Arab countries are among those affected.. This is how raising interest rates in America is stifling developing economies

Introduction to translation

How can US anti-inflation policies affect the economies of developing countries?

In his Foreign Affairs article, Gian Maria Melese-Ferretti, senior fellow at the Hutchins Center for Fiscal and Monetary Policy at the Brookings Institution and former deputy director of the International Monetary Fund's research department, argues that raising interest rates in the United States could have effects. devastating to emerging markets and developing countries, which mostly depend on the US dollar for international borrowing.

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US Federal Reserve Chairman Jerome Powell announced on March 16 that he would raise rates by 0.25%, the first in a succession of hikes designed to curb stubbornly rising inflation. in the United States.

Economists have debated whether this bout of inflation is the result of expansionary monetary policies - such as low interest rates and huge government spending - or whether it is triggered by special pandemic-related factors, including disruptions to supply chains around the world, followed by higher prices for manufactured goods. .

It remains unclear whether the rate hike planned by the US Federal Reserve is sufficient to curb the rise in prices, and to what extent it may reduce economic growth.

Jerome Powell, Chairman of the US Federal Reserve (the US central bank).

(Witters)

Whatever the effect of this, raising interest rates will not be limited to the United States, as high interest rates would raise the cost of borrowing in US dollars in global markets, as well as increase the demand for dollar assets compared to assets from other currencies. ;

Therefore, it causes the depreciation of other currencies.

As for countries whose debts are denominated in US dollars, paying the debts will be very costly for them.

The consequences of these effects will be dire for middle- and low-income countries.

In fact, these countries, compared to richer countries, have heavier debts, incur more cost to borrow, and are more exposed than others to the need to borrow in US dollars;

This is especially bad for emerging and developing markets, which are still suffering from the economic effects of the pandemic, and bad for food and energy importing countries.

Both prices have skyrocketed due to the war in Ukraine.

Most likely, these countries will see more pressure due to debt with a large float in their currencies;

This hinders its economic growth and makes it difficult to reduce poverty.

The world and the dollar

The US financial markets are by far the largest in the world, and the dollar is the world's primary reserve currency, the mainstay of global loans and the main currency used in international trade transactions and globally traded bonds.

Hence, the decisions of the US Federal Reserve have a tremendous impact on the economies of other countries.

This is especially true for emerging markets and developing countries, which mostly rely on the US dollar for international borrowing.

While the Fed is raising interest rates to curb inflation in the US, foreign borrowing in dollars becomes more expensive.

Increases in interest can also increase inflation in other countries;

As US assets have higher returns, they become more attractive to investors compared to assets from other currencies;

This increases the value of the dollar.

Therefore, this increases the cost of imports, which are often priced in US dollars.

The result of all this could be the resort to local austerity measures, which would slow down the pace of economic growth.

(The effect is that these effects are less severe in advanced economies, since they borrow mainly in their local currency, and prices are not likely to rise there when their currency depreciates.)

The US interest rate hike comes at a difficult time, as poor countries, to mitigate the effects of the pandemic, have had to borrow more, and because of the decline in economic activity during the pandemic, they are now struggling to pay the debts.

Economies based on tourism, for example, have seen their main source of foreign revenue dry up with the suspension of international travel.

Many emerging and developing economies are also facing domestic inflation resulting from production disruptions related to the pandemic and the rise in global food and energy prices.

It is precisely the rise in food prices that fuels inflation in these economies, as people spend a larger share of their income on basic commodities than people spend on food in rich economies.

In addition, rising food prices would fan the flames of social unrest.

Of course, the Fed can only set short-term interest rates. US long-term interest rates - such as the yield on government bonds maturing in ten years - have the greatest impact on economic activity and on long-term interest rates in other countries.

The increase is relatively small so far, and it indicates that markets are currently expecting that a short-term rate hike will have its effect at some point, and therefore inflation in the US will eventually subside, which is good news for emerging markets and developing countries.

If interest rate hikes remain small in the long run, the repercussions can be contained to a greater extent in the developing world.

But the quick and uneasy end of US inflation is not inevitable, as the world faces its first significant inflation shock in decades, an experience exacerbated by the turmoil of the pandemic and the war in Ukraine.

Inflation in the United States has already exceeded expectations, and exceeded expectations for 2021 by a large margin, and if demand remains strong in the United States and the labor markets remain in contraction in the country, inflation may prove more resilient than most expectations.

