Will the Russo-Ukrainian war have adverse effects on emerging economies that are already facing high inflation rates, an expected increase in interest rates, and an economic slowdown?
A question that has been the main focus of international financial institutions in the past days, studying the repercussions of the war on the global economy, which will be affected via three channels: the financial sanctions imposed on Russia, commodity prices increase, and supply-chain disruptions.
In this context, the Institute of International Finance declared that emerging markets have secondary direct links with Russia and Ukraine, but the conflict constitutes a global shock that will complicate the outlook for emerging markets that were starting to recover from the impact of the Coronavirus.
Furthermore, the institute added that external vulnerability factors do not flash red in most emerging markets. Current account deficits are unusually small due to higher export revenues, given the rise in commodity prices, and deficits are still lower than in previous global shocks.
Moreover, emergency reserves are high compared to a previous decade and sufficient for overall financing needs. Nevertheless, if commodity prices continue to increase, importers like India will witness increasing current account deficits, which still remain lower than in the period preceding 2013.
High inflation
Since the 1990s, when debt crises swept from Asia to Russia to Latin America in contagious rolling waves, many governments have built buffers to external shocks such as budget and current account surpluses and large foreign exchange reserves. However, the pandemic has drained those resources, leaving many economies exposed.
Today, the rise in commodity prices as a result of the Russo-Ukrainian war should drive up inflation worldwide. In fact, the Capital Intelligence Unit expects global inflation to jump above 6% this year.
Higher food and energy inflation could add around 0.5-1.0% to emerging market headline inflation, leading to a tighter monetary policy.
In contrast, observers expect emerging market central banks to raise interest rates to avoid a repeat of the hyperinflation that plagued the past, even if that means slowing down growth once again. This would increase the risk of stagflation – with slower growth and rising prices.
US Monetary policy
However, the uncertainty over US monetary policy is weighing on emerging markets. On the one hand, there are those who expect that the tightening of financial sanctions resulting from the Russian-Ukrainian conflict will cause the Federal Reserve to slow the pace of interest rate hikes. On the other hand, some argue that if higher energy prices keep inflation higher, the opposite may happen.
This situation surely has profound implications for emerging market investors. Expected increases in interest rates in developed countries might put emerging market debt at risk of outflows, make it less attractive to foreign investors, and raise borrowing costs for governments that have accumulated dollar-denominated debt.
Additionally, a hike in US interest rates could leave emerging markets vulnerable to lower foreign inflows, as risk-averse asset managers may seek good returns with lower risk in the US.
Although it’s true that the emerging markets were already preparing, before the Russian-Ukrainian war, for future scenarios about the possibility of foreign financial investments exiting, affected by the expected decision of the Federal Reserve to raise interest rates, the war came to hasten the exit of investors with the increased risks in emerging countries. Consequently, stock markets have plummeted across emerging economies.
Finally, the Institute of International Finance concluded that securities in emerging markets attracted about $17.6 billion in February 2022, of which $10.1 billion went to equity flows, and $7.5 billion to debt flows.
