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Rising interest rates and the relentless rise of the dollar

opinionRising interest rates and the relentless rise of the dollar

With distorted capital flows, shrinking global trade and stubborn inflation, a recession is around the corner.

As if the impact on the global economy of the prolonged war in Ukraine wasn’t enough of a blow, most nations—both advanced and developing—have recently witnessed a significant rise in interest rates. In fact, the current reality is that a large part of the world faces double digit inflation and unprecedented levels of fiscal deficits. At first, the high government-expenditures and the required related economic stimulus packages, were to meet the challenges of Covid-19; after the pandemic was somewhat managed, it were to finance the equally expensive post-pandemic measures to revive aggregate demand and repair the disrupted supply chains. In the backdrop of stagnant or falling production, the resulting soaring prices were inevitable. What was not so obvious was that the upward revision of interest rates could cause significant weakening of currencies around the globe vis-à-vis the American dollar, and that the two phenomena together could become the cause célèbre for a possible worldwide economic recession.
The narrowing of interest rates between the US and the rest of the world by almost 250 basis points i.e. 2.5% in the last couple of months, has caused a huge quantum of foreign debt and equity capital to flow back to US markets. In fact, since the last raise effected by the US Federal Reserve (Fed) a fortnight ago, US interest rates have become about 1% higher than the Bank of England’s base rate. Given the risk-free nature and the relative currency stability, the US debt markets in particular have become more attractive. The capital outflows from many a nation has affected the valuations of their currencies against the USD, which also happens to be the world’s only worthwhile reserve currency. With countries seeing their currency depreciate 10%-20%, the import dependent nations now find themselves paying out appreciably more than before. On the other hand, a stronger dollar has made US imports cheaper.
Servicing of past dollar-debts held across the world—including by governments—has become costlier. To fund their relief and recovery measures, a majority of national governments had borrowed heavily and run up huge debts. Even the US has added about $5 trillion to its deficit; consequently, it breached the debt-threshold of $30 trillion for the first time. The reckless spending envisaged by the new regime in the United Kingdom has caused government bond-rates to soar to a record high. The New York Times has projected that at this rate by 2029, the US expenditures on interest alone could exceed what it spends on national defence. The picture is fairly similar in other heavily indebted nations. Such a dramatic shift in the global economic landscape has been a significant factor for the rapid strengthening of USD vis-à-vis the other currencies.
With high interest rates likely to subsist into next year—the mighty Fed has already indicated that there would be two further raises, in all likelihood of 75 and 50 basis points respectively, by December ’22—there is well-grounded apprehension that the world is heading towards a prolonged economic slowdown or an economic recession. Last week, UNCTAD had warned that “monetary and fiscal policy moves in advanced economies risk pushing the world towards global recession and prolonged stagnation, inflicting worse damage than the financial crisis in 2008 and the Covid -19 shock in 2020.” Taking a more circumspect view, Kristalina Georgieva, the Managing Director of IMF, has observed that inflation would be bad for growth and that the situation is “more likely to get worse than to get better” with more economic shocks ahead. Some analysts project next year’s possible loss to the global economy to be upwards of $4 trillion. The doomsday economist, Nouriel Roubini, predicts that the global gloom spelt by “excessive debt amid chunky policies and supply shocks” could show up in a long and severe recession.
The Paris based OECD, colloquially termed the rich man’s club, has lowered the 2023 GDP growth forecast from the current 3% to 2.2% while highlighting the current course of action is hurting the most vulnerable, especially in developing countries. Joining the dismal chorus is the World Bank’s office for Europe and Central Asia, which observed that while global prices for oil, gas and coal had been picking up since early 2021, they “skyrocketed” after Russia’s invasion and have now sent inflation “to levels not seen for decades in the region”. They predict a 0.2% contraction in output in 2022 and peg growth at a lousy 0.3% the following year. In a similar vein, the World Trade Organisation has pared the global GDP growth to 2.3% and the expansion of global merchandise to 1% for 2023, as against 2.8% and 3.5% respectively for the ongoing year. It apprehends that the growing import bills for fuels, food, and fertilisers could lead to food insecurity and debt distress in developing nations.
UNCTAD’s well researched report lays out a similarly grim picture. They project middle-income countries in Latin America and low-income countries in Africa to register the sharpest slowdowns. Countries that showed signs of debt distress before the pandemic are now taking some of the biggest hits—in particular, Zambia, Suriname, and Sri Lanka—with climate shocks further threatening economic stability in some nations such as Pakistan. Its conclusions are based on the concern that net capital flows to developing countries have turned negative, with 90 odd countries seeing their currencies weakening against the USD. Developing countries have already spent $379 billion in reserves to defend their currencies this year alone. Overall, 46 developing countries are severely exposed to multiple shocks and another 48 are seriously exposed, increasing the threat of a global debt crisis. The debt service liability for the remaining of the current year for emerging nations itself is a staggering US$83 bn.
Though somewhat better prepared than its peers, India is no exception to the evolving economic events. In this context, the RBI Governor Shaktikanta Das observed “now we are in the midst of a third major shock [after the Covid 19 pandemic and the Ukraine invasion], a storm arising from aggressive monetary policy actions and even more aggressive communication from advanced economy central banks like the US Fed.” He further conceded that when the US is the world’s largest economy, and the USD is the global reserve currency, the prudent course is to “follow the leader”, implying that if the Fed increases interest rates, other central banks must do so as well. The Introduction of the RBI Bulletin of September ’22 puts it equally vividly: “we live in times of conflicting possibilities—elevated inflation and rising recession risks: economic stagnation and increasing debt: strengthening US dollar and weakening currencies in the rest of the world: easing supply chain pressures and reshoring: synchronization in policy actions and deglobalization: balance sheet normalization and liquidity stress.” While all these might be possible future scenarios, for the time being, the Indian authorities are left dealing with slow growth, high inflation, a worsening current account deficit and a declining rupee.
