Additional rate hikes will trigger a wave of defaults in emerging markets – leads to mass instability in Europe and Africa

The Federal Reserve’s efforts to fight inflation threaten to send the U.S. economy into a recession. They could also spark a series of economic crises in developing countries around the world. Higher interest rates are making it more expensive for many emerging economies to pay off the crushing debt they took on to survive the pandemic. On top of that, the war in Ukraine has sent the cost of staples like food and fuel skyrocketing. That’s bad news for dozens of countries where public finances are in perilous shape, such as Ghana, Kenya, Pakistan and El Salvador. The situation remains tenuous even for some larger emerging markets like Turkey that have underlying economic problems. “There is certainly a fragility that could interact with tighter financial conditions in a way that could trigger a certain amount of stress, even in some fairly healthy emerging markets,” said Tobias Adrian, director of the International Monetary Fund’s monetary and capital markets department. As the caretaker of the world’s reserve currency, the Fed has massive influence on global financial markets at a time when they are growing more tightly integrated. Monetary policies to slow inflation, such as raising borrowing costs, are transmitted primarily through these markets. As higher rates push up the value of the dollar, debt held in U.S. dollars anywhere in the world becomes more expensive to pay off. The Fed’s rate hikes can also lead to severe outflows of capital from other countries as investors pull their money out of emerging markets to get a better return in the U.S. This can have destabilizing effects on their economies. New data released Wednesday shows that emerging markets suffered a record-breaking fifth consecutive month of investors pulling their money out. The numbers, compiled monthly by the Institute of International Finance, a trade group for the global financial services industry, show that the capital flight — totaling $39.3 billion since March — is reaching the level of the “taper tantrum” crisis in 2013, when another move by the Fed to pull back support for the U.S. economy caused financial panic in some emerging markets. The stewards of the global economy are warning of extreme uncertainty as the Fed and other major central banks ratchet up their moves to tighten financial conditions around the world to battle spiking inflation. The IMF’s latest update to its global economic outlook revised inflation upward to 6.6 percent in advanced economies and 9.5 percent in emerging markets — nearly a full percentage point higher than previously forecast. Roughly 60 percent of low-income countries are in debt distress or close to it, according to the IMF. The amount of debt they could potentially default on totals $455.6 billion. If these countries were to default, it could mean hardship as governments would be unable to provide support for a wide swath of the world’s population. But former officials and experts say the shape of a potential Fed-induced global debt crisis looks different than in the 1980s, when rate hikes sent many economies into collapse. “Global financial markets have grown substantially as have capital flows, and the U.S. role in the global economy has somewhat declined with the rise of China and other emerging markets,” said Mark Sobel, a former Treasury official and U.S. chairman at the Official Monetary and Financial Institutions Forum think tank. The impact of the Fed’s policies may be felt the most in countries that are already fighting high levels of inflation and tighter financial conditions due to domestic and global pressures. That includes Central and Eastern Europe and sub-Saharan Africa, which are being hit the hardest by the shock of high commodity prices on fuel and food as a result of Russia’s war in Ukraine.