My take: Emerging markets could face serious economic headwinds
This year was to be the year of post-Covid global 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 be out of whack. The geopolitical forces unleashed by the war in Ukraine have now multiplied long-simmering economic problems.
Unsurprisingly, the International Monetary Fund has just reduced its global growth projection for the year. While the economic pain may be widespread with just about every country affected, the brunt, as always, will likely be borne by emerging markets.
There are many reasons why this turn of events could make this a very difficult year 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 historically low interest rates had pushed them into debt.
Behind credit expansion lie serious systemic risks. This, combined with the fact that the world – thanks to ultra-loose monetary policies – is now awash with cash, means that the standard prescription of spending out of trouble may not be achievable this time around. There is simply too little fiscal space to allow much leeway.
For many developing countries, policy flexibility, both monetary and fiscal, is severely restricted. Yet the long-simmering issues are now converging.
Inflation, the long-delayed normalization of interest rates, supply shocks and more recently with Russian sanctions, soaring oil prices, all promise to end the hoped-for recovery. With limited policy space, governments will have to deal with these issues with their hands tied.
Supply shocks and value chain disruptions are the second big concern. Supply shocks, which used to be associated with a select group of commodities, are now much more prevalent due to war and sanctions.
The rise of the energy complex will undoubtedly have far-reaching consequences. In the energy sector, it was not just oil, but natural gas, coal and others that all saw strong gains. With Brent rising above US$100 a barrel, oil importers in emerging markets, such as India, Pakistan and even Taiwan, will suffer severe fiscal imbalances.
China, Asia’s growth engine and the world’s largest importer and consumer of energy, will inevitably be affected. Even its sharply lowered gross domestic product growth target of 5.5% this year could prove to be a heavyweight given its own problems with domestic debt accumulation. China’s real estate sector, which accounts for about 20% of GDP, has been shrinking since late last year due to government efforts to contain the debt-fueled asset bubble. Add to all of this 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 major concern, could indeed be the Achilles’ heel. With central bankers mistaken that it was transitory, the inaction has meant inflation is now at its fastest growth in 40 years. The annualized rate of 7.9% reported last week for the United States hides a compound monthly rate of almost 10%. In other words, inflation is getting stronger and not even stabilizing. Moreover, these figures predate the war and the Ukrainian sanctions. The rise in oil prices is not even factored into the inflation figures yet.
All of this places central banks in a conundrum. Given the exogenous nature of oil price increases, raising interest rates today may not help stem the inflationary spiral, but not raising them will drive already negative real rates even further. Negative real rates will encourage 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 hike rates, developing countries have no choice but to follow, or risk massive capital outflows. Countries that relied on short-term and portfolio inflows into their capital account will be particularly vulnerable.
Rising interest rates in developed countries, unless offset by developing countries, act to reduce the exchange rate differential or risk premium available on investments in emerging markets. Such erosion effectively alters the relative risk-return profile and attractiveness of investing in emerging markets.
Capital outflows, particularly large and sudden, will not only lead to a collapse of their stock and bond markets and lead to liquidity imbalances, but will also put pressure on their currencies. A depreciated currency would bring a whole host of other problems. Higher domestic currency debt, higher debt servicing costs and, of course, imported inflation: in effect, a vicious cycle that will strangle future growth. Even if an emerging country is able to match rate hikes and avoid immediate capital outflows, the second-order effect of heightened risk aversion and a flight to quality could still exert pressure on 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 pressures on their currencies. These could translate directly into lower GDP growth, higher debt servicing costs and altered terms of trade.
It is this confluence of factors that will determine whether emerging markets can get away with reduced growth or suffer a recession or worse, stagflation. Either way, appearances are, emerging markets could be on a roller coaster ride.
Dr Obiyathulla Ismath Bacha is Professor of Finance at the International Center for Education in Islamic Finance (INCEIF)