integrated into global finance.

The sway of US monetary policy was notably evident during the seven-year period of easing measures (2007–2014) that were a response to the global financial crisis. This period was followed by a 4.5-year tightening phase, which began with the 2013 "taper tantrum."

Afterward, three years of easing (2019–2022), largely a result of the COVID-19 pandemic, led to a significant tightening in February 2022. This was a delayed response to the rapid increase in US inflation.

Given the global consequences of shifts in US monetary policy, capital markets in emerging economies are often at risk of destabilizing capital outflows during times of heightened uncertainty.

They are also susceptible to erratic capital inflows in search of yield during periods of low US returns. Notably, substantial inflows were observed when the Federal Reserve's extensive monetary easing brought the federal funds rate close to zero following the global financial crisis.

These episodes have broadly increased pressure on the macroeconomic prospects of emerging markets and elevated their risk profiles. They have also affected the currencies, debt servicing, and capital flows of these markets.

For example, in 2023, many developing Asian currencies saw significant depreciation against the US dollar due to the aggressive tightening by the Federal Reserve.

A pertinent question is why certain emerging markets exhibit greater resilience or vulnerability to US monetary policy cycles, a topic explored in the study "The Performance of Emerging Markets During the Fed’s Easing and Tightening Cycles: A Cross-Country Resilience Analysis" by Joshua Aizenman, Donghyun Park, Irfan A. Qureshi, Gazi Salah Uddin, and Jamel Saadaoui.

The study employs an empirical approach to assess whether macroeconomic factors, such as debt levels, and institutional factors, such as corruption, can account for an emerging market's resilience across different cycles.

The research also comprehensively evaluates emerging market resilience by examining the bilateral exchange rate with the US dollar, exchange rate market stress, and the country-specific Morgan Stanley Capital International Index (MSCI).

Additionally, policy factors like the type of exchange rate regime and inflation targeting are scrutinized.

Broadly, the research indicates that macroeconomic and institutional factors are indeed significantly correlated with the performance of emerging markets. Moreover, the determinants of resilience vary between tightening and easing cycles, with institutional quality being particularly crucial during challenging times.

Cross-country disparities in ex-ante macroeconomic fundamentals and institutional factors can explain the performance and resilience differences among a wide range of emerging markets during US monetary cycles.

These factors differ between tightening and easing cycles, with the importance of ex-ante institutional factors increasing during monetary cycles triggered by the global financial crisis and the taper tantrum. This suggests that strong institutions are especially vital during difficult periods.

To address these issues, policymakers in emerging markets should recognize that macroeconomic variables such as international reserves, current account balances, and inflation are key determinants of their resilience to US monetary policy fluctuations.

This reinforces the established view that solid fundamentals are a shield for emerging markets against significant external shocks.

Policymakers should especially focus on sovereigns with substantial external debt and economies with highly leveraged property markets and capital market vulnerabilities that are typically affected by changing interest rates.

The borrowing costs for these economies could increase if there is a sudden deterioration in global financial conditions, exacerbating their already fragile fundamentals.

To protect their economies from the volatility caused by US monetary policy, policymakers in emerging markets must prioritize strengthening macroeconomic fundamentals and institutions. This will help ensure long-term financial stability and support sustained economic growth in the face of global financial challenges.