Alongside the possibility of elevated inflation, global activity could remain anemic. Growth is already slowing, including in the world's major economies. The United States is withdrawing policy accommodation, the euro area is suffering substantial spillovers from the invasion of Ukraine, and activity in China is being hindered by difficulties in the real estate sector and lockdowns to control COVID-19. Growth could remain feeble for a prolonged period, as many of its structural determinants have weakened. Demographics represent a growing headwind to potential growth. Labor productivity has slowed considerably since the global financial crisis, largely as a result of weakness in both investment and total factor productivity (Dieppe 2021). The pandemic has left deep scars in the form of lower investment, lower human capital, and a retreat from global supply chains, all of which are likely to dampen potential growth in the longer term (World Bank 202la). Financial stress across EMDEs The current environment of elevated inflation and rising interest rates poses risks to the financial stability of many EMDEs. The increased cost of inputs, particularly energy, and of credit could trigger economic slowdowns, widen current account deficits, and generate significant financing gaps. Rising interest rates could result in fiscal pressures, widespread corporate defaults, and feeble global investment. These risks are particularly acute given that debt in many EMDEs has been on a decade-long upward trend capped by a broad-based surge during the pandemic, with increasingly tight interlinkages between the health of the government balance sheet and that of the banking system (Feyen and Zuccardi 2019; Kose et al. 2021). The most vulnerable EMDEs are those that could struggle to roll over debt in the face of significantly higher debt service obligations, or that hold large shares of debt that is denominated in foreign currencies, held by nonresidents, short-term, or subject to variable rates (figure 1.13.A). Historically, financial crises in EMDEs have been more likely when the U.S. Federal Reserve pivots toward a more aggressive tightening stance, as it is currently doing to rein in inflation well above
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CHAPTER 1
GLOBAL ECONOMIC PROSPECTS | JUNE 2022
FIGURE 1.13 Financial stress across emerging market and developing economies Emerging market and developing economies with debt vulnerabilities — such as a high proportion of variable-rate debt—could face higher debtservicing burdens or struggle to roll over debt in an environment in which aggressive
monetary tightening,
especially
in the United States, may
sharply raise borrowing costs. Inflation has risen to decade highs, which has kept real monetary policy increases, suggesting
rates negative
despite
recent
nominal
that policy continues to be accommodative. The
Phillips curve may have flattened, which suggests that central banks may need to significantly tighten monetary policy to rein in inflation.
A. Share of EMDE external debt subject to variable rates
B. Magnitude of rate hikes and U.S. core CPI during previous Federal Reserve tightening cycles Percentage points Percent • Magnitude of rate hikes over 10 course of cycle • Core CPI at beginning of cycle (RHS)
10
II II ll II ll
C. Real policy interest rates and inflation
10
• Latest
D. Time-varying estimates of the Phillips curve slope coefficient Blanchard(2016)
2000-21 average
Stock and Watson (2019)
5 0 -5 -10
Real rates
Inflation
United States
Real rates
Inflation
Euro area
1960-83
2000-19
Sources: Eurostat (database); Federal Reserve Economic Data; Haver Analytics; World Bank. Note: EMDEs = emerging market and developing economies. A. Figure shows the EMDE average of variable rate external debt as a share of total external debt. B. Blue bars show the extent of policy rate increases during previous tightening cycles. The value for 2023 is an estimate based on market expectations for the level of the Fed Funds rate in mid-2023. U.S. core CPI for 2023 shows latest data associated with tightening cycle. C. "Real rates" are policy interest rates minus consumer price index inflation. "Latest" refers to the last available data, which are for April 2022. D. Estimates from Blanchard (2016) and Stock and Watson (2019).
levels seen at the beginning of previous hiking cycles (figure 1.13.B). Some previous episodes of higher U.S. interest rates, such as the taper tantrum of 2013, have been followed by increased financial market volatility in EMDEs, including currency depreciation, rising bond spreads, portfolio outflows, equity price collapses, and liquidity shortages (Arteta et al. 2015; Hoek, Kamin, and Yoldas 2020). EMDE central banks may be forced to tighten monetary policy to stem capital outflows at the expense of domestic activity, as has occurred in the past.
