Fiscal sources of inflation risk in EMDEs: the role of the external channel

Summary

Focus

Many emerging market and developing economies (EMDEs) have seen inflation spike after the Covid-19 pandemic following large fiscal stimulus. This has rekindled interest in the fiscal determinants of inflation. Not only could larger fiscal deficits boost inflation by adding to aggregate demand. By eroding investors' confidence in the creditworthiness of the sovereign, they could also lead to a currency depreciation, magnifying the initial inflation response.

Contribution

To investigate how higher fiscal deficits can increase inflation risks, we estimate an open economy Phillips curve augmented with the fiscal balance using data from 26 EMDEs over the past six decades. We examine how the exchange rate reaction to higher fiscal deficits magnifies the initial inflationary impact. We further analyse how the composition of sovereign debt, foreign exchange reserves, and the monetary policy framework, affect both the inflation and the exchange rate responses to higher deficits.

Findings

We find that increases in fiscal deficits have large effects on inflation in EMDEs, in contrast to the more muted influence of deficits on inflation in advanced economies. Higher deficits especially increase inflation risks on the upside (ie the probability of high inflation outcomes). We show that the exchange rate channel is important in explaining the much stronger reaction of inflation to deficits in EMDEs. Moreover, higher foreign currency debt and a greater share of foreign investors magnify the inflationary effects of higher deficits. However, larger FX reserves and central banks' strong price stability mandates help attenuate the external channel.

Abstract

We examine how changes in fiscal deficits affect near-term future inflation in a panel of emerging market and developing economies (EMDEs). Using a novel method for quantile panel regressions with fixed effects, we find that an increase in the fiscal deficit has highly non-linear effects on inflation - that is, a larger impact on upside tail risks than on average inflation. These effects are substantially larger in EMDEs than in advanced economies. We then show that an increase in the fiscal deficit raises the risk of future currency depreciation which magnifies the initial inflation response. This external channel is closely related to sovereign risk, being greater when the share of sovereign debt in foreign currency is large or when a sizeable share of sovereign debt is held by foreign residents. Finally, we find that the effects of fiscal deficits on future inflation are strongly attenuated in inflation targeting regimes and also influenced by constraints on monetary policy.

JEL classification:  E31, E52, E62, E63 

Keywords: fiscal deficit, inflation, exchange rate depreciation, sovereign risk, emerging market and developing economies, original sin, inflation targeting