How emerging economies bear the burden of the dollar hegemony

The topic came up for discussion during the recent (virtual) Jackson Hole meeting of central bankers, where US Federal Reserve chief Jerome Powell sent markets his strongest signal yet that the US central bank is preparing to wind down its asset purchases, at present a staggering $120 billion per month. In a much-watched speech, Powell asserted that “substantial further progress" had been made on the Fed’s twin goals of keeping inflation on a low and stable path and the US economy moving closer to full employment.

The minutes of a recent meeting of the Federal Open Market Committee (FOMC), which sets Fed policy and met before the Jackson Hole event, suggest a broad-based consensus among panel members that QE should start winding down later this year, although it is expected that the Fed will continue to hold an elevated stock of bonds even as the inflow of additional purchases tapers and eventually comes to a stop.

It is noteworthy that in Powell’s remarks, he distinguished the tapering of QE from interest-rate normalization, noting that a much more “stringent test " would apply to the latter operation (bit.ly/3h0x4GC). The significance of this distinction should not be passed over lightly.

Readers will recall the ‘taper tantrum’ crisis of 2013, which created panic in global financial markets—especially emerging economy stock, bond and currency markets—after Ben Bernanke, the Fed chief then, loosely remarked that the central bank was planning to begin dialling down its asset purchases without being very clear about his likely forward guidance on a glide path for policy normalization.

Speaking on the possibility of Fed tapering in an interview to the Financial Times (“Emerging economies cannot afford ‘taper tantrum’ repeat, says IMF’s Gopinath", 29 August), the International Monetary Fund’s chief economist Gita Gopinath warned that emerging economies could not “afford" a repetition of the 2013 taper crisis. She said: “[Emerging markets] are facing much harder headwinds…. They are getting hit in many different ways, which is why they just cannot afford a situation where you have some sort of a tantrum of financial markets originating from the major central banks."

The danger that Gopinath and others have pointed out is that higher or stickier than expected inflation in the US will likely prompt the Fed to more aggressively ramp up interest rates as part of an accelerated normalization of monetary policy.

The danger scenario for emerging economies, especially heavily-indebted ones, would be the twin blows of rising debt service costs on their dollar-denominated debts as well as a likely outflow of a large quantum of capital funds enticed by higher returns to be earned in US dollars, to say nothing of the safe-haven value of the dollar in times of economic volatility. Indeed, this is exactly what spooked markets and shook many emerging economies, including India’s, back in 2013.

If such a “double whammy" scenario, as Gopinath terms it, returns today on the back of Fed tightening, the IMF estimates that $4.5 trillion of global gross domestic product could be wiped out by 2025. What is worse, the hit will likely be felt disproportionately by low-income developing and middle-income emerging economies, according to former IMF chief economist Maurice Obstfeld, also speaking to the Financial Times. That these shock waves would emanate in the context of a pandemic crisis that is worsening in many parts of the still largely-unvaccinated developing world might just make this a perfect storm.

In an unusually candid comment, Gopinath observed that one of the difficulties at the time of Bernanke’s 2013 remarks was that his announcement on QE tapering got “mixed up" with market expectations of faster interest-rate normalization. This confusion may indeed have abetted the seriousness of the 2013 crisis, as it created greater uncertainty, with many more ‘carry trade’ and other speculative investors in emerging markets bolting for the door at the same time. This time around, she noted, “super clear communication" is the need of the hour, and suggested that Powell is doing a good job. The implied criticism of Bernanke’s poor communication in 2013 is an inference easily drawn.

Some perspective may be useful. As I noted in one of my earliest columns in this newspaper (‘Illusions bred by a reserve currency’, 17 July 2014), reliance on a single global reserve currency, the US dollar—whether de jure, under the Bretton Woods system, or de facto, as at present—creates a peculiar dilemma, noted in the 1960s by economist Robert Triffin: The short term, domestically-driven goals of the reserve currency economy may diverge from the long term needs of the global economy. Inevitably, the hegemonic country that provides the reserve currency as a global public good will privilege itself at the expense of the rest of the world.

The ‘Triffin Paradox’ is still with us.

Vivek Dehejia is associate professor of economics and philosophy at Carleton University, Canada.