How Do Rising U.S. Interest Rates Affect Emerging and Developing Economies? It Depends

Layer 1 — Overview

Research Question

This paper examines how the effects of rising U.S. interest rates on emerging market and developing economies (EMDEs) depend on the underlying source of the interest rate increase. Specifically, it asks: what mix of inflation, reaction, and real shocks has driven changes in U.S. interest rates in recent years; how do these different shock types affect EMDE financial markets, capital flows, borrowing costs, and fiscal outcomes; and how do they affect the likelihood of EMDE financial crises?

Motivation and Context

Written in late 2022 against the backdrop of the Federal Reserve’s most aggressive tightening cycle since the 1990s, the paper argues that the standard practice of treating all interest rate increases as equivalent is misleading. Whether rising U.S. rates reflect strengthening growth, rising inflation expectations, or a perceived hawkish shift in the Fed’s reaction function carries very different implications for EMDEs already burdened by post-COVID debt at record highs and scarring from the pandemic.

Methodology

Three distinct empirical approaches are used, chosen to match the data frequency and parsimony requirements of each research question.

1. A sign-restricted Bayesian VAR model with stochastic volatility is estimated on monthly U.S. data (January 1982 - September 2022) using four variables: 2-year Treasury yield, 10-year Treasury yield, S&P 500 index, and 5-year breakeven inflation expectations. Sign restrictions identify three shocks: (i) real shocks raise both yields, equity prices, and inflation expectations; (ii) inflation shocks raise yields and inflation expectations but lower equity prices; (iii) reaction shocks raise yields but lower both equity prices and inflation expectations.

2. Panel local projection models (Jorda 2005) are estimated at quarterly frequency for 17-38 EMDEs over 1997Q2-2019Q4, excluding the 2008Q4-2009Q4 global financial crisis and the COVID-19 pandemic. The models link the VAR-identified quarterly shock series (normalized to represent a 25-basis-point move in the 2-year yield) to EMDE financial, real, and fiscal variables, including local-currency bond yields, EMBI+ sovereign spreads, capital flows, real GDP components, CPI inflation, the real effective exchange rate, primary fiscal balance, government revenues, expenditures, gross debt, and debt composition.

3. A panel logit model with random effects is estimated on annual data for 139 EMDEs over 1985-2018, linking the three shock types to the probability of banking, currency, and sovereign debt crises (as defined by Laeven and Valencia 2020).

Key Findings

Shock decomposition: Real shocks account for the largest share of variance in 2-year U.S. yields over the full sample (39 percent at a 10-month horizon); inflation shocks explain 14 percent and reaction shocks 13 percent. However, since the start of 2022, reaction and inflation shocks together account for approximately three-quarters of the cumulative increase in yields, with real shocks playing a negligible role.

Financial market and macroeconomic spillovers: Conditional on a 25-basis-point shock, reaction shocks produce significantly adverse EMDE outcomes: widening sovereign spreads (EMBI+), declining capital flows, real exchange rate depreciation, and unlike inflation shocks, statistically significant declines in private consumption and fixed investment. Inflation shocks raise domestic EMDE CPI significantly. By contrast, real shocks are associated with declining sovereign spreads, rising capital flows, real exchange rate appreciation, and higher real exports, with other real GDP components unaffected.

Fiscal outcomes: In response to inflation and especially reaction shocks, EMDE governments improve their primary balances almost exclusively through expenditure cuts, consistent with tighter credit availability constraining fiscal space. Real shocks also improve primary balances, but through both revenue gains and expenditure reductions. Government debt declines in response to all three shock types, though the decline is statistically significant only for real shocks.

Debt composition: Reaction shocks shift debt composition toward shorter maturities and foreign-currency instruments (the latter reflecting exchange rate depreciation mechanically raising the local-currency value of foreign-currency debt). Real shocks shift composition toward longer maturities and higher external creditor participation, consistent with improved market access.

Heterogeneity by credit rating: Investment-grade and noninvestment-grade EMDEs show broadly similar responses to reaction shocks, with the exception of statistically larger yield responses for noninvestment-grade economies. The paper notes this finding contrasts with several prior studies that find stronger fundamentals buffer spillovers.

