Type expectations: developing economies threatened by US inflation

While policymakers in the developing world are fighting the persistent spread of coronavirus, they are also facing the economic threat of inflation, and not just at home.

Rising price growth in major economies, particularly in the United States, is fueling investor expectations about rising interest rates. This increases bond yields, making it more expensive to sell debt to other countries, as buyers demand higher yields.

What should be good news, the start of a global recovery, has become a threat: that the cost of indebtedness will reach dangerously high levels in countries like South Africa and Brazil, causing their already precarious public finances are in disarray.

“Emerging economies should be more concerned about U.S. inflation than theirs,” said Tatiana Lysenko, chief economist of emerging markets at S&P Global Ratings.

He said not only inflation and rising yields in the US are increasing the costs of indebtedness in the developing world. The broader risk is that the U.S. economy will advance to emerging economies, causing outflows of its stocks and bonds, and eventually the weakness of the currency.

Although rich countries have been able to apply for loans during the pandemic at very low rates, many developing countries already face a much higher cost of financing.

S&P data show that refinancing costs in 15 of the 18 largest developed economies have fallen below their average cost of borrowing by more than one percentage point. Most pay a fraction of 1 percent. An increase in the cost of funding by one percentage point would be easy to bear for most.

In an interconnected world with many capital flows, American returns have important repercussions

The same cannot be said of developing countries. Egypt, which has to refinance a debt equal to 38% of gross domestic product this year, pays an average rate of 12.1%, above its average cost of 11.8%, according to S&P. Ghana pays 15%, compared to an average of 11.5%.

The danger lies not only in high rates. This year, Brazil has refinanced at an average rate of 4.7%, lower than the average cost of existing debt. But it did so by selling bonds that have to be repaid more quickly than in the past.

This breaks down the years of work in which Brazil sold fixed-rate, fixed-rate debt to make its finances more sustainable. Last year the average maturity of its new debt was two years, compared to five in 2019.

This year, Brazil has to refinance a debt equal to 13% of GDP, a proportion lower than that of the smaller nations, but a larger sum in total, and could be affected by rising rates or a slower-than-expected recovery.

Its central bank has already raised rates twice this year in an effort to stifle price pressure after inflation exceeded its target range of 2.25 to 5.25%. Another increase is likely to occur at the next meeting later this month and is forecast to be at a base rate of 5.5% at the end of the year, compared to a record low of 2% in March.

Brazil is a clear example of how inflation and rising yields are a threat to debt sustainability, said William Jackson of Capital Economics. “It has expanded public finances, rising inflation and a central bank raising rates, fueling debt service costs.”

South Africa is in the same category, he said, along with Egypt and others in dire need of refinancing.

There are mitigating factors. For example, Brazil, South Africa, and India depend much more on domestic lenders than on foreign ones. This makes them less vulnerable to capital outflows than during the debt crises of the late twentieth century.

India, in particular, has resorted to its national banking system to issue 10-year benchmark bonds at limited rates of around 6%. It has also borrowed loans at shorter maturities during the pandemic, although its low refinancing requirement this year (equal to 3.3% of GDP) makes it less vulnerable to rising rates.

But William Foster, vice chairman of Moody’s Investors Service’s sovereign risk group, said India’s fiscal problems depend on debt rather than government revenue to fund its response to the pandemic.

“India has large fiscal deficits and has a very high debt stock,” he said. “The most important thing for debt sustainability is to achieve a higher rate of growth in the medium term, through reforms and other measures to bring together private investment that we have not seen for years.”

If, as many policymakers expect, this year’s rise in inflation is transitory, interest rates in emerging economies may not have to rise much.

Roberto Campos Neto, governor of Brazil’s central bank, said this week at a conference that the question was whether inflation was temporary and justified by growth or whether central banks should raise rates even further. “The first case is benign for the emerging world,” he said. “The second one isn’t.”

Food and commodity prices are already growing at a rate that fuels consumer inflation expectations, Lysenko said. If interest rates rise significantly, reducing the debt of developing economies to sustainable levels (and economic growth) will be much more difficult.

“In a world interconnected with many capital flows, U.S. yields have significant repercussions,” he said. “It simply came to our notice then [for emerging markets] tighten [monetary policy], as doing so now could undermine their recovery. But some countries may not have much room left to tighten. ”