Though it was not a full recovery from the aftershocks of the COVID-19 pandemic, the global economy was on the mend until the invasion of Ukraine by Russia. Economic prospects have worsened since then, exacerbating the divergence between the economic recoveries of advanced economies and those of the developing ones. The prevailing uncertainties in global growth prospects come in the aftermath of frequent disruptions to worldwide supply chains in the last two years with recurrent lockdowns in key manufacturing hubs, creating supply bottlenecks.
As a consequence of the current situation, two key macroeconomic variables have a persistent effect on growth rebound. First, there is a tenacious price pressure, leading to policy trade-offs especially in developing economies; and second, there have been capital outflows and a tightening of financial conditions, affecting investment and growth in the medium and long term.
Inflation concerns
Globally, inflation has become a central concern. In some of the advanced economies, it has reached its highest level in the last 40 years. According to the International Monetary Fund (IMF), “inflation is expected to remain elevated for longer”. For 2022, it says “inflation is projected at 5.7 percent in advanced economies and 8.7 percent in emerging market and developing economies and in 2023 it is projected at 2.5 percent for the advanced economy group and 6.5 percent for emerging market and developing economies”. So, for the immediate foreseeable future, commodity prices, oil and gas prices, and with a lag, food prices, would remain high. The major contributors to high inflation are energy and food prices. A spike in oil and gas prices due to a tight fossil fuel supply and geopolitical uncertainty have led to substantial increases in energy costs worldwide. In developing economies, rising food prices have had cascading effects, culminating in higher overall inflation. This gets intensified if poor weather hits harvests and rising oil prices drive up the cost of producing and transporting fertilizers.
Impact on households
In developing economies, higher prices for food impacts different sections of the population differently, depending on the types of food consumed and the share of food expenditure in a household’s consumption basket. Households in the low-income strata often consume diets with just one type of grain and are particularly vulnerable to price changes. Higher energy prices affect cereal prices as a result of rising transportation costs and increased input prices such as fertilizers. This is aggravated by shortages due to disruptions in agricultural inputs (especially fertilizers) which impact supply and market availability. Persistent short supply and increases in food and fuel prices could significantly increase the risk of social unrest as the poorer sections are pushed to the edge of heightened deprivation.
Capital outflows
Apart from inflation, the other macroeconomic factor impeding growth recovery is the sudden spurt in capital outflows from emerging markets and developing economies. Capital outflows have increased in recent months. Emerging markets suffered their first portfolio outflows in a year in March 2022. The Institute of International Finance (IIF) says “foreign net portfolio outflows for emerging markets came to $9.8 billion in March. Developing stocks lost $6.7 billion, while bonds saw $3.1 billion depart. Investors have become more selective, as higher risk sensitivity mounts due to tighter monetary conditions and rising inflation. Moving forward we see greater volatility on flows dynamics, as some countries have bottomed up and could potentially benefit from higher commodity prices but may also be greatly exposed to risk factors”. Interest rates tightening in the United States is associated with capital flow reversals from emerging markets. For developing economies, the result of sudden large capital outflows is currency depreciation and tighter external sector conditions, leading to growth fluctuations. To complicate matters, domestic fiscal policy space has already been eroded in many developing countries by COVID-19-related spending. The increase in global interest rates will further reduce this contracted fiscal space in many economies.
Policy options
Though the factors contributing to high inflation (energy and food prices which are driven by global supply shocks) are beyond the control of central banks, they need to carefully monitor the pass-through of rising international prices to domestic inflation to calibrate their responses. It is also imperative that the pace of policy tightening needs to be attuned to prevailing economic situations and activity levels. Central banks could also signal a readiness to shift the monetary stance to maintain the credibility of their inflation-targeting frameworks by clearly communicating the importance of inflation stabilisation in their objectives and backing it with policy actions. As sudden capital flow reversals can threaten financial stability, foreign exchange interventions could address market imbalances.
As the IMF’s ‘World Economic Outlook’ makes it clear, data from developing countries show that debt levels have touched an all-time high following a huge fiscal expansion in many countries during the novel coronavirus pandemic. Massive expenditure programmes directed toward the health sector and income support measures had become necessary as part of such fiscal expansion. There exists an imperative to prune expenditure and get back to the road of fiscal consolidation. However, a push for consolidation should not prevent governments from prioritising spending to protect and help vulnerable populations affected by price increases and the pandemic. Expenditure pruning should encompass targeted income support measures that can be used to alleviate stress on household budgets. Such measures should be designed to deliver maximum relief to the most vulnerable at lower costs.
Safety nets needed
In the post-pandemic global economy, there will be a likely cross-sectoral labour reallocation. Economies are bracing for transitions and the energy transition could be the most significant one. These transitions require labour market and income support policies that are designed to provide safety nets for workers without hindering employment growth. Along with temporary public support for displaced workers, training programmes and hiring subsidies should remain a priority. The message from the current phase of global growth is clear. Policymakers in the developing economies have to prepare for tighter financial conditions and spillovers from geopolitical volatility. Pockets of elevated vulnerabilities within sections of the population have to be identified for early action and a set of selected prudential tools to target them needs to be devised.
M. Suresh Babu is currently Adviser to the Economic Advisory Council to the Prime Minister. He is also Professor of Economics at IIT Madras. The views expressed are personal
