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Central bank divergence suggests difficult decisions for emerging economies

As if the current environment was not already complicated enough, 2022’s first minutes from global central bank meetings highlight a growing divergence between hawkish central banks in the US and UK with the Doves in Europe and China. While the effect of these departures from accommodative pandemic easing across the world will only be born out with time, a second salient divergence has emerged between emerging and frontier economies.

At the onset of the pandemic-induced recession, low fiscal space and high exposure to the most profound economic casualties - tourism, trade, commodities, and remittances - forced policymakers to get creative in the developing world. One of the “innovations” widely adopted from Nigeria to Indonesia was unconventional monetary policy through extensive asset purchases and the expected public spending increases.

In a recent blog post, the IMF suggests a moderated approach that such policies offer temporary relief from market stresses but carry significant long-term risks in a recent blog post. Still, while heralded at the time, the experiment appears to have failed, with record inflation in part caused by high money supply while leaving little discernible benefit to proponents like Hungary, Brazil, and the Philippines.

This situation leaves developing countries in an unenviable position, with high consumer prices, limited fiscal space, and a large debt stock amid rising interest rates and slowing growth. But central banks are now facing the bill, as their monetary mandate (often singular like the ECB rather than the Fed) demands increased rates despite a still tenuous recovery. These conditions force policymakers to decide whether to raise rates and risk recession (as common in Latin American and Eastern Europe) or keep rates unchanged to protect the recovery and risk spurring inflation (Africa and Asia’s preferred policy).

Turkey offers an indicative albeit abnormal case of the costs faced by economies when conditions are accommodative. As such, central banks like Brazil, Argentina, Nigeria, and Indonesia are expected (cite) to raise rates multiple times in 2022. This trend is widely expected to continue as they race against the Fed, risking triggering recessions, like Q3 in Brazil, in the process.

While additional IMF special drawing rights (SDR) allocations and the Paris Club’s debt suspension service agreement (DSSI) helped create breathing room for EM’s, inflation is likely to increase the returns and risk premiums on sovereign debt over the next year. However, while the MSCI index might be at risk of underperforming from its dip in the last couple of weeks, strong borrowers like Chile and Columbia, despite the perceived political risk, and Indonesia and Vietnam, despite restrictive covid policies, are likely to still thrive in 2022.

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