This week, IMF Chief Christine Lagarde said that the global economy is facing a potential “vicious cycle” from a looming U.S. interest rate hike. Just last month, she warned that the Fed must be certain that the U.S. job market and inflation are strong enough to justify raising rates.

What is she concerned about?

First, let’s step back and think when emerging markets, including China, were growing at double digits. This was made possible by incurring substantial amounts of foreign debt. Large sums of capital investments from foreign countries poured into these emerging markets from about a decade ago, resulting in debt amounts much larger than what developed countries have in terms of private sector credit to GDP. It is great when the money is funneling through and propelling growth. It also helped reduce the gap between the emerging market countries and the advanced nations..  But when the trend reverses, things could worsen quickly too, especially if your country is NOT the U.S.!

It is bad enough even when exchange rates are stable. But remember, these debts are primarily denominated in USD because the USD is still the reserve currency. So as the USD strengthened substantially over the last year, the amount of debt has also accelerated, some by 15–30%.

Furthermore, to make things worse, commodity prices tend to weaken when the USD strengthens, once again because the USD is the reserve currency. There were already factors unrelated to the exchange rate that had put commodity prices under pressure, but the strong USD didn’t help either.

Ironically, many of these countries’ economies rely on exporting commodities, but they could not reap the benefit of a cheaper currency. Instead, the sharply strong USD left them with a larger amount of foreign debt, import-price inflation, but with no export revenues. This is why Ms. Lagarde is citing the “sharp deceleration” in global trade growth and the “rapid drop” in commodity prices, as her concerns.

My View: It almost seems to me that the IMF is most fearful that the global economy, especially emerging markets, would be strained to a pivotal point if the USD strengthened any further. This makes me also take a more controversial view that perhaps the USD may not strengthen as much as the market thinks from the current levels. At the same time, it may be time to rethink of speeding up the process of adding a different currency as a reserve currency, for the sake of stabilizing the global economy.

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