Emerging market countries were already facing increasing economic distress due to the large expenditures needed to fight the pandemic and, later, food and fuel price spikes caused by Russia’s invasion of Ukraine. . But tighter U.S. monetary policy will compound those problems, as rising U.S. interest rates can drive up the cost of debt financing for the dozens of low-income countries that borrow in dollars.
Soaring dollar could help the Fed fight inflation
The reaction of American and Western policymakers could have major political and economic consequences, both internationally and domestically. U.S. exports could be jeopardized if foreign markets deteriorate, and a global economic slowdown would threaten the U.S. recovery. Biden administration officials face questions about how aggressively to respond to these challenges. Yellen, for example, is pushing China to allow countries in crisis to reduce what they owe to Beijing. But administration officials are also prepared to reject calls from other Democrats to support disbursing additional aid through the International Monetary Fund (IMF), a move that would require U.S. support.
Asked about high levels of public debt in the developing world, Yellen told reporters last week that tighter monetary policy “can make these debt problems, which are already very serious, more difficult.” His comments were later echoed at meetings of the Group of 20 finance ministers in Indonesia by Kristalina Georgieva, the managing director of the IMF, which provides emergency financing. The European Central Bank’s surprise decision on Thursday to raise its benchmark interest rate by half a percentage point – the first such move in 11 years – could cause poor countries’ currencies to lose even more value. .
“With financial conditions tightening,” Georgieva said, “the burden of debt service is a heavy burden – and for some countries, unbearable.”
Many economists say countries considered emerging markets — generally defined as having some level of economic development but not yet “advanced” wealth — are already under the greatest pressure they have faced in about 30 years. According to the World Bank, around 60% of poor countries are “over-indebted or at high risk”. Sri Mulyani Indrawati, Indonesian Minister of Finance, warned at the opening of the G-20 of a “triple threat” facing the developing world: soaring inflation, the covid pandemic and the effects of the war in Ukraine. Already, the number of hungry people around the world has exploded from 135 million to 276 million this year alone, a trend that is part of deteriorating financial conditions in much of the world, she said.
“Every day there is something. Every day there is more news about the debt stress of developing economies, downward revisions to global economic growth and rising poverty and hunger,” said Mark Weisbrot, economist at the Center for Economic Policy and Research, a left-wing think tank in Washington. .
Poorer countries often borrow in US dollars, both to help pay for imports they cannot otherwise produce and to bolster the international credibility of their bank reserves. A downside is that “dollar-denominated debt” makes these countries vulnerable to fluctuations in the value of the US currency, changes beyond their control. When the Federal Reserve raises the interest rate, the dollar becomes more expensive against other currencies. This makes paying off borrowing countries’ debt more expensive.
The challenge is made more acute by the latest inflation report showing US prices rose at a blistering 9.1% in June; this report came out while Yellen was meeting with finance officials in Asia. The June report should prompt the central bank to hike rates even more aggressively when bank leaders meet on Wednesday. This will in turn make matters worse for low-income countries.
Yellen told reporters that a stronger dollar could benefit the economies of poorer countries, making their exports to the United States cheaper and more attractive to American consumers. And many analysts point out that emerging markets are, in general, in much stronger positions than they were during the liquidity crises of the 1980s in Asia and Latin America, which were triggered by the massive increases Fed rate at the time.
But danger signs are emerging in many parts of the world. Between the start of the pandemic and today, the average ratio of public debt to gross domestic product in the developing world has fallen from 52% to a record high of 67%, Weisbrot said. Some economists point to this month’s revolt in Sri Lanka as evidence of the financial threat to emerging markets, though that country is in many ways thwarted by idiosyncratic domestic challenges unrelated to the broader landscape.
A step that is becoming urgent is an attempt to push China to implement a global deal to relieve deeply indebted countries.
While in Japan earlier on her trip, Yellen criticized China for resisting attempts by low-income countries to renegotiate their repayment obligations. As countries grappled with debt stress during the pandemic, G-20 countries agreed in principle in 2020 to a “common framework” intended to create new rules for restructuring sovereign debt when it becomes clear. that it cannot be refunded. But while countries like Chad, Ethiopia and Zambia have asked for help under the revised guidelines, China has been reluctant to implement it.
This reluctance has made US and IMF officials increasingly exasperated. Briefing reporters in Indonesia ahead of the talks, Treasury officials said they were emphasizing to China that it was in that country’s interest to agree to the revised debt terms – because if the debtor countries’ economies collapsed, China would be even less likely to recover its loans. South African Finance Minister Enoch Godongwana raised the issue with Yellen in Indonesia, according to his spokesperson.
Yellen told reporters last week that it was “quite frustrating” that China had not cooperated with debt restructuring efforts. Later, in Indonesia, she again urged China: “More needs to be done to help the most vulnerable. … One of the main purposes of this trip is to push G-20 creditors, including China, to finalize debt restructurings for developing countries currently facing debt overhangs.
The United States faces its own pressure to ease the debt burden of distressed countries. The African Union, which represents more than 50 countries, has called for a new allocation of “special drawing rights”, an IMF-run program that provides emergency capital to countries in need. About four dozen congressional Democrats have also called on the administration to lead a disbursement of those drawing rights, similar to the $650 billion issued last year for pandemic relief, arguing that economic conditions are tougher. now than they were then.
But the Treasury Department said in a statement that the administration does not support such a move, instead pointing to a lesser effort to offer loans based on existing drawing rights. Republican lawmakers have characterized IMF funds as a form of unwarranted economic aid that enriches geopolitical enemies of the United States. Rep. French Hill (R-Ark.) recently told Bloomberg News that such aid is a “gift to rich countries and rogue regimes” like China, Russia and Iran. The Treasury statement indicates that the United States may be willing to support another allocation if global conditions change.
China has a role in Sri Lanka’s economic calamity
As the dollar rises, Treasury and IMF officials are also trying to figure out how to respond to the falling value of emerging market currencies.
Traditionally, the United States and its allies have largely discouraged attempts by nations to manipulate the value of their currencies for the purpose of gaining commercial advantage, which is done by exchanging substantial amounts of currency on international stock exchanges, altering artificially the market. Similarly, countries are discouraged from imposing “capital controls” – legal limits on outgoing investor funds – because such measures are seen as ineffective and likely to prolong nations’ underlying economic dysfunction.
At Nua Dusa during the G-20 meeting, however, Yellen stressed increased flexibility in allowing these tactics. She stressed that such interventions should be extremely rare and only used in certain circumstances when all other options have been exhausted. She backed new IMF guidelines that encompass what advocates see as a more nuanced approach to such maneuvers.
This revised prescription may soon be put to the test. With the Fed dramatically increasing the strength of the US dollar, countries could within months find themselves in the grip of a massive flight of investment into the US dollar. The Biden administration will face pressure to help craft the response to an unprecedented set of economic challenges.
“Even with sound fundamentals and strong institutions, financial flows can be volatile,” Yellen said. “…It may be beneficial to add a broader set of political tools to the playbook.”