The story so far: In the recently concluded Federal Open Market Committee meeting held on 26 July 2023, it was decided to increase the targeted federal funds rate to 5.25- 5 5%, i.e., yet another increase of the cost of funds by 25 basis points. With this, the federal funds rate has reached levels higher than that of 2001, it is at a 21-year high. Addressing the press conference after the FOMC meeting, Fed Reserve President Jerome Powell observed that the decision has been with the intent of reducing the rate of inflation to 2%. Justifying the decision, he argued that despite the increase in the interest rate, the numbers on the employment front have been on the rise.
What is the federal funds rate?
This is the rate at which banks lend and borrow excess reserves in the overnight market.
In any economy, there is a set of banks which want to extend loans far more than the reserves permit and another which have excess reserves to lend. These banks can loan funds among them and the rate in that market is the federal funds rate. The Federal Reserve intervenes by buying or selling bonds to maintain the targeted rate range, currently set between 5.25 to 5.5%. This ensures stability in the financial system.
A quick look at the trajectory of the federal funds rate. Following the global financial crisis and a large infusion of liquidity through the expansion of central bank balance sheets, the federal funds’ rates were near zero levels for a long period of time from 2008 to 2015. With the ease of monetary policies being reversed by the advanced country banks, the federal funds rate rose to 2.41% in March 2019. With the outbreak of the extraordinary pandemic and the huge shortage of liquidity, in the meetings of FOMC in March 2020, the same was reduced to 0.05%. Ever since March 2022, there has been a continual increase in the federal funds rate in all the consecutive FOMC meetings bringing it to 5.25% to 5.5% in the recent July meeting(Figure 1). Will the world economy be able to stand this steep increase of federal funds rate by more than 450 basis points just in the course of an year?
What consequences would this have on the rest of the world?
The rest of the world faces a different situation compared to the green shoots of growth seen in the U.S. economy, they are yet to come out of the pandemic and are battling with the rising concerns on climate change and growing debt servicing concerns.
The large-scale expansion of the balance sheets of the advanced country central banks since the global financial crisis had reduced interest rates to abysmally low levels. This has facilitated carry trade , with agents borrowing in dollars and investing in emerging markets to benefit from interest margin ( i.e., carry trade profits) due to the higher interest in developing countries.
Between 2011 and 2016, external debt stocks in low and middle-income countries doubled, reaching 181.1% of their GDP. By 2020, it exceeded 200% of their GDP.
A number of non-financial corporations in the developing world seized this low-interest environment in the global economy to borrow cheap. Out of the total outstanding dollar debt outside the U.S. to non-financial corporations of $13 trillion, as per the date of the Bank for International Settlements, approximately $5.14 trillion is held by emerging markets and developing economies. With the reversal of capital flows with increased interest rates and the associated depreciation of currencies, if these corporations have not hedged their dollar debts, they are in for serious trouble. Following the taper tantrum episode in 2013, a number of emerging market corporates had to go through a process of deleveraging and the same had deleterious effects on growth.
In the developing world, non-financial corporations took advantage of low global interest rates to borrow cheap. Approximately $5.14 trillion of the total outstanding dollar debt of $13 trillion held by non-financial corporations outside the U.S. is from emerging markets and developing economies. With rising interest rates and currency depreciation, unhedged dollar debts could pose serious problems for these corporations.
Will the rate hike mainly impact corporates, while governments remain unaffected?
It is a fact that there has been a huge increase in private non-guaranteed (PNG) debt taken by the corporations in the international economy. But governments continue to be important borrowers. In developing and least developed countries, as interest rates in the advanced countries increase, given the lower risk associated with the U.S. treasury securities, foreign investors would abandon the government securities of the developing economies , resulting in both exchange rate depreciation as well increase in the cost of borrowing or rollover of the loans. Unlike India, in a number of developing countries, foreigners are major investors in the government securities market. As they sell the domestic securities, the prices of these go down and the rate of interest shoots up, their currency depreciates vis-a-vis the dollar. This makes it impossible for the governments to borrow at the old rate. The debt serving concerns of the developing countries are going to be even worse.
Absent buoyant growth of revenues due to multiple factors like climate shocks, commodity price decline and lower levels of growth, some of the governments have been forced to default. It is also important to note that there are a group of vulture funds which purchase the bonds of the defaulting countries at abysmally low levels and further initiate litigation procedures against the governments in international courts seeking payments with higher interest , thus seeking far higher rates of return. The case of Zambia is known to all.
With the debt serving priorities on the borrowings undertaken by the governments accounting for a growing share of their expenditures, developing country governments are forced to cut down on expenditures on health and education, setting limitations on achieving targets on sustainable development goals ( SDGs). In many countries, there has already been a reversal of the modest gains on the social front. A recent report by UNCTAD estimates that 3.3 billion people live in countries where the interest payments are far higher than the total expenditure on health and education.
The recent International Debt Report of the World Bank remarks that the poorest countries which borrow through the International Development Association (IDA) wing of the World Bank now spend at least 10% of their export earnings to service the external debt incurred by their governments, the highest since 2000. Though keen on meeting their nationally determined contributions relating to reduction of emissions, many are forced to cut short on their goals with respect to climate goals. Unless supplemented with alternative sources of accessible finance the tightening of liquidity conditions would come with a lot of planetary risks. The continual fed funds rate hikes pretends to be unaware of the global concerns.
What could be done?
A collective endeavour is required to reform the international financial system replete with asymmetries. The initiative in this regard by Barbados Prime Minister Mia Mottley through the Bridgetown Initiative presumes importance in this context. The world eagerly awaits as to how the U.S. and others respond to these recent efforts. In the last decade, even the IMF has been supportive of measures relating to capital controls which alone would be able to reduce the risks borne by countries exposed to volatile capital flows.
It is indeed a fact that no Great Wall of China can resist the power of the monetary policy decisions of the US Federal Reserve. Even when this is the fact, the US monetary policy seems to be bothered only about domestic concerns, ignoring the larger considerations of a volatile global economy caught between the falling health and education infrastructure on the one hand and climate vulnerabilities and unusual weather events on the other hand. With leader country unable or unwilling to own up responsibility in providing leadership, a proper reform of the international financial system is warranted. But, given the asymmetric nature of voting in the IMF for major amendments, this too requires the support of the United States. Massive scaling up of contingency financing for needy countries and expansion of affordable long term financing for development is required to address the growing concerns of developing country debt.
(The author teaches economics at Sri Venkateswara College University of Delhi)