When global uncertainty increases, emerging markets are typically the most exposed. Historically, tighter US monetary policy has led to capital outflows, currency depreciation, and tightening financial conditions in emerging markets. This column examines how domestic vulnerabilities shape the transmission of US monetary tightening across countries. It shows that many emerging markets avoided widespread financial crises over the 2022-2023 tightening cycle due to improved monetary policy credibility and reduced foreign-exchange vulnerabilities. In a world of rising uncertainty, stronger domestic institutions are among the most effective forms of economic insurance.
The global economy has entered a period of heightened uncertainty. Growth remains uneven across regions, financial conditions continue to fluctuate as major central banks navigate the final stages of the post-pandemic inflation cycle, and geopolitical tensions are adding to volatility in global trade and capital flows and raising stagflation concerns. Most central banks paused their cutting cycle across the globe and started talking about interest rate hikes. In such environments, emerging markets are typically the most exposed.
A central feature of the policy debate is how US monetary policy shocks propagate globally through financial channels — affecting capital flows, exchange rates and risk premia, and shaping financial conditions beyond US borders. A key mechanism in this transmission is time-varying deviations from uncovered interest parity (UIP) — that is, country-level risk premia priced by international investors — through which global shocks affect emerging markets (Kalemli-Özcan 2019).
Historical evidence is robust: sharp increases in US policy interest rates have often triggered financial crises in emerging markets. Higher US rates tend to pull capital toward safer assets in advanced economies, leading to capital outflows, currency depreciation, and tightening financial conditions elsewhere. Episodes such as the Latin American debt crisis of the early 1980s, the Asian financial crisis in the late 1990s, and the taper tantrum of 2013 illustrate how quickly global financial shocks can destabilise emerging economies. These episodes typically reflect shifts in global risk premia and external financing conditions.
Yet the most recent tightening cycle has unfolded differently. Between 2022 and 2023, the US Federal Reserve raised interest rates by more than five percentage points at the fastest pace in decades, but many emerging markets remained relatively resilient. Despite expectations of widespread stress, the wave of financial crises that historically accompanied Fed tightening cycles did not materialise.
Understanding why the 2022-2023 tightening episode has been different provides important lessons for economic policy in a world likely to remain characterised by global shocks, global inflation, and interest rate hikes. In our recent work (Kalemli-Özcan and Unsal 2023), we examine this question by focusing on how domestic vulnerabilities shape the transmission of US monetary tightening across countries.
External shocks matter, but they rarely operate in isolation. Their impact depends critically on domestic vulnerabilities.
Emerging markets have learned this lesson the hard way. Over the past two decades, many countries have taken significant steps to strengthen their macroeconomic institutions and financial systems. Two developments stand out.
First, monetary policy frameworks have improved substantially. Many emerging markets have adopted greater central bank independence and developed more structured frameworks centred around inflation targeting and clearer policy communication. Using a recently constructed index that comprehensively evaluates monetary policy frameworks across independence and accountability, policy and operational strategy, and communications (Unsal et al. 2022), we document a steady increase in policy credibility across emerging markets. Between 2007 and 2021, the average credibility index rose from roughly 0.55 to about 0.70 on a 0–1 scale, while advanced economies remained broadly stable at already higher levels (Figure 1). These institutional improvements helped anchor inflation expectations and stabilise inflation in many emerging markets.
Figure 1 Policy credibility over time
Second, reliance on foreign-currency borrowing has declined substantially. Historically, what triggered central banks in emerging markets to defend their currencies in the face of Fed hikes was the foreign-exchange-debt-related vulnerabilities in their nonfinancial private sectors. What is remarkable is that the nonfinancial sector foreign exchange debt is below 20% of GDP and around 10% of total debt, down from the levels of around 40-60% for most of the emerging markets. This has dramatically reduced the balance-sheet – and more broadly financial sector – vulnerabilities to foreign exchange fluctuations. This balance-sheet channel — where currency mismatches amplify external shocks — is central in recent work on international risk spillovers and monetary transmission (Akinci et al. 2022, Akinci and Queralto 2024).
We next examine how these domestic vulnerabilities shape the transmission of US monetary tightening. Using quarterly data for 59 advanced and emerging economies between 1990 and 2019, we estimate the effects of US monetary policy shocks across countries with different levels of policy credibility and foreign-currency debt. This is consistent with recent evidence that global monetary shocks transmit through changes in risk premia — rather than exchange rates per se — highlighting deviations from uncovered interest parity as a key adjustment margin (Cristi et al. 2024).
The results show strong heterogeneity in the transmission of Federal Reserve tightening (Figures 2 and 3). Emerging markets with low monetary policy credibility and high foreign-currency debt experience the largest spillovers. Following a US monetary tightening shock, these economies see a sharp increase in sovereign spreads and risk premia, significant capital outflows, and stronger exchange rate depreciation. Financial conditions tighten substantially and economic activity declines more strongly. By contrast, emerging markets with high credibility and lower foreign-currency debt experience significantly milder spillovers. Risk premia increase much less, capital flows remain more stable, and exchange rate adjustments are better absorbed by the economy.
Figure 2 International transmission of the Fed hikes: The role of policy credibility
Figure 3 International transmission of the Fed hikes: The role of balance sheet foreign exchange vulnerabilities
These results help explain an important feature of the recent tightening cycle. Despite the most aggressive increase in US interest rates in decades, many emerging markets have avoided the widespread financial crises observed during earlier episodes thanks to improved monetary policy credibility and reduced foreign-exchange vulnerabilities.
Reducing foreign exchange related balance-sheet vulnerabilities has also allowed countries to rely more on exchange rate flexibility as a shock absorber. When foreign-currency exposure is high, policymakers often feel compelled to stabilise the exchange rate to avoid large balance-sheet losses. This can lead to heavily managed exchange-rate regimes that are difficult to sustain and can weaken the credibility of the monetary policy framework over time. Reduced currency mismatches make it easier for exchange rates to adjust to external shocks without threatening financial stability. In this environment, exchange rate movements can help absorb global shocks rather than amplify them, allowing monetary policy to focus on domestic objectives such as inflation stabilisation.
Stronger policy frameworks and healthier balance sheets therefore reinforce each other: credible monetary policy enables exchange rate flexibility, while lower foreign exchange related financial vulnerabilities make such flexibility sustainable.
The global economy is likely to remain volatile. Geopolitical fragmentation, financial market instability, and shifts in global monetary conditions all increase the likelihood of external shocks. Emerging markets cannot control global financial cycles. But they can shape how those shocks affect their economies.
The experience of the past decade suggests that strengthening domestic institutions — credible monetary policy frameworks and resilient financial systems — can significantly reduce vulnerability to external shocks. In a world of rising uncertainty, macroeconomic credibility and resilient balance sheets remain among the most effective forms of economic insurance.
Source : VOXeu
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