In its meeting in late September, the Open Market Committee of the US Federal Reserve announced a third 0.75 percentage point interest rate increase, lifted its target for its benchmark rate to 3-3.25 per cent, and put out a “dot plot” chart projecting the rate to rise to 4.4 per cent by the end of this year and a peak of 4.6 per cent next year.
Given recent history, this is a dramatic rise. The Fed funds target rate had been reduced from an already low 1.75 per cent in February 2020 to less than 0.25 per cent a month later in response to the COVID-19 pandemic. That so-called “zero interest-rate policy” was in place until the March 2022 meeting of the Federal Open Market Committee, when it began an inflation-induced rate hiking cycle with a 0.25 per cent increase in the Federal funds rate. Starting from that hesitant increase, a series of rate hikes have followed, taking the target Fed funds rate from 0-0.25 per cent before March, to 2.25-2.50 per cent in July and 3-3.25 per cent in September.
Clearly, rattled by inflation, estimated by the US Department of Labor at 8.3 per cent for the 12 months ended August 2022, the Fed has turned hawkish on interest rates. Combined with a March decision to end bond purchases as a way of injecting liquidity into the economy and a plan to shrink its balance sheet by divesting bond holdings, the era of cheap and easy money initiated after the 2008 financial crisis has come to an end. According to an estimate from Bloomberg Economics, G7 central banks are likely to shrink their balance sheets by about $410 billion between May and December 2022. That is a sharp reversal when compared with the addition to Fed assets of $2.8 trillion in 2021 and more than $8 trillion since COVID hit.
Turmoil in financial markets
The Fed’s moves have created turmoil in financial markets, not least because of the expectation that the Fed’s effort at reining in inflation would result in collateral damage in the form of a real economy recession. Fed officials have reportedly forecast that the US unemployment rate would rise from its current rate of 3.7 per cent to 4.4 per cent in 2023, and gross domestic product (GDP) growth would fall to 0.2 per cent by the end of the year and recover to around 1.2 per cent in 2023. This “hard landing” is not good news for the world hegemon, but it is not altogether disastrous for it if realised. What would be a disaster is the impact of the Fed’s monetary policy manipulations on less-developed or underdeveloped countries, especially the many heavily indebted among them.
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A direct effect of the US hike in interest rates is that it forces other countries, developed and not-so-developed, to raise their own rates to levels more than warranted by the inflation-targeting commitments of their own central banks. If the differential in a country’s interest rate vis-à-vis that in the US widens in favour of the latter, capital flows to dollar-denominated assets would spike. The resulting outflow from the rest of the world would exert downward pressure on their currencies that can depreciate steeply. To at least partially stall such depreciation, central banks world over are revising upwards their own policy rates. To the extent that such rate increases squeeze credit-financed investment and consumption demand in those jurisdictions, they too experience recessionary tendencies that are anyway under way because of the global slowdown in growth.
Needless to say, poor countries are victims of this tendency. Distressed debt in these countries is estimated at more than a quarter of a trillion dollars. While Sri Lanka led in the current cycle of default, El Salvador, Ghana, Egypt, Tunisia, and Pakistan are among those seen as vulnerable to default. But now, the higher cost of holding external debt because of the rise in interest rates portends an even more severe crisis in vulnerable countries. But not all less-developed countries are vulnerable. The more developed among the less-developed countries seem capable of sailing through.
According to the Institute of International Finance, global debt exceeded $305 trillion by mid 2022, or around 350 per cent of GDP. But not all of this debt is a problem because large chunks are held by countries like the US that can manage the burden. Borrowers from developed market economies as a group (consisting of governments, financial firms, non-financial corporations, and households) accounted for around two-thirds of the total. While some borrowers in these countries may be debt-stressed, the problem is not as yet systemic.
Further, of the $100 trillion or so held by borrowers in the emerging market economies (EMEs) group, a substantial share is with the more developed among them, especially China. Finally, a significant share of emerging market and developing economies’ (EMDEs) debt consists of local currency borrowing. Foreign currency debt is estimated at 10 and 15 per cent of GDP in China and India respectively, whereas local currency debt are at highs of 336 and 164 per cent respectively. This seems to suggest that actual or potential external debt crises, even if severe in some countries— Sri Lanka in South Asia; Ghana, Zambia, and Tunisia in Africa; and El Salvador and Argentina in Latin America—do not portend a systemic crisis of global dimensions.
