Rate hikes may have slowed inflation in the US – but they have also heightened the risk of financial crises for lower-income nations

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by Cristina Bodea, Michigan State University, [This article first appeared in The Conversation, republished with permission]

The campaign to fight U.S. inflation by upping interest rates has been going on for a year and a half – and its impacts are being felt around the world.

On July 26, 2023, the Federal Reserve announced another quarter-point hike. That means U.S. rates have now gone up 5.25 percentage points over the past 18 months. While inflation is now coming down in the U.S., the aggressive monetary policy may also be having significant longer-term impact on countries across the world, especially in developing countries. And that isn’t good.

I study how economic phenomena such as banking crises, periods of high inflation and soaring rates affect countries around the world and believe this prolonged period of higher U.S. interest rates has increased the risk of economic and social instability, especially in lower-income nations.

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Ripples around the world

Monetary policy decisions in the U.S., such as raising interest rates, have a ripple effect in low-income countries – not least because of the central role of the dollar in the global economy. Many emerging economies rely on the dollar for trade, and most borrow in the U.S. dollar – all at rates influenced by the Federal Reserve. And when U.S. interest rates go up, many countries – and especially developing ones – tend to follow suit.

This is largely out of concern for currency depreciation. Raising U.S. interest rates has the effect of making American government and corporate bonds look more attractive to investors. The result is footloose foreign capital flows out of emerging markets that are deemed riskier. This pushes down the currencies of those nations and prompts governments in lower-income nations to scramble to mirror U.S. Federal Reserve policy. The problem is, many of these countries already have high interest rates, and further hikes limit how much governments can lend to expand their own economies – heightening the risk of recession.

Then there is the impact that raising rates in the U.S. has had on countries with large debts. When rates were lower, a lot of lower-income nations took on high levels of international debt to offset the financial impact of the COVID-19 pandemic and then later the effect of higher prices caused by war in Ukraine. But the rising cost of borrowing makes it more difficult for governments to cover repayments that are coming due now. This condition, called “debt distress,” is affecting an increasing number of countries. Writing in May 2023, when he was still president of the World Bank, David Malpass estimated that some 60% of lower-income countries are in or high risk of entering debt distress.

More broadly, any attempt to slow down growth to lower inflation in the U.S. – which is the intended aim of raising interest rates – will have a knock-on effect on the economies of smaller nations. As borrowing costs in the U.S. increase, businesses and consumers will find themselves with less cheap money for all goods – domestic or international. Meanwhile, any fears that the Fed has pulled on the brakes too quickly and is risking recession will suppress consumer spending further.

The risk of spillover

This isn’t just theory – history has shown that in practice it is true.

When then-Fed Chair Paul Volcker fought domestic inflation in the late 1970s and early 1980s, he did so with aggressive interest rate hikes that pushed up the cost of borrowing around the world. It contributed to debt crises for 16 Latin American countries and led to what became known in the region as the “lost decade” – a period of economic stagnation and soaring poverty.

The current rate increases are not of the same order as those of the early 1980s, when rates rose to nearly 20%. But rates are high enough to prompt fears among economists. The World Bank’s most recent Global Economic Prospects report included a whole section on the spillover from U.S. interest rates to developing nations. It noted: “The rapid rise in interest rates in the United States poses a significant challenge to [emerging markets and developing economies],” adding that the result was “higher likelihood” of financial crises among vulnerable economies.

Widening the wealth gap

Research I conducted with others suggests that the kind of financial crises hinted at by the World Bank – currency depreciation and debt distress – can rip the social fabric of developing countries by increasing poverty and income inequality.

Income inequality is at an all-time high – both within individual countries and between the richer and developing countries. The 2022 World Inequality Report notes that, currently, the richest 10% of individuals globally take home 52% of all global income, while the poorest half of the global population receives a mere 8.5%. And such a wealth gap is deeply corrosive for societies: Inequality of income and wealth has been shown to both harm democracy and reduce popular support for democratic institutions. It has also been linked to political violence and corruption.

Financial crises – such as the kind that higher interest rates in the U.S. may spark – increase the chance of economic slowdowns or even recessions. Worryingly, the World Bank has warned that developing nations face a “multi-year period of slow growth” that will only increase rates of poverty. And history has shown that the impact of such economic conditions fall hardest on lower-skilled low-income people.

These effects are compounded by government policies, such as cuts in spending and government services, which, again, disproportionately hit the less well-off. And if a country is struggling to pay back sovereign debt as a result of higher global interest rates, then it also has less cash to help its poorest citizens.

So in a very real sense, a period of higher interest rates in the U.S. can have a detrimental effect on the economic, political and social well-being of developing nations.

There is a caveat, however. With inflation in the U.S. slowing, further interest rate increases may be limited. It could be the case that regardless of whether Fed policy has threaded the needle of slowing the U.S. economy but not by too much, it has nonetheless sown the seeds of more potentially severe economic – and social – woes in poorer nations.

Cristina Bodea, Professor of Political Science, Michigan State University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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