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The Developing World's Hidden Inflation Risks

A combination of specific inflationary shocks and vulnerabilities could seriously threaten developing economies' stability and prosperity. Although part of the policy response to these risks is in the hands of poorer countries themselves, the international community can and must help.

ABIDJAN/PARIS – As the global economy begins to emerge from the COVID-19 crisis, managing inflation risks will be much more challenging in developing countries than in advanced economies. That reflects the nature of the shocks driving inflation and the fact that lower-income countries are ill-equipped to respond to them decisively. A combination of specific shocks and vulnerabilities could thus seriously threaten these countries’ economic stability and prosperity.

For starters, developing countries have much greater exposure to environmental shocks, which will become more frequent and severe as a result of climate change. Extreme weather events in effect act as negative supply shocks, causing production to decline and prices to rise – the most difficult conditions for monetary policymakers. Several countries, including Nigeria and Sri Lanka, are currently facing skyrocketing food prices, while Madagascar’s drought and ensuing famine is another stark reminder of African developing countries’ vulnerability.

Developing economies are also more exposed to financial shocks. Sooner or later, monetary policy in advanced economies will normalize and, if past experience is any guide, many emerging markets and poor countries will experience massive capital outflows. The specter of capital flight may be particularly salient for poorer economies, particularly if accompanied by a reduction in development aid. Such sudden stops bring their own policy dilemmas, not least downward pressure on exchange rates. Policymakers can either let their currencies depreciate, which would fuel inflation, or hike interest rates, which would adversely affect growth and debt sustainability.

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