As policymakers in developing countries struggle against the continued spread of the coronavirus, they are also exposed to the economic threat of inflation – and not just at home.
Escalating price growth in major economies, particularly the US, is fueling investor expectations for rate hikes. This drives up bond yields and makes it more expensive for other countries to sell bonds as buyers demand higher yields.
What should be good news – the beginning of a global recovery – has turned into a threat instead: that borrowing costs in countries like South Africa and Brazil are reaching dangerously high levels and disrupting their already precarious public finances.
Inflation: A New Era?
Prices are rising in many large economies. The FT is investigating whether inflation is finally back.
DAY 1: Advanced economies have not faced rapidly rising inflation in decades. Will that change?
DAY 2: The global central banker consensus on how best to promote low and stable inflation is broken.
DAY 3: The canary in the coal mine for US inflation: Used cars.
DAY 4: How the virus disturbed official inflation statistics.
DAY 5: Why soaring prices in advanced economies are a problem for indebted developing countries.
“Emerging markets should be more concerned about US inflation than their own,” said Tatiana Lysenko, senior emerging economist at S&P Global Ratings.
It is not just that inflation and rising yields in the US are driving up borrowing costs in developing countries, she said. The general risk is that the US economy will be ahead of emerging markets, causing outflows in its stocks and bonds, and ultimately currency weakness.
While rich countries were able to borrow at very low rates during the pandemic, many developing countries are already facing much higher financing costs.
S&P data shows that refinancing costs for 15 of the 18 largest developed economies have fallen more than one percentage point below their average cost of borrowing. Most pay a fraction of 1 percent. A 1 percentage point increase in financing costs would be easy for most to cope with.
The same cannot be said of developing countries. Egypt, which will have to refinance debt equal to 38 percent of GDP this year, pays an average interest rate of 12.1 percent, which is above its average cost of 11.8 percent, according to S&P. Ghana pays 15 percent, compared with an average of 11.5 percent.
The danger is not just in very high rates. Brazil refinanced at an average interest rate of 4.7 percent this year, which is below the average cost of its existing debt. However, it did this through the sale of bonds that have to be repaid faster than in the past.
This offsets the work of the years Brazil sold longer term and fixed income debt to make its finances more sustainable. Last year, the average new debt maturity was two years, up from five in 2019.
Brazil will have to refinance 13 percent of GDP debt this year – a smaller proportion than smaller nations but a larger sum overall, and this could be undone by rising interest rates or a slower-than-expected recovery.
The central bank has already hiked rates twice this year to ease price pressures after inflation surpassed its target range of 2.25 to 5.25 percent. Another spike is likely at their next meeting later this month, forecasting a key rate of 5.5 percent by the end of the year, up from a record low of 2 percent in March.
Brazil is a clear example of how inflation and rising yields threaten debt sustainability, said William Jackson of Capital Economics. “It has fed public finances, rising inflation and a central bank that raises interest rates to the cost of debt servicing.”
South Africa is in the same category, he said, along with Egypt and other countries with major refinancing needs.
There are mitigating factors. Brazil, South Africa, and India, for example, all rely much more on domestic lenders than foreign ones. This makes them less prone to capital outflows than they were during the debt crises of the late 20th century.
India in particular has turned to its domestic banking system to issue benchmark 10-year bonds at interest rates no greater than 6 percent. It too took out shorter-maturity loans during the pandemic, although its lower refinancing needs this year – at just 3.3 percent of GDP – make it less vulnerable to rising interest rates.
But William Foster, vice president of the sovereign risk group at Moody’s Investors Service, said India’s fiscal troubles made it dependent on debt, rather than government revenue, to fund its pandemic response.
“India has large budget deficits and very high levels of debt,” he said. “The most important thing for debt sustainability is to achieve a higher growth rate in the medium term through reforms and other measures to encourage private investment that we have not seen in years.”
Should this year’s rise in inflation prove temporary, as has been hoped by many policy makers, then emerging market rates may not have to rise much.
Roberto Campos Neto, governor of Brazil’s central bank, said at a conference this week the issue was whether inflation is temporary and justified by growth, or whether central banks should continue to raise interest rates. “The first case is benign for emerging markets,” he said. “It’s not the second.”
Food and commodity prices are already rising at a pace that is fueling consumer inflation expectations, Lyssenko said. When interest rates rise significantly, it becomes much more difficult to bring developing countries’ indebtedness to sustainable levels – and grow.
“In a connected world with many capital flows, US returns have significant spillovers,” she said. “It’s too early [for emerging markets] lace a little tighter [monetary policy]as this could undermine her recovery now. But some countries may not have much space left to avoid tightening. “