The World Bank has warned that many smaller developing countries are facing a “silent debt crisis” as they confront the effects of high US interest rates on their already fragile economy. Ayhan Kose, deputy chief economist of the World Bank Group noted that lower-income nations with high debt levels have found the monetary policy tightening cycle to be a “nightmare.”

The foreign currency emerging market debt has faced challenges in bouncing back, as a result of a major decline in the previous year. This can be ascribed to a sharp rise in global interest rates and a robust US dollar. According to the World Bank, 23 percent of developing countries now find themselves grappling with borrowing costs that exceed those of the United States by more than 10 percent. This starkly contrasts the less than 5 percent recorded in 2019.

The proportion of government revenues allocated to debt interest payments reached its highest point since at least 2010. Lower-income countries are expected to bear the brunt of increased borrowing costs, as many of them accrued a lot of debts during the Covid-19 pandemic.

What is the Monetary Policy Tightening Cycle?

The tightening monetary policy is a set of measures implemented by a central bank, to moderate economic growth, curtail spending in a rapidly accelerating economy, or fight rapid inflation. To achieve this, the central bank enacts a tightening of policy by raising short-term interest rates through adjustments to the discount rate and federal funds rate. Increasing interest rates raises the expense of borrowing and diminishes its appeal.

The key components of a tightening cycle typically include raising interest rates, open market operations, and reserve requirements.

  • Raising Interest Rates – The central bank increases its benchmark interest rates, such as the federal funds rate in the United States or the key policy rate in other countries. This makes borrowing more expensive for businesses and consumers, leading to reduced spending and investment.
  • Open Market Operations – The central bank may also engage in open market operations to sell government securities and withdraw money from the banking system. This reduces the amount of money available for lending and spending in the economy.
  • Reserve Requirements – In some cases, central banks may adjust reserve requirements, which are the minimum amounts of money that banks are required to hold in reserve. Increasing reserve requirements can also reduce the amount of money banks have available to lend.

As interest rates rise in developed countries, investors tend to seek higher returns on their investments. This shift in capital flow negatively impacts developing countries, which often struggle to compete for these investments. Reduced foreign capital inflows limit their ability to finance economic growth, job creation, and social development. These countries find themselves trapped in a situation where they are forced to take on more debt at unfavourable terms to fill the investment gap.

Also, these emerging markets are particularly susceptible to external shocks, such as fluctuations in global commodity prices or unexpected economic crises. When high debt levels already burden them due to tighter monetary policies, their ability to withstand these shocks is severely compromised. This vulnerability can further perpetuate the debt crisis, as these nations may need to take on additional loans to weather unforeseen economic challenges.

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