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As US Federal Reserve Raises Rates, Emerging Markets Brace for Impact

Federal Reserve Board Chair Jerome Powell speaks during a news conference at the Federal Reserve, May 4, 2022 in Washington

Experts warn that the Federal Reserve's efforts to tamp down inflation in the United States could have damaging effects, perhaps lasting several years, on developing economies around the world by encouraging capital flight, raising the rates on sovereign debt and destabilizing their currencies.

On Wednesday, the central bank announced that the Federal Open Market Committee, which sets the benchmark federal funds rate, had voted to increase the target rate by one-half of 1%, to between 0.75% and 1%. Further, the Fed indicated that it aimed to impose a series of additional half-point increases through the remainder of the year.

"Inflation is much too high, and we understand the hardship it is causing, and we are moving expeditiously to bring it back down," Fed Chair Jerome Powell said in a news conference after the committee meeting Wednesday.

When Powell said that increases of more than 50 basis points were not currently part of the central bank's plan, he offered some relief to those wondering whether the Fed might be considering even larger increases. Nevertheless, the prospect of the Fed going into full inflation-fighting mode has many concerned about the impact its actions might have on developing countries.

Multiple concerns

There are a number of reasons emerging markets might suffer when U.S. interest rates rise.

One is the prospect of capital flight. Investors who have invested in emerging markets to take advantage of higher rates of return may find investment in the U.S. more attractive as rates rise, prompting them to move capital to the U.S.

Higher interest rates in the U.S. can also result in higher rates globally. In April, the International Monetary Fund issued a report that found that 60% of low-income developing countries were either already experiencing debt distress or were at high risk of doing so. The report warned, "Past episodes suggest that rapid interest rate increases in advanced economies can tighten external financial conditions for emerging market and developing economies."

Another danger to emerging economies in a rising interest rate environment is currency depreciation, which reduces purchasing power and increases the difficulty of servicing debt denominated in foreign currencies, such as the U.S. dollar.

Former Federal Reserve Chairman Ben Bernanke, left, talks to Federal Reserve Chairman Jerome Powell on June 4, 2019, in Chicago.
Former Federal Reserve Chairman Ben Bernanke, left, talks to Federal Reserve Chairman Jerome Powell on June 4, 2019, in Chicago.

Historical perspective

Economic historian Jamie Martin, an assistant professor at Georgetown University, told VOA that there is a strong historical correlation between sharp interest rate increases in the U.S. and catastrophic economic consequences in the developing world.

In the years after World War I, a rise in rates orchestrated in part by the Fed and the Bank of England helped reverse a recession in major industrialized countries. However, it resulted in several years of curtailed growth in nonindustrialized countries.

Similarly, the Fed's aggressive rate hikes in the early 1980s successfully tamed double-digit inflation in the U.S. but pushed global interest rates so high that numerous developing countries, particularly in Latin America, defaulted on their debts.

In 2013, when then-Fed Chair Ben Bernanke hinted that rate increases were on the horizon, the impact on emerging markets was instant, with capital rapidly flowing out and currency instability setting in.

"History should counsel extreme caution," Martin said. "Because, over as long as a century, when the U.S. Fed and other kinds of globally systemic central banks have moved to aggressively tighten monetary policy, almost every time, it's had dramatic global effects. Particularly in what we have come to call developing economies."

FILE - In this Nov. 26, 2008, file photo former Federal Reserve Chairman Paul Volcker listens to President-elect Barack Obama.
FILE - In this Nov. 26, 2008, file photo former Federal Reserve Chairman Paul Volcker listens to President-elect Barack Obama.

Fed research supports concern

The impact of U.S. rate increases on the developing world has not always been well understood. Paul Volcker, the Federal Reserve chairman who orchestrated the increasing of interest rates to nearly 20% in the 1980s, would later say that his focus had been on the U.S. and that the impact on the developing world hadn't been part of his calculus.

"Africa was not even on my radar screen," he said.

Now, though, the connections between actions by the Fed and the broader global economy are better understood.

In a 2021 article published by the central bank, Fed economists Jasper Hoek and Emre Yoldas, and Steve Kamin of the American Enterprise Institute noted that there are multiple instances in which rate increases in the U.S. have been shown to "increase debt burdens, trigger capital outflows, and generally cause a tightening of financial conditions that can lead to financial crises."

While they didn't find that economic crises in emerging markets always resulted from U.S. rate hikes, one of their observations would seem to apply to the current circumstances: "If higher rates are driven mainly by worries about inflation or a hawkish turn in Fed policy … this will likely be more disruptive for emerging markets."

Pushed 'over the edge'

Organizations that track the indebtedness of developing countries warn that conditions across the developing world are already dire. In particular, the effects of the coronavirus pandemic as well as a global spike in food prices exacerbated by the war in Ukraine have already created severe economic disruption.

A recent debt default by Sri Lanka has some concerned that further defaults may be coming.

"Many lower income countries have already been pushed into (a) deep debt crisis by the pandemic and rising energy and food prices," Jerome Phelps, head of advocacy for the London-based Jubilee Debt Campaign, told VOA in an email exchange.

"They are diverting crucial resources away from healthcare and the needs of communities to debt payments, often to U.S. and European banks who stand to make large profits if repaid in full," Phelps wrote. "Rising U.S. interest rates will push many over the edge by making their debt payments suddenly more expensive, for no fault of their own. We need urgent debt cancellation so that countries can prioritize recovery from the multiple crises they face."