In these times of uncertainty and expensive funding, a pragmatic approach requires collaboration and focus on what really matters. And we must ensure that this approach is consistent with concerted and large-scale efforts to achieve climate and social goals. Only then can we improve well-being. In this outlook, we answer five questions about the challenges emerging markets face in these turbulent times and what this means for poorer countries.
The COVID pandemic and the war in Ukraine are extreme events that are testing the ability of investors, policymakers and households to adapt to unexpected shocks. These shocks are causing long-term shifts in military spending and energy markets, but also geopolitical fragmentation and perhaps even a new era of tightening monetary policy. But undoubtedly one of the more undesirable shifts is the setback in well-being progress, as seen in the deteriorating progress on many of the Sustainable Development Goals.
How are emerging markets dealing with higher food and energy prices?
Fiscal policies were scaled back in many emerging markets in the wake of the pandemic but are now reaching their limits again as governments seek to mitigate the impact of higher energy and food prices. And that’s understandable; In emerging markets, food and energy can account for up to 50% of consumers’ shopping baskets, which has a significant impact on household spending power as prices rise. To make matters worse, the war in Ukraine has triggered food shortages for the world’s poorest.
Even before the war, a large group of emerging economies depended on subsidized food and energy. Household spending had to be increased further to offset recent increases in food and energy prices. Others have, for the first time, taken measures to offset high inflation, including cutting consumption taxes and imposing fuel price caps. Apparently, commodity exporters were better able to limit the impact than commodity importers. As understandable as they are, these subsidies leave less room for other much-needed investments in the future, such as in education and meeting climate commitments.
Can emerging markets handle inflation without too much pain?
Central banks in advanced economies are determined to fight inflation and are tightening faster than expected, albeit at the cost of a recession. Emerging market central banks are following a similar trajectory, albeit in smaller increments lately. A total of around 90 central banks have raised their key interest rates this year.
But there are many differences between countries and there is a growth rotation. The US, China and India continue to support modest increases in global growth this year, while Europe flirts with a recession. In fact, India has overtaken the UK as the fifth largest economy in the world. Although China is still grappling with the strain of COVID and a fragile real estate market, it has shown an improvement in economic activity in recent months. In addition, given the low level of inflation, the Chinese authorities have scope for additional support.
Many commodity exporters, including Indonesia and Malaysia, have fared well in the first half of 2022, reporting stronger growth and lower inflation levels than other emerging markets. However, the smaller commodity-importing countries, including Myanmar, Sri Lanka and Pakistan, which were already shrinking before the war and were struggling to fight inflation, are facing deep recessions and double-digit inflation rates.
Barring the war in Ukraine escalating, global inflation is likely to ease over the next 12 months as monetary policy tightens. And this is necessary because high inflation primarily worsens the well-being of those living in poverty or on the brink of poverty.
What are the downside risks for emerging markets?
Our baseline scenario for emerging markets remains one of low GDP growth and slowly declining inflation over the coming quarters. Average inflation will remain above central banks’ targets in the near term, provided monetary tightening and complementary measures are sufficient to contain inflation. Recurring rate hikes in advanced economies are likely to constrain global demand and trade. As demand falls, food and energy prices will gradually fall again. And while an energy crisis continues to loom in the near term, countries are finding alternative solutions in new markets and policies, including price caps, to bring down rising energy prices.
However, the Fed’s aggressive rate hikes have increased fears of a recession. A flight to safety has already boosted the US dollar index along with its major trading partners by 20% year-to-date. As a result, an overwhelming number of emerging market currencies have depreciated against the US dollar. This has led to higher import prices, inflationary pressures and debt burdens as central banks that intervene to support their currencies are sometimes forced to run down international reserves.
These developments have increased the downside risks to our base case. The potential for policy mistakes is great, and the relief that governments and central banks can offer in stressed financial markets is severely limited. Losing central banks’ credibility in setting inflation will only make the dollar stronger and the pain for emerging markets even greater. This negative scenario must be averted as the poor will bear the brunt of these developments.
Are emerging countries still attractive for investments in the current situation?
From an impact perspective, investing in emerging markets is more relevant than ever. Emerging markets are home to more than three-thirds of the world’s population, and a backslide on the Sustainable Development Goals will have significant and far-reaching spillovers. Not only because of potential migration flows and environmental degradation resulting from the disorderly exploitation of natural resources, but also because social unrest resulting from a deterioration in living conditions can affect trade and the normal functioning of markets.
Countries that are in the early stages of development are more vulnerable to risk than developed countries, but excluding them from funding would mean denying them the capital they need to develop further. Understanding country risks is therefore crucial to take the necessary mitigation measures. But there are other risks, including geopolitical risks, that transcend national borders. The only correct answer is to make these countries more resilient. And time is ticking. International support is becoming increasingly important in the search for sustainable development. Emerging markets must work hard to become creditworthy, and private investors must do more to support emerging markets in their transition, or we will all suffer the consequences.
How can emerging markets become more resilient?
Past experience shows that the resilience of certain emerging markets often reflects a combination of policy choices, generally taken in a favorable international environment. Countries including Uruguay and Botswana, the who have capitalized gains from trade by placing an emphasis on social protection and internal inclusion, and developing quality institutions are success stories.
But of course it depends on the level of development of a country.Countries that fall far short of the Sustainable Development Goals have a more difficult task, and progress cannot be made without international support. Otherwise, how will these countries be able to seize the opportunities of major transformations, including climate change and digital transformation? For these vulnerable countries, ravaged by COVID and war, with limited access to capital markets, harnessing collective strength is the only way forward resilient future.
