SDR allocation, monetary tightening, inflation, and banking crisis

While the International Monetary Fund (IMF) continues to not provide a much-needed special drawing rights (SDRs) allocation, and instead pushes countries, including Pakistan, under its programmes to adopt austerity and procyclical policy stance – raise policy rate to control inflation, and produce primary surplus – it is raising the risk in global South in particular to have recession and for a rather long period of time, and weakening, in turn, their capacity to deal with an otherwise difficult debt servicing situation.

Lack of counter-cyclical and non-austerity policy will further diminish the capacity of developing countries to reduce the impact of the supply-side channel of inflation. Moreover, not only are higher levels of interest rates reducing economic activity and stoking stagflationary headwinds, they are also putting the banking system into a lot of stress. A recent ‘Monetary Policy Institute Blog’ published article ‘The Fed’s dissonant monetary policy and the 2023 March Banking Crisis: Part I – Silicon Valley Bank’ argued, among other things: ‘We are witnessing a Global Banking Crisis.

In the past two weeks, three banks — Silvergate Bank, Silicon Valley Bank, and Signature bank — have failed. It’s also astonishing to see that Credit Suisse was taken over by rival UBS. While rating agencies such as Moody’s and Standard & Poor’s are busy downgrading the credit ratings of other banks, the Federal Reserve once again collaborated with other major central banks such as the ECB, the BoC, the BoE, the BoJ, and the SNB in order to provide U.S. dollar liquidity through its swap lines facility.’

While a dwindling banking system, on the lines of 2007/08 Global Financial Crisis (GFC) could be better dealt with by rich, advanced countries by providing stimulus, in developing countries this could pose some serious dangers to financial stability as likely increase in the levels of non-performing loans at the back of sharp and deep rise in interest rates, and lack of provision of stimulus to banks may not only dent otherwise much-needed pool of loanable funds, it may also generate panic runs on the bank.

In countries like Pakistan, with high level of government borrowing from banks, to service already high level of domestic debt repayments could likely push government towards higher money printing to meet debt obligations and, in turn, contribute to inflation.

There strongly appears to be brewing an unnecessary trade-off on the global horizon with all the more dangerous consequences for financial stability and poverty alleviation, and that is either fighting inflation or preventing a banking crisis. It need not be for two reasons.

Firstly, raising interest rates to the extent and duration for which they have been is counter-productive, since rather than reducing inflation and remaining a healthy growth sacrifice for attaining long-term stability, high interest rates and for longer time are perpetuating greater inflation – from the supply side, cost push, imported inflationary channels – and retarding growth (increasing unemployment in turn), and also strongly forcing a banking crisis at the back of both increasing non-performing loans, and instilling possible run on banks’ situations.

Both creative fiscal side/governance-related initiatives at the domestic policy level – better targeted development/welfare spending by the public sector and more progressive taxation on, for instance, capital gains, and incomes of high-income groups – and allocation of appropriate levels of SDRs by the IMF could immensely help follow a counter-cyclical, non-austerity policy with likely favourable consequences for growth, employment, debt sustainability, inflation, and banking/financial stability.

A recent Project Syndicate (PS) published article ‘Where is the global South’s rescue brigade?’ pointed out in this regard: ‘Once again, Africa and the rest of the developing world are left to stand by and watch as the Bank of England and the Fed take swift action to contain the domestic effects of their own policies.

As always, pressures imposed on emerging-market economies by exogenous decisions are seen not as liquidity events but as insolvency issues born of those countries’ poor macroeconomic fundamentals.

And, as always, the prescribed treatment will involve a protracted visit from the doctor – the International Monetary Fund – rather than a quick liquidity injection.

We already know from history that this unequal treatment will have huge consequences for development and financial stability across the Global South. … To provide today’s global economy with sufficient liquidity to prevent another escalating crisis, the G7 and other major IMF shareholders should consider a new issuance of special drawing rights (SDRs, the Fund’s reserve asset) to serve this liquidity purpose.’

Moreover, an overly-protective economic policy by US Federal Reserve – by over-relying on tight monetary policy stance to control inflation than needed – for domestic consumers, has also spelling deep and unnecessary economic hardship for debt distressed, foreign exchange-starved developing countries like Pakistan in the global South.