Crisis probabilities: A 25-basis-point increase in 2-year U.S. yields driven by a reaction shock almost doubles the baseline probability of financial crisis in the average EMDE, from 3.5 percent to 6.6 percent. Extrapolating the nonlinear logit relationship to the 114-basis-point reaction-shock-driven increase in 2-year yields that occurred from January through September 2022 implies the probability of financial crisis in the average EMDE rising approximately 36 percentage points, to nearly 40 percent. The paper cautions that no comparable yield episode occurred in the 1985-2018 estimation sample, so this extrapolation carries substantial uncertainty. Inflation shocks are associated with only small, statistically insignificant changes in crisis probability; real shocks reduce the probability of sovereign debt crisis while raising currency crisis probability by less than reaction shocks do.

Historical episode analysis: The 2013 taper tantrum was dominated by reaction shocks, causing 10-year yields to rise by approximately 100 basis points; sovereign spreads widened by 60 basis points in the May-June 2013 window and capital flows dropped sharply. The 2022 tightening episode was driven by reaction and inflation shocks (reaction shocks adding 114 basis points to 2-year yields through September 2022), with five-year breakeven inflation expectations breaching 3 percent for the first time in the two-decade history of the series. The 2004-2006 build-up to the global financial crisis involved a mix of all three shock types with real shocks prominent, and EMDE financial conditions remained broadly benign.

Layer 2 — Q&A

Q1: How are the three shock types identified, and what makes this identification strategy credible?

The identification uses sign restrictions imposed on a Bayesian VAR with stochastic volatility. A real shock is identified as one that simultaneously raises 2-year yields, 10-year yields, S&P 500 equity prices, and inflation expectations. An inflation shock raises all yields and inflation expectations but lowers equity prices the equity decline signals that higher rates are not accompanied by stronger growth prospects. A reaction shock raises all yields but lowers both equity prices and inflation expectations the fall in inflation expectations distinguishes it from an inflation shock and signals that markets perceive the Fed is tightening beyond what current inflation warrants. Covering both short- and long-maturity yields in the sign restrictions ensures the identified shocks capture both conventional and unconventional (e.g., quantitative easing tapering) policy moves.

Q2: What share of 2-year yield variation do the three shocks each explain over the full sample?

At a 10-month horizon, real shocks explain 39 percent of the forecast error variance in 2-year U.S. Treasury yields, making them the dominant driver over the full sample (January 1982 - September 2022). Inflation shocks account for 14 percent and reaction shocks for 13 percent. Together the three identified shocks explain roughly two-thirds of total yield variation; the remaining one-third reflects residual or unclassified movements.

Q3: How did the composition of shocks driving 2-year yields change from 2021 into 2022?

Starting in September 2021, as inflation mounted and the Fed pivoted toward aggressive tightening, reaction and inflation shocks became the dominant drivers of 2-year yield increases. By September 2022, reaction and inflation shocks together accounted for approximately three-quarters of the cumulative increase in yields from the beginning of 2022, with reaction shocks alone contributing 114 basis points to the 2-year yield.

Q4: What are the financial market effects of a 25-basis-point reaction shock on EMDEs?

Reaction shocks produce significant adverse effects on EMDE financial markets within one quarter: 10-year local-currency government bond yields rise significantly, EMBI+ sovereign spreads widen significantly, capital flows decline significantly, and the real effective exchange rate depreciates significantly. Short-term (3-month) yields and equity prices also deteriorate, but these movements are not statistically significant at conventional levels.

Q5: How do financial market effects of inflation shocks compare to reaction shocks?

Inflation shocks generate adverse directional effects similar to reaction shocks rising 10-year yields, declining capital flows, real exchange rate depreciation, and falling equity prices but with the notable difference that, except for equity prices, these effects are generally not statistically significant. The paper thus finds that reaction shocks are more potent drivers of EMDE financial market tightening than inflation shocks.

Q6: How do real shocks affect EMDE financial conditions?

Real shocks produce outcomes broadly opposite to those from inflation and reaction shocks. They are associated with significant declines in EMBI+ sovereign spreads, significant increases in capital flows, significant real effective exchange rate appreciation, and significant increases in equity prices. Ten-year government bond yields do rise consistent with global bond market integration but this occurs alongside improving risk sentiment, not financial stress.

