Fed policy could create belt and road debt default headache for China
- The US central bank will do whatever it takes to curb inflation, including cutting the supply of US dollars and raising borrowing costs, leaving emerging economies struggling to buy dollar-denominated goods
- Even China, seemingly protected by its huge reserves of US dollars, is at risk as a major lender to smaller economies
With US consumer price inflation currently above 8 per cent, way above its 2 per cent target, the Federal Reserve is going to do whatever it has to do to remedy that situation and, let’s not be under any misapprehensions, the Fed sets monetary policy only with the interests of the US economy in mind. If that is a problem for other countries, c’est la vie.
In 1994, the Federal Reserve embarked on a sequence of US rate hikes that helped precipitate the Mexican peso crisis.
In the second half of that year, growing market nervousness about the sustainability of Mexico’s domestic fiscal and monetary policies, allied with rising yields on US Treasuries, prompted massive capital outflows out of the Mexican peso and into the US dollar that put the peso’s then-pegged value to the greenback under enormous strain.
Unable to hold the line, Mexico moved the peg on December 20, 1994, devaluing the peso versus the greenback, only to find that the pressure on the Mexican currency did not dissipate. Throwing in the towel, the Mexican authorities opted for a full float and further devaluation before the end of that year. A full-scale Mexican sovereign debt default looked a real possibility.
Recognising that instability in its southern neighbour was not in the US national interest, the Clinton administration, by the end of January 1995, orchestrated a multinational and supranational bailout for Mexico.
As for the Federal Reserve, it still pushed up rates to 6 per cent at the end of January 1995, holding them there until July when it trimmed them by 25 basis points.
A similar convergence of attractive US yields with investor scepticism about the sustainability of the existing financial situation and, by extension, existing exchange rate levels also fuelled the Asian currency crisis of 1997-98.
That is potentially a massive problem for any nation that lacks US dollars or the wherewithal to acquire them, greenbacks that are nevertheless required to buy essential US dollar-denominated commodities.
Big economies, such as China, which have extensive foreign reserves, including copious amounts of US dollars, are better placed to withstand the side-effects of US monetary policies that have been crafted by the Federal Reserve to address solely the issue of elevated US consumer price inflation.
Emerging and frontier market economies, with fewer foreign reserves but which still have plenty of debt to service and US dollar-denominated commodities to purchase, are far more vulnerable.
That US$6.5 billion is potentially just the tip of a belt and road debt default iceberg. The Fed will forge ahead regardless.
China’s own economic strength provides protection from the direct side-effects of tighter US financial conditions, but the economic weakness of other countries could mean Beijing ends up with a belt and road debt default headache.
Neal Kimberley is a commentator on macroeconomics and financial markets