Emerging economies across the world must prepare for interest rate hikes in the U.S. based on their circumstances and vulnerabilities, said the International Monetary Fund (IMF), as ripple effects of the hike could result in adverse feedback loops like financial instability, currency depreciation, and rapid inflation.
Surging prices, tight labor market, and Omicron-related disruptions have led to the U.S. Federal Reserve tightening its monetary policy and accelerating the tapering of asset purchases to rein in the 39-year-high inflation.
“These changes have made the outlook for emerging markets more uncertain. These countries also are confronting elevated inflation and substantially higher public debt,” said the International Monetary Fund in a blog post on Monday.
The average gross government debt in emerging markets has been increasing, “reaching an estimated 64 percent of GDP by end 2021, with large variations across countries. But, in contrast to the United States, their economic recovery and labor markets are less robust.”
The IMF pointed to two scenarios, one of which is the gradual tightening and rate hike, where the effect on emerging economies will be likely “benign.” In this case, the strengthening U.S. economy will sustain domestic demand, and emerging economies can offset any negative impacts like currency depreciation through an increase in trade.
A rapid increase in rates is the second scenario. In this situation, financial markets in the sensitive economies would be shaken up, as financial conditions are tightened globally. Large capital outflows relative to the U.S. Dollar and currency depreciations would send economies spiraling down.
As some countries have begun the process of adjusting their monetary policies, the IMF recommends economies with weaker institutions to start acting swiftly and comprehensively. The international lender suggests countries allow their currencies to depreciate while raising benchmark interest rates.
The trade-offs for these economies include not supporting their domestic markets like local businesses with credit facilities. While this helps in tightening financial conditions, it would result in a weakened economy.
For countries with more debt in foreign currencies, they should work towards reducing the debt, hedging exposure, and increasing the payback period. For economies with corporates riding on high amounts of debt and bad loans, the IMF points to lenders facing solvency issues.
Fiscal policies like increasing taxes, making public spending more efficient, and implementing structural fiscal reforms will help economies weather such disruptions in the international markets.
Besides this, countries may rely on the support of the IMF, but the amount of lending will be dependent on how these economies strengthen their fiscal postures during these critical junctures of economic turbulence.
The emerging markets include China, India, Indonesia, Malaysia, the Philippines, Singapore, Thailand, Russia, Brazil, Mexico, Saudi Arabia, Nigeria, and South Africa.