Q7: What are the macroeconomic (real activity) effects of the three shock types?

Reaction shocks produce a statistically significant decline in real GDP components, particularly in private consumption expenditure and gross fixed capital formation (fixed investment), within one quarter. Real shocks lead to higher real exports consistent with beneficial demand spillovers from stronger U.S. activity while leaving other GDP components unchanged. Inflation shocks induce a large and statistically significant increase in domestic EMDE CPI inflation, while real shocks reduce it; neither produces significant real GDP effects beyond the export channel.

Q8: How do EMDE fiscal balances respond differently to the three shock types?

Both inflation and especially reaction shocks are followed by an improvement in the EMDE primary balance (smaller deficit or larger surplus), achieved almost exclusively through declines in government expenditure. The paper attributes this to tighter credit availability and higher borrowing costs constraining fiscal space. Real shocks also improve primary balances, but the mechanism differs: both revenue increases and expenditure decreases contribute to the improvement. Declines in gross government debt occur in response to all three shocks but are statistically significant only for real shocks.

Q9: How does the composition of government debt shift in response to the different shocks?

Following inflation and reaction shocks, debt held by external creditors declines significantly as a share of total government debt, consistent with reduced access to global credit markets. Short-term debt eventually rises following both shock types. Foreign-currency debt rises considerably following reaction shocks likely reflecting the mechanical effect of currency depreciation boosting the local-currency value of pre-existing foreign-currency obligations. Conversely, following real shocks, external creditor participation rises significantly (improved market access), foreign-currency debt shares remain broadly stable, and short-term debt declines significantly (consistent with maturity extension by fiscal authorities seeking to minimize rollover risk under favourable conditions).

Q10: Do investment-grade and noninvestment-grade EMDEs respond differently to reaction shocks?

The paper finds little evidence of important differences between investment-grade and noninvestment-grade EMDEs in their responses to reaction shocks across most variables. Noninvestment-grade economies do show statistically larger increases in 10-year bond yields, and larger increases in EMBI+ spreads and 3-month yields than investment-grade economies though the latter two differences are not statistically distinguishable. For fiscal, GDP, and capital flow outcomes, the two groups respond similarly. The paper notes this finding is inconsistent with several prior studies but consistent with others, concluding the role of fundamentals remains unresolved.

Q11: How does the probability of financial crisis in EMDEs respond to the three shock types?

In the baseline (explanatory variables at sample means), the average EMDE faces a 3.5 percent probability of experiencing any type of financial crisis in a given year, with currency and banking crises the most common and sovereign debt crisis the least. Reaction shocks drive by far the largest increase: a 25-basis-point increase in 2-year yields from a reaction shock almost doubles the crisis probability to 6.6 percent. Inflation shocks produce small and statistically insignificant effects. Real shocks reduce the probability of sovereign debt crisis (consistent with their benign effects on financial markets) while raising currency crisis probability by less than reaction shocks.

Q12: What does the nonlinear logit relationship imply for the 2022 tightening cycle specifically?

Because the logit function is nonlinear, a doubling of the shock size leads to a more-than-proportional increase in crisis probability. Applying the estimated model to the 114-basis-point reaction-shock contribution to 2-year yields from January to September 2022, the model implies that the probability of financial crisis in the average EMDE increased by approximately 36 percentage points, to nearly 40 percent. The paper emphasizes this estimate carries wide uncertainty because no comparable yield increase occurred during the 1985-2018 estimation period, placing this extrapolation well outside the sample’s support.

Q13: What crisis dynamics were already materializing in 2022 consistent with the model predictions?

By the time of writing (late 2022), seven EMDEs had experienced currency depreciations of at least 30 percent against the U.S. dollar meeting the Laeven and Valencia (2020) threshold for a currency crisis and 21 EMDEs had reached agreements with the IMF for additional financing. The paper notes these developments had occurred despite standard macroeconomic factors (interest rate differentials and flight-to-safety flows) not fully explaining the magnitude of depreciations.

Q14: What robustness tests were conducted, and did they alter the main conclusions?

