Continued monetary tightening poses additional risk to the real economy, Unctad says

Advanced economies need to change course in their fiscal policies since continued monetary tightening could worsen economic conditions, according to a new report.

The crises resulting from the coronavirus pandemic combined with debt distress, inflation, climate change and the war in Ukraine have turned a global slowdown into a downturn, the UN Conference on Trade and Development (Unctad) said in its latest report.

“Even as growth in advanced economies slows down more sharply than anticipated, the attention of policymakers has become much too focused on dampening inflationary pressures through restrictive monetary policies, with the hope that central banks can pilot the economy to a soft landing, avoiding a full-blown recession,” the report said.

“Not only is there a real danger that the policy remedy could prove worse than the economic disease, in terms of declining wages, employment and government revenues, but the road taken would reverse the pandemic pledges to build a more sustainable, resilient and inclusive world.”

Last month, the US Federal Reserve raised its key interest rate by 75 basis points, its third consecutive three-quarters of a percentage point increase. It also hinted at further increases to tame surging inflation. The Bank of England also raised its base interest rate by 0.5 percentage points to 2.25 per cent, vowing to “respond forcefully, as necessary” to soaring inflation.

“Continued monetary tightening — through rising central bank rates and the normalisation of their balance sheets — will have little direct impact on the supply sources of inflation and will instead work indirectly to re-anchor inflationary expectations by further reducing investment demand and pre-empting any incipient labour market pressures,” Unctad said.

A more immediate impact could be a sharp correction in asset and commodity prices, from cryptocurrencies to housing and metals.

“Monetary tightening poses additional risk to the real economy and the financial sector: given the high leverage of non-financial businesses, rising borrowing costs could cause a steep increase in non-performing loans (NPLs) and trigger a cascade of bankruptcies,” it said.

If monetary authorities are unable to stabilise inflation quickly, governments might resort to additional fiscal tightening, which “would only help precipitate a sharper global recession”, it added.

The International Monetary Fund lowered its growth forecast for the global economy for the second time in July this year, due to Russia’s war in Ukraine that has exacerbated inflationary pressures and a slowdown in China.

The IMF now projects global growth at 3.2 per cent in 2022 and 2.9 per cent in 2023, revising it down 0.4 and 0.7 percentage points from its April forecast, respectively. This compares with a 6.1 per cent expansion last year.

The fund warned if further risks materialise and inflation rises further, global growth could decline to about 2.6 per cent and 2 per cent in 2022 and 2023, respectively, which would put growth in the bottom 10 per cent of outcomes since 1970.

The Unctad report forecasts that the world economy will grow 2.5 per cent in 2022.

“The estimated 2.5 per cent growth in 2022 is less than half the growth rate of 5.6 in 2021, when economic activity resumed after the sharpest recession in living memory … A similar fluctuation happened after the GFC [global financial crisis], with a strong recovery in the year immediately after the shock followed by a subsequent slowdown,” the report said.

The agency said it expects the world economy to grow 2.2 per cent in 2023, but with risks of a further drop if financial conditions deteriorate in leading economies and this in turn hits emerging economies.

If such a low-growth scenario persists for two or more years, world output will be on course for a slower expansion than after the GFC, it added.

The immediate prospects for many developing and emerging economies will depend, to a large extent, on the policy responses adopted in advanced economies, Unctad said.

The rising cost of borrowing and a reversal of capital flows, combined with a sharper-than-expected slowing of China’s growth engine and the economic repercussions from the war in Ukraine, are already dampening the pace of recovery in many developing countries, with the number of those in debt distress rising and some in default, according to the report.

“With 46 developing countries already severely exposed to financial pressure from the high cost of food, fuel and borrowing, and more than double that number exposed to at least one of those threats, the possibility of a widespread developing country debt crisis is a very real one, ending any hope of meeting the sustainable development goals by the end of the decade,” Unctad said.

The impact of Fed tightening will be more severe for vulnerable emerging economies with high public and private debt, substantial foreign exchange exposure, a high dependence on food and fuel imports and higher current account deficits, it added.

“If monetary tightening in the advanced economies continues over the coming year, a global recession is more likely, and it will almost unavoidably harm potential growth rate in the developing economies,” according to Unctad.

“The permanent damage to economic development in these countries will not only be substantial but will also leave the ambition to achieve a better world by 2030 dangling by the most precarious of threads.”