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Emerging Market Central Bank Experiments Risk Reigniting Inflation

When price The uncharacteristically rapid rise began two years ago, and one group was the quickest to respond: emerging market central bankers. Realizing that inflation is already well ahead of their rich-country counterparts in the long run, they keep raising interest rates as prices soar. In difficult decision-making environments like those in Brazil and Russia, officials have resisted pressure from politicians to cut rates. In the two decades before that, emerging market central bankers had achieved an impressive feat of reducing inflation where it seemed intractable. The whole period has been a victory not just for officials involved, but also for economists who insist that emerging economies need independent central banks — and who are as focused on keeping prices stable as policymakers in rich countries.

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However, even if the inflation monster remains untamed, ongoing experiments by emerging market central banks put this progress at risk. Some of the new measures are in response to changes beyond their control, such as Vladimir Putin’s invasion of Ukraine. Others try to overcome painfully familiar problems, such as currency debasement. All of this threatens to undermine the recent progress that ultimately rests on the credibility of central banks. Over the past few decades, the more successful policymakers have been at controlling inflation, the more their goals have been believed and the more prices have been constrained. Median inflation in emerging economies was 10% in 1995; by 2017, it had fallen to 3%. This is the culmination of a slow and magical transformation.

The most expensive recent experiments have been those trying to prevent currency debasement. Central bankers used to make their currencies more attractive by raising interest rates and dumping reserves. They are now less keen to protect the exchange rate by raising rates, more willing to do so just to counter inflation, and some were short of reserves after sales when the covid-19 pandemic started. So officials are trying new ways to entice savers to deposit funds in local currencies rather than dollars. In late 2021, amid the lira’s months-long collapse, Turkey’s central bank offered to compensate anyone still willing to deposit in the currency, no matter how much they ended up losing against the dollar. Shortly before the Sri Lankan government defaulted in April, it offered similar guarantees to citizens abroad. In October, Hungary’s central bank opened a one-day window in which savers could earn lucrative interest rates. The problem is not that these measures are ineffective. By mid-2022, the lira has stabilized despite Turkish interest rates remaining ultra-low. But by the end of the year, the Turkish government, which shoulders the central bank’s expenses, had to raise an additional 92 billion lira ($5 billion, or 0.5%) gross domestic product) to cover the deposit scheme fees.

The Central Bank of Russia is another enthusiastic experimenter. It stockpiled gold and currency from China and other friendly countries, which helped when sanctions slashed $300 billion in reserves held by U.S. and European banks. Officials also stabilized the situation early in the war by doubling interest rates, helping to stabilize the ruble exchange rate. Since then, however, things have gotten harder. With the country running a larger-than-expected fiscal deficit, an obscure budget rule forced the central bank to buy back lost reserves in rubles. That has prompted policymakers to try to make Russia’s dependence on China uncomfortable. When officials replenish reserves, they will do so by buying more renminbi, with Beijing planning to issue 60 percent of the country’s total reserves, up from less than 20 percent before the war. Work on the digital currency has accelerated; pilots are planned for April. It will be done with Chinese banks.

Other experiments involved playing with central bank balance sheets. Finance ministries in advanced economies seldom run their budgets at a bare minimum because they are well capitalized and have the option to issue more debt. In contrast, governments in emerging markets such as India and the United Arab Emirates are increasingly filling the gap by tapping into central bank “fundraising” accounts. It’s a risky move. If tax revenues do not exceed expectations, the government ends up overdrawn to make up the difference. As long as the overdraft is small and the interest rates high enough to encourage politicians to borrow elsewhere if possible, nothing can go wrong.But in recent years the government has used these accounts – which are considered borrowing by the government International Monetary Fund and the World Bank, though not by the countries involved — to bypass debt ceilings set by domestic lawmakers. Nigeria’s overdrafts are now roughly equal to its entire official domestic debt.


Central bankers in countries including Ghana and Nigeria have come up with a solution that, at first glance, seems clever: converting overdraft lines into bonds with lower interest rates and easier restructuring. However, there is a catch. Emptying accounts by issuing bonds allows the government to increase overdrafts again, relying on the central bank to provide another lifeline in the process. Ultimately, this is tantamount to backdooring government borrowing — which often ends up with runaway inflation priced in by the market.

Emerging market central banks already face many threats. Chief among these is that it is harder to get policy right when inflation is falling than when it is rising. As emerging-market central bankers quickly discovered, the global turmoil sent prices everywhere. But the economy has cooled in vastly different ways, depending on how consumers, industry and politicians react. Emerging-economy central bankers lack the granular data available to advanced-economy central bankers to track these changes. They are better off taking the time to scrutinize the limited information available to them than dreaming up innovations that could destroy their hard-earned credibility.

Read more from our economics column Free Exchange:
Case against Google hinges on antitrust ‘mistakes’ (March 2)
What would the perfect climate change lender look like? (February 23)
The Case for Global Optimism (February 16)

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