The monetary policies of major advanced economies have been obsessively nationalistic for more than two decades now, with virtually no real international cooperation beyond some coordination among G7 economies. These policies have in turn had all kinds of impacts – often very negative – in the rest of the world, and in particular in low- and middle-income countries collectively known as emerging and developing economies (EMDEs).
After the global financial crisis, advanced economies triggered historically loose monetary policies, with a large expansion of liquidity and very low or even negative interest rates from their central banks. This enabled and encouraged massive increases in debt both within their own economies and in the rest of the world, as banks and other financial firms sought to use cheap money to maximize returns in sectors and locations that would otherwise not see much capital inflow. Since these cross-border capital flows were inherently speculative, much of this debt was short-term in nature or in bond markets that facilitated withdrawal.
This rush to finance from emerging and “frontier” markets has not necessarily translated into productive investments. Instead, they have generally pushed up the prices of domestic assets and caused exchange rate appreciation in the recipient countries, which has actually prevented encouraging more investment in tradable sectors, even if they made the balance of payments more fragile and vulnerable to sudden shocks.
Impact of Covid stimuli
The impact of this became starkly evident during the Covid-19 pandemic, when advanced economies again engaged in massive liquidity expansion, this time accompanied by very large fiscal stimuli. By contrast, EMDE governments spent on average much less (in budgetary terms) than they had after the global financial crisis, and their own monetary policies were affected by the need to manage highly volatile capital flows. worldwide from 2020.
Then, as inflationary pressures created the knee-jerk reaction of tighter monetary policies and interest rate hikes in advanced economies, a new and different set of pressures emerged, this time causing recession. EMDEs that have barely recovered from the pandemic and are already facing large external debt overhangs, supported by the public and private sectors, are forced to react to interest rate hikes in the United States and the world. EU, forcing their own rates.
True to form, EMDEs must now impose even steeper interest rate hikes than advanced economies, with even more detrimental effects on domestic economic activity and employment.
As a result, real interest rates rose sharply in all developing regions. Chart 1 shows that, despite significant recent increases, real short-term rates in the United States remained negative until July 2022, although they have probably moved into positive territory since then. But real interest rates turned positive in developing Asia (and would rise even more if China were excluded) and in Central and Eastern Europe, and reached a very high positive rate in Latin America.
Despite their domestic macroeconomic policy efforts (or partly because of them, since it is obvious that the outcome of higher interest rates and tight fiscal policy will be recessive), bond markets punished EMDE due to policies implemented in advanced economies.
Figure 2 shows that median sovereign bond spreads have risen sharply in the year to August 2022, with truly dramatic and destructive increases in Central and Eastern Europe and Sub-Saharan Africa. Once again, the situation has probably deteriorated further since then, making reimbursement even more difficult and more likely for many countries.
Despite higher interest rates (to the detriment of national economies) and fiscal tightening, the outflow of capital from EMDEs continues. This generated a significant nominal depreciation of most EMDE currencies. Figure 3 shows that the average EMDE index of currencies against the US dollar recorded a significant decline throughout the year, and this included all regions other than Latin America. Of course, some over-indebted countries have experienced really significant drops, in the order of 20 to 40% since the start of the year.
The depreciation of the exchange rate is generally considered to have contradictory effects: a positive effect on exports and tradable goods (and therefore on domestic economic activity) and a negative effect on inflation and on imports of essential goods. . In the current global scenario, the net positive effect on exports is expected to be extremely small, if not absent, for most countries, as global trade continues to weaken. Instead, the problem of rising import costs, and in particular food and fuel imports, will be compounded by exchange rate devaluations that add to the impact of rising world prices. .
Indeed, as we noted in a previous MacroScan, even as global food and fuel prices broke through the speculative bubble and have now returned to pre-Ukrainian war levels, prices in EMDEs continued to rise.
Table 1 shows the growing impact of food and energy on headline consumer price inflation in developing countries in sub-Saharan Africa and Asia and the Pacific. In countries where food still constitutes between a third and a half of the consumption basket, especially among the lower half of the population who are already poor, this is a serious problem. And because energy prices necessarily enter into the production and distribution of all goods and services, energy-importing countries are also very hard hit.
What makes the situation even worse is that most EMDEs – under the misleading advice of the IMF – follow the same hatchet approach to monetary policy as advanced economies, higher interest rates and fiscal consolidation.
It’s counterproductive, because it doesn’t address the causes of inflation while aggravating the forces of recession. Instead, more imaginative policies that are better tailored to specific needs are needed: capital controls that prevent volatile capital movements that worsen depreciation; price management of essential commodities, especially those with strong forward linkages; specific policies to ensure a greater supply of these goods; and a fiscal policy focused on social protection for those affected by inflation and loss of livelihoods.