Emerging Markets Navigate Global Interest Rate Volatility

Global interest rates in recent months have gone on a rollercoaster,
especially those on longer-term government bonds.

Yields on 10-year US Treasuries are climbing again after pulling back from
a 16-year high of 5 percent in October. Interest rate moves in other
advanced economies had been equally prodigious.

Emerging market economies, however, saw much milder rate moves. We take a
longer-term perspective on this in our

latest Global Financial Stability Report, demonstrating that the average sensitivity to US interest rates of
10-year sovereign yield of Latin American and Asian emerging markets
declined by two-thirds and two-fifths, respectively, during the current
monetary policy tightening cycle compared with the

taper tantrum in 2013.

While the lower sensitivity is in part due to the divergence in monetary
policy between advanced economies’ and emerging markets’ central banks over
the past two years, it nonetheless challenges findings in the economic
literature that show large spillovers from advanced economies’ interest
rates to emerging markets. In particular, major emerging markets have been
more insulated from global interest rate volatility than would be expected
based on historical experience, especially in Asia.

There are other signs of resilience in major emerging markets during this
period of volatility. Exchange rates, stock prices, and sovereign spreads
fluctuated in a modest range. More remarkably, foreign investors did not
leave their bond markets, in contrast to past episodes when large outflows
ensued after surges in global interest rate volatility, including as
recently as 2022.

This resilience was not just good luck. Many emerging markets have spent years
improving policy frameworks to mitigate external pressures. They have built
additional currency reserves over the last two decades. Many countries have
refined exchange-rate arrangements and moved towards exchange-rate
flexibility. Significant foreign exchange swings have contributed to
macroeconomic stability in many cases. The structure of public debt has
also become more resilient, and both domestic savers and domestic investors
have become more confident investing in local-currency assets, reducing
reliance on foreign capital.

Perhaps most importantly, and closely aligned with IMF advice, major
emerging markets have enhanced central bank independence, improved policy
frameworks, and gained progressively more credibility. We would also argue
that central banks in these countries have gained additional credibility
since the onset of the pandemic by tightening monetary policy in a timely
manner and bringing inflation toward target as a result.

During the post-pandemic era, many central banks hiked interest rates
earlier than counterparts in advanced economies—on average, emerging
markets added 780 basis points to monetary policy rates compared to an
increase of 400 basis points for advanced economies. The wider interest
differentials for those emerging markets that hiked rates created buffers
for emerging markets that kept external pressures at bay. In addition, the
rise in prices of commodities during the pandemic also helped the external
positions of commodity-producing emerging markets.

Global financial conditions too have remained quite benign during the
current global monetary policy tightening cycle, especially last year. This
contrasts with previous hiking episodes in advanced economies, which were
accompanied by a much more pronounced tightening of global financial
conditions.

Looking ahead

Despite reaping rewards from years of building buffers and pursuing
proactive policies, policymakers in major emerging markets need to stay
vigilant with an eye on the challenges inherent in the “last mile” of
disinflation and rising economic and financial fragmentation. Three
challenges stand out:

Interest rate differentials are narrowing as some emerging markets
are anticipated by investors to cut rates faster than advanced economies,
which could entice capital to leave emerging market assets in favor of
assets in advanced economies;
Quantitative tightening by major advanced economies continues to
withdraw liquidity from financial markets, which could additionally weigh
on emerging market capital flows;
Global interest rates remain volatile, as investors—reacting to
central banks emphasizing data-dependency—have grown more attentive to
surprises in economic data. Perilous for emerging markets are market
projections that central banks in advanced economies will materially cut
rates this year. Should this prove wrong, investors may once again reprice
in higher-for-longer rates, weighing on risky asset prices, including
emerging market stocks and bonds.

A slowdown in emerging markets, as projected by the latest World Economic
Outlook update, operates not only through traditional trade channels, but
also through financial channels. This is particularly relevant now, as more
borrowers globally are defaulting on loans, in turn weakening banks’
balance sheets. Emerging market bank loan losses are sensitive to weak
economic growth, as we showed in a

chapter of the October Global Financial Stability Report.

Frontier emerging markets—developing economies with small-but-investable
financial markets—and lower-income countries face greater challenges, the
primary one being the lack of

external financing. Borrowing costs are still high enough to effectively prohibit these
economies from obtaining new financing or rolling over existing debt with
foreign investors.

High financing costs reflect the risks associated with emerging market
assets. Indeed, the dollar returns on these assets have lagged similar
advanced economies’ assets during this high-rate environment. For
instance, emerging market bonds for high-yield, or lower-rated, issuers have
returned about zero percent on net over the past four years, while US
high-yield bonds have provided 10 percent. So-called private credit loans
provided by nonbanks to lower-rated US companies have returned even more.
The sizable differences in returns may not bode well for emerging markets’
external financing prospects as foreign investors with mandates that allow
for investments across asset classes can find more-profitable alternative
assets in advanced economies.

While these challenges for emerging market and frontier economies require
close attention by policymakers, there are also many opportunities.
Emerging markets continue to see significantly higher expected growth rates
than advanced economies; capital flows to stock and bond markets remain
strong; and policy frameworks are improving in many countries. Hence the
resilience of major emerging markets that has been important for global
investors since the pandemic may continue.

Vigilant policies

Emerging markets should continue to build on the policy credibility they
have gained and be vigilant. Facing elevated global interest rate
volatility, their central banks should continue to commit to inflation
targeting, while remaining data dependent in their inflation objectives.

Keeping monetary policy focused on price stability also means using the
full spate of macroeconomic tools to fend off external pressures, with the
IMF’s

Integrated Policy Framework providing guidance on the use of currency intervention and macroprudential
measures.

Frontier economies and low-income countries could strengthen engagement
with creditors—including through multilateral cooperation—and rebuild
financial buffers to regain access to global capital. In the bigger
picture, countries with credible medium-term fiscal plans and monetary
policy frameworks will be better positioned to navigate periods of global
interest rate volatility.

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