Fitch: Fed Lift-Off Poses Threat to Vulnerable Emerging Markets

Emerging markets (EMs) are becoming an increasing source of risk to global growth as the collapse in commodity prices and political shocks exacerbate a secular slowdown, Fitch Ratings says in a new report.

Our latest forecast for global growth of 2.3% in 2015 is the weakest since the global financial crisis in 2009. Against this backdrop, the Fed's looming tightening of monetary policy after an unprecedented period of historically low rates will add to the macroeconomic and external financing pressures on EMs.

EM bonds were boosted in the last decade by international investors' search for yield and increased funding disintermediation in local debt markets. This makes EM borrowers vulnerable to rising US rates and the reversal of previously strong capital flows.

Fitch reviewed 19 EM countries, selected based on their weights in the J.P. Morgan EMBI and CEMBI indices, to identify cross-sector sensitivities to rising US rates. All but one are rated investment grade but almost one-third are on the edge at 'BBB-'.

Turkish issuers stand out as most exposed across all main sectors, although many of these risks are longstanding and the country has weathered adverse conditions in the past. Latin American countries, notably Brazil, also face challenges, but mainly due to weakening fundamentals rather than high levels of unhedged US dollar funding.

In general, EM sovereign credit fundamentals improved in the past decade, with rising foreign-currency reserves, more countries having floating exchange rates, a higher proportion of government debt in local currencies and longer debt maturities. But there have been net downgrades of EM sovereigns in 2015 and Fed tightening is looming at a time when many EMs face slowing growth, lower commodity prices, weakening currencies and, in some cases, heightened political risk.

Some EM banks without high levels of dollar-denominated debt are looking forward to a US rate rise, which holds the promise of higher profitability. But for most banks any increased profitability is outweighed by risks, including the reduced ability of some sovereigns to support their banks, and pressure on asset quality and capital.

Within the corporate sector, highly leveraged companies with US dollar-denominated debt, operating expenses and/or capex are most exposed - especially those lacking US dollar revenues and/or balance sheet hedging. Sector bubbles continue to inflate and burst, such as in steel, sugar and ethanol, and small commodity companies.

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