US rate hikes trample on developing countries – East Asia Forum | Vette Leader

Author: Nischal Dhungel, NIPoRe

The International Monetary Fund’s latest World Economic Outlook report paints a bleak economic future. It has downgraded global growth forecasts from 6.1 percent in 2021 to 3.2 percent in 2022. With the global economy still recovering from the COVID-19 pandemic, central banks in advanced economies are raising interest rates – a policy change that will have a significant global impact.

The depressing growth forecasts are a consequence of tighter monetary policy and the increasing danger of social and economic risks, especially for emerging and developing countries. Food and fuel prices have skyrocketed due to the Russia-Ukraine war and supply chain shortages. The Russia-Ukraine conflict has made it a challenge to fight inflation, support the global economic recovery, help the vulnerable and restore fiscal buffers.

The US Federal Reserve (Fed) stepped up its fight against inflation after consumer prices in the United States rose 8.6 percent. On June 15, 2022, the Fed voted to raise the target range for the federal funds rate to 0.75-1 percent. Further rate hikes are planned for the remainder of 2022. But efforts to lower inflation by raising interest rates in the United States could hurt the rest of the world.

As interest rates rise in the United States, those investing in emerging markets looking for higher returns can invest in the more attractive US market. This will lead to massive capital inflows into the United States and increased outflows from developing countries. Without proportionately tighter domestic monetary policy, the resulting rise in borrowing costs will eat up foreign exchange reserves, strengthen the US dollar and result in balance sheet losses for countries with net US dollar liabilities.

Rising US interest rates have the greatest impact on economies with higher macroeconomic vulnerabilities. Between 2019 and 2021, the COVID-19 pandemic caused public debt in developing countries to rise sharply – on average, it rose from 54 percent to 65 percent of GDP.

38 emerging countries are now threatened by a debt crisis or are currently in one. At least 25 developing countries spend more than 20 percent of government revenues on servicing foreign government debt. For this reason, interest rate increases in advanced economies could tighten external financing conditions for emerging and developing countries.

There is a worrying comparability between today’s economy and the economy of the 1970s and early 1980s, which was characterized by high inflation, slow growth and rising borrowing costs. In the 1970s, oil exporters, benefiting from rising energy prices, used their surpluses to increase funding for emerging market debt markets. Fed rate hikes in the early 1980s reduced inflation in the United States but pushed up global interest rates, leaving many emerging market countries unable to pay their debts.

The debt crisis that followed the Volcker shock was worrying for developing countries. The Fed’s rate hike had a devastating impact on Latin America. The region experienced a collapse in GDP and rising unemployment and poverty. The following decade was lost to a gradual and uneven economic recovery. The consequences of the Latin American debt crisis were felt in a similar way in the heavily indebted countries of Africa. The Fed didn’t pay enough attention to how its decisions would affect the rest of the world.

Although today’s economic situation has similar origins to those of the 1970s and 1980s, there are some significant differences. Today, oil producers are clearly feeling that the world’s dependence on oil is decreasing. Real oil price increases are lower than in the past. Policy tightening in response to the economic downturn also began earlier than in the 1970s and 1980s, particularly in certain emerging and developing countries. Unlike the 1970s and 1980s, there hasn’t been as much time for recycled petrodollars to fuel imbalances in developing and emerging economies.

Despite these encouraging developments, new risks have emerged. Due to increased exposure to sizable bilateral creditors and the recent COVID-19 pandemic, public debt has increased and stunted the growth potential of many countries.

While international financial institutions do their part to provide debt relief and stop punitive measures such as surcharges – additional fees imposed on countries that default on their debts – rapid and systematic debt resolution measures must be taken. This must include working with private creditors and large sovereign creditors like China. Big food and fuel companies must be stopped from profiteering and speculation.

Special Drawing Rights (SDRs) – foreign exchange reserves issued by the IMF that can be used alongside gold or the US dollar for currency stability – need to be redistributed to countries that need them badly. A $650 billion reissue of special drawing rights is required to provide immediate relief. The UN Conference on Trade and Development has advocated an alternative way to enable fair and orderly solutions to debt crises. It would include a multilateral legal framework for sovereign debt restructuring involving both public and private creditors.

Rate hikes in advanced countries will always affect low-income countries. However, this does not preclude the need to advance structural reforms in low-income countries. Structural reforms are the only way to find short and long-term debt management solutions.

Nischal Dhungel is a Fellow at the Nepal Institute for Policy Research.

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