Further rate hikes will decimate emerging markets

The U.S. Federal Reserve is set to raise interest rates by 0.75 percent for the second consecutive month as it tries to fight inflation. But while the U.S. central bank is trying to right the ship in the United States, its actions send ripple effects around the world. Whether those ripples become tsunamis depends on the timing of the Fed’s hike. If it’s during a time of economic growth, then the overseas impacts tend to be positive. When it’s during uncertain economic times, the outlook is less rosy. It also depends on how strong an economy is; advanced economies, which can usually raise money no matter the economic headwinds, are largely insulated. But for poorer countries, the effects can be dire. That’s because a U.S. rate rise can have a number of indirect effects internationally. It not only increases the cost of borrowing dollars; it also encourages investors to park their money back in the United States, draining poorer countries of investment. That, in turn, tends to boost the value of the dollar relative to other currencies, making it harder for poorer countries to pay back their U.S.-dollar-denominated debt. In its updated World Economic Outlook, released on Tuesday, the International Monetary Fund (IMF) warned of the effects interest rate rises in advanced economies could have on those further down the income ladder. The IMF particularly singled out the danger to low-income countries, 60 percent of which are at “high risk of debt distress.” “Higher borrowing costs, diminished credit flows, a stronger dollar and weaker growth will push even more into distress,” the IMF cautioned. The phenomenon is already playing out across emerging markets. Sri Lanka’s economic problems have several causes, but one is the high cost of debt repayments, which has only increased over the past year. Ghana has also been affected by the interest rate surge, which in part caused it to seek an IMF bailout this month. Bangladesh has followed the same IMF route, as its depreciating currency and import dependence left it burning through foreign reserves. On Tuesday, local media reported that its government was seeking $4.5 billion from the lender. Other countries could soon be next, with Argentina, El Salvador, Egypt, Tunisia, and Turkey all showing warning signs, Liliana Rojas-Suarez, a senior fellow at the Center for Global Development, told Foreign Policy. Rojas-Suarez said the problems plaguing some emerging-market countries are not just caused by rising rates but are best understood as an evolution: First came the pandemic, which encouraged these countries to go further into debt—at low rates—to survive the worst of that downturn. Then came the spiral of inflation as markets opened back up, followed by the ultimate shock: the war in Ukraine and the resulting price increase in key commodities like food and fuel. She blames the Fed for not dealing with the inflation warning signs earlier: “It means that now to contain inflation, the Fed has to increase interest rates much higher than if it had reacted earlier on. And that is the big problem for emerging markets. Because now, the cost of financing is going up and up and up.” The problem has not gotten worse largely due to savvy policy on the part of other emerging economies, particularly in Latin America, which began increasing interest rates earlier than the United States. There’s also the fact that this shock comes shortly after the previous one, so countries that got hit by the coronavirus pandemic have already taken on a lot of strain. “Emerging market currencies as a basket are not anywhere near back to where they were before the pandemic. And so that actually gives—maybe not more of a cushion—but less of a height to fall from,” Brian Nick, chief investment strategist at global asset manager Nuveen, told Foreign Policy. Emerging markets won’t suffer damage in the same way. Rojas-Suarez divides them into two groups: For those that can source their own fuel and food and have relatively low debt burdens, the shocks can be weathered (and, in some cases, even profitable), but hard times are ahead for net importers of commodities—especially for those with high debt. The good news for emerging markets is that if the Fed continues as expected, with a slight raise today followed by another at the end of the year, then the damage has already been priced in. “​​If that’s roughly what we get, then I don’t think emerging markets are in for incrementally more pain,” Nick said.