Fatihah Ramzi, DigitalCFO Asia | 28 November 2022
In 2022, there has been a noticeable tightening of global financial conditions, which is in part an intended result of policy normalization.
The COVID-19 epidemic, Russia’s ongoing war with Ukraine, and other geopolitical and economic uncertainties have caused disruptions in the markets as well as persistently high inflation, a problem the world economy has not encountered in decades. Since inflationary pressures were reduced after the global financial crisis, central banks maintained interest rates very low for several years, and investors grew acclimated to a low-volatility environment.
Economic growth was aided by the consequent loosening of financial conditions, but it also encouraged risk-taking and the development of financial vulnerabilities. In order to prevent inflationary pressures from becoming entrenched and inflation expectations from de-anchoring, monetary authorities in developed economies are speeding up the pace of policy normalization now that inflation is reaching multi-decade highs. Despite significant regional variations, policymakers in developing markets have continued to tighten policy in response to rising inflation and currency pressures since they began raising interest rates in 2021.
In 2022, there has been a noticeable tightening of global financial conditions, which is in part an intended result of policy normalization. As a result, several emerging and frontier market nations with worse macroeconomic fundamentals have seen capital outflows. There is a risk of a disorderly tightening of global financial conditions, which might be exacerbated by vulnerabilities created over time. The global economy is confronting a number of issues, and authorities are continuing to normalize policy to manage excessive inflation.
In the current macro-financial context, which is unfamiliar to many policymakers and market participants, there is a focus on some of the most important conjunctural and structural vulnerabilities in advanced economies and developing markets. In April 2022, the outlook for the world economy significantly deteriorated.
The possibility of higher-than-expected inflationary pressures, a worse-than-expected slowdown in China due to COVID-19 outbreaks, lockdowns, and further deterioration in the real estate market, as well as additional fallout from Russia’s invasion of Ukraine, are just a few of the downside risks that have materialized. The outcome has been a worsening of the global economic slump and persistently rising inflation.
Many Frontier Markets Faced Defaults & Difficult Restructuring
Frontier markets in 2022 face difficulties as a result of weakening fundamentals, tightening financial conditions, and a high level of sensitivity to commodity price volatility. Since 2010, the median debt-to-GDP ratio for frontier markets has almost doubled, however 2022 saw a little reduction. Government debt interest costs have risen steadily throughout the year, putting more strain on liquidity and raising the possibility of unfavorable policy outcomes like crowding out of public investment.
To reduce local refinancing costs and regain access to global markets, credible medium-term fiscal consolidation plans are essential. Despite the midyear decline brought on by escalating recessionary fears, commodities prices—particularly for metals and oil—remain higher than they were before the outbreak. The macroeconomic outlook for importers has been further dimmed by this, yet many frontier markets export commodities and have profited from increased prices.
By raising the policy trade-offs – higher inflation calls for tighter monetary policy, but aiding the most vulnerable would require additional fiscal space or expenditure reprioritization – the rise in global food prices, on the other hand, is escalating vulnerabilities in frontier markets. Defaults could occur in a situation with weak fundamentals and low investor risk appetite.
In the event that frontier markets go into default, a growing number of complex creditors and holes in the global framework for dealing with sovereign debt could result in protracted debt negotiations involving a wide range of creditors, further delaying market access and driving up the cost of financial distress. A protracted period of high borrowing rates could result in increased policy uncertainty and a debt overhang for years to come, even in the event of an actual default.
Policy Recommendations
Policymakers all around the world have continued to normalize monetary policy despite inflation reaching levels not seen in decades and price pressures expanding beyond those associated with food and energy prices. In many nations, especially in advanced economies, the rate of tightening is intensifying in terms of frequency and size. Some central banks have started to shrink their balance sheets as they get closer to normalization.
To bring back price stability, financial conditions must be tightened. Monetary policy can decrease domestic demand to alleviate widespread demand-related inflationary pressures, but it cannot resolve lingering pandemic-related constraints in global supply chains and disruptions in commodity markets owing to the crisis in Ukraine. A necessary condition for long-term and inclusive economic growth is price stability. The upside risks to the inflation forecast suggest that central banks should continue to normalize monetary policy in order to prevent the emergence of persistent inflationary pressures.
They must take decisive action to return inflation to the target level while preventing any de-anchoring of inflation expectations that would jeopardize the credibility they have worked so hard to establish over the years. Policymakers should take note of historical lessons: going too slowly to control inflation and restore price stability necessitates a costlier tightening in the future as well as more difficult and disruptive economic adjustments. Lessons can be learned from the US monetary policy’s historical experience in the 1970s and early 1980s.
It is important for central banks to keep this experience in their sights as they navigate the difficult road ahead. With policy rates moving away from the effective lower bound that has prevailed in many countries since the global financial crisis, policymakers should rethink the modalities and objectives of the forward guidance they provide. The high uncertainty clouding the economic and inflation outlook hampers the ability of central banks to provide explicit and precise guidance about the future path of monetary policy.
But in order to maintain credibility, it is essential that they are transparent about their policy function, including the goals, intertemporal trade-offs, and procedures needed to bring inflation down to target. To guarantee orderly market reaction and prevent excessive volatility, clear communication about the need to further normalize policy in line with the evolving inflation forecast is also crucial.
With higher interest rates and normalization, businesses can expect inflation to go back to normal levels in 2023. Having survived a high inflationary year, businesses should give themselves a pat on the back and welcome the incoming year with open arms. Although other challenges and disruptions may come their way, it is evident that businesses of today must be fit to survive a highly volatile climate.
