Will emerging economies suffer a hard landing?


Policy Center for the New South

The start of 2022 has been marked by both signs of slowing global economic growth and a shift towards tighter monetary policies in advanced economies. In his Global Economic Outlook report, published on January 11, the World Bank predicts that after a global growth rate of 5.5% last year, it should moderate to around 4.1% in 2022 and 3.2% in 2023.

In addition to the effects of the Omicron COVID-19 variant in early 2022, less tax support and persistence supply chain disruptions and bottlenecks indicate a slowdown. In the United States, the business and consumer confidence surveys for December already suggested a landing in progress.

For China, the World Bank expects GDP growth of 5.1% this year, lower than the 8% estimated for 2021. In addition to possible restrictions on mobility due to the “zero COVID” approach of China, the adjustment of the real estate sector will contain consumer spending. and residential investment.

As advanced economies and China reduce their pace of expansion, central banks are on a tightening trajectory, with the exception of China. The Federal Open Market Committee (FOMC) of the Federal Reserve Bank (Fed) of the United States meets on January 25 and 26. But the reorientation of its monetary policy since October is clear in the minutes of its meetings since then, and in the statements of its chairman Jerome Powell. In addition to a US unemployment rate below 4%, consumer price inflation ended the year at 7%, a level not seen since the early 1980s. Treat it as a “transitional” phenomenon was dropped by the Fed.

While the September 2021 FOMC meeting suggested an interest rate hike this year, the stakes are now three or four hikes. Additionally, the end of the Fed’s bond-buying program was brought forward to March, while Jerome Powell telegraphed that the Fed’s balance sheet reduction would begin sooner than expected, possibly as early as mid-term. ‘year.

After interest rate hikes in the UK, Norway and New Zealand, the same is expected in Canada later this month. Moves in the same direction from the European Central Bank and Sweden are now expected for early 2023.

This is the external scenario facing emerging and developing economies, whose slow recovery from the pandemic is expected to continue. The World Bank does not expect them to return to pre-pandemic GDP and investment trends in 2022-23 (Figure 1).

High inflation rates and public debt during the pandemic limit the adoption of expansionary fiscal and monetary policies in emerging and developing countries. It is no coincidence that higher interest rates and the downward revision of budgetary support are observed in most cases. The question is whether the slowdown in growth as financial conditions tighten in advanced economies is likely to be disastrous for emerging markets, with a hard landing in their case.

Tighter external financial conditions will undoubtedly accentuate the challenges facing policymakers in emerging markets. For emerging market economies that are currently under significant domestic inflationary pressures, the risk of further pressures being passed on by currency depreciations after markets price in higher US interest rates will be key in setting monetary policy. In this case, while monetary policy tightening cycles began in 2021 in Brazil, Mexico and Russia, following inflation rates exceeding their targets, the central banks of India and Indonesia maintained an accommodating position, given the low national underlying inflation rates.

The procyclicality of capital flows would also be a factor impacting these countries. Emerging market economies with a high share of foreign participation in domestic capital markets and more open financial sectors are vulnerable to the volatility of these flows. The central banks of these countries could be forced to tighten their monetary policy beyond what would be adequate from the point of view of growth. South Africa and Mexico are such potential cases. In cases where financial markets are largely domestically funded, as is currently the case in India, Brazil and Malaysia, the vulnerability to capital outflows leading to substantial currency depreciation is lower.

However, the answer to the question about the nature of the landing facing emerging market economies will ultimately depend on how aggressively the reorientation of monetary policy in advanced economies takes place. . Several factors favor such a scenario.

First, there has been no massive inflow of foreign capital into emerging market economies in recent years. Jonathan Fortun, in the Institute of International Finance (IIF) Capital Flows Tracker for January 10, suggested that there has already been a “sudden stop” in these flows, although with great differentiation between emerging markets. We can expect that there will be no external resources to flee massively in the event of a gradual rise in external interest rates.

Sergi Lanau and Jonathan Fortun, of the IIF, also pointed out that current account deficits in emerging markets have been remarkably low or zero over the past two years. Figure 2 illustrates this by displaying trade imbalances. In the case of Latin Americaforeign exchange reserves increased in 2021, following the strengthening of liquidity buffers started in the second half of 2020, in addition to the increase in special drawing rights (SDR) approved by the IMF in the middle of last year.

Hard or soft landing EM Figure 2

What about exchange rates? Are they at levels of overvaluation that make them vulnerable to sudden and catastrophic devaluations? Right here Robin Brooks, Jonathan Fortun and Jack Pinglefrom the IIF, suggest a more heterogeneous picture: although most EM currencies have experienced real devaluation over the past decade, there is huge differentiation, with some now showing a steep devaluation and others an overvaluation.

In the case of Brazil, for example, they estimate a degree of around 20% excessive devaluation of its local currency below what one would expect from its fundamentals, such as current account balances and gold stocks. foreign assets and liabilities. The exchange rate’s failure to return to pre-pandemic levels contributed to Brazil’s double-digit inflation at the end of 2021, in addition to food and energy shocks. In any case, in Brazil and other emerging countries without exchange rate overvaluation, a high probability of dramatic exchange rate adjustments is not expected … provided that, in turn, the reorientation of policy monetary policy in advanced countries does not take on dramatic contours either.

Thus, we maintain the scenario proposed last July. Barring drastic monetary adjustments in advanced economies, one needs to focus on domestic factors to understand the weaker performance of emerging markets in the immediate future, as shown in Chart 1.

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Otaviano Canuto, based in Washington, DC, is a Principal Investigator at Policy Center for the New South, lecturer in international affairs at the Elliott School of International Affairs – George Washington Universitynon-resident principal investigator at Brookings Institutionprofessor affiliated with UM6P, and principal at Center for Macroeconomics and Development. He is a former vice president and former executive director of the World Bank, former executive director of the International Monetary Fund and former vice president of the Inter-American Development Bank. He is also a former Deputy Minister of International Affairs at the Brazilian Ministry of Finance and a former Professor of Economics at the University of São Paulo and the University of Campinas, Brazil.

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