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Emerging Markets: Damned If They Do, Damned If They Don’t Lorenzo Forni
The COVID-19 pandemic has already had large negative effects on emerging economies. When the crisis hit, most emerging economies were in relatively good shape from a macroeconomic point of view. Their central banks were successfully adopting inflation targeting, exchange rates were flexible and could be used to correct external imbalances, reserves were replenished, and external debt was not excessive. When faced with recession, many of these economies activated central bank asset purchases to support their countercyclical fiscal policies. These efforts did not match the scale of those in advanced economies, but were still a surprisingly positive development for economies that often have struggled with high inflation.
The problem has been that COVID-induced weak economic activity has strained the fiscal positions of these emerging economies and, as the saying goes, it never rains, but it pours! Inflation started to increase globally due to strong demand for goods by advanced economies coupled with supply constraints, value chain disruptions, and labor shortages. The ensuing increases in food and commodity prices pushed up domestic inflation even further. This is especially true in non-Asian emerging economies. (I will skip why inflation has not spiked in most of Asia.) Inflation is running substantially above central bank targets in Brazil, Russia, Turkey, and Mexico and, in some of these countries, inflation is growing rapidly. High inflation has relevant social costs and also offsets some of the fiscal supports introduced by governments during the pandemic. However, the biggest concern is that this situation risks compromising the macro-stability of these countries. As I argue in The Magic Money Tree and Other Economic Tales, economic policies are limited by the fact that they have to respect inevitable economic constraints. When they do not, they risk triggering abrupt adjustments that can materialize into crises.
…economic policies are limited by the fact that they have to respect inevitable economic constraints. When they do not, they risk triggering abrupt adjustments that can materialize into crises.
In the current climate of weak economic activity and difficult health conditions, some emerging economies might be damned if they increase interest rates forcefully to fight inflation, as well as damned if they do not. In both cases they could see their currency falling. If they raise interest rates, they might further weaken the economy and their recovery prospects. Investors will require a risk premium to be compensated for the additional uncertainly, which will further weaken currencies. This seems to be consistent with what is happening in Brazil and Russia, where recent increases in interest rates have not prevented their currencies from depreciating, contributing to high inflation. On the other hand, if policy makers shy away from heaping more pain on already battered economies—as has happened so often in the past—the inflation-targeting regimes in these countries will lose credibility and currencies will continue to depreciate, causing an inflation–depreciation spiral with currency in free fall. If savers in advanced economies are worrying about how to protect their savings from inflation, imagine how savers in countries where inflation is spiraling out of control must be feeling. Savers and investors could quickly begin switching to foreign currencies, at least where they can (for example, Brazil has restrictions on foreign currency deposits). Indeed, trust in the local currency is often already limited in some of these nations because of a history of currency crises.
Inflation-depreciation spirals would be extremely costly from many points of view (see a discussion of some illustrative real-world episodes in my book). Foreign investors will try to assess the future performance of various asset classes. An important aspect for the macro-stability of these countries will be how the situation might impact their external debt-servicing needs in terms of domestic resources—that is, GDP. This will depend on the evolution of global risk-free interest rates (which are expected to increase as monetary policy normalizes in advanced economies), risk premiums, and exchange rates. Although a detailed analysis is beyond the scope of this blog post, it is worth recalling a few basics.
If savers in advanced economies are worrying about how to protect their savings from inflation, imagine how savers in countries where inflation is spiraling out of control must be feeling.
True, most emerging economies do not have very large external total debts: official data for Q2 2021 indicated Argentina stands at about 65 percent, Turkey at about 60 percent, Brazil and South Africa at about 45 percent, and Russia at about 30 percent. But, since the outbreak of the COVID-19 pandemic at the beginning of 2020, the Turkish lira has depreciated by about 130 percent, the Argentinian peso by about 70 percent, the Brazilian real by some 40 percent, and the South African rand by around 20 percent. Inflation currently is running at about 15pp above target in Turkey, above 8pp in Brazil, and above 4pp in Russia. (In South Africa, it is close to target, but the economy is very weak.) Argentina is an outlier, with inflation at above 50 percent. And if resuming a credible inflation targeting regime proves difficult, these devaluations could escalate. In the case of a cumulative further 50 percent devaluation over the course of the next couple of years, this would amount to about 15–30 percent more external debt to GDP depending on the country, without considering likely increases in the servicing costs. Unless the nominal anchor were to be re-established quickly, the external debt position would soon become unsustainable.
As I explain in The Magic Money Tree, although economic constraints can be avoided for some time, and sometimes for a very long time, they will eventually bite back unless well managed. The inflation-targeting regime has disciplined monetary policy. The ensuing moderation of inflation and stability of exchange rates pre-COVID created a sense of stability—although this was fragile—and in turn prompted capital inflows to emerging economies and accumulation of domestic and external liabilities. This borrowing, in some cases, has imposed further burdens on already stretched public finances. Now policy makers are in a difficult position. Should they stick to their inflation targets and impose the relevant costs on their economies during a continuing global pandemic or should they give in to inflation? Either way, there is a real possibility that we will see currency crises in emerging markets, something we thought had been relegated to the past.
Lorenzo Forni is professor of economic policy at the University of Padua and head of the think tank Prometeia Associazione. He has previously worked at the Bank of Italy and at the International Monetary Fund. He is also the author of The Magic Money Tree and Other Economic Tales, recently chosen by Martin Wolf of the Financial Times as one of the best economics books of 2021.
