Specter of Stagflation Hangs over Emerging Markets Jayati Ghosh

Spare a thought for finance ministers and central bankers in the developing world. They probably heaved sighs of relief when the U.S. Federal Reserve decided against raising interest rates at its latest meeting on July 28. Yet they know that the reprieve is only temporary. Even though the delta variant of the COVID-19 virus could slow down the economic recovery, the relevant question is not if the Fed will tighten U.S. monetary policy, but when.

When that happens, it will inevitably add to the current woes of emerging markets, which are already severe and complicated. Over past decades, these countries have been forced to get used to dealing with the spillovers from the advanced economies’ macroeconomic policies. But it is possible that they have never felt as cruelly used by this interdependence as today. While policymakers in advanced economies fret and argue about whether the combination of aggressive fiscal stimulus and a relatively rapid economic recovery will generate inflation in their countries, that inflation has already reached the developing world in the form of rapidly rising global commodity prices, including food. Worse, several emerging markets now face the much more serious threat of stagflation: rising inflation even as economic activity and employment remain low or even decline.

Consider the quadruple whammy now faced by most emerging-market countries: a still-raging pandemic with no clear end in sight, external and internal constraints on their government spending, unwanted impacts of the advanced economies’ fiscal and monetary policies, and trade patterns that create rising food prices and other inflationary pressures but do not deliver wider markets for developing-country exports. If we add the impact of climate change, the cup of unhappiness clearly flows over.

To begin with, the COVID-19 pandemic continues unabated in many of these countries, leaving more deaths, adverse long-term health impacts, and economic destruction in its wake. The unequal spread of vaccination is a major reason for this, as a few rich countries quickly grabbed global supplies of available doses by making advance purchases that were several times what they would need to vaccinate their own populations. They continue to hoard vaccine supplies that they are unlikely to use, despite promising otherwise at the G-7 summit in June. Several G-7 countries also continue to oppose a waiver to World Trade Organization intellectual property rules, which would make it easier for other countries to manufacture vaccines. Similarly, no rich-country government has yet pushed its own vaccine-makers to share technology through the World Health Organization’s COVID-19 technology access pool.

It bears repeating: This strategy is blatantly nationalist, selfish, unjust, stupid, and self-harming. As the pandemic spreads, the virus inevitably mutates; already, the delta variant seems to have infected significant numbers of vaccinated people in Britain and the United States. Where there is a lack of vaccine access, the pandemic is once again creating health havoc. Emerging markets that were hoping to recover must now contend with underfunded and exhausted public health systems and continued economic disruption.

Meanwhile, even as the advanced world has suddenly rediscovered the joys of public spending to buy vaccines, support incomes, and boost the economy, most developing countries lack the fiscal space necessary to address these challenges The International Monetary Fund estimates that of the $9.93 trillion of additional government spending and lost revenues between January 2020 and March 2021 worldwide, $7.98 trillion (or 80 percent) came from the G-7 and three other advanced economies. The United States alone, with $5.33 trillion, accounted for more than half of the total. The World Bank calculated that by June 2020, the first wave of fiscal support in response to COVID-19, including loans, guarantees, and foregone revenues, averaged 20.3 percent of GDP in the advanced economies, 5.9 percent in emerging markets, and 1.8 percent in low-income countries.

In emerging and developing economies, some governments are bowed down heavily by external debt, spending more to service debt than on public health. The lack of effective international measures to forgive or restructure sovereign debt is to blame for this, possibly leading to a future debt implosion. Other governments are cowed by the fear of the financial markets’ response if they allow their fiscal deficit to rise too much, even if deficit-to-GDP ratios are going up anyway because of collapsing revenues. Such constraints on more spending mean that governments have not done enough to counteract the contractionary impact on consumption and investment created by the pandemic and its associated lockdowns.

Now, developing countries have two more problems to contend with: the possibility of domestic inflation because of rising global prices and the likelihood of tighter international credit markets as mobile capital is sucked in by the rich countries, especially the United States, whose economies and asset markets have been juiced up by fiscal and monetary stimulus.

Concerns about inflation in the developed world are mostly misplaced and premature, with recent price increases the result of short-term supply bottlenecks as demand recovers in these economies. But with the exception of China and a few outliers, most of the developing world is still suffering from subdued demand and contracting economies. Inflationary pressures would be unlikely in this scenario, were it not for the sharp rise in many global prices.

The recent increase in inflation rates in many countries where economic activity continues to decline—countries as otherwise different as Mexico, Saudi Arabia, South Africa, and the Philippines—shows how this can play out. In Brazil, even though output remains well below the pre-pandemic level and official unemployment is above 14 percent, the central bank raised interest rates in March after the consumer price index had increased by more than 6 percent year-on-year. In Mexico, which has had one of the weakest recoveries in Latin America, inflation of nearly 6 percent is being met with a double whammy of tighter monetary policy and fiscal austerity—likely to cause further economic decline. In the Philippines, food and fuel price increases have led to an inflationary surge that has directly impacted the poor.

In India, the rise in inflation has a more domestic cause: It largely results from the government’s strategy of seeking to extract ever more revenues through fuel taxes, to the point that now such taxes now account for nearly two-thirds of the retail price for gasoline and diesel. Since energy directly and indirectly enters the price of all other products, this has led to consumer price inflation of more than 6 percent in a country with the largest number of hungry people in the world, where people are already reeling from fewer jobs and falling wages.

And then there is the other unfortunate consequence of the so-called global economic recovery that has been largely confined to the United States, some other advanced countries, and China. It has already led to a significant rise in many commodity prices, with the global metals price index up by 80 percent over 12 months and energy prices up by 108 percent over the same period. If these rises are sustained, they could benefit commodity exporters in Africa, South America, and elsewhere. A more disturbing aspect of this commodity price inflation is the one-year rise in the global food price index of 32 percent (after peaking at a 42 percent increase in May). The pandemic was already estimated by the United Nations Food and Agriculture Organization to have nearly doubled the number of acutely hungry people in the world—even before the rise in global food prices made basic food unaffordable for even more people. Most hungry people are in the developing world, where governments already face multiple constraints on public relief spending.

Finally, there is the renewed concern about capital flows—and how debt and bond markets will react when the inevitable monetary tightening in the United States and other advanced economies finally does come about. Financial capital is notoriously fickle and responds to even the smallest changes in interest rates and liquidity provision in these so-called safe countries. When capital rushes out of emerging markets, it leaves declining currencies, damaged banking systems, and concerns about debt repayment in its wake. Central banks in such countries are often forced to respond in ways—like raising interest rates or depleting foreign-exchange reserves to shore up their currencies—that could further damage domestic economic prospects.

Just like climate change is no longer a future problem but a contemporary one, stagflation is already an ongoing process in some developing countries and a genuine prospect in many others. The consequences are likely to be dire, as governments will likely adopt strategies to control price rises that worsen recessionary tendencies and prevent recovery. Just like the coronavirus, the economic devastation this causes will not stay confined just to the poor or just to developing countries—the negative fallout will inevitably spread to the advanced economies as well.

Some impacts of financial globalization have already led to major political pushback in northern countries. With an uneven recovery generating even more global inequality, it may not be long before more people in the developing world start to question the supposed advantages of global economic integration as well.

(This article was originally published in Foreign Policy on August 5, 2021)