Inflation, monetary policy, borrowing costs, and debt sustainability

‘The start of this year is an eerie echo of 2021. A new variant of coronavirus has sent infections rocketing in all parts of the world, threatening economic prospects for the year ahead. But rather than a rerun of the severe downturns we saw in 2020, the outlook is one of high global inflation and rising interest rates, with severe risks for the more vulnerable emerging and developing economies.’ An excerpt from a recent Financial Times (FT) article ‘Monetary policy widens the gap between poor and rich countries’ by Chris Giles.

Inflation has virtually become a global phenomenon mainly at the back of global commodity supply shock. At 7 per cent, the US saw the highest inflation rate for 39 years. A recent FT article ‘US inflation soars to 7% for first time since 1982’ pointed out in this regard that ‘US consumer price growth rose at the fastest pace in almost four decades in December… The consumer price index (CPI) increased at a 7 per cent year-on-year pace last month, a step up from the 6.8 per centrate registered in November and the largest jump since June 1982.’

Similarly, inflation in eurozone has also been rising significantly, and at 4.9 per cent, reached an unprecedented level in the bloc’s history, as pointed out by a Guardian article ‘Inflation in eurozone soars to 4.9% - highest since euro was introduced’ from the first day of December last year as follows: ‘Inflation across the 19-member eurozone soared to 4.9% in November… High gas prices and the cost of imported goods were blamed for the inflationary surge. …France suffered a 3.4% inflation increase, its highest in a decade, but it was in Germany among the bloc’s largest economies where prices rocketed, taking the inflation rate to 6%. In Estonia, the inflation rate jumped 8.4%, while in Lithuania it reached 9.3%.’

In England, inflation has seen a huge rise and is now the highest in around 30 years. Another Guardian article ‘Inflation is back, and there’s plenty more in the pipeline’ pointed out in this regard: ‘Inflation was supposed to be yesterday’s problem. …Now it stands at 5.4% – the highest in almost 30 years – and it has not peaked yet. With the lagged impact of the supply-chain bottlenecks of last autumn feeding through into prices in the shops and a likely 50% jump in domestic energy bills to come, inflation will certainly exceed 6% in April and may be closer to 7%.’

In the wake of high inflation, a quick and significant move towards a tighter monetary policy stance is appearing, overall, on the global horizon. Given the latest significant rise in inflation, the Federal Reserve will now reportedly be looking for at least four policy rate hikes this year, as against reports of three such raises a month ago. A recent Bloomberg article ‘Four Fed hikes may be just the start as traders boost trade bets’ pointed out in this regard: ‘The drumbeat for the Federal Reserve to implement four quarter-point interest-rate hikes this year is growing — and with the speed that markets have been moving, there’s a possibility that traders may soon look to protect themselves against the risk of even faster tightening. …Swaps are already indicating the central bank’s target will be 88 basis points higher by the end of this year… Bloomberg Economics economist David Wilcox thinks that the latest forecasts for the unemployment rate and core inflation are consistent with six hikes this year and another three in 2023.’

Higher borrowing costs will add to already difficult debt situation in developing countries, including Pakistan, where the external debt has seen considerable rise over the years. Moreover, rising borrowing costs will also limit governments’ capacity to enhance development expenditure and stimulus spending. This, at the back of high inflation, would mean that developing countries, which are also net importers of commodities that global supply shock has immensely impacted in terms of prices and where the component of imported inflation is also significant, would overall raise the risk of a severe balance of payments, and debt crises.

As per the same FT article by Chris Giles, a tighter monetary policy stance by US would mean a difficult economic outlook for developing countries overall, whereby he pointed out: ‘The problem for poorer countries is that tighter, but still stimulative, US policy might well spell trouble for them. As the World Bank notes in this week’s outlook for the global economy, tighter US monetary policy is likely to exacerbate an already difficult outlook for emerging and developing economies. …the World Bank estimates that recoveries in poorer countries will fall almost 6 per cent short of pre-pandemic expectations. This further limits their ability to service existing debts, which have risen by 10 percentage points of national income since the start of the pandemic, according to the IMF. This is likely to bring a hard landing, debt distress and social discontent in weaker countries. None of this is made any easier by the possibility that the Fed will press harder on the brakes than expected this year…’

Hence, it is important that the US adopts a less aggressive monetary policy stance, given the risks that such an approach may lead to a global debt pandemic. Rising debt servicing costs would also reduce an already small fiscal space for developing countries to make needed public expenditures, and enhance stimulus spending, not to mention the further depreciation of currencies that this may lead to, in turn, bringing further imported inflation pressures on net importer developing countries like Pakistan of commodities such as oil. As per

the same FT article by Chris Giles, ‘The outlook is difficult. The World Bank expects 40 per cent of emerging and developing economies still to have national income below the 2019 level in 2023.’