No room for complacency
However, these characteristics do not give cause for complacency for a number of reasons. To start with, the recent sharp hike in interest rates and the slowdown in global growth as a result will affect a range of countries that are already burdened by balance of payments difficulties following the pandemic, which squeezed forex earnings, and the invasion of Ukraine, which raised food and energy import costs. Moreover, private financial investors are pulling out of emerging market economies in the wake of the monetary tightening in the developed countries. Because of the foreign exchange squeeze, no country with exposure to hard currency liabilities is insured against a crisis.
Second, even among the more developed among the less-developed countries, some have exposure to external debt that is high. Thus, the ratio of foreign exchange debt to GDP is 97 per cent in the case of Turkey, 62 per cent in Chile, 48 per cent in Argentina, 31 per cent in South Africa, 28 per cent in Brazil, and 26 per cent in Mexico. Some of these countries are already in default, and others could find themselves in a similar situation if global economic conditions worsen or do not improve soon.
Third, financial firms and institutions from the developed countries are significantly exposed to debt in poor countries. Bloomberg reported in July that emerging-market governments are holding $1.4 trillion of outstanding sovereign external debt denominated in dollars, euros or yen. More than $230 billion, or nearly 20 per cent of that, consists of debt held by bondholders which is currently trading in distress, or at interest rates that are 10 per cent higher than US. Treasuries of similar maturity. A debt default in these countries will have ripple effects in the financial sector and markets in the developed world, which in any case are in turmoil.
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Moreover, resolving debt crises by reducing and rescheduling debt will prove extremely difficult when a number of players with a small but significant share of external debt need to agree on a bailout package. If there are defaults in the more developed emerging markets as well, especially among financial and non-financial firms that borrowed heavily abroad when interest rates were low but have to repay when interest rates are high, the probability of severe ripple effects is greater.
Finally, a large number of debt-stressed developing countries are also climate vulnerable and need to undertake large expenditures to cover for private losses from extreme events and adapt to worsening climate conditions. If they are unable to do that because of debt stress, and if developed countries are not willing to cover these expenditures, the crisis in these countries may be longer term, with implications that can be far more damaging than a pure external debt crisis needing resolution.
Central Banks’ role
The responsibility of central banks in developed countries for this situation goes beyond the impact of their decisions to raise interest rates in response to inflation. Part of the reason for accumulation of external debt in less-developed countries was the easy availability of credit from abroad. This, in turn, was the result of easy money policies adopted by these central banks. Financial speculators in search of high yields could borrow cheap in advanced country markets to invest in lucrative bonds issued by sovereigns and corporations from the less-developed countries. The poorer and/or riskier the country, the larger the share of sovereign borrowing in the total.
When this process was under way, neither did foreign lenders exercise due diligence, nor did the IMF recommend that these countries should shut off inflows to prevent the excess build-up of foreign liabilities in the form of debt or footloose capital. In the event, the era of easy money justified by the low rates of inflation during the “Great Moderation” of the 1990s and 2000s resulted in debt accumulation at a rapid pace even before the pandemic and the war in Ukraine intensified the balance of payments strain. Low inflation encouraged a policy stance on the part of central banks in the developed world that led to debt accumulation. The return of inflation is triggering a policy shift that renders that debt unsustainable.
This pattern is, however, not new. During the late 1960s and 1970s, financial liberalisation and loose monetary policy in the US and the surpluses deposited by oil exporters in the international banking system resulted in surplus liquidity that found its way to the developing countries. The result was a sharp increase in debt. Lending by US commercial banks to Latin America rose from less than $30 billion in 1970 to $159 billion in 1978 and $327 billion in 1982. However, when inflation raised its head in the US and Paul Volcker was put in charge of the Federal Reserve, interest rates were hiked massively, precipitating the debt crises of the 1980s and after.
A similar fate is likely to overwhelm poor nations this time round as well.
C. P. Chandrasekhar taught for more than three decades at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi. He is currently Senior Research Fellow at the Political Economy Research Institute, University of Massachusetts, Amherst.