External Debt Vulnerability in Emerging Markets and Developing Economies During the COVID-19 Shock

Abstract

The COVID-19 shock is threatening emerging markets and developing economies (EMDEs) in multiple ways: revealing present debt vulnerabilities and accelerating an already anticipated crisis driven by pre-existing debt conditions, pre-COVID-19 weak growth outlook, and rising geopolitical tensions. Based on the works of Irving Fisher, Hyman Minsky, and Ben Bernanke, this paper presents two indices of overindebtedness and financial fragility for a sample of EMDEs. The indices capture EMDEs’ specific debt characteristics and together illustrate their overall external vulnerability. Results show EMDEs are even more vulnerable than they were at the onset of the global financial crisis (GFC), suggesting the impact of the current shock might be more devastating and recovery more distant. An excessive fear of debt-deflation spirals after the GFC prompted EMDEs to expand their growth trajectories through a pattern of cheap private lending, loose accommodative policy measures, and in some cases unmonitored fiscal expansion. While overall debt buildup is generally alarming, current debt threats in examined EMDEs arise mainly from debt composition, architecture and the domination of volatile debt forms - primarily foreign currency denominated bonds. This emphasizes the need for country-level debt portfolio management as well as timely global actions in response to the shock. Furthermore, EMDEs need to strike a balance between temporary accommodative measures and the post-shock monetary-fiscal policy mix that prevent a deflation spiral without worsening indebtedness and financial fragility. Financial systems are further urged to maintain greater prudence in the face of growing credit demand. This is particularly important in light of the perceived too-optimistic sentiment driven by monetary expansion and injected liquidity; it already increased speculative activities and raise concerns about growing Ponzi finance activities and fears of a repeated Minsky’s moment after the COVID-19 shock.