In many emerging markets the use of the dollar is quite widespread. Companies might issue dollar denominated debt, the same goes for governments like Argentina, and even consumers might borrow in foreign currency.
Consequently, Fed policy does not only affect the US economy, but also affects many countries around the world, mostly emerging markets. The gradual rise in interest rates in the US over the last two years thus corresponds to monetary tightening (tighter credit conditions) in emerging markets. Unfortunately, it looks like there might be another emerging market debt crisis looming on the horizon. Argentina's Peso has been in free fall over the recent year, depreciating by more than 50% over the last year. More worrisome, Argentina's Central Bank hiked domestic interest rates to 40% last week without being able to stop the Peso's decline or put an halt to the capital outflows. As Argentina has borrowed again a lot money in dollar denominated government securities in recent years, the value of the debt outstanding has exploded as measured in Pesos. And since the country's tax revenue are in Pesos obviously, the country will have increasing difficulty to service its dollar denominated debt.
Consequently, the government has already asked the IMF last week for assistance and a possible bailout. It looks like financial markets have very short memories indeed the country has defaulted already a number of times over the last 100 years.
However, the trouble in emerging markets does not seem to be confined to one country alone.
Turkey's currency has been depreciating as well over the last two years, with domestic rates of inflation exceeding 10% now. It looks like the recent growth in the country has been bought with cheap money and expansionary fiscal policy with obvious implications for domestic inflation as well as for the value of the domestic currency. The only way out of this mess would be a shift towards tighter monetary policy, which on the other hand would be contractionary for the economy in the short-run. It is doubtful whether Erdogan would approve of such measures, especially now that elections are approaching. The combination of expansionary and fiscal policy might in the end turn out to be a toxic policy mix as such high rates of inflation are surely an impediment to economic growth.
Besides Argentina and Turkey, we also have Mexico and Brazil that have experienced relatively strong currency depreciations over the last year. While it really looks like the monetary tightening in the US is quite toxic for some emerging markets in general, one should not forget that the current troubles those countries find themselves in right now are unfortunately mostly of their own making. One of the biggest impediments to long-run growth and escaping the middle income trap are poorly designed macroeconomic policies and policy regimes, mostly a result of flawed institutions. This could be Argentina's government relying over and over again on foreign currency denominated debt or the Turkish Central Bank not being independent enough as Erdogan seems to put pressure on the institution to accommodate his polices with easy money.
It thus could very well be that we are approaching yet another emerging market debt and/or financial crisis. As of now, the countries just mentioned above are simply not large enough to spell trouble for advanced economies if a financial crisis would occur. Regardless, such an event could also lead to dramatic declines in living standards in the countries that would be affected. Policy makers in advanced economies and international institutions like the IMF would do well to address the current headwinds emerging markets are facing right now before they evolve into a full-blown crisis.