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Debt and Capital Flows

Between Monetary Easing and Tightening

30 March 2024

It was not until 2007-2008, when the subprime crisis broke out, that the global economy began to suffer from distorted market mechanisms. These distortions were mostly induced by the aggressive adoption of quantitative easing by central banks all over the world.

The US Federal Reserve lead this trend by injecting trillions of dollars into the US economy. However, instead of commercial banks channeling these funds through to households and firms to help the national economy recover from the aftermath of the credit crunch, the money started flowing overseas through arbitrage, interest-rate and currency speculations, and capital flight.

Inflated Balance Sheets of the US Fed

As a result, Central banks became deeply involved in the capital markets. Highly exposed to price volatility and liquidity issues. Inflation targeting is no more the main concern of such banks, as their Inflated balance sheets triggered many greater concerns.

Prior to the recession, the US Federal Reserve System held $700 billion to $800 billion in treasury notes on its balance sheet. Between 2009 and 2014, the Federal Reserve's balance sheet grew by over $4 trillion[1]. Following the Covid-19 shock, an additional $2 trillion in assets were added to that balance. These substantial liabilities for the US Fed have a significant impact on debt issuers everywhere.

The Impact of Quantitative Easing on Capital and Investment

Since the subprime crisis, the US Federal Reserve has carried out four waves of quantitative easing. The first wave began in November 2008, the second wave in November 2010, and the third wave in September 2012. The fourth wave was led by the US Federal Reserve in March 2020 as an attempt to contain the negative impact of the Covid-19 pandemic. While the Bank of Japan is thought to have pioneered quantitative easing as early as 2001, the US Federal Reserve has a significantly greater ability to influence global financial markets, due to the pace and volume of its interventions.

Quantitative easing pushes down interest rates. This reduces the returns investors expect from the safest investments available, i.e. money market accounts, certificates of deposit (CDs), Treasury bills and bonds, and corporate bonds. Consequently, investors are compelled to assume higher levels of risk in order to achieve higher returns. Many of those investors choose to allocate their investments towards equities, which in turn drives up stock prices, regardless of their underlying fundamentals.

The way the United states dealt with its bad debt situation, reversed a mainstream of relatively stable open trade, rational capital movements, and mature foreign exchange markets, that prevailed for decades since 1945. The Federal Reserve and Treasury tended to inflate the economy out of debt by increasing bank liquidity and credit, resulting in even more debts. This is occurring largely at the expense of other countries, in a way that floods the global economy with bank credit, while the US balance of payments deficit grows, and the public debt soars beyond any foreseeable means of payment.

Debt Issues between Easing and Tightening

Near-zero interest rates resulted from excessive use of monetary easing, created an over inflated bubble of debts. The global outstanding debt now exceeds three times the global GDP. Low-income countries, tempted by relatively cheap capital flows, have stretched their external debt positions to new limits, endangering global stability, in a manner similar to what occurred in Latin America during the 1980s.

Countries with significant debt levels are suddenly required to repay their loans under completely different financial conditions. The post-COVID supply side shocks, along with the Russian-Ukrainian war, compounded by the effects of deteriorating climate change and deglobalization trends, have all contributed to enormous inflation shocks. As a result, aggressive monetary tightening policy measures have been implemented.

To prevent de-dollarization, the US Federal Reserve is concerned about the potential loss of the dollar's supremacy if it does not continue to pursue the unachievable target of a 2% inflation rate. Again, the federal reserve leads the world on a reverse path of monetary tightening, which may put an end to cheap capital for many years. Following the March 2022 meeting, the Fed hiked interest rates and concluded its asset-purchase program, signaling the start of a tapering policy cycle. It is predicted that further easing will occur soon, albeit at a slower pace. This will involve the implementation of more interest rate policy measures and a reduction in quantitative easing.

Cost of Capital and the Development Needs

The increasing cost of capital not only threatens the solvency of low-income countries, pushing its credit rating deeper into junk, but also raises the risk of recession and poverty by making development costlier.

Countries are increasingly fighting for fewer and fewer cash flows. The race to attract these flows takes many forms. One popular policy measure is to hike interest, which helps a country attract hot money. However, this approach is only effective as long as the “real” interest rate is lucrative. Hot money can be retained, if proper investment stimulus is offered to portfolio investors to become direct investors, holding a position on the ground.

However, these hikes exacerbate the suffering of indebted countries, making it nearly impossible for future generations to repay the entire debt invoice. Debt restructures and haircuts then become necessary to keep these countries barely surviving. Restructures come with a cost, as they damage the country’s credit rating and increase the risk associated with its debt products. Thus, further interest rate hikes are necessary to issue such products. This creates an endless loop of inefficiency in financial markets, that can only be broken by implementing major reforms in the debt market. These reforms should include strong debtor controls and obligations, limiting the ability to transmit the burden down to future generations.

Up-to-Date Regional Interest Rate Rally

The Central Bank of Egypt (CBE) increased key interest rates by 600 basis points on March 6, bringing the main operation rate to 28.25%. This move aims to tackle persistent inflation and stabilize the country's foreign exchange rate, as Egypt grapples with foreign currency shortages, a deteriorating national currency, and high inflationary pressures. These factors have driven headline inflation to unprecedented highs, surpassing the CBE's target of 7% in 2024. The recent rate hikes, combined with currency devaluation, have helped Egypt regain some capital inflows into treasury issuances, partially compensating for a loss of nearly $20 billion of outflows, on the eve of the Russian-Ukrainian war in March 2022.

Turkey's central bank made a surprising move on March 21st, raising interest rates by 500 basis points to 50% from 45%. This decision shocked most economists, who had anticipated rates to remain unchanged until after nationwide local elections on March 31st. The immediate impact of this rate hike was seen in the Turkish lira, which surged to 32 per dollar. Additionally, dollar-denominated Turkish government bonds soared, rising by up to 2.1 cents on the day. The major index of Turkish bank equities also saw a notable rise of 3.4%, while the broader Istanbul stock market increased by 1.7%.

These extraordinarily large payoffs for hot money pose new challenges for investments in the region that require a reasonable return on capital. . Such payoffs raise the opportunity cost of investing in any productive asset. A higher cost of capital entails less production, less supply of commodities, greater inflationary shocks, and higher unemployment and poverty rates.

What the World Expects Next

All eyes are on the US Federal Reserve for its upcoming meeting in June. The expected round of easing will signal to central banks and capital markets if the global economic recession can be avoided in the short term. If the Fed decides to slow the pace of easing, the anticipated weaker dollar will not alleviate the pressure on countries seeking capital flows. These countries will need to maintain benchmark interest rates as high as possible in order to attract investors, despite the temptation of the US's relatively high interest rates.

Such kind of pressure obliged the Bank of Japan (BOJ) to finally end eight years of negative interest rate policy, raising their policy rates to a range of 0-0.1%. The BOJ's move this month was its first policy rate hike since 2007. This move does not suggest a forceful tightening policy, but rather ushers in a new era of expensive money that even the world's most stubborn central bank could not resist!

In the face of significant global transitions, Bretton Woods financial institutions should be prepared to adapt and restructure. Further financial governance is required to prevent the indefinite expansion of the debt bubble. The opportunities presented by deglobalization, energy and technology transitions and higher cost of capital should be seized by the IMF and the World Bank, to accommodate and pay more attention to balanced regional finance, as well as more due care for the article 4 consultations (conducted by the IMF), to demonstrate more disciplined capital flows and to lead by example.

[1] Congressional Research Service. “The Federal Reserve’s Response to COVID-10: Policy Issues,” Page 24. https://crsreports.congress.gov/product/pdf/R/R46411