How hidden inflation risks threaten developing countries’ recovery
- Accelerating inflation, along with worsening growth and employment prospects, will expose developing economies to greater sociopolitical instability
- While Covid-19 has yet to be defeated, monetary policymakers should start preparing to address potentially serious inflation threats
That reflects the nature of the shocks driving inflation and the fact that lower-income countries are ill-equipped to respond to them. A combination of specific shocks and vulnerabilities could seriously threaten these countries’ economic stability and prosperity.
Developing economies are also more exposed to financial shocks. Monetary policy in advanced economies will eventually normalise and, if past experience is any guide, many emerging markets will experience massive capital outflows.
Policymakers can either let their currencies depreciate – which would fuel inflation – or raise interest rates, which would adversely affect growth and debt sustainability.
Both types of inflationary shock will be a severe test for policymakers in poorer countries. Many lack the experience and track record needed to ensure credibility and stabilise inflation expectations. Several negative feedback loops could thus develop.
Part of the policy response to these inflation risks is in the hands of developing countries themselves. A credible fiscal policy framework would help stabilise expectations.
Corruption costs developing economies an estimated US$1.3 trillion per year. The pandemic should spur developing-country governments to crack down on the misuse of public funds. This will create fiscal space to soften the impact of inflation on the poorest households while setting the stage for recovery and sustained economic growth.
But the international community also can help lower-income countries navigate inflationary pitfalls. Macroeconomic stability in the poorest countries depends heavily on external finance. The international community thus needs to prop up developing economies’ international reserves to support their currencies and tame inflation risks.
Accelerating inflation, along with worsening growth and employment prospects, will expose developing economies to greater sociopolitical instability. The spillover effects from such turmoil are just what the world economy does not need as it recovers from the pandemic.
Fortunately, the International Monetary Fund’s recent US$650 billion allocation of special drawing rights (SDRs) represents an ideal opportunity to help developing economies. Although SDRs are increasingly viewed as a development tool, they are essentially a reserve asset that can have important anti-inflationary benefits.
Ensuring more of the new SDRs go from advanced economies to developing countries will bolster poorer countries’ international reserves and help shield billions of people against the risk of inflation. That will provide room for national authorities and the private sector to act decisively to reignite growth and reduce poverty.
Much of the developing world is still in the throes of the pandemic. But even before Covid-19 is defeated, monetary policymakers might have to address potentially serious inflation threats. They should start preparing now.