My Say: As the Fed battles inflation, emerging markets risk being collateral damage

This article first appeared in Forum, The Edge Malaysia Weekly, on October 3, 2022 - October 09, 2022.
My Say: As the Fed battles inflation, emerging markets risk being collateral damage
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After having been flippant about inflation, calling it transitory even as late as last year, the US Federal Reserve (Fed) now appears determined to battle inflation. After five consecutive rate hikes this year, bringing the overnight fed funds rate from 0.25% to 3.25%, the Fed may have dug in its heels, but so too, it seems, has inflation. The latest numbers show US inflation to be getting hotter, broader-based and more entrenched. It appears that several more rate hikes may be necessary.

The Fed may have been behind the curve, but it is not the only one. Both the European Central Bank and Bank of England seem to be in the same position. All three central banks have raised rates aggressively and committed to quantitative tightening, reversing their earlier bond purchases. This synchronous tightening in the developed world is bad news for the developing world. Coming as it does with the marked decline of growth in China and Europe and the downward revision by the International Monetary Fund of its global growth forecast for emerging markets, all these must mean serious headwinds ahead.

Given the dominance of the USD in the developing world’s trade, capital flows and funding of growth, rapidly rising US interest rates would invariably set off a series of knock-on effects, all with bad consequences. Among the immediate effects are:

(i)     The USD’s appreciation due to higher rates increases debt servicing costs of dollar-denominated debt.

(ii)     The global risk-return trade-off gets altered. Higher USD returns increases its relative attraction, causing a reversal of capital flows from the emerging world to the US. Capital that had once sought higher returns in emerging markets would now reverse, causing sharp falls in domestic equities, rising bond yields and eroding foreign reserves.

(iii)  To check the capital flight and minimise depreciation of the local currency, emerging markets would have little choice but to raise domestic interest rates, at least proportionately, if credit spreads are to be kept even.

(iv)     It is this necessity to raise interest rates that can be very painful. If the domestic economy is highly leveraged as most emerging markets post-pandemic are, the consequences can be brutal.

More than merely increasing the cost of all outstanding debt, sharp rate hikes can trigger loan defaults, higher nonperforming loans at banks and, if combined with capital flight, a potential full-blown banking/balance of payments crisis.

Yet, for emerging market central banks, there really is little choice. In the absence of tight capital controls, not raising interest rates is simply not an option. Unchanged domestic rates would mean interest spreads against the US narrows, the risk-return trade-off becomes favourable to the USD, capital outflow ensues resulting in a falling home currency, falling reserves, imported inflation and even more outflows to service foreign debt. A nightmarish virtuous cycle.

It is this combination of events that a World Bank report has recently warned of. In addition to possible recession in 2023, the report warns of a potential string of financial crises in emerging markets. Asia, where foreign reserves were once plentiful, has seen rapid depletion. Fitch Ratings estimates reserves in the Asia-Pacific region to have declined by US$590 billion since end-2021. Where reserves had averaged 16 months of imports in mid-2020, they were estimated to be at 10 months at end-2021 and, currently, about seven months. This is a reflection of the persistent outflow recorded for every month of 2022 by the Washington-based Institute of International Finance.

What makes the situation worse are the high debt levels. According to East Asia Forum, a think tank, 38 emerging economies are already on the verge of a debt crisis while at least 25 nations spend more than 20% of government income on servicing foreign debt. Clearly, further rate increases by the Fed could tip several emerging markets into serious financial problems.

Alas, all this is not new; every time the Fed raises rates, emerging markets suffer financial distress. What is surprising is the recurring nature of the phenomenon. As with several other crises, the 1997 Asian financial crisis was indeed preceded by sharp increases in US interest rates. Is the Fed to be blamed for this? Surely it is not mandated to protect the world. Yet the USD’s hegemony of the global financial system gives it the power to determine and influence global well-being and, if necessary, weaponise its currency and monetary policy.

Despite its erosion as an industrial power, the US continues to be the centre of the financial universe. Global financial markets dance mainly to one tune, that of the Federal Reserve — that tune having been scripted at Bretton Woods in 1944 and hard-coded since then. For example, in recent months, while the Fed has been tightening, the People’s Bank of China and the Bank of Japan have been loosening. Yet, even in Asia, it is the Fed’s actions that matter. Why is this so? It probably has to do with the fact that while Germany, Japan, South Korea and China may have challenged the US in industrial power and technology, none have been able to, nor challenged the US in financial hegemony. The foundation for this dominance may have been laid at Bretton Woods, but it has been the openness and transparency of US financial markets and the clever use of soft power that have perpetuated the hegemony.

Another reason for the recurring susceptibility to Fed policies has to do with developing countries themselves. These nations appear to have nothing other than a debt-financed growth model to develop themselves. Despite the repeated vulnerabilities that such debt-funded growth causes, there seems to be no new thinking in alternative growth models. This is unfortunate as there indeed are alternatives. Islamic finance, for example, offers quasi-equity risk-sharing alternatives that policymakers in Muslim nations ought to know of.

The inability of emerging markets to wean themselves out of debt and interest rate sensitivity even after decades is testimony to bad policy formulation and deep-seated inertia to seeking alternatives to debt-funded growth. And until they do so, they run the risk of being collateral damage every time the Fed tightens.


Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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