Federal Reserve’s inflation fight leaves emerging markets scrambling for answers
- The US central bank’s aggressive interest rate increases, coming amid the pandemic and Ukraine war, have amplified challenges for emerging markets and started a reverse currency war
- With these markets looking at drastic measures to stay afloat, it’s time for urgent action from international lenders and central banks
In this context, central banks in emerging markets are stuck between a rock and a hard place. High inflation makes it virtually impossible to let exchange rates adjust external imbalances, causing even more capital to flow out of emerging markets.
At the same time, central banks need to raise their own rates to contain imported inflation, which tightens domestic financing conditions even more. In fact, with public finances stretched because of measures implemented during the pandemic, most emerging markets are leaning on monetary policy to tackle inflationary pressures, which are now expected to peak in early 2023 as the global energy shock has intensified.
In these countries, the global tightening cycle could cause periods of stress in terms of severe capital outflows, especially if the right counterbalancing measures are not taken. If inflation remains high for longer than expected, keeping interest rates above 3.5 per cent in the US and 2.5 per cent in the euro zone, the risks could spread to a second set of countries including Mexico, South Africa and Poland.
The World Bank and regional development banks have also scaled up their lending to the most vulnerable countries. However, countries themselves must do their part, including by adopting more efficient financial management practices, rebalancing expenditures towards growth-friendly policies and establishing transparency on all external creditors.
There are no quick fixes, but supporting market functioning should be top of the list. Safe collateral is crucial for market liquidity, but much of it remains parked on central bank balance sheets.
Making securities lending more widely accessible at lower cost could address current collateral scarcity. Finally, widening collateral eligibility for accessing central bank money could boost precious liquidity in the corners of the capital market that are most at risk of liquidity squeezes, which would especially help emerging market debts.
Ludovic Subran is the chief economist of Allianz and a member of the Council of Economic Advisors to the French prime minister