Fed tightening cycles are widely seen as bad news for EM Markets

Higher interest rates from the Fed need not be bad news for EM. After all, the Fed initiates a tightening cycle because it views the US economy strong enough to cope. Moreover, the Fed has been warming up for this tightening cycle for so long that most of the adverse effect on EM may have happened already.

What could go wrong is most easily measured using the current account. During the major EM crises of the 80s and the 90s, most EMs ran large current account deficits and thus relied on Advanced Economies (AE) to finance part of their economic activities. Foreign financing vanished as these crises unfolded and sharp contraction in economic activity became inevitable.

The Global Financial Crisis of the 00s that followed the most recent Fed tightening cycle did not trigger major EM crises. That might have been the case because EMs had built up large current account surpluses that acted as a cushion to absorb parts of the external shock when AEs went into recession and commodity prices collapsed. One region that ran large current account deficits during the Global Financial Crisis was Central and Eastern Europe (CEE), which ended on the brink of a banking crisis.

This time, the Fed can make foreign financing scarce once again, prompting serious economic adjustment in EMs with large current account deficits. Therefore it is somewhat comforting that EM as a whole are running a balanced current account, though the overall EM current account balance masks significant differences between regions and countries. Large EMs like Colombia, Turkey, South Africa, Brazil, Egypt, Saudi Arabia, Kazakhstan and Venezuela are all expected by the IMF to end up with current account deficits greater than 3% of GDP in 2015, making them more exposed to a potential worsening of foreign financing conditions. Emerging Asia still runs a current account surplus, and has done so since the Asian crisis.

Another factor and major "this time is different" is the exchange rate changes towards greater flexibility. Foreign financing need not vanish and prompt real economic adjustments when a country has a flexible exchange rate. Instead, the price of foreign currency, the exchange rate, adjusts to prevent a shortage of foreign currency. More EM FX weakening could thus be in store.

"Not all EMs have flexible exchange rates and several EMs with managed exchange rate regimes have in fact already run into foreign liquidity problems. Countries like Nigeria, Egypt, Argentina and Venezuela have chosen not to allow their currencies to weaken and currently suffer from a shortage of foreign currency. Pressure for more devaluations and more real-economic adjustment are likely", says Nordea Bank.