The specter of inflation looms over the horizon of developing countries
By Rabah Arezki and Jean-Pierre Landau *
Abidjan / Paris – As the global economy begins to emerge from the COVID-19 crisis, managing inflation risks will be much more difficult in developing countries than in advanced economies. This reflects the nature of the shocks that drive inflation and the fact that low-income countries are ill-equipped to respond decisively to them. A combination of specific shocks and vulnerabilities could thus seriously threaten the economic stability and prosperity of these countries.
For starters, developing countries are much more exposed to environmental shocks, which will become more frequent and more severe as a result of climate change. Extreme weather events indeed act as negative supply shocks, leading to lower production and higher prices – the most difficult conditions for monetary policy makers. Several countries, including Nigeria and Sri Lanka, are currently facing soaring food prices, while MadagascarThe drought and ensuing famine are another stark reminder of the vulnerability of developing African countries.
Developing economies are also more exposed to financial shocks. Sooner or later monetary policy in advanced economies will normalize and, based on past experience, many emerging markets and poor countries will experience massive capital outflows. The specter of capital flight can be particularly salient for poorer economies, particularly if accompanied by reduced development assistance. Such sudden stops bring their own political dilemmas, including downward pressure on exchange rates. Policymakers can either let their currencies depreciate, which would fuel inflation, or raise interest rates, which would negatively affect growth and debt sustainability.
Both types of inflationary shocks will be a severe test for policymakers in the poorest countries. Many lack the experience and track record to ensure their credibility and stabilize inflation expectations. Several negative feedback loops could thus develop. For countries with high levels of foreign currency denominated debt, the exchange rate depreciation could lead to fatal currency asymmetry, triggering a debt crisis and spike in inflation. And the de-anchoring of inflation expectations could have other ramifications for the already fragile financial systems of developing economies.
In addition, inflation tends to persist long after exchange rate devaluations. Spending reorientation policies to replace increasingly expensive imports with cheaper domestically produced goods have often resulted in only poor growth and stubbornly high inflation. This has eroded the purchasing power of households, fueling poverty and social instability.
Part of the policy response to these inflation risks lies with the developing countries themselves. A credible fiscal policy framework would go a long way in stabilizing expectations and removing the risk of fiscal dominance. While fiscal consolidation in the midst of a pandemic is clearly not appropriate, tighter control of corruption and reduced leakage would help ensure that public spending reaches its intended beneficiaries and maximize its impact.
Costs of corruption developing economies about $ 1.3 trillion per year, or three-quarters of sub-Saharan Africa’s GDP. The COVID-19 crisis is expected to prompt governments in developing countries to crack down on embezzlement of public funds. This will create fiscal space to mitigate the impact of inflation on the poorest households while paving the way for a recovery and sustained economic growth.
But the international community can also help low-income countries overcome inflation traps. In such cases, macroeconomic stability in the poorest countries depends heavily on external financing. The international community therefore urgently needs to strengthen the international reserves of developing economies in order to support their currencies and control inflation risks. While inflationary pressures generally remain under control for now, the risk of inflation in these economies can materialize in a non-linear fashion. For example, the continued depletion of international reserves could lead to a sudden depreciation of a country’s currency. This can precipitate runaway inflation, especially if the authorities lack the credibility to anchor expectations.
Accelerating inflation, along with deteriorating growth and employment prospects, will expose developing economies to the kind of socio-political instability recently observed in Tunisia, South Africa, Nigeria and Senegal. The fallout from such unrest is exactly what the global economy does not need as it recovers from the pandemic.
Fortunately, the recent allocation of US $ 650 billion in Special Drawing Rights by the International Monetary Fund represents an ideal opportunity to help developing economies. While SDRs are increasingly (and rightly) viewed as a development tool, they are essentially a reserve asset that can have important anti-inflationary benefits. Getting more of the new SDRs to flow from advanced economies to developing countries will strengthen the international reserves of the poorest countries and thus help protect billions of people from the risk of inflation. This, in turn, will enable national authorities and the private sector to act decisively to revive growth and reduce poverty.
Much of the developing world is still in the grip of the pandemic. But even before the corona virus is defeated, policymakers may have to deal with potentially serious inflationary threats. They should start preparing now.
* Rabah Arezki is a former Chief Economist of the Middle East and North Africa region of the World Bank, currently Chief Economist and Vice President of Economic Governance and Knowledge Management at the African Development Bank. Jean-Pierre Landau is associate professor of economics at Sciences Po.
Copyright: Project Syndicate, 2021.