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This Is How Emerging Markets Will Survive The Recession

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A recession is coming and this is how the emerging markets will adapt to survive, or not, in the coming months.

We are analysing a report from the Institute of International Finance to give our readers an insight of what to expect in the second half of the year.

First, we have to see how the EM economies reacted after the Russian invasion of Ukraine, which is used by IIF as a barometer for the EMs economic study.

The IIF says when Russia invaded Ukraine in February, there was a spike in global energy and food prices. These were sparked mostly by the sanctions against Russian oil and goods export. The sanctions were imposed by the West against Moscow in an attempt to force the Russians to end their invasion of Ukraine.

In the meantime, the resulting spike in both energy and food prices was good news, says IIF, for many emerging markets that are commodity exporters, especially those in Latin America.

This brought capital inflows and caused their currencies to appreciate. But with fears of a global recession now growing, this ‘dynamic has gone into reverse’ says IIF.

Commodity prices have fallen and the terms of trade of many commodity exporters are almost back to pre-invasion levels.

Emerging Markets shock absorber

“This reversal has brought capital outflows, which in turn have caused currencies to weaken. We do not think that this shock poses a systemic risk for much of EM because most countries have learned – as they demonstrated during the first COVID wave in 2020 – that currency depreciation is an important shock absorber.,” writes IIF in its latest report on EM.

The picture looks more serious in frontier markets, however, many of whom were hit by higher food prices and now are struggling with capital flight, as mounting fear of recession causes global risk aversion to rise.

But the big, systemic EMs are bound to weather this shock. They learned long ago how to abandon the “fear of floating” and use currency depreciation to mitigate exactly this kind of shock.

A frontier market is a country that is more established than the least developed countries (LDCs) but still less established than the emerging markets because it is too small, carries too much inherent risk, or is too illiquid to be considered an emerging market. Frontier markets are also known as pre-emerging markets – Investopedia.

Frontier Markets countries include: Bahrain, Bangladesh, Burkina Faso, Benin, Croatia, Estonia, Guinea-Bissau, Iceland, Ivory Coast, Jordan, Kenya, Lithuania, Kazakhstan, Mauritius, Mali, Morocco, Niger, Nigeria, Oman, Pakistan, Romania, Serbia, Senegal, Slovenia, Sri Lanka, Togo, Tunisia and Vietnam – MSCI Frontier Markets Index.

Slow growth

In June, Barrons said, with inflation raging, many countries will have to slam the brakes on growth to slow inflation. But how hard are they willing to slam the brakes?

“Policymakers may find they are unable to bring price pressures under control without forcing their economies into recession. For emerging markets, this quandary appears especially difficult.

“Some central banks are already hinting they will need to kill growth to restore price stability. Banco Central de Chile sees inflation peaking later this year before falling in 2023. Annual consumer price growth in Chile is over 11%, way above the central bank’s 3% target,” says Barrons.

Many countries are following the U.S. FED in raising rates. Is it still early to tell whether it is working, that is, it is killing inflation and in turn, it is slowing growth?

Nevertheless, Barrons says interest rate hike suggests monetary authorities are willing to drag the economy into recession to slow an overheating economy and reduce inflation to target.

It means the EM will not escape the recessionary pressures. They will need to survive against these pressures and prevent a Sri Lankan situation within their borders.

According to textbook models, a central bank should set monetary policy to keep inflation as close to target as possible while avoiding both overheating and a too-deep decline in output relative to an equilibrium level.

Tighter monetary policy

In the current situation, a big problem remains inflation and growth. They may respond differently to tighter monetary policy, says Barrons.

“Over the medium term, inflation should be close to the target when the economy is at potential output. But in the short-term, it may require rapid rate increases to get inflation down to the desired level, leading to a sharp slowdown in growth or a contraction,” it says.

On the other hand, IIF says frontier markets are to suffer the most. Systemic emerging markets will face limited impact.

“The picture is less benign in many frontier markets, however, because the initial rise in food prices hurt many of them. This is now being compounded by rising risk aversion, which is causing capital flight and, in some cases, encumbering market access.

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“The only major emerging market where markets have expressed concern is Turkey (Exhibit 6), where the 12-month interest differential embedded in currency forwards is now approaching 2001 levels,” says IIF.

In the end, what it all means is that a tightening of expenditures is expected and to achieve that, central banks will increase rates and that will help, if it works, to increase savings. When savings are on the rise, there are less spending by the population.

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