China and Turkey, on the other hand, have been swimming against the trend of raising policy rates; these two countries could bring a good balancing direction for countries overall to use a mix of fiscal and monetary policies to deal with inflation, which after all may ease out as the global supply shock diminishes at the back of receding pandemic and better regulation. In a recent Bloomberg article ‘China bucks the trend’ with regard to rate cuts in China, it was pointed out that ‘China is heading in the opposite direction as fellow central banks march towards tighter monetary policy. The People’s Bank of China on Monday cut its key interest rate for the first time in almost two years, lowering the rate at which it provides one-year loans to banks by 10 basis points. …Further policy interest rate cuts and a reduction to the reserve requirement ratio, or the amount of cash banks must set aside in central bank reserves, will also follow, according to China watchers. The rate cut is part of Beijing’s efforts to put a floor under growth in a crucial year of leadership transition for the world’s second-largest economy.’ Hence, rather than pushing the paddle of monetary policy tightening too forcefully, a greater focus should be placed on increasing inoculation rates – which are anyways important for the first priority of saving lives – and government interventions in markets increased considerably to reduce the imprint of ‘greed’ or unwarranted profits in an overall effort to reduce global supply shock.

This is important for insulating the world from a likely debt pandemic. Such a more balanced approach is important for both developed and developing countries to not undo the already injected stimulus during the pandemic, not to mention the need for more public and private investment to increase much-needed levels of purchasing power during the inflation onslaught, especially in developing countries where poverty and inequality has risen significantly during the pandemic. In the same article, Chris Giles highlighted in this regard: ‘Two decades in which emerging economies’ living standards caught up with their richer cousins have now ended. The World Bank estimates that real incomes in 70 per cent of emerging and developing economies will grow slower than those in advanced economies between 2021 and 2023.’

Another important step to reduce the reliance on monetary policy to deal with inflation, and in turn, increase debt sustainability in developing countries is for rich countries and multilateral agencies to significantly practice ‘debt-for-climate swaps’. A recent Project Syndicate (PS) article ‘Debt-for-climate swaps make sense’ pointed out in this regard that ‘European Commission President Ursula von der Leyen has said that “major economies do have a special duty to the least developed and most vulnerable countries,” and International Monetary Fund Managing Director Kristalina Georgieva said that “it makes sense” to seek to address debt pressures and the climate crisis jointly. The idea is to arrange “green debt swaps.” …An ambitious “Green Brady Deal” could mobilize public and private flows for climate finance in countries suffering from both high debt and climate risk. It would not be a magic bullet, nor would it be the main dish on the menu of climate finance. But it could make a big difference for some of the most vulnerable countries.’

Pakistan, on its part, should also look to reduce the issue of debt sustainability at home by adopting a balanced approach by not overly relying on monetary policy tightening. Such restraint in monetary policy tightening will also be important for raising the much-needed level of development expenditure and stimulus spending, especially in view of the presence of the Covid-19 pandemic. Yet, with only little sway over State Bank of Pakistan after the recent legislation, the government may find it very difficult to align such interests with the Bank’s policy, especially in a timely manner. This aspect needs going back to the amendment to re-balance the relationship there. At the same time, the government needs to make greater efforts in the direction of economic diplomacy to sway major treasuries, and multilateral agencies for adopting a less aggressive monetary stance and rely more on other measures (some directions indicated above), including greater vigour shown on measures that allow tackling both debt sustainability issues and climate crisis.

(The writer holds a PhD in Economics from the University of Barcelona; he previously worked at the International Monetary Fund)

He tweets@omerjaved7

Copyright Business Recorder, 2022