The US Federal Reserve’s decision to raise interest rates by 475 basis points over the course of 12 months, in a bid to curb inflation, was bound to be perilous.
As should have been expected, it precipitated a dramatic shift in yield curves and exposed vulnerable financial institutions to interest rate risks.
The collapse of Silicon Valley Bank, SVB, which was particularly exposed, with around 94 per cent of its deposits uninsured, revealed the threat posed by the Fed’s strategy. But it also highlighted another major tension in the Fed’s monetary tightening campaign, one of the most aggressive it has waged since the Volcker era: the tradeoff between price stability and financial stability.
For months, the Fed’s dramatic rate increases elicited two primary concerns: how to bring inflation to heel without causing a recession, and the implications for fiscal and debt sustainability in emerging-market and developing economies or EMDEs, which are always among the first victims when major central banks tighten monetary policy.
Last year was especially difficult for EMDEs. Initially plagued by sharp capital-flow reversals as investors sought higher yields in the United States, these countries are now also contending with increased debt-servicing costs following the dollar’s dramatic appreciation.
The ‘original sin’ of denominating external debt in foreign currency – usually dollars – is all too common in low-income countries, which lack developed bond markets. According to the United Nations Conference on Trade and Development, the foreign currency share of these countries’ debt is between 70 per cent and 85 per cent, making them extremely vulnerable to exchange rate volatility.
Yet there could be an unlikely silver lining to the United States financial system’s cloudy outlook. Recent interconnected developments – the collapse of SVB and other regional banks, the Fed’s forecast of slower US GDP, and last month’s precipitous drop in the Institute for Supply Management’s manufacturing index, indicating a possible recession – may lead to a rebalancing of US monetary policy, triggering a depreciation of the dollar.
This, in turn, would greatly reduce the pressure on low-income countries’ depleted foreign exchange reserves, creating the fiscal space they need to boost investment and economic growth.
The stronger dollar has resulted in interest rate spikes, higher import costs, and anaemic growth in these countries. In fact, a recent study found that a 10 per cent dollar appreciation leads to a real GDP decline of about 1.5 per cent relative to trend in emerging economies. Moreover, the exchange-rate pass-through has magnified already high inflation and further eroded households’ purchasing power, increasing the incidence of poverty and exacerbating the sharp deterioration in living standards caused by the COVID-19 pandemic.
Tighter financial conditions have also raised refinancing risks in EMDEs, most of which were slapped with large credit rating downgrades at the height of the pandemic. Coupled with steep currency depreciations – the Egyptian pound, for example, lost more than half its value last year – this has left many EMDEs on the verge of debt distress and without access to international capital markets.
According to the Institute of International Finance, emerging market net issuance of hard-currency debt was negative in 2022. As more and more EMDEs were shut out of the global financial system, bond issuance collapsed, and the few that could still access capital markets were forced to offer far higher risk premiums.
Even more dramatic was the impact of the dollar’s appreciation on the beneficiaries of the G20’s Debt Service Suspension Initiative, also known as DSSI, under which governments could defer payments on external debt for two years to free up fiscal space for pandemic-related spending. Among the 45 DSSI beneficiaries, comprising the world’s poorest countries, US$12.9 billion of debt service was suspended in 2020 and 2021.
But the dollar’s appreciation against these countries’ currencies, which averaged a whopping 22.5 per cent, increased their debt burden in domestic currency terms by more than US$34 billion. For example, in Zambia, which moved from the DSSI to the G20’s Common Framework for Debt Treatments after defaulting in 2020, the depreciation of the kwacha raised the debt burden to US$1.7 billion, more than double the US$700 million in temporary relief it received under the DSSI.
The operating environment in vulnerable countries, however, could become more favourable following SVB’s collapse. The dollar’s depreciation will continue and perhaps even accelerate later this year as the downward shift in US Treasury yields takes hold.
The Fed’s resumption of a more incremental approach since its March meeting – when it raised rates by 25 basis points, compared to the 75-basis-point increases of late 2022 – may mark a turning point in its monetary policy.
In a departure from the status quo under Fed Chair Jerome Powell, market expectations and the Fed’s interest rate trajectory are converging.
The market is pricing in a policy pivot, based on the belief that the Fed will cut rates later this year. And in their latest dot plot, most Fed officials indicated that a target federal funds rate between 4 per cent and 4.75 per cent would be appropriate for 2023 and saw rates falling to 3 to 4 per cent in 2024.
In that case, the dollar’s depreciation would act as a fiscally neutral stimulus to EMDEs.
For most, especially low-income countries, it will reduce the costs of servicing external debt, increase their fiscal space, and alleviate pressure on foreign exchange reserves. Moreover, a weakening dollar and the Fed’s policy pivot could also bolster demand for developing-country assets, which could enable more sovereign and corporate borrowers to return to international capital markets.
To be sure, another geopolitical shock could spark a new bout of inflation, which might lead the Fed to revert to interest-rate hikes. But in the immediate future, the global outlook points to deceleration, with the threat of a credit crunch intensifying downward pressure on US prices, ultimately to the benefit of the world economy.
To the extent that it has rebalanced the Fed’s policy objectives, the SVB debacle may have set the stage for an alignment of interests between the Global North and the Global South. For EMDEs, the potential fiscal relief cannot come soon enough.
Hippolyte Fofack is Chief Economist and Director of Research at the African Export-Import Bank (Afreximbank).(C) Project Syndicate 2023www.project-syndicate.org