Friday 29 Mar 2024
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This article first appeared in Forum, The Edge Malaysia Weekly on March 21, 2022 - March 27, 2022

This year was to have been the year of the global post-Covid recovery. As the pandemic winds down and countries remove restrictions and open up their economies, the outlook was for a strong global recovery.

That expectation may now have come unhinged. The geopolitical forces unleashed by the war in Ukraine have now magnified manifold the economic problems that had long been simmering.

Not surprisingly, the International Monetary Fund has just cut its global growth projection for the year. While the economic pain may be widespread with just about all countries affected, the brunt, as always, is likely to be borne by emerging markets.

There are many reasons why this turn of events could make this year a highly challenging one for emerging markets.

First, with very few exceptions, most developing countries are up to their necks in debt. The economic disruptions of the pandemic and the historically low interest rates had lulled them into gorging on debt.

Underneath the credit expansion lie serious systemic risks. This, together with the fact that the world — thanks to ultra-loose monetary policies — is now flooded with liquidity, means that the standard prescription of spending one’s way out of trouble may not be feasible this time. There is simply too little fiscal space to enable much manoeuvrability.

For many developing countries, policy flexibility, both monetary and fiscal, is severely restricted. Yet, the problems, long simmering, are now converging.

Inflation, the long delayed interest rate normalisation, supply shocks and most recently with the Russian sanctions, the oil price spike, all promise to up-end the hoped-for recovery. With policy space restricted, governments will have to face these problems with hands tied.

Supply shocks and dislocations in the value chain are the second big worry. The supply shocks, which were previously associated with a narrow group of commodities, are now far more widespread as a result of the war and sanctions.

The rise in the energy complex will undoubtedly have serious consequences. Within energy, it is not just oil, but natural gas, coal and others that have all seen sharp rises. With Brent crude exceeding US$100 a barrel, emerging market oil importers, the likes of India, Pakistan and even Taiwan, will suffer serious budget imbalances.

China, Asia’s growth locomotive and the world’s largest importer and energy consumer, will inevitably be hit. Even its sharply lowered gross domestic product growth target of 5.5% this year could turn out to be a heavy lift given its own problems of domestic debt accumulation. China’s property sector, which accounts for about 20% of GDP, has been in contraction since late last year on the back of government efforts to rein in the debt-fuelled asset bubble. Add to all these the rising costs of basic food ingredients, wheat, edible oils and other food staples, and we have sharply deteriorating global economic conditions.

Inflation, the third big worry, may indeed be the Achilles heel. With central bankers having deluded themselves that it was transitory, inaction has meant that inflation is now at its fastest growth in 40 years. The 7.9% annualised rate reported last week for the US hides a near 10% compound monthly rate. In other words, inflation is strengthening and not even stabilising. Further, these numbers are pre-Ukrainian war and sanctions. The oil price hike is not even captured in the inflation numbers as yet.

All these place central banks in a conundrum. Given the exogenous nature of oil price hikes, raising interest rates now may do little to check the inflationary spiral, yet not raising will drive real rates, already negative, even further down. Negative real rates will incentivise consumption and risk-taking and discourage savings, precisely the wrong signal to send.

For emerging markets, the rate decision may not even be in their hands. As the US Federal Reserve and other Western central banks raise rates, developing countries have little choice but to follow, or risk massive capital outflows. Countries that have been dependent on short-term and portfolio inflows in their capital account will be particularly vulnerable.

Raising interest rates in developed countries, unless matched by developing countries, acts to reduce the currency spread or risk premium available on emerging market investments. Such erosion effectively alters the relative risk-return profile and attractiveness of emerging market investments.

Capital outflows, particularly large and sudden ones, will not only cause their stock and bond markets to tank and lead to liquidity imbalances but would also put pressure on their currencies. A depreciated currency would bring a host of yet other problems. Higher debt in home currency terms, higher debt servicing costs and of course, imported inflation: effectively a vicious circle that will throttle future growth. Even if an emerging market nation is able to match the rate increases and avoid immediate capital outflows, the second-order effect of heightened risk averseness and flight-to-quality could still pressure currencies.

Emerging markets therefore face a potential triple whammy: (i) inflation and rising interest rates; (ii) higher energy/input costs; and (iii) capital outflows and pressure on their currencies. These could directly translate into lower GDP growth, higher debt servicing costs and altered terms of trade.

It is this convergence of factors that will determine whether emerging markets can get away with just reduced growth or suffer a recession or worse, stagflation. Whatever it is, appearances are, emerging markets may be headed for a rollercoaster ride.


Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)

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