Will the Fed’s Rate Hikes Trigger Financial Crisis?
Author: WEN Bin，LI Xin and WEN Yuli
In order to battle the soaring inflation，the Federal Reserve (Fed) has started raising interest rates since March 2022 at an accelerating pace. A single rate rise in June and July reached 75 basis points，the most aggressive hike since November 1994. Historically，the Fed’s rate hikes often led to financial crises in some countries and regions. Will this round of rate hikes trigger financial crisis? Which countries are more vulnerable?
How do the Fed’s rate hikes provoke financial crises?
In previous process of “Fed’s rate hike—capital outflows—financial crisis”，the most common and critical link is the currency crisis. Although it is usually caused by a debt crisis or the bursting of an asset bubble，sharp currency depreciation can exacerbate debt crises，banking crises，and financial market meltdowns，further escalating into a full-blown crisis. However，the Fed’s interest rate hike is only a common external trigger for each financial crisis，while some economic factors within a country are the main culprit. These internal factors broadly fall into four categories are as follows.
Basic background factors are: current account deficit and free flow of capital. Financial crises often occur in emerging economies with rapid growth and relatively open capital markets，attracting large inflows of international capital. In addition，the common features include a low savings rate，excessive reliance on foreign capital，long-term current account deficit，difficulty in building up sufficient foreign exchange reserves，and lack of strong "immunity" to the impact of international capital flows.
Key imbalance factors are excessive short-term external debt and bubbles in asset prices. Current account deficit and international capital inflows do not necessarily lead to financial crises. What really puts a country in trouble is excessive short-term or floating-rate external debt，or unsustainable asset price bubbles. Capital outflows either -make the high cost of external debt unsustainable and trigger a debt crisis，or cause asset sales to burst asset price bubbles. Both a debt crisis and the bursting of asset bubbles can spark a currency crisis.
Policy regulation factors are inflexibility of the exchange rate policy and dependency of the interest rate policy. Under the pressure of capital outflow，biased policy choices tend to exacerbate internal imbalances. This is mainly reflected in two aspects: First，the exchange rate adjustment lacks flexibility. If the US dollar appreciates，the fixed exchange rate system will passively appreciate the local currency，which will suppress exports and economic growth，and increase the current account deficit. Second，the interest rate policy lacks independence. Passively following interest rate hikes regardless of the actual domestic situation will escalate domestic economic conflicts，inhibit economic growth，and aggravate the problem of external debt or asset price bubbles.
Other special factors include over-reliance on resource exports and high inflation rate. Such factors can fuel the fire in certain circumstances. First，the industrial structure is over dependent on resource exports. The US dollar appreciation will cause deterioration in a country's terms of trade，thereby increasing the current account deficit. Second，the inflation rate is high. This in itself will create pressure for the local currency devaluation，which may lead to a currency crisis if external debt problems or asset bubbles concur. Additionally，a high fiscal deficit rate tends to provoke a sovereign debt crisis under the impact of interest rate hikes，or push up inflation and result in currency devaluation.
Study on the risk of financial crisis in emerging economies
Given a large amount of international capital inflows in the early stage，emerging economies are most vulnerable to the reversal of capital flows. Meanwhile，a financial crisis breaking out in these countries will give the international market the hardest hit. Therefore，this article probes into 25 emerging economies by using the MSCI Emerging Markets Index. On the basis of above mechanism analysis，this article studies the risk of financial crisis in each economy with the following indicators.
Currency crisis indicator. A sizable currency devaluation soon after the Fed’s rate hikes indicates that the economy is showing signs of capital outflows，which in itself is a signal of a currency crisis. From this point of view，Egypt and Turkey have experienced severe currency depreciation; Colombia and Chile are also worthy of attention.
Basic background indicator is current account. Greece and Turkey run huge current account deficits，and Egypt，Colombia and Saudi Arabia are also worthy of attention.
Key imbalance indicator is short-term external debt. Considering the share of short-term external debt in exports and primary income of goods and services，and that in total reserves (2020)，Turkey is burdened with massive short-term external debt，and South Africa and Colombia are also worthy of attention.
Key imbalance indicator is asset bubbles. Continued sharp rises in asset prices far above average (MSCI Emerging Markets Index) will likely build up bubbles. In light of the situation in the past one，two and three years (as of the end of 2021)，the stock market bubbles in Turkey; Taiwan，China; and India are at graver risk，and Saudi Arabia and Russia are also worthy of attention.
Special factor indicator is inflation. In 2021，Turkey'