Central Banks in Emerging Markets

The extra challenges central banks in developing economies face, from volatile capital flows and currencies to food-driven inflation.

Central banks in emerging and developing economies, such as India, Brazil, Indonesia and South Africa, face challenges that central banks in rich countries often do not.

Volatile capital flows

Foreign investment can flow in rapidly when global conditions are calm and flow out suddenly during global stress, often when U.S. interest rates rise. Sudden outflows weaken currencies, raise inflation and tighten financial conditions. The 2013 “taper tantrum” hit many emerging markets this way.

Fear of floating

Economists Guillermo Calvo and Carmen Reinhart described fear of floating: many emerging-market central banks officially allow their currencies to float but intervene heavily to limit swings. They worry that sharp depreciation raises import prices, increases the burden of foreign-currency debts and can trigger panic.

Tools

Emerging-market central banks often use:

Foreign exchange intervention, buying or selling reserves to smooth currency moves.
Large reserves as a buffer.
Capital flow management measures in some cases.
Interest rate changes in response to global conditions, not only domestic ones.

Food and supply shocks

In many developing countries, food makes up a large share of the consumer basket. Weather-driven food price swings can move inflation sharply, even though monetary policy has limited ability to affect harvests. Central banks must judge whether such shocks will spread into broader inflation and expectations.

Credibility

Historically, many emerging markets suffered high inflation. Adopting inflation targeting and central bank independence, as Brazil did in 1999 and India in 2016, helped build credibility. During the 2021 to 2022 inflation surge, several emerging-market central banks, including Brazil’s, raised rates earlier and faster than the U.S. Federal Reserve.

The global spillover

The U.S. Federal Reserve raises interest rates sharply. Investors move money from emerging markets to the United States to earn higher returns. The Indian rupee weakens. The RBI sells some dollar reserves to slow the fall and may raise its own rates, even if domestic conditions alone might not require it. Decisions in Washington affect policy in Mumbai.

Thinking emerging-market central banks only respond to domestic conditions

Global interest rates, capital flows and commodity prices strongly influence emerging-market monetary policy. Central banks in these economies must watch global conditions closely.

Key takeaways

Emerging-market central banks face volatile capital flows and currencies.
Fear of floating leads many to intervene in currency markets.
Food and supply shocks strongly affect inflation in developing countries.
Inflation targeting helped build credibility, as in Brazil in 1999 and India in 2016.