As central banks across the world hike interest rates amid a global burst of inflation, a relentless logic dictates that many foreign economies may buckle before the Federal Reserve’s hiking cycle is complete. The US economy has continued to show strength despite the Fed’s actions to date, so US interest rates (and the US dollar) have further to rise before the Fed achieves a domestic slowdown sufficient to quell inflation. But other economies, notably the emerging-market and developing economies (EMDEs), are closer to recession.
These economies are now beset by capital outflows and in some cases currency depreciations approaching or beyond levels that last prevailed at the height of the panic of March 2020 (see figure 1). Still laboring under pandemic legacies, many of these economies could soon face crises that the international financial system remains ill equipped to handle in an orderly fashion. Now is the time for richer countries—the grouping often referred to as “the West”—to provide more support for the world economy, and it is in their interest to do so.
EMDEs face a double threat
EMDEs must absorb a two-fold blow under current macroeconomic conditions. After making impressive progress to contain inflation over recent decades, they are raising domestic interest rates to prevent inflation from again becoming entrenched. At the same time, dollar appreciation and its flip side, the depreciation of EMDE currencies, worsens the financial capacity of EMDE borrowers with dollar debts while also accelerating import price inflation.
These rising import prices reduce the real value of incomes, add to overall domestic inflation, and induce further contractionary rises in interest rates. At the world level, synchronized monetary contraction in response to the strong dollar risks an unnecessarily deep global recession. Clear stress signs for EMDEs are appearing in financial markets, for example, in the rising prices of insuring sovereign debts from default (see figure 2).
Policy options are constrained
What policy options do EMDEs have? Those that are available may have limited effectiveness and come with significant tradeoffs, though some EMDEs are already pursuing them. One option is foreign exchange intervention, that is, sales of hard-currency reserves (mostly dollars) for the domestic currency, aimed at resisting its depreciation. However, many EMDEs rely on sizable reserve war chests to inspire market confidence, and they could burn through large volumes of their holdings in prolonged battles against a strong dollar.
A second approach would be tighter controls on financial capital outflows. But this route also comes with costs. EMDEs that tighten nonresident outflows will face reputational damage that would worsen their future access to international capital markets. Prohibitions exclusively targeting resident outflows might yield limited benefits while inflicting considerable domestic administrative and political costs.
Strong countercyclical fiscal responses are mostly off the table in light of higher sovereign debt levels everywhere.
How richer countries can help
Central banks around the world have been correct to take decisive action against inflation—especially the richer countries, which were slower to appreciate the inflationary threat than were many EMDEs.
Ultimately, a failure by central banks in the United States and other rich countries to contain inflation now will impose immense costs around the world. But their belated scramble to hike rates on an accelerated schedule is forcing a rapid financial tightening onto EMDEs.
As the pressure on those countries intensifies, richer countries could take several actions that would ease EMDEs’ policy tradeoffs while not materially undermining the battle against global inflation.
- A collectively agreed, deliberate path of interest rate hikes, including by the Fed, would allow well-telegraphed and credible action on inflation that reduces the risk of an overshoot into deep global recession. Central banks can make better-informed decisions and avoid beggar-thy-neighbor outcomes if they exchange their planned policy moves as well as their likely responses to others’ moves.
- The renewal of Federal Reserve currency swap lines in March 2020 played a key role in limiting the sharp capital outflows and currency depreciations sparked by the pandemic’s initial phase. It is time once again for a range of rich-country central banks to extend swap lines to a broad set of EMDEs. Swap lines effectively expand available foreign exchange reserves, while also signaling support from the international community.
- Richer countries could intervene in some EMDE currency markets to buy EMDE bonds after due consultation with the issuing countries. Adam Posen and I suggested this tactic in April 2020 as a contingency should disorderly markets drive the dollar to stratospheric heights, but the massive monetary and financial loosening by advanced-economy central banks, most importantly the Fed, quickly restored balance in EMDE currency markets. We now face the danger of disorderly markets once again. Given the smaller size and liquidity of EMDE markets, rather modest official rich-country trades could have significant positive impacts, while likely also netting capital gains on purchases of oversold currencies. The positive impacts would include not only stronger exchange rates but also lower bond risk premia, which tend to rise in EMDEs when the Fed tightens.
- Longer term, the International Monetary Fund’s major shareholders should ensure adequate resources for this central component of the global financial safety net. They should quickly complete the 16th General Review of Quotas by raising quota resources as well as the representation of emerging-market and low-income economies on the Fund’s board.
And why they should
Such low-cost actions would clearly be in the interest of the richer countries. Most obviously, an unnecessarily severe global recession would draw in Western economies. Apart from the purely economic costs, the political costs would be large in the current setting of high political polarization. The world trading system is also at risk, as it was during the sharp dollar appreciation of the early 1980s (which led to the Plaza Accord of 1985). In the United States, for example, monetary tightening is falling most harshly on tradable manufacturing compared with services, suggesting that sharper trade tensions could emerge before the Fed has achieved a broader US slowdown.
There is also an important geopolitical rationale for the West. Russia’s aggression in Ukraine has highlighted and accelerated the risk of global economic fragmentation into blocs centered on the US-European axis and China, respectively. The United States returned to its pre-COVID-19 growth trend before other countries, thanks in part to a massive fiscal stimulus with effects felt beyond US borders. Poorer countries everywhere are suffering more collateral economic damage from the Russia-Ukraine war and the Western response, however justified that response is for preserving postwar principles of international order. But protecting that order as well as the global economic integration achieved over past decades may depend on keeping emerging-market and lower-income economies on-side.
Lip service to acknowledge the EMDEs’ plight will not be enough. Policy support, however, will help—especially if followed up by more concrete actions and support on other global crises (notably in climate, food security, and health) that also call for urgent collective action.
The data underlying this analysis are available here.