High interest rates by advanced countries like the US, European Union overall, among others, have all meant greater capital flight, and pressure on domestic interest rates, along with keeping (and rising) high interest payment burden on external borrowing.

The same PS published article pointed out in this regard: ‘Over the last few months, a G7 economy (the United Kingdom), a midsize US bank (Silicon Valley Bank), a small African economy (Ghana), a lower-middle-income South Asian economy (Pakistan), and the fastest-growing global services sector (technology) have all faced short-term cash constraints.

Monetary-policy tightening in the United States – where the Federal Reserve raised interest rates by 475 basis points in the space of a year – has produced knock-on effects around the world. …Many currencies have depreciated against the dollar by over 30%, as investors have withdrawn from emerging and frontier markets in a flight to safety. Emerging-market economies’ debt-servicing costs have increased by more than $1 trillion in less than a year.

Reserves as a share of imports have dropped, and inflation in Africa has risen to over 14% in the low-income countries in 2022. Worse, the rate hikes are compounding a pre-existing “polycrisis” that also includes Covid-19, climate change, violent conflict, and higher costs of living (owing to the war in Ukraine and other factors).’

This last comment in the article cited above, with regard to the current ‘polycrisis’ situation, clearly points out that the current highly hawkish US Federal Reserve policy stance, and austerity-inclined policy conditionalities of IMF programmes, had more relevance to a far less financially liberal world of the 1970s by people like Paul Volker (former US Federal Reserve Chairman) – who adopted a highly tight monetary policy stance to tackle high inflation back then – than the world currently, where inflation is significantly determined by supply-side bottlenecks, and where the existential threats of fast-unfolding climate change and likely Pandemicene crises require cheap and abundant finance for economic resilience and its green transition; especially by developing countries, who are also overall highly debt distressed with significant proportion owed to private borrowers unlike around a decade ago.

A recent Bloomberg published article ‘Volker slayed inflation. Bernanke saved the banks. Can Powell do both?’ highlighted the difficult task with the current chairman of US Federal Reserve, Jerome Powell, of both managing inflation, and avoiding a banking crisis, as follows: ‘History remembers Paul Volcker as the slayer of inflation, and Ben Bernanke as the crisis firefighter.

Jerome Powell is in danger of having to play both roles at once – or, what may be worse, to choose between them. … Just a couple of weeks ago, threats to financial stability barely registered on the troubleshooting list for central bankers.

Now they’ve rocketed toward the top. …the basic problem for monetary chiefs is that, in extremis, policy prescriptions for taming prices and bolstering banks point in opposite directions. To get inflation down, central banks jack up rates and withdraw liquidity from the banking system. To short-circuit crises, they shove money out to stricken lenders and cut the cost of credit.

And the danger is that they end up with the worst of both worlds: A full-blown crisis that triggers a recession. That would force central banks to abandon the inflation fight before it’s finished, as they rush to shore up a teetering financial system.’

While the Bloomberg article frames the dilemma quite well with regard to the difficult challenge at hand for the US Federal Reserve, former Finance Minister for Greece, Yanis Varoufakis, in his recent PS published article ‘Let the banks burn’ calls for breaking the mantra quite prevalent since GFC of bailing out the banks and creditors through keeping high interest rate and providing stimulus, since this formula has left the general public hanging in unnecessary economic distress.

Instead of bailing out the banks that have been unjustifiably risk taking for quick profits, the more socially-responsible ones should remain.

He argued in the article in this regard: ‘Faced with the stark choice between curbing inflation and saving the banks, venerable commentators appeal to central banks to do both: to continue hiking interest rates while continuing with the post-2008 socialism-for-bankers policy, which, other things being equal, is the only way to stop the banks from falling like dominoes.

Only this strategy – tightening the monetary noose around society’s neck while lavishing bailouts on the banking system – can simultaneously serve the interests of creditors and banks. … The banking system we take for granted is unfixable. That’s the bad news. But we no longer need to rely on any private, rent-seeking, socially destabilizing network of banks, at least not the way we have so far.

The time has come to blow up an irredeemable banking system which delivers for property owners and shareholders at the expense of the majority.’

Copyright Business Recorder, 2023