EM vulnerability to external financing shocks increased

The EM external borrowings have increased substantially in recent years, reflecting cheap financing in DMs and weak growth outcomes/low real rates in DM versus EM. Indeed, external borrowings were crucial in boosting domestic credit across the EM space. As the Fed leads the DM out of the low rates environment and with external borrowings by EMs being primarily USD denominated (eg, 87% of external issuance is in USDs), a Fed tightening represents a liquidity shock that would lead to weaker EM FX and higher EM rates, suspects Barclays.

The correlation of short-term EM real rates with the US is low, but it is substantially higher for long-term real rates. Nonetheless, a Fed hike of short-term rates is likely to lead to a move lower in EM FX as real rate differentials narrow. 

"Weaker EM FX is likely to increase the repayment of external borrowings and increase refinancing in local markets - pressuring domestic interest rates higher. A Fed delay will likely be seen as temporary as the Fed seeks to ensure a recovery, which would leave long-term real rates in EM vulnerable. Hence, we do not see either scenario as supportive of a constructive view on EM assets, especially those local-currency denominated", says Barclays.