Moody's: Fed rate rise would underscore US strength, but emerging markets face risks

"A rise in the short-term interest rate target by the Federal Reserve now appears likely this Wednesday," said Steven Hess, a Senior Vice President at Moody's.

A potential increase in short-term interest rates by the Federal Reserve after this week's FOMC meeting would confirm that the US economic expansion remains on track. However, higher rates could bring risks to some emerging market sovereigns, says Moody's Investors Service.

The direct impact of any rate increase on the US economy should be minimal. The fed funds rate will likely only rise by a small amount and any subsequent rate increases will be gradual, according to the report "Sovereigns -- Global: Likely Fed Rate Hike Reflects Strength of US Recovery, But Exposes Some EM Sovereigns to Volatile Capital Flows."

"A rise in the short-term interest rate target by the Federal Reserve now appears likely this Wednesday," said Steven Hess, a Senior Vice President at Moody's. "Such a move would reinforce our view that the US economy is on track for above-trend growth."

While a Fed rate hike would remove an element of uncertainty for emerging market sovereigns, some will remain at risk to adverse capital flows and investor sentiment. For example, there is a low risk of a disorderly reaction should investors abruptly adjust their expectations for yields.

The large emerging markets that will likely be most affected are those, such as Brazil, Russia, Turkey and to some extent South Africa, where severe domestic challenges have contributed to exchange rate and financial market instability. These sovereigns have little policy room to protect growth and buffer themselves from external shocks.