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

Ludovic Subran

Published: 4:30pm, 20 Oct, 2022

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The mood at the annual meetings of the World Bank and International Monetary Fund was all doom and gloom. Global debt is ringing alarm bells. Increasingly restrictive US monetary policy is having an outsize tightening effect on the rest of the world and hitting emerging markets the hardest.

Central banks in emerging markets put an end to extraordinarily low interest rates induced by the Covid-19 crisis much earlier. However, as inflation in the United States continues to surge, the US Federal Reserve’s aggressive rate increases in the last three months have amplified existing challenges for emerging markets, kick-starting a reverse currency war.

Uncertainty sparked by the war in Ukraine and rising US interest rates have driven up the US dollar, squeezing emerging markets that borrow in foreign currencies. The stronger dollar is also intensifying inflation elsewhere by making commodities even more expensive.

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.

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Emerging Europe, Latin America and Africa are expected to see the largest interest rate increases. Emerging markets as a whole are expected to start gradually easing only in mid-2023, though central banks in emerging Europe and Africa, where inflation is likely to be more sticky, will lag behind. In this complicated context, emerging markets are left with limited ammunition against the reverse currency war – more drastic policy measures, such as intervening in foreign exchange markets, or even imposing capital controls.

Which countries are most at risk? Since the last “ taper tantrum” in 2013, most emerging markets have gradually improved their external positions and built policy buffers, but net food and energy importers in particular have become very vulnerable. Of these, 11 countries could face balance of payments crises: Hungary, Romania and Türkiye in eastern Europe; Egypt, Ghana, Kenya and Tunisia in Africa; Pakistan in Asia and, to a lesser extent, Argentina, Colombia and Chile in Latin America.

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.

Potential balance of payments crises also make sovereign defaults more likely. While most of the countries at high risk are small developing economies such as El Salvador, Ethiopia, Ghana, Kenya, Malawi, Mozambique and Tunisia, the defaults could hit larger and more systemic ones – Argentina, Egypt, Pakistan or Türkiye – that are in stressed situations as well.

There are some signs that emerging markets are more resilient today than they were during previous debt crises thanks to floating exchange rates, a larger role of the local debt market and their early tightening of monetary policy. However, with the Fed likely to stay the course in fighting inflation, urgent policy action is needed to address the rising rollover risk in emerging markets as more than US$75 billion worth of hard currency bonds are maturing by the end of 2023 alone.

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This year, the IMF set a record with more than US$130 billion in loans disbursed to vulnerable economies. The IMF’s lending headroom has increased by US$650 billion after the last special drawing rights allocation in August 2021. More support is possible and probably necessary at a moment when the decades-old Paris Club collective debt-resolution process could lose its effectiveness.

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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.

Central banks can also help directly and indirectly. Cross-currency swap lines would offer a direct way to reduce liquidity risk in many emerging markets. Indirectly, they could also address the adverse impact of the current pace of monetary tightening on market functioning.

Rapidly deteriorating liquidity conditions matter a great deal for the valuation of emerging market debt, which relies heavily on intermediation. As high volatility puts a large amount of pressure on market makers subject to margin calls, they suffer disproportionately if liquidity dries up and access to central bank money is limited.

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