The Federal Reserve's impending decision on whether to hike interest rates for the first time in nine years will have repercussions far beyond its borders, particularly for emerging markets, which have been a major beneficiary of ultra-loose monetary policy in the world's largest economy.
The Fed's Open Markets Committee is meeting this week and on Thursday will reveal whether interest rates are going to be lifted from record lows.
Why are emerging markets under pressure?
Emerging markets from South Africa to Mexico have benefited from large capital outflows in recent years. As the Fed cut interest rates aggressively, investors seeking higher returns went overseas to countries with better economic prospects. The tide is turning.
Emerging markets are grappling with deteriorating growth prospects as well as tanking commodity prices. This has raised concerns about a renewed bout of capital outflows, particularly out of markets with shaky economic fundamentals.
How have emerging markets reacted?
Cash has already been flowing out of emerging markets, with investors pulling a net $8.7 billion out of emerging market stocks in August, according to the Institute of International Finance (IIF), the largest outflow since the mid-2013 "taper tantrum".
Taper tantrum refers to the dramatic episode of capital flight out of emerging markets during the summer of 2013, triggered by jitters around the Fed scaling back its massive monetary stimulus program. Markets with the biggest economic imbalances – such as large fiscal and current account deficits – were the worst hit.
This week, the World Bank warned there was a risk of a "substantial" hit to capital flows if investors started to expect more aggressive hikes and drove up long-term bond yields.
"Emerging and frontier market economies may hope for the best during the upcoming tightening cycle, but given the substantial risks involved, they would do well to buckle their seatbelts in case the ride gets bumpy," Carlos Arteta, economist at World Bank said in a paper published on Tuesday.
Hold on, are all emerging markets the same?
No. Each emerging market is facing its own set of challenges, with some coping better than others. The Indonesian and Malaysian economies, for example, are struggling amid lower demand for commodities exports, while the Philippines and India are holding up better thanks to strong domestic consumption, which helps insulate their economies from external shocks. This is reflected in their gross domestic product (GDP) growth projections for 2015.
There are also variations in terms of the ability of countries to repay overseas creditors or honor their import commitments. Foreign exchange reserves in China and the Philippines as a share of imports and outstanding debt are greater, theoretically providing a greater cushion against sharp swings in markets.