The Federal Reserve Is Making The World A Much Riskier Place
In response to US inflation the Federal Reserve has recently reversed direction on its position for the last decade. The easy money is gone, interest rates are being hiked and its balance sheet is shrinking. Americans will ‘feel some pain’ Chairman Powell warned in May.
The fed has made the macabre calculation that raising interest rates, and risking a recession that could cause millions to lose their jobs and homes is a better outcome than exposing hundreds of millions of Americans to inflation, and they’re probably right.
But the actions of the fed have repercussions far beyond the pacific and Atlantic oceans.
The majority of emerging market (EM) countries can’t fund government defecits with their own currency, as lenders don’t trust them to not inflate the debt away. As as result, if an EM country runs a defecit, it needs to borrow in USD. Over time, this means that these countries will run up significant amounts of dollar-denominated debt, and the EM economy will need a steady stream of dollars in order to service it, usually paid for by the exportation of raw resources, the demand for which is largely dependent on the strength of developed economies.
The last time the Federal Reserve tightened its monetary policy was 2013, following the measures it took in the wake of the 2008 crisis. The fed policy between 2013–2016, the so-called ‘taper tantrum’ prompted a flow of capital out of emerging market currencies and prompted the strengthening of the US dollar against those currencies, a pattern we can expect to repeat again in 2022–2023.
This is bad news for developing economies. In addition to servicing their debt, 88% of all international transactions involve USD. For developing countries running deficits, this increases the cost of dollar borrowing and international transactions making it much harder for governments to fund their programs.
Shortages of energy and food are going to further boost volatility and political risk, especially in countries reliant on imports. Sri lanka already effectively collapsed earlier this year and is unable to import oil, with many other countries around the world restricting agricultural exports.
Increased cost of borrowing and completing international transactions means that the governments of developing economies need to cut back their spending or face economic ruin of runaway debt and inflation. The last time these cutbacks happened prompted a wave of political change. 2013–2016 saw some of the largest political changes in decades across the developing world. Narendra Modi was elected in India in 2014, Bolsonaro came to power in 2016, President Erdogan seized power after surviving an attempted coup in turkey in 2016. The middle east fractured with the Syrian civil war, the rise of ISIS and the Egyptian crisis were all exacerbated by economic hardship.
The 2013–2016 ‘Taper Tantrum’ happened in a different environment than today. Middle-income developing economies have a median ratio of debt-to-GDP of 60%, compared to 40% in 2013.
Further strengthening of the US dollar and increases in interest rates by the federal reserve will put more pressure on fragile economies and create conditions that are ripe for major political change.
As with any systemic pressures, the countries most at risk are the ones at the extremes: the countries running the largest deficits and most dependent on imports of critical goods like energy and food.
As with all things ‘Geopolitical’ it’s hard to see clearly whether or not any outcomes are certain, but if present trends continue the stage is being set for another wave of instability, populism and political upheaval that changed things so dramatically only a decade ago.
