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

Rabah ArezkiandJean-Pierre Landau

Published: 2:30pm, 25 Sep, 2021

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As the global economy begins to emerge from the Covid-19 crisis, managing inflation risks will be much more challenging in developing countries than in advanced economies.

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.

For starters, developing countries have much greater exposure to environmental shocks, which will become more frequent and severe as a result of climate change. Extreme weather effectively acts as a negative supply shock, causing production to decline and prices to rise – the most difficult conditions for monetary policymakers.

Several countries, including Nigeria and Sri Lanka, are facing skyrocketing food prices. Madagascar’s drought and ensuing famine is another stark reminder of African developing countries’ vulnerability.

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.

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The prospect of capital flight might be particularly salient for poorer economies, particularly if accompanied by a reduction in development aid. Such sudden stops bring their own policy dilemmas, not least pressure on exchange rates.

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.

For countries with high levels of debt denominated in foreign currency, exchange-rate depreciation could lead to a fatal currency mismatch, triggering a debt crisis and a surge in inflation. The de-anchoring of inflation expectations could have further ramifications for developing economies’ already frail financial systems.

Why the world should stop worrying about inflation

Moreover, inflation tends to persist long after exchange-rate devaluations. Policies aimed at replacing costly imports with cheaper, domestically produced goods often result in mediocre growth and stubbornly high inflation. This has eroded households’ purchasing power, fuelling poverty and social instability.

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.

While fiscal consolidation during a pandemic is clearly not appropriate, stricter control of corruption and a reduction of leakages would help to ensure public spending reaches its intended beneficiaries and maximise its impact.

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.

While inflationary pressures generally remain under control, the risk of inflation in these economies could materialise in non-linear ways. For example, continued depletion of international reserves could cause a country’s currency to depreciate suddenly. This could precipitate spiralling inflation, especially if the authorities lack the credibility to anchor expectations.

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.

Rabah Arezki, a former chief economist of the World Bank’s Middle East and North Africa Region, is 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