Emerging economies and Fed tightening

WASHINGTON: For most of last year, investors priced in a temporary rise in U.S. inflation given the shaky economic recovery and slow resolution of supply bottlenecks.

Now the sentiment has changed. Prices are rising at the fastest rate in nearly four decades and the tight labor market has started to affect wage increases. The new Omicron variant has raised additional concerns about supply-side pressures on inflation. The Federal Reserve has called the evolution of inflation a key factor in its decision last month to accelerate the reduction of asset purchases.

These changes have made the outlook for emerging markets more uncertain. These countries also face high inflation and significantly higher public debt. Average gross public debt in emerging markets has increased by nearly 10 percentage points since 2019, reaching around 64% of GDP by the end of 2021, with large variations across countries. But, unlike the United States, its economic recovery and labor markets are less robust. While dollar borrowing costs remain low for many, concerns about domestic inflation and the stability of foreign funding drove several emerging markets last year, including Brazil, Russia and South Africa, to start raising interest rates.

New risks to the recovery

We continue to expect robust growth in the United States. Inflation is likely to moderate later this year as supply disruptions ease and fiscal contraction weighs on demand. The Fed’s policy stance that it would raise borrowing costs faster did not cause the market to reassess the economic outlook substantially. If policy rates rise and inflation moderates as expected, history shows that the effects on emerging markets are likely to be mild if the tightening is gradual, well announced and in response to a stronger recovery. Emerging market currencies could depreciate further, but foreign demand would offset the impact of higher funding costs.

Even so, the spillovers to emerging markets could also be less benign. Widespread U.S. wage inflation or long-lasting supply bottlenecks could drive prices higher than expected and fuel expectations of faster inflation. Faster rate hikes from the Fed could shake up financial markets and tighten financial conditions globally. These developments could be accompanied by a slowdown in US demand and trade and lead to capital outflows and currency depreciation in emerging markets.

The impact of Fed tightening in such a scenario could be more severe for vulnerable countries. Over the past few months, emerging markets with high public and private debt, currency exposures and low current account balances have seen their currencies already fluctuate against the US dollar. The combination of slower growth and elevated vulnerabilities could create negative feedback loops for these economies, as the IMF pointed out in its October World Economic Outlook and Financial Stability Report releases. world.

Difficult compromises

Some emerging markets have already started to adjust their monetary policy and are preparing to reduce their fiscal support to deal with rising debt and inflation. In response to tighter funding conditions, emerging markets should tailor their response based on their circumstances and vulnerabilities. Those with credible inflation-control policies can tighten monetary policy more gradually, while those with stronger inflationary pressures or weaker institutions need to act quickly and comprehensively. In either case, the answers should be to let currencies depreciate and raise benchmark interest rates. If faced with disorderly conditions in foreign exchange markets, central banks with sufficient reserves may intervene provided that such intervention does not substitute for justified macroeconomic adjustment.


Nonetheless, such actions can pose tough choices for emerging markets, as they trade off support from a weak domestic economy with safeguarding prices and external stability. Similarly, extending business support beyond existing measures can increase credit risks and weaken the long-term health of financial institutions by delaying the recognition of losses. And reversing these measures could further tighten financial conditions, weakening the recovery.

To manage these trade-offs, emerging markets can take steps now to strengthen policy frameworks and reduce vulnerabilities. For central banks to tighten policy to contain inflationary pressures, clear and consistent communication of policy plans can help the public better understand the need to pursue price stability. Countries with high levels of foreign currency denominated debt should seek to reduce these asymmetries and hedge their exposures where possible. And to reduce refinancing risks, bond maturities should be extended even if this increases costs. Highly indebted countries may also need to initiate fiscal adjustment sooner and faster.

Continued financial policy support for businesses should be reconsidered, and plans to normalize this support should be carefully calibrated to the outlook and to preserve financial stability. For countries where corporate debt and bad loans were high even before the pandemic, some weaker banks and non-bank lenders could face solvency problems if financing becomes difficult. Resolution regimes should be prepared.

Commitments and trust

Beyond these immediate measures, fiscal policy can help build resilience to shocks. Establishing a credible commitment to a medium-term fiscal strategy would help bolster investor confidence and regain room for fiscal support in the event of a downturn. Such a strategy could include announcing a comprehensive plan to gradually increase tax revenue, improve spending efficiency, or implement structural fiscal reforms such as revising pensions and subsidies (as described in the IMF’s October Fiscal Monitor).

Finally, despite the expected economic recovery, some countries may need to rely on the global financial safety net. This may include the use of swap lines, regional financing arrangements and multilateral resources. The IMF helped with the allocation of $650 billion in special drawing rights last year, the highest level ever.

While these resources strengthen buffers against potential economic downturns, past episodes have shown that some countries may need additional financial breathing room. This is why the IMF has adapted its financial lending toolkit for member countries. Countries with strong policies can tap into precautionary credit lines to help prevent crises. Others can access loans tailored to their income level, although the programs must be anchored in sustainable policies that restore economic stability and promote sustainable growth.

While the global recovery is expected to continue this year and next, growth risks remain elevated due to the stubborn resurgence of the pandemic. Given the risk of this coinciding with more rapid Fed tightening, emerging economies should prepare for possible periods of economic turbulence.

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