The Federal Reserve’s new anti-inflation campaign has many investors in sight, as Wall Street showed again on Wednesday. But don’t even think about emerging economies, which often suffer crises as a result of policy mistakes elsewhere and are vulnerable to another risk.
The underlying problem is the massive financial flows that the Federal Reserve and other central banks have unleashed with ultra-wide monetary policies during the pandemic. Central banks wanted investors to pursue returns by taking on greater risks, and some of the best-returning risks were in developing economies. Capital flows to South and Southeast Asia, South America and Africa.
The hunt for foreign capital has lowered borrowing costs, allowing emerging market governments to increase borrowing to an average of 67% of GDP from 52% before the pandemic. The private sector in developing economies has also expanded its debt, reaching an additional $5.8 trillion in borrowing by households and non-financial firms over the past year, according to a report released Wednesday by the Institute of International Finance (IIF).
The danger is that those bills will come due now, a long time ago. High interest rates is an urgent issue, especially for governments. Interest expenditures as a percentage of government revenue, at about 10%, is the highest since before the 2007-2008 panic and is expected to rise.
To make matters worse, interest rates in the West are rising due to rising inflation and despite signs of fragile economic growth. A slowdown in global trade due to slowing demand in the United States and Europe would exacerbate developing economies’ debt problems by reducing corporate income and tax revenue on which those countries depend to pay off debt.
Exchange rate fluctuations are another risk as the dollar has appreciated over the past several months. Although the majority of borrowing in emerging economies is done in local currency, dollar borrowing as a share of GDP in developing countries (excluding China) has hit a record high of about 17% under the pandemic and remains high. This is the classic recipe for a currency mismatch crisis, in which borrowers have to pay out larger amounts of declining local currency to service dollar debt.
This is mainly corporate debt. As of the first quarter of this year, corporate debt in dollars as a share of GDP was 10.3% in Thailand, 20.3% in Turkey, 8.1% in Indonesia, 14.5% in Brazil, and 32.4% in Chile, according to the Institute of International Finance. . Central banks in emerging markets may have to tighten monetary policy to counteract this phenomenon by boosting the value of their currencies – leading to increased debt servicing costs.
This is how countless crises in emerging markets have developed over the years. No one can say with confidence whether someone else is in the near future. But if it does emerge, advanced economies will not be immune to damage.
The United States and Europe escaped the debt crises in Russia and East Asia in the 1990s because Western economies were in good health. Since then, supply chains have become more complex, and Western economies have become more fragile due to the pandemic and their own debt and policy mistakes. The emerging market crisis is now an experiment that no one wants to do.
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appeared May 19, 2022, print edition.