The world's economy saw a sharp decline in growth due to COVID restrictions and their aftermath. Though governments around the world talked about increasing their spending to boost the sluggish demand, as a result of earlier restrictions, not all economies have been successful in doing so. Increased supply of currency in the financial ecosystem is followed by steep inflation, as every currency around the world is fiat. Owing to the same fact, not all economies supported increasing the supply of money by printing additional currency. Some major economies like the US printed new currency during the initial stages of economic recovery. As a result of which, US consumers experienced record inflation in the previous year.
However, the supply of new currency in the financial ecosystem cannot only be blamed for the resulting inflation, which has not only hurt US consumers but has hurt overseas consumers too. There are inter-related incidents that have resulted in the current inflation. Speculation that the real estate sector and the capital market might crash was surrounding everywhere when the restrictions were initially called on. However, to everybody's dismay, nothing of that sort happened. These branches of the economy which were supposed to crash turned into a money minting machine and gave a huge return in a very short amount of time.
What actually happened that turned impossible into possible?
When the economies were locked down, the ingredients for current instability were nourished in the background. Due to the sudden closure of the economy, the supply chain was highly affected. As supply chains were noticing issues, everything related to it went idle. This idle situation pushed the ever-moving money cycle to a halt. The present economic situation around the world is good only if the money circulation is not affected. However, the same thing didn't happen due to COVID restrictions. Trading with the present form of fiat currency implies, "You work for me today, I will work for you anytime in the future." A basic concept that makes the current fiat currency valuable was given a pause command during the restrictions.
This resulted in idle funds in the banks; with a narrower scope of investing or pushing such funds into productive sectors. In addition to this, developing economies whose major foreign currency source is remittance, saw a sharp increase in remittance as a result of their workforce returning back home. Developing countries experienced considerably higher idle funds than other countries as much of the imports they use to make during this period were affected. The banks aggressively started lending loans for importing goods, investing in the capital market and real estate. These loans not only helped the banks reduce their interest expenses, but also generated a situation that supported the inflationary activities which were already induced by the COVID restrictions.
Developing countries that were dependent on medium to large scale tourism also started experiencing a dent in their economies as the tourism sector was highly affected by COVID restrictions. Developing countries have started noticing a sharp decline in their foreign currency reserves as a result of inflation in the products which they highly import, seeing no growth in foreign currency reserves. The inflation has pushed the countries to spend more foreign currency reserves for the same unit of goods they earlier imported. The decline of foreign currency reserves in these countries is not only linked to inflation and loss of tourism. In addition to all these, many countries have started noticing a fall in their remittance income which should have grown as larger economies are towards the path of stability.
The entire scenario can be linked to fears that previously used to surround small economies. Whenever the Fed in the US increases interest rates on its bonds, investments around the world are pushed into investing in such bonds. An increase in bond yields in the US brings huge investment in the US financial ecosystem as those bonds start working both as a financial instrument to trade around the world and an instrument to receive good passive income. Small economies fear such incidents as much of their foreign currency might go away for a long time. Though the US government is planning to increase yields on their bond but have not yet done anything of that sort. Thus, an outflow of foreign reserves through non-banking channels must be linked to something else.
Governments of developing countries have started noticing a cash crunch as a result of heavy imports after COVID restrictions, rising inflation, falling foreign reserves due to falling remittance and disturbed supply chain, and an idle tourism sector. All of these have started restraining governments to spend to boost the domestic economic cycle. The economic cycle has been given a pause to control the growing loans, rising imports, and unaccounted foreign transactions. The governments have not been able to spend even when the dire need of present is government spending. Those countries like Srilanka which were already laden with extreme international and domestic debts are already facing acute imbalance in the economy while the countries such as Nepal whose debts are not high are moving towards the same path. The entire economic cycle has been disturbed due to reduced government spending and erosion of foreign currency reserves.
Though regulations to control imports have been taken introduced by governments of most of the developing countries, the erosion of foreign reserves has not stopped. Once money-minting factories, capital market, and real estate sector have started seeing a fall as a result of cash crunch within these economies. This incident has started creating a cumulative effect of a cash crunch. Investments that were earlier diverted to the domestic market by both the residents of these countries and the ex-pats are now diverted to some other money-minting factories possibly through non-banking channels. The intense interest of residents of developing countries has started moving to money-minting factories which were earlier in the control of residents of developed countries. This interest has started pushing the investments from developing markets to developed markets. Cryptocurrencies such as BTC and ETH have seen record trading after restrictions and are continuing. In addition to this speculation of investments into the capital market of developed countries by residents of developing countries is also high. All of these scenarios have started creating a cumulative impact on the depletion of the foreign currency reserve of developing countries.
The reduced government spending as a result of political instability, once idle funds that generated inflation, the troubled supply chain, the falling income of foreign currency from imports and tourism, generation of gambling areas whose regulation is close to impossible, and governments short-sightedness to impacts that may induce to economic restrictions have started widening the already existing dents in developing countries. Though these dents can be healed off, the internal political conflicts within these countries are troubling the possible actions that a stable and powerful government could take.
In addition to internal measures to help control the outflow of foreign currency reserves, developing countries can make use of already available tools that were used in the past by major economies to move out of the problematic economic cycle. A brief of which is explained in my earlier blog post on Is Srilankan Economy Really Under Pitfall?
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