Therefore, the Fed will have to raise interest rates faster and more aggressively than the current market expects, which will lead to higher long-term interest rates.

Thus, the US economy may slow down more severely, and the global financial repercussions will also be more severe.

Uncertainty and economic uncertainty can hurt low- and middle-income countries, as, during periods of economic and geopolitical uncertainty, investors tend to withdraw from higher-risk markets.

The unfortunate end result may again be capital flight from developing countries;

Those countries that are in dire need of investment.

Belt tightening policy

Predicting the future is hard for economists, so economic analysts need to be modest about their forecasts.

No one knows exactly what path inflation will take in the US, how the Fed will respond to it, and what the ultimate consequences will be for other countries.

However, the past is the best guide that tells us what the developing world could be like when the United States tightens its belt on its fiscal policies, and sometimes history is hopeful.

The rise in interest rates, along with domestic economic and political factors, led to the collapse of the Mexican peso, causing a recession in the country.

Ultimately, Mexico needed a global financial rescue plan to avoid the risk of defaulting on its debt.

When the US Federal Reserve raised its interest rate from 1% to 5.25% between 2004-2006, emerging market economies were spared financial turmoil, in part because the US and global economies were growing rapidly.

Investors expected in mid-2013 that the US Federal Reserve would raise interest rates (and they did not rise recently), and as a result;

Long-term interest rates rose by 1 percentage point.

Many emerging markets have faced a decrease in the direct purchase or sale of debt securities by foreign residents, and the currencies of these markets have witnessed a decline in their value, but this effect is diminishing and evaporating within a few months.

In other cases, higher interest rates had clearer consequences.

Between February 1994 and February 1995, the Fed raised short-term interest rates by about three percentage points, while long-term rates rose by about two percentage points.

These increases, along with local economic and political factors, led to the collapse of the Mexican peso, which caused a recession in the country.

Ultimately, Mexico needed a global financial rescue plan to avoid the risk of defaulting on its debt.

Argentina was also hit then, but even then, there was no widespread wave of emerging market crises.

Similarly, when the Fed raised interest rates between March and December 2018, Argentina and Turkey faced sharp devaluations in their currencies, but the fallout was contained elsewhere.

However, a higher interest rate can cause major problems.

In the late 1970s and early 1980s, US Federal Reserve Chairman Paul Volcker doubled interest rates by 20% to tackle US inflation.

He has already succeeded;

But the shock waves of US fiscal tightening created a debt crisis with many defaults in developing and emerging economies.

GDP declined between 1981 and 1983 by 2.8% in Brazil, 4% in Mexico, 7.5% in Venezuela, and 16% in Chile.

Many poor countries are not well protected, with US inflation the highest in decades.

The impact of higher interest rates so far may be minimal, since many middle-income countries have strong financial institutions (and independent central banks are involved) much more than they did in the 1970s, 1980s, or even the early 2000s.

These countries today are less dependent on borrowing in US dollars, and have large foreign exchange reserves.

It also allows and allows its currencies to float more than it was previously, which means that it can devalue its currency in periods of crisis without provoking these dire local repercussions.

In addition, higher commodity prices help emerging and developing economies to export goods, as they can now sell their goods at higher prices.

However, many poor countries are not well protected from the effects of these repercussions in light of the highest US inflation in decades.

Perhaps Washington's policies to adapt to this situation are more severe than any that it has implemented since 1994. The Fed's decisions to raise interest rates by other central banks could become even more severe, given that advanced and emerging economies are also facing rising inflation.

This means that, despite the low probability of a severe crisis in the prominent emerging economies, many poor countries - already suffering from increasing rates of poverty - will not tolerate increased levels of external debt.

An increasing number of countries may request loans from the International Monetary Fund, as Sri Lanka did recently, and then face renegotiation with external creditors.

Since the pandemic began, the International Monetary Fund, the World Bank, and the world's richest countries have been discussing debt forgiveness for poor countries, as well as forgiveness for countries facing severe consequences from the pandemic.

As the US Federal Reserve seeks to control inflation in the United States, the necessity of this exemption will become more urgent.

A large part of the developing world may be able to weather this inflationary storm.

But if US interest rates rise sharply;

More countries will be in dire need of international financial support, and will be forced to restructure their public debt to avoid catastrophic economic downturns.

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Translation: Karim Muhammad

This report is a translation of Foreign Affairs and does not necessarily reflect the website of Meydan.