The COVID-19 epidemic, rising interest rates, unpredictable commodity prices made worse by Russia’s invasion of Ukraine, and other challenges continue to affect the world economy. Emerging markets (EMs) are in a challenging situation when these variables come into play, especially after increasing their debt loads to confront the pandemic. Many people are struggling financially, and some, like Sri Lanka, are already in default or nearly so. The International Monetary Fund (IMF), the World Bank, and advanced economies (AEs) should support emerging markets (EMs) to handle market volatility by implementing capital controls in particular situations, creating more efficient debt resolution processes, and giving funding. Both the stability of the global economy and decades’ worth of progress in EMs’ living standards are in danger.
Around the world, governments used significant deficit spending to help their economies weather the COVID-19 storm. In EMs, the average public debt to GDP ratio just prior to the pandemic was 52 percent. In 2021 it increased to 67 percent, a historic high. This follows a decade-long upward trend following the 2008 financial crisis. EM debt could more quickly spill over into domestic economic activity due to the large “sovereign-bank nexus” which characterizes many EMs. Their banks extended credit under government-backed stimuli. If EM governments face growing financial pressure and the public debt banks hold loses value, banks may be forced to freeze credit in a dramatic fashion.
EMs currently face multiple pressure points. First, among them was the increase in global inflation, which caused central bankers in AEs to set higher interest rates. When AE central banks raise interest rates, EMs usually face capital outflows, higher borrowing costs, and currency fluctuations that impact their terms of trade. This time around, the JPMorgan EMBI Global Diversified EMs sovereign bonds index recently suffered its worst loss in nearly 30 years.
At the same time, Russia’s invasion of Ukraine has exacerbated pandemic supply chain disruptions and significantly increased commodity prices for EMs. EM food and energy prices, especially when imported, have skyrocketed. The rising prices for key inputs, higher borrowing costs, and the continued fallout from the pandemic are leading to extremely difficult situations for EMs. Sri Lanka defaulted on its debt last month and more countries could easily follow suit. For example, Pakistan is currently negotiating with the IMF for assistance in managing its debt burden. A growing percentage of EMs are considered “distressed” — defined as potentially unable to fulfill financial obligations on present terms.
Economic and financial instability in EMs would have major negative impacts, none more so than for these countries’ people. Divergent pandemic recoveries mean that most EMs’ income growth was less than America in the past few years, for the first time in nearly four decades. EMs are likely facing even worse conditions ahead; more poverty, greater food insecurity, and even slower growth that could lead to a “lost decade” of worsening living standards. According to the World Bank “the level of per capita income in developing economies this year will be nearly five percent below its pre-pandemic trend” and the forecast for the next several years has been revised down.
Aside from the moral necessity of addressing these issues, the entire global community has an economic interest in doing so. Financial and economic crises in EMs would create another meaningful headwind given financial and trade linkages. EMs (including China) represent around 45 percent of both global Foreign Direct Investment and trade, as well as about 35 to 45 percent of global GDP.
In addition, the opportunity cost of EMs forgoing climate spending, to instead service debt, is not a high-return proposition. EMs are projected to emit an increasing share of global emissions and are already struggling to make investments in sustainable development in wake of the pandemic. There is evidence that the latest debt developments are further limiting some EMs climate change investments. Notably, AEs have also not fulfilled their obligations in pledged climate finance assistance. Moving forward, AEs and multilateral institutions must help in multiple ways.
Economic and financial instability in EMs would have major negative impacts, none more so than for these countries’ people. Divergent pandemic recoveries mean that most EMs’ income growth was less than America in the past few years, for the first time in nearly four decades. EMs are likely facing even worse conditions ahead; more poverty, greater food insecurity, and even slower growth that could lead to a “lost decade” of worsening living standards. According to the World Bank, “the level of per capita income in developing economies this year will be nearly five percent below its pre-pandemic trend” and the forecast for the next several years has been revised down.
Aside from the moral necessity of addressing these issues, the entire global community has an economic interest in doing so. Financial and economic crises in EMs would create another meaningful headwind given financial and trade linkages. EMs (including China) represent around 45 percent of both global Foreign Direct Investment and trade, as well as about 35 to 45 percent of global GDP.
In addition, the opportunity cost of EMs forgoing climate spending, to instead service debt, is not a high-return proposition. EMs are projected to emit an increasing share of global emissions and are already struggling to make investments in sustainable development in wake of the pandemic. There is evidence that the latest debt developments are further limiting some EMs climate change investments. Notably, AEs have also not fulfilled their obligations in pledged climate finance assistance. Moving forward, AEs and multilateral institutions must help in multiple ways.
EMs Energy Transition Indicators in 2021
First, in certain situations, EMs should be encouraged to use capital controls — policy steps to curb the flow of foreign capital in and out of an economy. The international economics community has long frowned upon capital controls, believing they were inefficient. While free-flowing global capital does have many economic benefits, research has shown the merit of smoothing out capital flow volatility depending on the country and macro environment. Capital controls can help prevent a surge of inflows from creating financial bubbles. They can also help manage “sudden stops” when foreign investors swiftly reverse course. For example, in the current context, temporary restrictions on capital outflows that are triggered based on preset crisis conditions could help prevent a downward financial system spiral and benefit most stakeholders. The IMF recently updated its Institutional View, although some suggest it should approve of capital controls even more broadly. Nonetheless, this evolution has come at the right time and should be a component of how some EMs manage the challenges ahead.
Second, mechanisms for debt restructuring must be enacted. At the onset of the pandemic official bilateral debt payments were frozen for certain countries, but they have since resumed. A new freeze for a broader set of countries should be instituted. The G20 framework for debt resolution also needs strengthening, most importantly by engaging private creditors and gaining clarity from Chinese State-Owned Enterprises on their lending terms extended to EMs.
As they did earlier in the epidemic, global institutions should once more finance EMs in need. The quantity of assistance provided to EMs during the epidemic has drawn criticism for being insufficient. Member nations must be clear about their expectations and offer enough funds and room to support a potential sizable wave of troubled EMs in order to assure effective support.
The COVID-19 epidemic has shown us that nations are interdependent, which is one of its most important lessons. Debt management for EMs is comparable. The outcome of this process will have an influence on people in EMs and other economies around the world, both now and in the future. Policymakers would be wise to take note of this crucial lesson and act audaciously as they cooperate with EMs to support the preservation of economic stability.
