Uneven resilience: Why some emerging markets better navigate US monetary policy cycles

by · Ideas for India (I4I) · Join

As the US dollar and monetary policy continue to have a significant impact on global financial dynamics, some emerging markets are observed to be more resilient than others to the policy cycles. Analysing data on a large sample of emerging markets, this article highlights the role of consistent strategy that strengthens macroeconomic fundamentals and institutional quality across all phases of the cycle. 

The United States (US) dollar continues to reign supreme among the currencies. The dollar dominates international trade and financial transactions, and the foreign exchange reserves of central banks across the world. As such, US monetary policy still drives global financial cycles, impacting global capital flows and credit growth. Dollar dominance ultimately limits the policy choices of financially integrated emerging markets. 

The global influence of US monetary policy was especially visible during the seven years of easing (2007-2014) induced by the global financial crisis and its aftermath. This was followed by 4.5 years of tightening that was kicked off by the 2013 ‘taper tantrum’ (Davis 2021). Subsequently, three years of easing (2019-2022), largely induced by the Covid-19 pandemic, eventually led to a major tightening beginning in February 2022 as a delayed reaction to rapidly rising inflation in the US (Figure 1). Interest rates in the US and other advanced economies have breached levels not seen since before the global financial crisis of 2008. 

Figure 1. Monetary cycles in the United States – Easing versus tightening

Sources: Wu–Xia Shadow Federal Funds Rate from Atlanta Federal Reserve Bank; Federal Funds Effective Rate from St. Louis Federal Reserve Bank. 

As US monetary policy shifts have global repercussions, capital markets in emerging economies are often vulnerable to destabilising flight-to-quality outflows during periods of heightened uncertainty. They are also vulnerable to volatile search-for-yield1 inflows during periods of low returns in the US. Large inflows were observed when the Federal Reserve's (Fed) massive monetary easing pushed the federal funds rate close to zero following the global financial crisis. 

At a broader level, these episodes placed increasing pressure on the macroeconomic outlook of emerging markets and raised their risk profile. They also impacted emerging market currencies, debt repayments, and capital flows. For instance, 2023 saw many currencies in developing countries in Asia depreciate substantially versus the US dollar due to aggressive tightening by the Fed (Asian Development Bank, 2023). 

Our study

A natural question that arises is why some emerging markets are more resilient or less vulnerable to US monetary policy cycles, an issue we examine in our research (Aizenman et al. 2024). One approach is to empirically assess whether macroeconomic variables such as debt levels, and institutional variables such as the degree of corruption, can explain an emerging market’s resilience during each cycle. We also take a holistic approach to measuring emerging market resilience by focusing on (i) the bilateral exchange rate against the US dollar, (ii) exchange rate market pressure (for details, see Goldberg and Krogstrup (2023)) and (iii) the country-specific Morgan Stanley Capital International Index (MSCI). In addition, we analyse the role of policy factors such as exchange rate regime type and inflation targeting. Thus, we analyse data from a broad sample of emerging economies to explore this research question.2 

Broadly, there are two key findings. First, cross-country differences in ex-ante (at the beginning of a US monetary policy cycle) macroeconomic fundamentals and institutional variables can help explain the differences in performance and resilience of a large cross-section of emerging markets during different US monetary cycles. Second, these determinants differ during tightening versus easing cycles. Third, the significance of ex-ante institutional variables increased during the monetary cycles triggered by the global financial crisis and taper tantrum. This suggests that good institutions matter more during difficult times. 

The analysis highlights key asymmetries in how government stability impacts emerging markets during tightening and easing cycles. During US monetary tightening, countries with higher government stability experience less currency depreciation, as shown by the green line in Figure 2. This suggests that stable governments help maintain investor confidence, mitigating the negative effects of rising interest rates and capital outflows. 

Conversely, during easing cycles, higher government stability is linked to larger currency depreciations, indicated by the blue line in Figure 2. This counterintuitive outcome may be due to other factors, such as inflation or external imbalances, which become more significant when global liquidity is plentiful. This finding underscores the need for a consistent strategy that strengthens economic fundamentals and institutional quality across all phases of the US monetary cycle. 

Figure 2. Asymmetries during tightening cycles for the bilateral exchange rate

Notes: i) The ICRG, or International Country Risk Guide index measures political, financial and economic risk. ii) The score of Government Stability is observed one year before each cycle. iii) The blue and green lines depict the regression results.

Source: Authors’ calculations. 

Similarly, the impact of government stability on stock market performance also shows asymmetries between tightening and easing cycles. During US monetary tightening, better government stability correlates with stronger stock market performance, as shown in Figure 3. This suggests that stable governments help sustain investor confidence and market stability during periods of financial stress. 

However, during easing cycles, higher government stability is paradoxically linked to weaker stock market performance. This may reflect the idea captured in Warren Buffett's famous quote: “A rising tide floats all boats… only when the tide goes out do you discover who’s been swimming naked.” In other words, the quality of institutions might not be as visible during times of abundant liquidity and favorable market conditions. It is during periods of financial and economic stress that the true importance of strong institutions becomes apparent. 

Figure 3. Asymmetries during tightening cycles for the MSCI index

Notes: i) The score of Government Stability is observed one year before each cycle. ii) The blue and green lines depict the regression results.

Source: Authors’ calculations. 

Conclusion and policy recommendations

Emerging market policymakers can derive significant policy implications from these findings. The research underscores the importance of maintaining strong macroeconomic fundamentals, such as substantial international reserves, a positive current account balance, and controlled inflation, as key determinants of resilience to US monetary policy shifts. These factors are crucial in protecting emerging markets from the destabilising effects of external shocks. 

This is particularly applicable to policymakers in economies with high external debt and those with highly leveraged property markets or weak capital markets, as these are often the most vulnerable during periods of tightening. In such cases, rising borrowing costs could exacerbate existing vulnerabilities, especially if global financial conditions suddenly deteriorate. Strengthening these fundamentals will help safeguard against the adverse impacts of fluctuating interest rates and ensure greater economic stability in the face of global financial uncertainties. 

Notes:

  1. In search-for-yield, financial institutions shift their fixed-income portfolios into riskier assets with higher yields as interest rates decline.
  2. The methodology involves cross-sectional regressions, pseudo-panel regressions, and quantile regressions

Further Reading