The VAR decomposition was re-estimated using weekly rather than monthly data. The three-shock model was simplified to two shocks (real versus monetary, combining inflation and reaction). The VAR was extended to include real GDP and PCE inflation with contemporaneous exclusion restrictions to insulate shock identification from current macroeconomic conditions. Inflation expectations were replaced with the Haubrich, Pennacchi, and Ritchken (2012) model-based measure throughout, rather than only pre-2003. For the crisis probability models, panel probit with random effects and panel logit with fixed effects were estimated alongside the baseline panel logit with random effects. In all cases, the results were not materially different: inflation and reaction shocks remained more adverse than real shocks for EMDE financial and fiscal variables, and only reaction shocks produced statistically significant increases in overall crisis probability. One noteworthy robustness finding: when combining inflation and reaction into a single monetary shock, the relative importance of the inflation component appears somewhat larger than when the two are separated.

Q15: What are this paper’s main contributions relative to existing literature?

The paper makes three stated contributions. First, it is the first to decompose the evolution of U.S. interest rates over the COVID-19 pandemic recession, subsequent recovery, and 2021-22 inflation surge into the separate contributions of real, inflation, and reaction shocks. Second, it extends prior work on EMDE spillovers (e.g., Arteta et al. 2015; Hoek, Kamin, and Yoldas 2021, 2022) by showing how different shock types affect government budget balances, revenues, expenditures, and debt composition, and by expanding the EMDE country sample. Third, it is the first to examine how real, inflation, and reaction shocks differentially affect the probability of banking, currency, and sovereign debt crises in EMDEs.

Key Concepts

Reaction shock: In this paper’s framework, a change in U.S. interest rates caused by a perceived shift in the Federal Reserve’s reaction function toward a more hawkish policy stance. Identified as a shock that raises both 2-year and 10-year Treasury yields while simultaneously lowering equity prices and lowering inflation expectations. The fall in inflation expectations distinguishes this shock from an inflation shock and signals that markets believe the Fed is tightening beyond what current inflation alone would warrant.

Inflation shock: A change in U.S. interest rates caused by rising expectations of U.S. inflation. Identified as a shock that raises both yields and inflation expectations but lowers equity prices. The equity decline signals that higher rates reflect inflationary pressure rather than improved growth prospects.

Real shock: A change in U.S. interest rates driven by improved prospects for U.S. real economic activity. Identified as a shock that simultaneously raises both yields, equity prices, and inflation expectations. The equity increase distinguishes this shock from the other two and signals that higher rates are accompanied by strengthening U.S. growth.

Sign-restricted Bayesian VAR with stochastic volatility: The paper’s primary model for decomposing U.S. yield movements. Sign restrictions on four variables (2-year yield, 10-year yield, S&P 500, 5-year inflation expectations) identify the three shock types without requiring timing restrictions. Stochastic volatility is incorporated to handle the heteroskedastic financial data and the COVID-19 period’s unusual size and nature; the model covers February 1982 to September 2022 at monthly frequency.

Panel local projection (Jorda 2005): The empirical framework linking the VAR-identified shock series to EMDE outcomes at quarterly frequency. Direct estimation of impulse responses at each horizon h avoids the misspecification accumulated in iterated VAR forecasts and permits straightforward incorporation of state-dependent (investment-grade vs. noninvestment-grade) heterogeneity via a dummy-variable interaction specification.

Capital flows (as used in this paper): Defined specifically as increases in net portfolio and other investment liabilities of EMDEs, excluding foreign direct investment liabilities. This definition isolates the more volatile, financially driven flows rather than the longer-horizon FDI component.

Financial crisis typology (Laeven and Valencia 2020): The crisis classification underlying the logit analysis. Sovereign debt crises are defined as a government default or restructuring of debt owed to private creditors. Banking crises require significant distress in the banking system combined with significant policy intervention measures. Currency crises are defined as a sharp nominal depreciation of at least 30 percent against the U.S. dollar. The paper uses these definitions from Laeven and Valencia (2020), extended through 2018 in Kose et al. (2021).

Primary budget balance improvement via expenditure compression: In the paper’s framework, the fiscal adjustment mechanism triggered specifically by inflation and reaction shocks: EMDE governments improve their primary balance (reduce deficits or increase surpluses) almost exclusively by cutting expenditures, rather than raising revenues, as a response to the credit tightening and higher borrowing costs associated with adverse U.S. interest rate shocks.