Domestic institutional strength prevents US rate hikes from triggering emerging market crises

Emerging markets avoided widespread financial crises during the 2022-2023 tightening cycle despite the US Federal Reserve raising interest rates by more than five percentage points at the fastest pace in decades. This resilience is the result of two domestic shifts. Nonfinancial sector foreign exchange debt in these markets has fallen below 20% of GDP and around 10% of total debt, down from previous levels of 40% to 60%. Simultaneously, the average policy credibility index for emerging markets rose from 0.55 to 0.70 on a 0-1 scale between 2007 and 2021.

Historically, higher US rates pull capital toward safer assets in advanced economies. This triggers capital outflows and currency depreciation in emerging markets. International investors price these shifts through country-level risk premia based on deviations from uncovered interest parity. In previous episodes, such as the 1980s Latin American debt crisis and the 2013 taper tantrum, these mechanisms caused significant destabilization.

Emerging markets with low monetary policy credibility and high foreign-currency debt now experience the largest spillovers, seeing sharp increases in sovereign spreads and risk premia. By contrast, those with high credibility and lower foreign-currency debt experience milder spillovers where risk premia increase less and capital flows remain more stable.