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Banking Updated: 02 Nov 2018

How the U.S. rate rise will affect Latin America, Europe and Asia

Those countries with a high level of foreign investment and doubts over the effectiveness of their monetary policy, will be most sensitive to the change in U.S. Federal Reserve policy.

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With the US Federal Reserve (Fed) raising interest rates to 0.5%, as announced on 16 December by its Chair, Janet Yellen, this first rate rise in nine years sets the global economic and financial system a new challenge over the coming months.

The Fed's press release, which is always closely scrutinized by both analysts and investors, provides a few clues about how this new period of rate rises will play out; a period, however, which will be far less typical than the previous ones, having started from a much lower level and with U.S. economic recovery well advanced. In her speech, Yellen, reiterated that the increase in rates will be "gradual, cautious, very prudent" and will take into account a "multitude of data". The Fed aims to set the official lending rate at a midpoint, "neither expansionary nor contractionary".

Change in Latin American capital flows

The Fed's decision will have a short term effect on Latin America because it could change the direction of capital flows. The region is in slowdown due to factors such as falling raw material prices and the economic and political crises in countries like Chile, Venezuela and Brazil. Activity in Latin America is expected to stagnate or even fall for the first time in five years. Up to 2013, when the Fed announced the end of its expansionary monetary policy, Latin America received some $100 billion a year and in 2015 this figure is forecast to be around $50 billion. U.S. rate rises will not exactly help Latin American currency appreciation. Quite the opposite.

Central banks are going to have to decide whether to increase interest rates to avoid currency depreciation or to keep them as they are to fight recession.

Euro heading towards parity with the dollar

Turning to Europe, the euro is likely to fall against the dollar and move towards parity. This will limit European purchasing power in the US but, in exchange, it willincrease the ability of eurozone firms to compete and encourage U.S. citizens to visit the Europe. As a result, short-term bouts of major volatility could occur, but as long as normalization is gradual, it will be a transitory phase, which will not halt the overall positive trend.

It could also affect the financial market, by making dollar-denominated assets more attractive, which could lead fixed income investors away from Europe and towards the U.S. in search of higher returns. Janet Yellen's move could be copied by Mark Carney, Governor of the Bank of England. If so, decoupling of monetary policy among the major world powers would be even greater and could force Draghi to put rates up sooner than planned. In such a scenario, the Euribor would rally.

Vulnerability among Asian countries

In Asia, the most vulnerable markets to the Fed's decision are Turkey, Indonesia and Malaysia. This rate rise could hit growth in these countries, which are alreadyunder pressure from the slowdown in China, the drop in exports, the fall in commodity prices and the depreciation of their currencies.

There are fears over the future solvency of firms in emerging countries which have deleveraged over the last decade. Since 2008, when U.S. monetary policy drove investment flows in the direction of emerging markets in search of better returns, firms in those countries (especially in the energy and construction sectors) have increased their debt, taking advantage of the long period of cheap money.

The leader of this corporate debt is China, where it has grown rapidly to 180% of GDP, the fourth highest in the world. However, in China this debt is mainly financed in local currency, which strengthens its position in the face of a change of sentiment in the global market.