How the Fed Helped Create Another Calamity: The Ongoing Emerging Market Debt Crisis
When in March the Federal Reserve finally moved to belatedly embark on a series of rate hikes to slow the hottest inflation in the United States since the 1980s, it signaled impending trouble for many emerging market economies.
Often unable to market securities denominated in their own unstable currencies to international investors, many emerging market borrowers turn to floating bonds denominated in a major foreign currency, still overwhelmingly US dollars, to gain better access to global credit markets. Borrowers then make payments on those bonds by spending their reserves of that currency or, more often, by purchasing the necessary currency on the open market. This makes these borrowers particularly vulnerable to rises in interest rates, which can quickly and substantially raise their debt burdens, imperil their continued debt service, and threaten their wider local economies.
Even before the spike in global debt precipitated by the response to the pandemic, the World Bank could see trouble on the horizon. With the Federal Reserve having held interest rates so low for the past decade and a half, investors had been pushed back into the debt of riskier emerging markets in their search for yield. In the private sector, cross-border bank loans and corporate bonds denominated in dollars had proliferated in the years following the great financial crisis.
The danger, as an International Monetary Fund (IMF) paper released in the summer of 2021 succinctly put it, was that as the Federal Reserve was forced to raise rates, it also would raise debt servicing costs and reverse the already meagre postpandemic emerging market capital inflows at the same time it increased the cost of those countries’ vital imports, such as food, medicine, and fossil fuels. With growth already slow and total emerging market debt at the end of 2021 at a record high, over $90 trillion, 2022 was shaping up to be a difficult year for some two dozen emerging market economies already experiencing surging yields and widening credit default spreads.
While many of these crises are occurring or will occur at the global economy’s periphery, as in Sri Lanka or El Salvador, and therefore can be expected to have a minimal impact on wider markets, some have the potential to cause serious problems. In Pakistan, a nuclear-armed state is experiencing its worst political crisis in a generation under conditions of extreme fuel and food shortages and soaring inflation. Things have gotten so bad that in July the IMF (again) stepped in. In Kenya, elections in Africa’s sixth-largest economy are being disputed, while Nairobi’s largest creditor, China, has declined to offer the country any debt relief as its fiscal position continues to deteriorate, and like Pakistan, the country wants for natural gas.
Then there is Argentina. One of the usual suspects, inflation is once again out of control in South America’s second-largest economy, with political instability and dwindling foreign currency reserves to boot. While in Egypt, a transit point in global trade, Abdel Fattah al-Sisi’s government faces interest payments nearing 10 percent of its gross domestic product (GDP) on a debt load closing in on 100 percent of GDP, with high unemployment and an annual tax take on course to be overtaken by interest payments on the debt in the coming years.
Of course, it isn’t just the emerging economies that are being sunk by bad monetary and fiscal policy while being buffeted by continued postpandemic supply chain disruptions and the economic spillover from the conflict between the West and Russia over Ukraine. While the Fed’s hawkish pivot hasn’t impacted upon the European Union in anything like the way it is hitting much of the developing world, the ECB has plenty of problems to deal with within the currency bloc.
Greece, the real dead man of Europe, is still hanging around with 30 percent youth unemployment, a debt-to-GDP ratio of 210 percent, and interest payments on that debt amounting to over 6 percent of its annual GDP. More importantly, Italy, the EU’s third-largest economy is proving frail, with the ECB having to resort to a yield cap to prevent the further widening of the debt spreads facing one its most endangered members.
While each case has its specifics, and there are notable exceptions such as Ukraine, the general factors contributing to the crisis facing each endangered debtor country is some combination of what should by now be the familiar warning signs: a high and growing debt-to-GDP ratio, large structural deficit, monetary mismanagement, maturity mismatch, indebted private sector, declining tax take, and reliance on currency reserves or short-term funding to cover critical imports. Even in the absence of the current, daunting macroeconomic and geopolitical environment, therefore, it is hard to see how Sri Lanka, Lebanon, or Zambia was ever going to avoid a debt crisis.
While it is easy, even tempting, to reach for historical comparisons, like the Latin American debt crisis of the 1980s or the East Asian financial crisis of the 1990s, much of the most recent emerging market borrowing was conducted in local currencies, which will provide an inflationary buffer. With emerging market central banks experimenting with debt monetization using the now familiar credit facilities and programs, and the IMF and China already engaged in variously restructuring and supporting these governments, such an abrupt, systematically imperiling financial event seems unlikely.
Not that it will prove much, or any, consolation to those in the affected countries, who are suffering and will continue to do so. And the risk to the wider world, especially from an economic and political crisis in Islamabad, whose IMF funding is unlikely to cover the increasing costs of Pakistan’s food and fuel imports over the winter, should not be ignored.