Six themes for emerging markets

The International Monetary Fund (IMF) annual meetings are always a chance to reflect on the key trends affecting emerging markets. This year was no different. Carmen Altenkirch and Nafez Zouk engaged with policymakers and delegates to ascertain the real impact of the COVID pandemic on growth, fiscal metrics, and debt burdens.

The key themes at the IMF meetings were: diverging growth outlooks; IMF support; the nature of inflation (whether transitory or persistent); the monetary response of EM central banks; the risks posed by rising twin deficits; the challenges and opportunities posed by higher commodity prices; and climate change.

1. Downward growth revisions have hit those that can least afford them

Low-income countries are experiencing higher output losses, notably slower vaccine rollouts and generally less policy support.

Disappointing vaccination rates are dampening the recovery

Disappointing vaccination rates, particularly in low-income countries like Egypt and Nigeria, are dampening the recovery. The IMF notes that if differencees in vaccine access persist, inequalities in economic outcomes are likely to increase. While those countries with high vaccination rates are normalising more quickly, low-income countries are exposed to a longer, more structurally damaging impact from the pandemic. The IMF sees a certain degree of economic scarring across EM – in many cases, the Fund’s forecasts suggest GDP will fail to return to their pre-pandemic trend-implied levels, posing additional challenges for income convergence in these countries.

Figure 1: Progress in vaccinations against COVID-19 remains highly unequal across the world1
Progress in vaccinations against COVID-19 remains highly unequal across the world
Source: International Monetary Fund, October 2021

2. IMF: Financial saviour or policy overlord?

Within frontier markets, the recent allocation of Special Drawing Rights (SDRs), effectively free money from the IMF, is being used to help close the fiscal gap across several countries. This provides countries who were considering tapping the capital markets with some breathing room amid the current market volatility. In some cases, like Ghana, this may be contributing towards a delay in the much-needed policy response.

The recent allocation of Special Drawing Rights is being used to help close the fiscal gap across several countries

At the same time, Sri Lanka also plans to use SDRs to help stave off a potential default in 2022 yet is vehemently opposed for now to subjecting its economy to IMF-led fiscal consolidation and reforms. Egypt, once the darling of the IMF, has also opted not to renew its program with the Fund. New IMF money would require exceptional access, given how much money the IMF has lent to Egypt, which would come with more stringent reform requirements.

Our meetings with the IMF suggest that, while the Fund always stands ready to lend to countries facing a funding crisis, particularly when driven by external events, it is likely to be less lenient with countries that aren’t willing to carry out structural reforms. Pakistan is a case in point as the IMF is currently playing hard ball on fiscal consolidation and reform.

3. Inflation – transitory AND persistent

In most meetings, central bank policymakers made the same observation – that they were taken aback by how persistent inflation. Some stressed that the almost-exclusive focus on supply-side issues, labour shortages, bottlenecks is only one part of the story.

Policymakers are seeing signs of a change in the composition of demand

Indeed, policymakers are seeing signs of a change in the composition of demand – brought about by changes to spending patterns post COVID – which is resulting in additional price pressures (and perhaps explaining why inflation in countries like Mexico and Russia has been stickier than expected). Others stressed the difficulty in relying on traditional measures of economic slack to determine the appropriate monetary response. The two-speed nature of recoveries in many EMs – with manufacturing recovering faster than services – means traditional measures of output gaps as a key input into reaction functions may be less accurate than previously.

4. The Phillips curve is not dead in EM

In considering the degree of demand-pull inflationary pressures, central banks typically look at signs of a tight labour market, with low unemployment rates typically translating into higher wages and thus higher price pressures. The evidence from EM seems to be of a Phillips curve (the inverse relationship between the unemployment rate and inflation) that is alive and kicking, particularly in Central and Eastern Europe, South Africa and Colombia.

A Phillips curve that is alive and kicking

Other factors that are catching policymakers by surprise are some core components of inflation – such as rental inflation (which is rebounding more strongly than expected) – creating extra core price pressures in countries like Colombia and Poland.

5. Worry about twin deficits is rife

Many policymakers are fretting over the likely tightening of global policy next year at a point where financing needs are still high. Current accounts are still in better shape than before the crisis, but most attribute the improvement to temporary terms of trade gains that could reverse.

Supply-chain issues and lockdowns have impacted economic recoveries

While higher commodity prices have been a boon this year to many emerging markets, production challenges in Ghana, Nigeria, Colombia and Malaysia have meant that they have not benefited as much as they could have, providing another example of how supply-chain issues and lockdowns have impacted recoveries. In other countries, the path of fiscal consolidation is expected to be slow, translating into fiscal deficits that will remain wider for longer than pre-pandemic trends, posing an additional challenge in attracting sufficient capital flows to meet larger financing needs (e.g. Colombia and Indonesia).

6. Climate change and financing a low-carbon transition to receive a greater focus 

Ongoing droughts in Brazil, historically low water levels in Paraguay’s Paraná River and floods in South and Eastern Asia, were all cited as recent examples of weather-related calamities. Conflict and cross-border migration, financial and healthcare costs, were also raised as issues.

Flows to emerging markets have increased during the pandemic – although total flows remain small

Flows to emerging markets, driven by environmental, social and governance factors, have increased during the pandemic – although the Global Financial Stability Report highlighted they remain relatively small as a share of total flows. 

We have previously highlighted the potentially large fiscal costs for less-developed countries if governments are left to finance the climate transition. The growing shift towards sustainable investment can support the transition through two important channels. Investors' growing preference for sustainability-linked products should increase the supply of capital to countries whose agendas support the climate transition. Furthermore, the growth of sustainable funds and investor engagement should influence countries' climate policies and investment strategies, thereby creating a positive feedback loop.

Figure 2: Emerging market ESG sovereign and NFC issuance2
Emerging market ESG sovereign and NFC issuance
Source: International Monetary Fund, October 2021

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