A frequent question that arises when addressing concerns from the impact of a stronger dollar is whether the central banks in the rest of the world are capable—either alone or collectively—of taming the USD, which has witnessed a relentless rise. There is little doubt that in its role as the monetary policy setter, the Fed has explicit advantages of scale and on accord of the USD being the main reserve currency. Almost every global central bank of any meaningful size conducts itself on cues from it, and ends up following the Fed’s actions rather than make its own decisions with complete sovereignty. With their own actions being centripetal, viz. emanating from the Fed at centre and they being at the periphery, these banks have necessarily to act in tandem with one another to have any meaningful impact. Steven Barrow, the head of G-10 strategy of the South African central bank, in fact argues that the time has come for coordinated measures and the need to be “dragged to the forex intervention table kicking and screaming.” In this context, it is worthwhile to recall that the greenback’s strength against a basket of currencies had surged last fortnight to the highest levels since 2005, the euro meanwhile fell to its lowest point since 2002, the Japanese yen to its weakest since 1998, and the pound sterling slid to an all-time low.
As a starting point, central banks have recently demonstrated a degree of resolve to maintain order in their financial markets. The Bank of Japan is looking to stop a selloff in the yen, while the Bank of England has indicated that it would “buy long bonds to calm a chaotic gilt (government bonds) market.” Some historical precedents also exist—earlier in March 2020, the central banks had worked together to improve USD liquidity through swap line arrangements, they had coordinated to weaken the yen in 2011, and taken action to strengthen the euro in 2000. The last time central banks had taken concerted action to weaken the dollar was under the Plaza Accord of 1985; though a key difference from back then was that the US had already broken the back of inflation at that point whereas the outcome now is very much undecided.
Actions this time may be more by way of currency interventions rather than a global effort in bond markets which would certainly have inflationary impact. According to oft-cited Barrow and other financial analysts, only after the gilt market stabilizes, the Bank of England would step back and return to its plan to sell gilts; while other central banks that have bought bonds in the past will be unable to stage a volte face as long as inflation is high, and rates are being raised. They warn that markets may be underestimating the inflationary effect of a rising dollar on the rest of the world. In this context it has been noted that the central banks around the world have been raising interest rates with a degree of synchronicity not seen over the past five decades, and these moves will unfortunately continue triggering instability around the world.
Another question being asked is whether the USA is right to pursue the course of action it has chosen, viz., aggressively hike the interest rates. Prima facie, the answer is in the affirmative. It faces the highest rate of inflation it has seen in the last 4 decades, and its administration as well as the Fed, have a responsibility to alleviate adverse inflationary impact on its citizens and businesses. That, however, needs to include making use of fiscal and various other policy alternatives and not merely relying on the easier option of a monetary policy based on raising interest rates (which can by itself become the reason for future inflation). Anne Krueger, a former World Bank and IMF chief economist and current professor at Johns Hopkins University, has listed some alternatives stating: “Biden Administration should join the CPTPP (Comprehensive and Progressive Agreement For Trans-Pacific Partnership), relax immigration restrictions and deploy carefully targeted subsidies for semiconductor and solar panel production.”
Another obvious question making the rounds is whether the US, as the world leader of all it purveys, especially the financial sphere, has a larger responsibility to maintain a stable global order. For one, its own self-serving experience has shown that the relative peace and favourable geo-political configurations, since the end of the last world war, has facilitated more rapid growth of income and wealth over time than earlier in a more disrupted world. Secondly, there is invariably a price to pay for assuming the self-appointed role of a global monitor. In defence-terms, this is reflected in the humungous expenditure it incurs on building and maintaining a lethal military force around the globe. In the economic arena, this weight should translate into an obligation to ensure that the fruits of progress and prosperity are more evenly shared; this would only grow the markets for its products and services and ensure the ongoing economic dominance. The American obsession historically with Europe (and NATO) has come at the cost of Asia, Africa and South America, despite the three continents accounting for 80% of the world’s land mass (replete with mineral and other natural resources) and a humongous population of potential consumers of US products and services. When viewed in this light, the future of the world lies as much in their development as with Europe or North America’s progress.
Finally, the USA has now to also necessarily reconcile to the emergence of a multi-polar world, with nations like China, Russia and possibly Brazil and India as alternate leaders in their region. Obviously, it hadn’t reckoned with such an eventuality when it had assiduously wooed an underdeveloped China to open its doors to western capital and technology over five decades ago. The consistent inflows into China of these two critical factors of production since then, has added significantly to the productivity of its own local workforce, the other key factor. This has enabled the erstwhile dormant dragon to turn itself into a formidable economic and military giant. The USA and its European associates can ill-afford to ignore this new position, and such a reality must weigh on any economic calculus.

Dr Ajay Dua, a development economist by training, is a former Union Secretary of Commerce & Industry.

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