The Fed’s rate hikes may have saved the economy but also caused a crisis for emerging markets.

The Fed's rate hikes may have saved the economy but also caused a crisis for emerging markets.

The Ripple Effect: How U.S. Interest Rates Impact Developing Nations

On July 26, 2023, the Federal Reserve announced another quarter-point hike, marking a total increase of 5.25 percentage points over the past 18 months. While this move may signal a positive outlook for inflation in the U.S., its long-term impact on developing nations is a cause for concern. As an expert in the field, I have studied the effects of economic phenomena on countries around the world. I firmly believe that this prolonged period of higher U.S. interest rates has increased the risk of economic and social instability, especially in lower-income nations.

Ripples around the world

Monetary policy decisions, such as raising interest rates in the U.S., have a ripple effect on low-income countries. The global economy heavily relies on the U.S. dollar, and many emerging economies engage in trade denominated in dollars, while also borrowing in this currency. These borrowing rates are influenced by the Federal Reserve, which means that when U.S. interest rates rise, other countries, especially developing ones, tend to follow suit.

The primary motivation behind this trend is the concern for currency depreciation. When U.S. interest rates increase, American government and corporate bonds become more attractive to investors. Consequently, foreign capital flows out of riskier emerging markets, leading to a decline in the value of their currencies. In response, governments in lower-income nations scramble to adjust their monetary policies to mirror the U.S. Federal Reserve, compounding the risk of recession due to the already high interest rates in these countries.

Furthermore, the rising interest rates in the U.S. have put countries with substantial debts in a difficult position. Many lower-income nations had taken on significant international debt to mitigate the financial impact of the COVID-19 pandemic and subsequent rising prices caused by the war in Ukraine. However, the increased cost of borrowing makes it challenging for these governments to meet their repayment obligations. Consequently, a growing number of countries are facing “debt distress,” as highlighted by David Malpass, former president of the World Bank, who estimated that about 60% of lower-income countries are currently in or at high risk of entering debt distress.

Moreover, any attempt to curb inflation in the U.S. by slowing down growth will have adverse effects on smaller nations. As borrowing costs increase in the U.S., both domestic and international businesses and consumers find themselves with less access to cheap money. Concerns that the Federal Reserve may be risking a recession can also dampen consumer spending further, exacerbating the situation.

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The risk of spillover

This is not mere theory; history has shown that the spillover from U.S. interest rate hikes to developing nations can have severe consequences. In the late 1970s and early 1980s, then-Fed Chair Paul Volcker fought domestic inflation with aggressive interest rate hikes, resulting in an increase in borrowing costs worldwide. This contributed to debt crises in 16 Latin American countries and led to an era known as the “lost decade” characterized by economic stagnation and rising poverty.

While the current rate increases may not be as dramatic as those experienced in the early 1980s, they still raise concerns among non-advanced and non-BRIC (ANBLE) economies. The World Bank’s Global Economic Prospects report includes a dedicated section on the spillover effects of U.S. interest rates on developing nations. It highlights that the rapid rise in U.S. interest rates poses a significant challenge to emerging markets and vulnerable economies, increasing the likelihood of financial crises.

Widening the wealth gap

Research conducted by myself and others suggests that the financial crises potentially triggered by higher U.S. interest rates can exacerbate poverty and income inequality in developing nations, further widening the wealth gap. Currently, income inequality is at an all-time high, both within individual countries and between richer and developing countries. The World Inequality Report for 2022 reveals that the richest 10% of individuals globally earn 52% of all global income, while the poorest half of the global population receives a mere 8.5%.

The consequences of such a wealth gap extend beyond economic concerns. Inequality of income and wealth has been shown to undermine democracy, reduce support for democratic institutions, and contribute to political violence and corruption. Financial crises triggered by higher interest rates increase the likelihood of economic slowdowns or recessions, with the poorest and least-skilled individuals bearing the brunt of these conditions.

Moreover, government policies aimed at addressing economic challenges, such as spending cuts and reductions in government services, often disproportionately impact the less well-off. Additionally, if a country struggles to meet its debt obligations due to higher global interest rates, it has limited resources available to support its most vulnerable citizens.

In light of these issues, it becomes evident that a period of higher interest rates in the U.S. can have profoundly damaging effects on the economic, political, and social well-being of developing nations.

However, it is worth noting that with inflation in the U.S. slowing, further interest rate increases may be limited. Regardless, whether the Federal Reserve has managed to strike a delicate balance in slowing down the U.S. economy without causing excessive harm, the long-term consequences for poorer nations may already be set in motion.

Cristina Bodea is a Professor of Political Science at Michigan State University.

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