Currencies of emerging market (EM) nations could come under "significant depreciation pressure" in 2022 if US monetary policy is tightened at a faster clip, Fitch Ratings said in a note on February 21.
The ratings agency added that exchange rate pressures could force EMs into taking monetary policy decisions they would not make otherwise, with risks also emanating from an increase in the interest burden on their dollar-denominated debt.
"A number of EMs, such as Brazil, Chile, Poland, and Russia, have raised policy rates ahead of the US tightening cycle, reducing the potential for capital outflows. In past cycles, EM rate increases often lagged behind those in the US. Inflation in the US is also higher than it has been in decades, making real interest rates there less attractive," Fitch Ratings said.
"Nonetheless, we believe that there is still a risk that EM exchange rates could come under greater pressure this year as US monetary tightening progresses. An increase in global risk aversion could also increase capital flows into US assets."
Fitch said its EM exchange rate index has shown "a marked depreciation" against the US dollar in recent months, although this is largely due to two countries: Turkey and Argentina. Both, Fitch said, are vulnerable as their foreign-currency debt is large.
Fitch's EM exchange rate index weighs emerging economies by the value of their outstanding foreign-currency government debt.
US inflation is at 40-year high, forcing both markets to recalibrate their expectations of how much the central bank may raise interest rates by in 2022. Fitch expects the US federal funds rate target range to be raised by 100 basis points this year and by a similar amount in 2023.
In December 2021, it expected the US central bank to effect a 25-basis-point rate hike in 2022 and a 50-basis-point one in 2023.
An increase in foreign-currency debt burden for EMs due to a stronger greenback would come at a time when government debt has risen across the world to deal with the economic fallout of the pandemic. According to Fitch, the median EM foreign-currency government debt had risen to 31 percent of GDP by the end of 2021 from 18 percent in 2013.
"Policymakers in EMs may feel pressure to raise rates to attract capital inflows or to prevent depreciation that might threaten inflation targets, or financial stability where balance sheets are exposed to exchange-rate risk. This could weigh on growth outlooks, at least in the near term, and so complicate the task of fiscal consolidation for EMs in the wake of the pandemic," Fitch warned.
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