With a new Federal Reserve chairman and higher U.S. interest rates on the horizon, some emerging markets are more vulnerable than others to tightening monetary conditions in 2018. One country seen in the cross hairs is Saudi Arabia, already in the throes of broad economic reform.
Although last year was favorable for developing countries, investors remember the painful "taper tantrum" that ensued several years ago, when the Fed signaled it would begin pulling back on its massive bond purchases that kept rates low while injecting liquidity in markets.
Some markets are likely to fare better than others, but observers say countries with currencies linked to the dollar, like Saudi Arabia and other Gulf countries, have a lot riding on the outcome.
So-called "dollar-sphere" markets have monetary policy that is at least partly outsourced to the Fed, and by extension are vulnerable to rate hikes. "These are the countries that must heed the Fed," L. Bryan Carter, head of emerging markets Fixed Income with BNP Paribas Asset Management, said.
Citing upside risks to inflation that may boost the U.S. dollar, Bank of America this week said 3 Fed hikes this year was a real possibility.
"Most central banks across emerging markets have completed rate cutting cycles," said Jim Barrineau, co-head of emerging markets debt at Schroders Investment Management.
"If Fed rate hikes do not result in a stronger dollar — as has been the case so far — then these countries should be relatively unaffected," said Ed Al-Hussainy, senior interest rate and currency analyst at investment firm Columbia Threadneedle.
"If U.S. rates move too quickly, they will dislocate [high yielding] assets more broadly and the most liquid emerging markets will not be immune to a selloff," he added, pointing to the 2013 taper tantrum as an illustration of this idea in action.
The key question for emerging market investors is whether the dollar will head higher if the Fed decides to hike rates. If the dollar remains stable or in its softening trend, then local rates are still broadly attractive.
And dollar pegged-currencies, mainly Saudi Arabia's riyal, which is pegged at 3.75 to the greenback, could take a significant hit. For decades, Gulf nations have maintained their currencies at certain levels to the dollar, so tighter U.S. policy could undermine their efforts to manage their economies.
The issue is particularly sensitive for Saudi Arabia, which is transforming its economy ahead of an expected initial public offering by state-owned oil company Saudi Aramco. While most market observers don't believe the kingdom will abandon its monetary arrangements, U.S. policy could inject more uncertainty into an already volatile situation.
"In order to maintain the peg, the Saudi authorities have to move interest rates in lockstep with the Fed," Marcus Chenevix, a London-based MENA analyst with TS Lombard, told CNBC.
"If they do not raise interest rates as the Fed raises rates, then the riyal becomes unattractive to hold because the dollar would give a higher rate of return than the riyal, while still being exchangeable for the same amount or riyals, it would be a huge incentive" for investors to bet against the riyal/dollar peg.
As the Fed raises rates, the Saudi Arabian Monetary Authority (SAMA) is likely to follow suit. According to investors, therein lies the dilemma for Saudi policymakers: The country is only just pulling out of recession, and the last thing that the economy needs is a sustained dose of tightening, Chenevix explained.
Deputy Crown Prince "Mohammed bin Salman's (MBS) plans to rejuvenate the Saudi economy while keeping public finances stable will be a lot harder with such an inappropriate monetary policy," he said.
Dollar-pegged countries like Saudi Arabia, Qatar, Kuwait and the United Arab Emirates (UAE) don't have currency depreciation to help offset to higher domestic interest rates. Without the release valve of cheaper money — and the economic boost provided by exports — credit conditions may tighten.
"The risk is that this translates into lower growth and has to be offset by fiscal stimulus funded by additional government borrowing at higher interest rates," Chevenix added.
With oil prices stabilizing in double-digits, Saudi Arabia is looking ahead to what could be a significant move on the global stage — the massive and strategically important Saudi Aramco IPO, which is being watched by investors around the world.
Should MBS want to have an economic recovery and at the same time hike rates, "then he is going to have to spend more from the public purse," Chevenix said.
"The worse the fiscal situation, the more careful investors need to be about examining how the government is planning to extract money from Aramco when it is finally listed," the analyst said. "One does not want to own part of a company when the majority shareholder is running out of money."