Wars, weapons, and currencies — IV

Mahmoud Mohieldin
Tuesday 12 Dec 2023

The high volatility of exchange rates and the probability that inflation rates remain high make it crucial to activate inflation-targeting frameworks in the developed and developing countries alike, writes Mahmoud Mohieldin



lthough global inflation has fallen below seven per cent this year, down from nine per cent last year, and is expected to fall to below six per cent next year, interest rates are unlikely to return to levels familiar to the public and policymakers before the last inflationary wave.

Inflation rates must be brought down to avert the recessionary cycle that the major economies narrowly escaped this year thanks to higher growth than expected. However, they are likely to remain high for some time, given the experiences scale of the inflation in the US and Europe, which has revived vivid memories of the runaway prices of 40 years ago.

The developing countries will be forced to live with these high interest rates and a longer period of higher financing costs as a result. This will aggravate the difficulties of many of these countries, which had indulged in borrowing sprees in hard currency from international lenders without factoring in the risk of shocks due to changing interest and exchange rates.

According to the UN Conference on Trade and Development (UNCTAD), public debt rose from 35 per cent of the GDP of the developing nations in 2010 to over 60 per cent in 2021, while external debt climbed from 20 to 30 per cent over the same period. As a result, these countries grew increasingly vulnerable to interest rate fluctuations and sudden changes in hard currency exchange (FX) rates.

Then the Covid-19 pandemic hit. Over the next two years (2020-2022), the developed nations scrambled to counter the economic fallout of this through measures of monetary easing that were so excessive that they were like showering banknotes from helicopters. Their central banks had to contain the inflationary impacts that came from this, but they hemmed and hawed as they scratched their heads over whether the inflation was temporary and would go away on its own or permanent and requiring some firm intervention.

When at last they determined that it was the latter, they jacked up interest rates in a rapid succession of hikes.

In the developing nations, monetary policies, already confused about global interest rate and FX trends, were thrown into havoc. The sudden changes in the international economy sent tremors through financial and investment markets, and financial flows to emerging markets and the developing economies (EMDC) began to falter and shrink.  

The volatility of the ebb and flow of money complicated debt management and the financing of growth and development programmes. Economic planners should have taken steps to guard against the risk of short-term shocks, especially in countries with low net foreign assets calculated by deducting a country’s external debt from its FX reserves.

I share the views of eminent Harvard economist Kenneth Rogoff, co-author of a major work entitled This Time Is Different: Eight Centuries of Financial Folly. He predicts that interest rates will remain higher for the next decade than they were in the decade that followed the 2008 global financial crisis. This would still be the case in the event that the major economies cut interest rates out of fears of recession or in response to public pressure.

Rogoff lists several factors that encourage interest rates to remain high, such as soaring debt levels, deglobalisation, increased defence spending, the green transition, populist demands for income redistribution, and persistent inflation. In the developed nations, they will impact corporate borrowing and the real-estate sector, which had been counting on relief in the form of a drop in interest rates that it now appears will not materialise before 2025.

All this is bad news for the economic policies of the Global South, where inflation has sunk its teeth into many countries, including those in which policymakers dream of a quick return to the age of cheap borrowing so that they can recoup the sums that have evaporated from their ledgers.

They had mistakenly thought that such money represented investment, when in fact it was simply short-term speculative debt. With some deft manipulation of the exchange rates, they were able to boast of the inflow of such money as a sign of economic progress – until the day of reckoning came with its repercussions on economic stability, which can now only be restored after some costly reforms.

Economic policymakers in these countries should familiarise themselves with the public policy basics laid out by the Dutch economist and one of the first recipients of the Nobel Prize in Economics, Jan Tenbergen, in his work on economic policy that goes back to 1952.  In this work, Tenbergen differentiated between policy targets and measures. Based on this approach one can simply argue that targeting inflation is preferable to targeting exchange rates.

As I explained in 2004, many developing and industrialised nations can achieve progress in monetary stability, investment, and, hence, economic growth through the application of a monetary policy framework that requires, first and foremost, effective coordination between public and monetary policies, the independence of central banks, curbing increases in the money supply, the adequate and timely use of monetary measures such as interest rates, an efficient foreign-exchange market, and continuous and clear communications with economic stakeholders and the general public to keep them informed and up-to-date with the latest developments.

As the inflation-targeting framework gains credibility, monetary stability becomes achievable, investments and remittances start to flow again, and producers, exporters, and importers can price their goods, conduct their activities, and manage their risks efficiently while avoiding exposure to uncertainty or ambigious behaviours that raise doubts and undermine confidence.

Given the high volatility of exchange rates worldwide and the probability that inflation rates will remain high for some time, it is crucial to activate the inflation-targeting framework that has been adopted by various developed and developing countries.

In a forthcoming article we will show how these countries, owing to hard work, specially in institutions building and policy coordination have realised their aspirations for a return to economic stability in a tumultuous, crisis-ridden world.

* A version of this article appears in print in the 14 December, 2023 edition of Al-Ahram Weekly

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