Developing economies have to be prepared for outbreaks from tighter financial conditions and geopolitical instability.
Developing economies have to be prepared for outbreaks from tighter financial conditions and geopolitical instability.
Although it had not fully recovered from the aftershocks of the COVID-19 pandemic, the global economy had recovered until Russia’s invasion of Ukraine. Economic prospects have worsened since then, widening the gap between the economic reforms of advanced economies and developing economies. The current uncertainties in global growth prospects come after persistent disruptions in supply chains across the world over the past two years, with repeated lockdowns in major manufacturing centers leading to supply bottlenecks.
As a result of the current situation, two major macroeconomic variables have a consistent impact on the growth rebound. First, there is a strong price pressure, leading to a policy trade-off, especially in developing economies; And second, capital outflows and tightening financial conditions are impacting investment and growth in the medium and long term.
inflation concerns
Inflation has become a central concern globally. In some advanced economies, it has reached its highest level in the past 40 years. According to the International Monetary Fund (IMF), “inflation is expected to remain prolonged”. For 2022, it says “inflation is projected at 5.7 percent in advanced economies and 8.7 percent in emerging market and developing economies, and 2.5 percent for the advanced economy group in 2023 and 6.5 percent for emerging market and developing economies”. Therefore, for the foreseeable future, commodity prices, oil and gas prices, and with a lag, food prices will remain high. Major contributors to high inflation are energy and food prices. Energy costs around the world have increased significantly due to tight fossil fuel supplies and rising oil and gas prices due to geopolitical uncertainty. In developing economies, rising food prices have had a cascading effect, resulting in higher overall inflation. This is exacerbated when inclement weather affects crops and rising oil prices increase the cost of producing and transporting fertilizers.
impact on homes
In developing economies, high prices for food affect different sections of the population differently, depending on the type of food consumed and the share of food expenditure in the household’s consumption basket. Low-income households often consume only buckwheat diets and are particularly sensitive to changes in prices. Higher energy prices affect grain prices as a result of rising transportation costs and rising prices of inputs such as fertilisers. This is compounded by shortages in agricultural inputs (especially fertilisers) due to disruptions that affect supply and market availability. Persistent short supply and rising food and fuel prices can greatly increase the risk of social unrest as the poor are pushed to the edge of extreme deprivation.
capital outflow
Besides inflation, other macroeconomic factors that hinder the recovery of growth are the sudden increase in capital outflows from emerging markets and developing economies. Capital outflows have increased in recent months. Emerging markets faced their first portfolio outflow in a year in March 2022. The International Finance Institute (IIF) says that “foreign net portfolio outflows to emerging markets reached $9.8 billion in March. Developing stocks lost $6.7 billion, while bonds saw a $3.1 billion decline.” Investors have become more selective due to higher risk sensitivity due to monetary conditions and rising inflation. Going forward, we see greater volatility on flow dynamics, as some countries are on the downside and potentially benefit from higher commodity prices but also exposed to risk factors. Stricter interest rates in the United States are associated with a reversal of capital flows from emerging markets. For developing economies, sudden large capital outflows result in currency depreciation and hardening. It is the external sector situation, leading to volatility in growth. To complicate matters, spending related to COVID-19 in many developing countries has already outpaced domestic fiscal policy. Rise in global interest rates multiple economies will further reduce this contracted financial space in locations.
policy options
Although the factors contributing to high inflation (energy and food prices driven by global supply shocks) are beyond the control of central banks, they need to carefully monitor the pass-through of rising international prices to domestic inflation to calibrate their responses. is required. It is also imperative that the pace of policy tightening needs to be adapted to current economic conditions and activity levels. Central banks can signal readiness to change monetary stances to maintain the credibility of their inflation-targeting framework by clearly communicating the importance of inflation stabilization in their objectives and supporting it with policy actions. Since a sudden reversal of capital flows can threaten financial stability, foreign exchange intervention can correct market imbalances.
As the IMF’s ‘World Economic Outlook’ clarifies, data from developing countries shows debt levels have touched an all-time high following massive financial expansion in many countries during the novel coronavirus pandemic. As part of such fiscal expansion, large-scale spending programs directed towards the health sector and income support measures became necessary. It is imperative to reduce expenditure and get back on the path of fiscal consolidation. However, rising prices should not deter governments from prioritizing spending to protect and help vulnerable populations affected by the pandemic. Expenditure cuts should include targeted income support measures that can be used to reduce the strain on the household budget. Such measures should be designed to provide maximum relief to the most vulnerable at the lowest cost.
safety net needed
In the post-pandemic global economy, there will be a potential cross-sectoral labor relocation. Economies are ready to transition and the energy transition may be of paramount importance. These changes require labor market and income support policies that are designed to provide a safety net for workers without hindering employment growth. Training programs and rent subsidies should be a priority, along with temporary public support for displaced workers. The message of the current stage of global development is clear. Policy makers in developing economies have to be prepared for the effects of tighter financial conditions and geopolitical instability. High-sensitivity areas within sections of the population need to be identified for prompt action and a set of selected judicious tools need to be developed to target them.
M. Suresh Babu is currently an advisor to the Prime Minister’s Economic Advisory Council. He is also Professor of Economics at IIT Madras. Views expressed are personal